Money Velocity Lethargy

Logic, common sense, and rational deduction are useful means for comprehending the world.  But they are merely tools.  The user will always be limited by the quality and quantity of the information available and their ability to properly interpret it.

Data and knowledge gaps can lead to false conclusions.  A wrong turn in the thought process can lead down a dead end street.  Where the economy’s concerned, people must make decisions with incomplete information.  That’s why things are often not what they seem.

For example, as night follows day and day follows night, should not price inflation follow the massive $3 trillion Fed balance sheet expansion that’s happened over the last 7-years?  Simply connecting the dots quickly leads one to a ‘yes’ conclusion.  More money chasing a static number of goods and services should result in price inflation.  For prices must rise to balance out all the new money.

This, of course, makes good practical sense.  In fact, it might even lead someone to sell dollars and buy gold.  They’d have a bullet proof rationale guiding their decision, wouldn’t they?

Indeed, their conclusions would be totally sound if they were only considering part of the Quantity Theory of Money equation.  Specifically the part that says greater money supply equals higher prices.  But what about the other part the equation?

The Other Part of the Equation – Velocity

The other part of the equation is the part nearly everyone omits, or assumes is constant and doesn’t need consideration.  Specifically, the velocity of money part.  For if the money supply increases yet the velocity of money decreases, the policy maker’s monetary stimulus programs accomplish nothing.

The velocity of money is simply the average frequency a unit of money is spent in a specific period of time.  For example, a mechanic buys $40 of maintenance supplies and detergents from a storeowner in the morning.  Midday the storeowner spends $50 to have his car tuned up by the mechanic.  That evening the mechanic picks up two pounds of ground beef, a 2-liter bottle of soda pop, and a candy bar, all totally $10, from the storeowner.

Thus $100 changed hands over the day, even though there was only $50 of actual money.  The reason it was possible for the $100 to change hands is because each dollar was spent twice.  The velocity of money was 2 per day.  Based on these transactions, the storeowner and the mechanic each contributed $50 in spending to the economy for the day.

But what happens if the storeowner takes the proceeds from the initial $40 sale and stuffs the money in his mattress…and the mechanic, not having earned $50 in tune up services, passes on the meat, soda, and candy?

In this example, just $40 in gross spending would have taken place.  Moreover, each unit of money was used just one time.  Thus the velocity of money was half that of the first example.  So, too, economic activity was greatly reduced.

Money Velocity Lethargy

The point is, while the money supply has greatly expanded over the last 7-years, the velocity of money has been lethargic.  Perhaps this is why consumer price inflation – as calculated by the Bureau of Labor Statistics – is practically non-existent.  This may also be why gold’s price, which peaked around $1,900 an ounce in 2011, is currently at about $1,075.  That’s over 43 percent off its high.

Like interest rates, price inflation and money velocity appear to move in long multi-decade cycles.  In 1980, for instance, when price inflation hit 14 percent, the velocity of money was at a ratio of about 3.5.  Since then price inflation has slid down a soft slope to about 0.2 percent.  Similarly, the velocity of money has taken a long graceful swan dive to a ratio of less than 1.5.

So despite the $3 trillion increase in the Fed’s balance sheet since 2008 price inflation, and economic growth, has been meek.  The missing factor has undeniably been the slow movement of money throughout the economy.  Until this changes, the Fed’s stimulative efforts will be pushing on a string.

In other words, until the velocity of money speeds up, increases to the Fed’s balance sheet will not result in the transmission of greater money into the economy.  Instead, the abundance of cheap credit will continue to be holed up within bank balance sheets.  Banks will continue to hoard the cheap credit or stuff it into government debt.

Under these circumstances, the money will not flow into the economy at a rate fast enough to raise prices and stimulate demand.  Policy makers understand this.  But they rarely acknowledge it.

However, the next time the economy freezes up they could aim down their sights on increasing the velocity of money.  One policy antidotes they may try is QE for the people, where the Fed creates money from nothing and then the Treasury sends out checks to everyone.  Another is to push interest rates to negative, where banks charge a fee for holding money, and abolish cash.  This would directly penalize savers and would prohibit them from stuffing money in their mattress.

Regardless, the velocity of money could one day increase because the multi-decade cycle reverses.  Attitudes change over time.  Even without further mischief from the Fed and Treasury, people could become weary of the great efforts being taken to trash their money, and begin trading it for anything they can get their hands on.  When that happens the velocity of money will rapidly spike upward…along with the price of anything and everything.

At that point, the Fed will be hard-pressed to contain it.

Sincerely,

MN Gordon
for Economic Prism

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