Friday, July 4, 2014

Revisiting the Velocity of Money

Several months back, I took a brief look at the velocity of money, a concept that can be rather abstract and one that seems to be unreported in the monthly slew of economic data.  Given that the economy in the first quarter of 2014 contracted, I thought that it was a good time to revisit and update my posting.

As I have done in the past, let's open with a look at what has happened to the supply of money as defined by the term M2 as shown in this graph from FRED showing M2 back to 1980 since it is a very critical component of the economy:

M2 is defined as the total number of dollars in the economy as cash and chequing accounts as well as what could be termed "near money" or money that is easily accessible which includes savings accounts, retail money market mutual funds and certificates of deposit or CDs.

The first thing that you should notice of the graph above is the subtle steepening of the curve between 2008 and the present compared to the period between 2000 and 2008 and 1990 to 2000 as highlighted with the green, blue and red arrows.  After each recession since 1991, the Federal Reserve has ramped up the growth in the money supply rather significantly. 

Now, let's focus on what happened to M2 since the beginning of the Great Recession: 

Thanks to the Federal Reserve's "printing presses", M2 has rapidly expanded from $7.43 trillion at the beginning of December 2007 to its current level of $11.317 trillion, an increase of $3.887 trillion or 52.3 percent in six and a half years.  You can't say that the Fed hasn't created a situation where the economy is awash in "cash"!

Now, let's look at the concept of the velocity of money.  The velocity of money refers to the speed at which a given dollar in the economy moves from transaction to transaction.  The more often that a dollar is used to buy a service or a consumer item, the higher its velocity and the higher its velocity, the faster the economy grows.  Given that the economy is now five years out of recession, you'd think that the velocity of money would be back to its normal pace, wouldn't you?  Unfortunately, as you can see on this graph, you'd be dead wrong:

Going all the way back to 1959, the velocity of money has never been slower.  Between 1959 and 1990, the velocity of money ranged between 1.7 and 1.9 which means that each dollar was spent between 1.7 and 1.9 times in a given year.  The velocity of money rose dramatically during the 1990s, hitting a high of 2.2 in the second and third quarters of 1997, falling gradually to its new millennium high of 2.0 in 2006.  

Here is a graph showing what happened to the velocity of money during and after the Great Recession:

In the fourth quarter of 2007, the velocity of money was 2.0.  By the end of the Great Recession in mid-2009, the velocity of money had dropped to 1.7.  Since then and despite the "heroic" attempts of the Federal Reserve to get consumers back to spending/overspending, the velocity of money has continued to drop to its current multigenerational low of 1.5.

With all of the money that the Fed has "pumped and dumped", GDP would have to grow at an annual rate of nearly 10 percent annually to keep up with the growth in the money supply.  Unless you happen to be China or maybe India, that is NOT going to happen.  Since the economy isn't mopping up all of those new dollars, something else is at play and goes a long way to explaining why all of that new money that normally would fan the fires of inflation simply hasn't.  If the newly minted money isn't being spent, it isn't pushing prices up.  It also means that GDP growth does this:

Rather than seeing GDP growth in the normal inter-recessional rate of 3.5 to 4.0 percent, we've had economic growth that averaged only 2 percent since the first quarter of 2010.

Will the velocity of money return to its normal levels or are we in a "new monetary reality"?  I suggest that no economist knows for certain but one thing we do know, if consumers start to spend again like they have after most recessions, with the volume of cash that has been injected into the system since 2008, we'd better brace ourselves for very a very painful dose of inflationary pain.  While the Fed fears the prospect of deflation, it is consumers that will suffer the most if prices rise in what could be an uncontrollable fashion.  After all, we do live in unique monetary times and the Fed's long-term monetary experiment hasn't yet reached its conclusion.


  1. Part of the reason the velocity of money has stagnated is due to the capital requirements that have been enacted as a result of the Basel III initiative. I would suspect that you are a proponent of such a policy that requires financial institutions to maintain liquidity in the event of tight credit (as we saw in 2008). Moreover, many corporations shored up on their cash positions to offer insulation from market volatility. Thus, investments in capital and RD (which has an affect on velocity of money) were temporarily shelved in the event of further market instability. Additionally, American consumers aggressively started paying down debt and focussed on deleveraging and saving (a reaction to the severe recession in 08) also, reduced stated velocity.

  2. If the intention of the Fed's monetary experiment was to get consumers to borrow and spend, it would appear to be a complete failure...and I believe that it was.

    Thanks for your comment!

  3. ...and not to mention the $2.544 trillion in excess reserves that the American banking system has on deposit with the Federal Reserve. You can find that information here:

  4. Thanks for the reply PJ. While it was not my intention to dispute the efficacy of monetary policy inacted by many of the worlds central banks, I was merely offering clarification on possible reasons for the reduction in VM.

    Many Libertarian/Austrian economists espouse the same position that you have regarding the Feds monetary policy of late. A question I would be interested in having you answer is, what your possible solution would have been in lieu of QE that was implemented primarily to counter reduced liqidity (aka, the credit crunch) in 2008?

    I think you and I can agree on the causes for The Great Recession (CDO's, CDS, derivitives, deregulation, greed, profits, etc.). Where we may depart ways is in policy thereafter. Do you really believe (as many Libertarian/Austrian economists) that allowing, companies, countries, banks, completely collapse as a result of the aforementioned causes, would have been conducive to maintaining social. economic, political stability? As such, what possible solutions would you assert the Federal Reserve should have implemented instead of QE?

    Thanks for your time and consideration.

    1. I honestly don't know. My fear is that the length of the ZIRP experiment is going to cause the inflation of yet another asset bubble down the road (i.e. corporate debt, junk debt etcetera). I think that the Fed has put a bandaid on what could prove to be a monetary hemorrhage and that there will be a bigger price to pay down the road than what may have happened if select and obviously insolvent companies and banks had been allowed to fail.

      We'll never really know, will we?

      Thanks for making me think!

    2. Hi - QE has not worked because the banks were loath to lend and small business; the powerhouse of innovation and employment, no longer had sufficient credit ratings to borrow, invest and employ. In my view QE would have worked much better if the government had devised a simple bank-bypass scheme and targeted the QE monies directly to SME businesses.

      Here's how.

      Identify those areas that are most likely to see growth in the medium term in both domestic and international markets. Seek to reach all SMEs in the categories determined most to be able to grow the economy. They need to already exist, to have been around for 2 - 3 years, have a minimum of 4 employees (stable for the last 2 years) and are operating in areas which are confidently predicted to grow as the economy recovers. Take a percentage of each QE release and assign packets of money on a first come - first served basis - say a $250,000 grant per business - awarded for them to spend as required with 4 simple conditions
      1) you must employ 2 people for 2 years each and pay them at full living wage level or above,
      2)the business must lodge the money in a business bank account and provide a business plan which is approved by that bank and
      3) that the business will not make any other staff redundant as a consequence of this new employment.
      4) the business owner/s are liable for the entire sum if the business stops trading for any reason with the responsibility for the conditions of the grant going automatically to any purchaser of a business which has benefitted from the scheme.

      Banks would therefore need to compete with each other to attract the businesses to deposit these funds into their accounts in order to reduce their over-leveraged positions. The business plan requirement would allow a business to leverage larger sums in borrowing based on a legitimate business case and it could happen very quickly - within weeks. Banks would effectively become the administrators for the scheme with a firm interest in ensuring that additional borrowing happened. The net result would be 8 + new jobs per $1m spent. Small businesses could wipe out accumulated debt, there would be a surge of energy and optimism as businesses take the opportunities that the new capital and new staff afford. $250,000 suddenly appearing in your account equates to a one-off increase in your notional turnover for the previous 12 months of $1,250,000 (assuming a healthy 20% profit margin). These new staff are likely to be employed in development roles and will come off the unemployment register or move from other less skilled jobs (how many graduates are not working in their skills areas but in dead-end jobs) thereby creating a strong demand for career orientated employment, reducing the benefits burden and releasing opportunities for less skilled people into work. These two groups are precisely the people who will spend. Even a small percentage of the trillions spent on QE would transform the business world; allowing cash-strapped businesses to reinvest in plant, machinery, publicity, new skills etc. Each 8 new employees for $1m will stimulate further employment with a repayment period for the QE of approximately 5 - 6 years in increased tax take - used to reduce budget deficit and gradually removing the QE from the money supply as a modifier against inflationary pressure .

    3. Another similar approach is to have the government spent money on infrastructure and public services, things that taxes have to pay anyway. That way money goes into circulation in a very similar way but doesn't require any complicated administration. It just so happens that the Canadian government did this from 1935 to 1974 through the (publicly owned) Bank of Canada.

  5. As pointed out, velocity has reduced due to the increased dollars in circulation has outpaced the number of dollars spent.
    That is why I do not understand continuing to increase the dollars available, if they are not being utilized.
    People cannot spend dollars they do not have. Their excess dollars have dwindled as the savings rate has declined.
    I do not understand why deflation has not occurred, due to this disconnect between dollars in the system versus dollars spent.
    Inflation would occur if these excess dollars were spernt. The only excess dollars we are spending is borrowed dollars.
    Don Levit

  6. How about the acceleration rate of money which I define as gdp divided by the total value of printed dollars?

  7. It would seem the velocity of money is both important and hard to control. It might soon become apparent the economic efficiency of credit is beginning to collapse and the additional money poured into the system coupled with lower rates can no longer drive the economy forward. When this happens we are at the end game.

    At some point the return on loaning money is simply not worth the risk! Why do you want to loan money if most likely you will never be repaid or repaid with something that is totally worthless? When this happens the only safe place to store wealth will be in "tangible assets" and the only lenders will be those who print the money that nobody wants.

    The collapse of credit can pose major problems such as what we saw when many sellers were forced to demand payment up front before shipping goods in 2008. More on this subject below.

  8. Interesting information you have shared here about the economic movement.

  9. Around 17 trillion dollars has already been dropped from the helicopters for the uber wealthy. Now, all we need is to drop 17 trillion dollars from helicopters onto the streets of America (for the common people to pick up and SPEND).
    This will surely fix the problem.

  10. The record hints that the velocity of money is falling into an all-time low, but what exactly is causing the slowing down of economic deflation, and what is keeping the excess dollars from being spent? I think it is evident that none of the financial market trends are being addressed to the full extent. Anyway, the Federal Reserve's plan is definitely failing. The monetary experiment doesn't seem to be producing the numbers they thought it would from the consumers. So what exactly will be their next step? In any case, thanks for your amazing insights. All the best!

    Daryl Cross @ Nahi Gazal