All that noise, and all that sound, all those places I have found. And birds go flying at the speed of sound, to show you how it all began. Birds came flying from the underground, if you could see it then you’d understand. Ah when you see it then you’ll understand. So states the chorus to The Speed of Sound, the 2005 megahit written and recorded by the British rock band, Coldplay. While the song has a lot of velocity – it was actually inspired by the Kate Bush song Running up that Hill, the same cannot be said of the economy.
First a little economics lesson. The velocity of money is the rate at which the money supply turns over in a given year. In effect it is the number of times that each unit of currency is used to buy something during the period. It can be calculated by dividing the GDP (in effect spending) by the money supply (generally a statistic that the Federal Reserve calls M2).
In terms of the economic impact studies that John Dunham & Associates does for clients, the higher the velocity of money, the larger the multiplier effect, or the larger the induced impact of a given industry or activity.
I was born in 1964. Since that time and about 1990, the velocity of money was pretty flat (at around 1.7). This meant that every dollar in circulation bought something about 1.7 times a year. Beginning in 1990 there was a big jump from 1.7 to about the turn of the last century the velocity of money generally was on a rising track. It rose from about 1.7 to around 2.2, then it began to tumble, reaching a generational low of just 1.426 earlier this year.
That means families, businesses, and the government, are not using the cash on hand to buy goods and services at the rate that they used to. Now this could be because overall demand has fallen, or because the money supply has risen. Lets look at the video tape.
As the table shows, between 1990 and 2000 the economy grew faster than the money supply. Accordingly the velocity of money grew and inflation was also somewhat high as fewer dollars were chasing more demand. After 2000, the trend reversed, with the money supply growing over twice as fast as the economy. Note that this growth really took off after 2008, as the Federal Reserve embarked on its series of Quantitative Easing (printing money) programs. Since the economy was growing nowhere nearly as fast as the economy, the velocity of money collapsed, falling by nearly 34 percent during the period.
Now if the velocity of money were actually related to the size of the economy (as many Keynesian economists and people in the government would have us believe), had the velocity of money simply fallen back to the 1.7 rate, the economy would be about $4 trillion larger today than it is. Had it stayed at its peak 2.3 rate the economy would be $10 trillion larger. Of course most right thinking people know that money is simply a token and not productive in itself so of course this would not happen. But something should happen. If the amount of money available grows relative to the amount of goods and services in the economy, should not its value fall? Should there not be inflation?
Interestingly over the past 17 years, inflation has been quite tame on average, up by just about 2.1 percent a year. So why did not all of this new money lead to inflation. Simply put, there was no actual demand for it. This is why interest rates have remained at rock bottom levels since 2008. All of the money the Federal Reserve was creating simply ended up back in banks – essentially on the Federal Reserve balance sheet (which incidentally is up by just about the same $3.5 trillion in excess money.
Now the Federal Reserve says that it will be bringing the balance sheet down over time, in effect retiring money from the money supply. If GDP continues to grow, this should increase the velocity of money back toward normal levels. With fewer dollars chasing more demand for goods there should be increases in both interest rates and inflation, but this will likely not happen for some time, as the velocity of money has a long way to go.
So right now there is a lot of that noise, and that sound, as folks try to figure out what the economy will do as things start trending back toward normal. I for one think that there is a lot of slack in the system that will keep inflation and interest rates from rising too quickly. Ah when you see it then you’ll understand.