What Recovery? __ Part I, Velocity of Money

Posted on February 4, 2013

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The recession officially ended in 2009. Government reports tell us that the United States has been in recovery for four years now. The vast majority of Americans don’t feel as if they experienced any recovery. Is it because the rate of economic growth has been the slowest in US history? Shouldn’t the average American feel some benefit from an average GDP growth of 2%? Unemployment is the same today as it was in 2009. Why? The Federal Reserve  has used a policy called Quantitative Easing to pump trillions of dollars into the economy over those four years.  At the same time, the Fed has maintained a Zero Interest Rate Policy (ZIRP). Federal Reserve Chairman, Ben Bernanke, has said on numerous occasions that these policies are designed to help the economy grow faster by providing low-interest loans to home buyers and businesses, which would in turn cause businesses to invest and, thereby, create jobs.

Well, job growth is not keeping up with the number of people who have dropped out of the workforce nor with the number young people entering the potential workforce. So, where is all of that QE money. After all, through its QE policy, the Fed has created and put over $3 trillion into a $15 trillion economy. Adding 20% to the economy must be showing up in somebody’s pocket, right?  And, why do most Americans not feel the 2% growth in the economy?

To answers those questions, we need to understand some terms used in analyzing economic data. So, let’s se if we can get a handle on three terms: Gross Domestic Product (GDP), Money Supply, and Velocity of Money. We are going to see that Velocity of Money tells us more about the economy than the GDP does.

Gross Domestic Product (GDP)

The GDP is calculated by summing consumer spending with government spending and business investment spending plus the difference between exports and imports. If exports exceed imports, there is a positive impact on the GDP calculation. The opposite is true if exports are less than imports. Not all economist agree that exports and imports should be part of the GDP calculation, but that the subject of another post some day. We must deal with GDP as it is calculated. To repeat:

GDP = Cons. spending + Gov Spending + Bus Investment Spending + Exports – Imports

Currently, the United States GDP is about $15 trillion. Government spending, under the Obama administration, has been about 25% of GDP. Unfortunately, the governments income has been only about 18% of  GDP, which is why the national debt is now over $16 trillion.

Money Supply

In economics, the money supply or money stock, is the total amount of monetary assets available in an economy at a specific time. In the US the money supply depends on how it is defined. We will look the two most common, M1 and M2, and  a lessor known way of defining the money supply called MZM.

M1 Money Supply: When economist refer to M1, they are talking about  all the notes and coins in circulation plus travelers checks, demand deposits, and other checkable deposits.

M2 Money Supply: The M2 money supply includes M1 plus savings deposits and Time deposits less than $100,000 and money-market deposit accounts for individuals.

MZM Money Supply: The MZM money supply includes M2 plus all money market funds.

Because MZM money supply is the broadest measurement of the money that is easiest to use in economic activity, we will use MZM for our discussion of money velocity. But, first we need an explanation of what money velocity is and why is important to us.

Money Velocity

Joshua Kennon helps understand the velocity of money.

The velocity of money is one of the most important economic concepts you can ever learn.  It isn’t perfect, and it doesn’t fully capture vital influences on the way a nation’s money supply behaves as driven by behavioral economic considerations such as mass panic, fear, overoptimism, et cetra, but it does have very important implications for determining an appropriate taxation policy to generate the optimal amount of governmental revenue from the population.  This is meant to be a very basic, simplified explanation so beginners can grasp the velocity of money, and how it interacts with the so-called Laffer Curve.

What Is the Velocity of Money?

Simply defined, the velocity of money is a measure of the economic activity of a nation.  It looks at how many times a unit of currency ($1 in the case of the United States) flows through the economy and is used by the various members of a society.

All else equal, the faster money travels (the higher the velocity of money) and the more transactions in which it is used, the healthier the economy, the richer the citizens, and the more vibrant the financial system.  The velocity of money tells you how efficient $1 of money supply is at creating economic activity.

In simple terms, the velocity of money of money velocity is equal the GDP of an economy divided by the money supply. And, the more times money circulates through an economy, the higher will be its GDP for the same supply of money. Mr. Kennon gives a very simple example of an economy of only three people where there is no government spending or business investment spending or exports or imports to worry about.  Let’s take a look.

Imagine that a farmer, a grocer, a doctor, and a scientist live in the world’s smallest country.  Between all of them, they have $1,000 in money supply.  Over the course of a month, the following transactions take place:

  • The farmer sells $500 worth of food to the grocer.
  • The grocer marks up the price and sells $700 worth of food, split among the doctor and scientist who are his two customers.
  • The grocer falls and hurts his knee.  He goes to the doctor and pays $200 to the physician.
  • The scientist needs fertilizer for an experiment.  He goes to the farmer and pays him $300.
  • The physician is working on a liquid band-aid product with the scientist.  He pays him $300.

The total value of the transactions in our time period is $2,000.  We have $1,000 in money in our economy, so the velocity of money is 2.

In this little example the GDP was the consumer spending or $2000. The money supply was $1000. When the GDP is divided by the money supple, we see that the velocity of money was 2.0. If we had our three person economy do many more transactions with each other, we could get the money velocity up to 3.0 or even more. They would be enjoying a very rapidly growing economy (GDP).

In this example, the money supply was fixed over the time frame of the analysis. Things get more complicated when the money supply is constantly growing. When banks use fractional reserve accounting, they create credit and ,thereby, the amount money in circulation. Also, when the Federal Reserve uses Quantitative Easing to buy mortgaged back securities or US Bonds with money they don’t have, they are effectively creating money. Since they started QE, they have created over $3 trillion in just the last four years. So, let’s look at how America’s money supply *MZM) has increased over time.

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Graph of MZM Money Stock

We see that the broadest form of easily available  money, MZM, has increased from less than a trillion dollars in 1980 to nearly twelve trillion in early 2013. If you are interested, you can look at the growth of the M1 money supply here and M2 money supply here. The patterns are much the same.

The Federal Reserve in Saint Louis also has a graph of what the velocity the MZM  money supply over time. Here it is.

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Graph of Velocity of MZM Money Stock

We see that except for a spike in the velocity of money in the early 1980′s, the velocity was a fairly constant 2.5 from 1975 to 1995. Since then it has fallen to about 1.4 in January of this year. That, my friends, explains why most Americans do not feel that the economy is getting better. The GDP is growing, but the money supply is growing even faster. This trend started, however, not in the Obama or the Bush presidencies; but in the Clinton Presidency. According to this graph the velocity of money is now much lower than it was in 1960. But, this article has the same graph going back to 1920 and the current velocity of money, at 1.4, is worse than the years of the Great Depression and World War II. Are you beginning to understand just how bad our economy is today?

But, wait a minute.  Something doesn’t jive. The S&P 500 index is back to 1400; regaining its loses from the 2008 financial collapse. Look at what this CNBC article says:

The stock market has gone from wealth destroyer to the nation’s largest manufacturer of new millionaires and billionaires. The market moves are creating a new virtuous cycle of confidence for the wealthy. A new survey from Spectrem Group shows that millionaire confidence in the economy hit the highest level in two years, led by their bullishness on the economy and corporate earnings.

Corporations and the big banks are making big profits and paying management big bonuses. Wall Street investors are doing well, aren’t they. The Feds velocity of money graph doesn;t tell the whole story. The graph is an aggregate for the entire economy and doesn’t show what is going on with different segments of the economy; such as, the part made up by big corporations and banks and big Wall Street investors. That segment of the economy is doing very well. The velocity of money they are seeing is much higher than the aggregate 1.4. And, that of course means that the velocity of money you are experiencing is less than the aggregate 1.4. In fact, most people on Main Street are probably experiencing  a velocity of money of less than 1.0, which explains why the folks on Main Street, you and I, are not experiencing the same recovery as the big boys.

So, do you now understand why the income gap keeps growing at an accelerated rate? The Fed’s efforts to stimulate the economy by printing money Quantitative Easing has done nothing to reverse the trend that started in the Clinton era. WHAT IS GOING ON!

In Part II, we will investigate further why the economy for the middle class appears to be in systemic decline. We will also look at what a pessimistic pundit has to say about structural changes in our economy that mean high unemployment will be the norm, for the foreseeable future. But, in Part III, we will look at what an optimistic pundit has to say about increasing freedom and innovation in the world, which he says will be positive for the United States.

Well, now you know what I’m thinking. What are your thoughts?