When you see this word you may think about a major league pitcher's fastball or the speed of a bullet leaving the muzzle of a gun.
Not many would equate velocity with what ails our economy. However, the "velocity of money" in our economy today may be the best explanation for why we have not seen the economic recovery we would expect this far into the recession that began over four years ago.
What is the velocity of money?
Simply stated, it is the average frequency that a unit of money in an economy is spent or turned over. For example, assume you and I live on an island alone and there is a total money supply of $100. I have the $100 and a pineapple farm. You have coconut trees. I pay you $50 to buy some of your coconuts because I am tired of eating pineapples every day. You get tired of drinking coconut milk and want some pineapple juice so you take the $50 and buy some pineapples from me. We do the same thing every month. By the end of a year we will have created $1,200 of "gross domestic product" from that $100 monetary base which remains static.
From this example I hope you can see that GDP really is a function of both the money supply and the velocity of money in the economy. For an economy to grow it requires an increase in the velocity of money, an increase in the money supply, or both.
If you put it into a mathematical formula it would look like this.
GDP=Money Supply x Velocity
John Mauldin wrote a particularly good piece about "The Velocity of Money" back in 2008 that is worth the read if you are interested in learning more. Mauldin points out that there is no exact way to determine what the right size of the money supply should be in an economy. Ideally, the money supply should be allowed to grow each year by the growth in population, production and population to keep things in balance. We have delegated this responsibility to the Federal Reserve in the United States. If we get too much money supply we will have too much money chasing too few goods (coconuts or pineapples) and inflation is going to be the result. If the money supply is too constrained, deflation is the risk.
This is a chart of the velocity of money that Mauldin had in his article on velocity back in 2008 right before the financial meltdown that began in the second half of 2008. Note that the average amount of money velocity has been around 1.67. 1997 saw the high of 2.12 and lows of around 1.2 were seen in the Depression and right after World War II.
Here is the most recent chart of the Velocity of Money from the Federal Reserve Bank of St. Louis. As you can see, velocity has been dropping almost continuously since 2007 from almost 1.9 to its current level of close to 1.5. We are not yet at Depression levels but we are at levels of velocity that we have not seen in over 60 years.
Compare that chart with the chart of M2 money stock over the last five years.
And for the growth in M2 since 1960.
The lack of velocity of money in our economy is the reason that we are still stuck in the mud despite the fact that the Federal Reserve has been printing money out of thin air in unprecedented fashion. It is also the reason that we have not seen any significant inflation to this point. Chairman Bernanke said at one point that he would throw money out of helicopters if he had to. He has done almost everything but that so far to very little effect.
I wish I had an explanation for the steep drop in velocity. It almost seems as if the more that the Federal Reserve has tried to intervene with its Zero Interest Rate Policy (ZIRP) the more velocity has slowed. Of course, they obviously believe the opposite. They would argue that they need to pursue this course because of the drop in velocity. If not, the economy might go into a full-fledged depression.
Two conclusions seem certain. First, we will not get a real economic recovery until velocity starts returning to something closer to long-term averages. Second, if velocity turns around, the Fed better be prepared to get some of the money out of system or we are going to see some serious inflation in our future.
No comments:
Post a Comment