Imagine yourself in a small isolated community with just ten people. Each person trades with others in the community, but none trade with the outside world. Each person holds a certain amount of cash.
One day, you magically come across an additional amount of cash. Your cash balance doubles overnight. You decide to hang on to it for a rainy day. Then, shortly after you found that cash, you find another stash of cash. Once again, you increase your cash balance. You have more cash than you really need, but you don’t see any reason to spend it.
Then one day you are chatting with one of your nine colleagues in this little isolated community. The conversation drifts to personal finances. You comment about your cash balance and how fortunate you are to have found these new sources of cash. Your colleague, low and behold, has found a similar stash. His cash balance has increased as well. He too has found no reason to spend it.
He makes the comment in passing that a third colleague had mentioned something about finding some cash and increasing his cash balances.
All this new cash entering your isolated community has not as of yet affected market prices. People in the community absorb each increment of new cash by adding it to their cash balances. Nobody spends it.
Your vocation is baking bread. You supply your colleagues with bread and they supply you with other necessities in life. One day a fourth colleague comes to you and says he too found a stash of currency. Unlike the others, he wants to splurge and spend some of it. Instead of his usual one loaf of bread, he wants two loaves. The demand for bread in the community just increased by ten percent.
With a ten percent increase in the demand for your product, you think about raising prices. You hold off. People in the community need bread to survive. As more and more people spend their newly-found cash on goods and services, prices of other items in the community start edging up, including the price of the flour you buy to make your bread and the prices of other necessities you need to live and survive. Eventually you have no choice. You capitulate. You increase the price of your bread.
It dawns on you one day that with prices increasing in the community, the purchasing power of your cash keeps dropping with each passing day. Your policy has been to keep and save the extra cash you have come across. You really don’t need the cash, though, and you would like to preserve purchasing power. The one way to preserve purchasing power is to reduce your cash balance; to convert some of your cash into something else that better holds its value.
That move of reducing your cash balance has little effect on the economy, as long as someone else in the community increases his or her cash balance by a similar amount. The two would merely offset each other. The problem arises when others in the community also want to reduce cash balances. Eventually, of course, they do and for the same reason. With prices rising, others want to preserve purchasing as well and move to reduce cash balances just like you did.
With everyone in the community wanting to reduce cash balances at the same time, there is no place for the excess liquidity to go. I reduce my cash by buying something from you. You reduce your cash balance by buying something from someone else. Currency becomes a hot potato: nobody wants to hold it due to its declining purchasing power. The demand for the currency shrinks. Prices spiral upward.
That change in attitude about holding cash is the turning point between the initial phase of an inflation when prices increase less than the money supply and a second phase when prices increase faster than the money supply. Decreasing cash balances in that second phase create an incremental supply of cash. That incremental supply of cash pushes prices up faster than the money supply is increasing.
It is in that second phase when central banks have problems keeping a lid on rising prices. With people and institutions all trying to reduce cash balances in unison, the central bank must reduce the money supply significantly in order to offset the effect of the incremental supply of cash and keep price inflation in check. That almost never happens.
We believe many economies around the world, including the U.S. economy, are at that turning point at the moment. We are entering a period when prices will increase far faster than the money supply.
