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As The Money Turns, Not!

Source: St. Louis Fed

If anyone wonders why the economy is weak, and more than likely to weaken further one need look no further than the velocity of money.

So what is the velocity of money? Velocity of money is defined as the average frequency with which a unit of money is spent on new goods and services at any given time. So velocity of money is related to the money supply. As an example if you spend $100 on something and that person takes that $100 and spends it again then $200 changed hands but there is only $100 in the system. That meant that the $100 was spent twice on the year.

On a slightly more complex basis the velocity of money is a ratio of nominal GDP to a measure of money supply and is a rate of turnover of that money supply.

Today the velocity of money is just under 1.6 which is just below a level seen back in the 1960's. Except during the 1960's the economy was growing and was far healthier than it is today. So if the money velocity rate is the same as it was in the 1960's then why isn't the economy performing as well as it did back in the 1960's?

The answer is simple actually. Debt. Far too much debt. Back in the 1960's the debt level was relatively low and the savings level was high. Today it is the opposite. The debt level is too high and the savings level is too low.

All of this, however, gives a lie to the axiom that by putting more money into the financial system the velocity of money should increase. But that might only be true in an economy with low debt and high savings indeed as all that extra money might indeed go to purchasing of goods and services thus allowing the GDP to grow.

Money supply has sharply increased in the past several years (thanks to low interest rates and quantitative easing (QE)). M1 the lowest measurement of money supply has grown 65% since the end of 2007 while M2 has grown at a more modest pace up 32%. As was shown in the July 12, 2012 issue of COTW the monetary base has exploded upwards by 208% in the same time period. Total debt in the US has grown by roughly 20% but the bulk of the growth has come from the government even as households have contracted. The consumer instead of spending on goods and services has been paying down debt and that has been a significant contributor to a fall in the velocity of money as the money instead of going to the purchase of goods and services that would increase GDP it is going instead to try and pay down debt.

Note how during the 1990's the velocity of money went from around 1.8 to 2.1. Following the stock market crash of 1987 and the recession of the early 1990's the monetary authorities believed that by expanding the money supply at a higher rate it would improve the economy. And it did to a point. Except it was also a prime cause of a huge growth in debt particularly at the consumer level and even the corporate level. The US Federal government at the time was doing the opposite and actually running a surplus. The result was the growth was spurred by debt growth at the consumer and corporate level.

While encouraging growth the massive expansion of money supply during the 1990's also flowed into speculative activity and contributed considerably to the resulting stock market bubble of the late 1990's. When the recession of the early 2000's happened following the bursting of the high tech/internet bubble the velocity of money fell. Once again the monetary authorities stepped in lowering interest rates and flooding the financial system with liquidity. The result was the money supply grew rapidly once again. The US government helped the monetary growth along by slashing taxes and moved the surplus into a substantial deficit.

Again it seemed to work as money velocity picked up but it never reached the levels seen at the peak from 1996 to the early part of 1998. GDP grew but it was tepid. While the velocity of money didn't reach the previous heights the debt grew at a rapid rate and money supply once again underwent rapid growth. All of the debt and monetary growth helped contribute to the housing and derivatives bubble that burst in the 2007-2008 financial panic. The velocity of money plunged once again and the debt imploded resulting in foreclosures and bankruptcy. In order to prevent a complete financial meltdown the government stepped in and government debt exploded upwards. Since the end of 2007 US government debt has increased by $5.6 trillion or 110%. GDP growth has been tepid at best or continued to contract.

Pumping all of that money into the financial system may have prevented a complete meltdown and depression but given the ongoing fall in the velocity of money it is not doing much good. In theory pumping all of those funds into the financial system is supposed to help improve the velocity of money. But it isn't as there is just too much debt and until that debt is lowered either by default or paying it down the economy will continue to be slow growing or worse it could go into contraction once again. Another crisis on the scale of the 2007-2008 financial crisis could push the economy over the edge and the economy would fall not into a steep recession but more likely a depression.

The cycle to cleanse the debt is still young. The excesses of the 1990's and early part of the 2000's is most likely going to take years to resolve. The resultant fall out from that cycle of excess should also continue to be with us for some time as well. The fall out has increased societal tensions, social unrest and even the potential for global warfare.

 

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