There is a relatively little discussion about one particular parameter of the economy, the velocity of money. As you will see in this posting, recent changes in the velocity of money may be a harbinger of things to come for the economy.
Let’s start with a bit of background information and some definitions. The velocity of money, according to the Federal Reserve, is a ratio of the nominal (before inflation adjustments) GDP to a given measure of the supply of money, either M1 or M2. WTF?
Here are a couple of definitions that might help. First, M1 is the most liquid measure of the money supply and includes all physical money including coins and currency plus demand deposits (chequing accounts); basically money that is available immediately. Second, M2 includes the aforementioned components of M1 plus money market funds, savings deposits and all time-related deposits.
Now, let’s go back to the velocity of money. Putting Fedspeak into terms that mere mortals can understand, the velocity of money can be thought of as how often the money supply "turns over" or the number of times a single dollar is used to purchase the goods and services that comprise the GDP in a given period of time. The velocity of money can also be thought of as the average frequency with which a unit of money is spent or how many times a given dollar bill is spent by all of the consumers that spend it as it works its way through the American economy in a given period of time.
Here’s an example to make the concept easier to understand:
I earn $500. I take that $500 and buy a plasma television from you. In turn, you take the $500 and buy an iPad from someone else who then takes the $500 and buys a week’s worth of groceries. We have now turned over the original $500 three times and the result is $1500 of "GDP" and, since the $500 was spent three times, the velocity of the money is 3.0. Stepping back to the entire economy, GDP is basically a function of the velocity of money; the more times a given dollar is spent, the faster the economy grows and the higher the resulting GDP.
When the velocity of money is high, the supply of money needed to keep the economy working is relatively low compared to periods where consumers are not spending as much and the velocity is very low. If the value of money is low, prices are high and a larger supply of money is necessary to fund purchases. If the supply of money is constant and prices are high, velocity must increase to fund purchases. Similarly, when the supply of money is changed by the Federal Reserve, it will impact the velocity of money. Basically, for a given level of GDP, a smaller money supply will result in increased velocity since each dollar must change hands more often to facilitate spending and vice versa.
Why would the velocity of money slow? It can do so for a couple of reasons. First, the velocity of money will slow in times of deflation when a contraction in the amount of money in circulation declines, resulting in lower prices. Secondly, the velocity of money will slow during a recession as consumers decide to hold onto their cash rather than spend it on new televisions, cars, refrigerators and iPads. Thirdly, the velocity of money can slow because of the accumulation of debt in the economy. This is most apparent in the accumulation of government debt; since one of the factors making up GDP is government spending as shown in this formula:
GDP = C + I + G + (X-M)
C = Consumer Spending
I = Gross Investment
G = Government Spending
X-M = Exports – Imports or Net Exports
Government spending or "G" is an important part of GDP meaning that growth in government spending is an important part of GDP growth. Unfortunately, in today’s reality, government spending grows through the use of increasing levels of debt, a factor that actually slows the velocity of money. Just for fun, here’s what total federal government spending has looked like over the past six decades, showing how its growth has become nearly exponential:
With GDP hovering around $15 trillion and federal government spending at roughly $3.75 trillion, government spending makes up around 25 percent of GDP. This tells us how massive the impact of reduced government spending will be on GDP growth.
Now, let’s look at what has happened to the velocity of money over the past few decades and its relationship to recessions starting with M1 followed by M2. Note that the velocity of M2 has dropped to lows not seen since the early 1960s.
Notice that the growth in M1, in particular, has become nearly exponential with a very steep growth rate in M2 as Mr. Bernanke had the Federal Reserve "printing presses" working overtime during and after the Great Recession.
Now let’s look at the velocity of money and the growth in the supply of money from Helicopter Ben in combination. Basically, the Federal Reserve is pumping money into the economy but the velocity of money is dropping and approaching or passing fifty year lows. This could suggest that the Fed’s actions simply are not spurring economic activity despite recent growth in GDP (which could be a result of government spending increases). Is it possible that the economy has entered a liquidity trap where nominal interest rates are basically zero and increasing the supply of money has no impact on the economy, rendering monetary policy by central banks completely ineffective? In this state, low interest rates do not result in a state of full employment and consumers are not interested in consuming more. As well, increased injections of money cannot push interest rates any lower since they are already basically zero.
At the very least, I would suggest that the rather dramatic drop in the velocity of money signals that there is looming change in the economy. Only time will tell whether carnage or better times lie ahead.