Money Velocity Myth

Re-examining the Money Velocity Myth and What it May Be Telling Us

Many economists denigrate the Money Velocity index as yet another useless index that many analysts try to draw correlations without causations concerning the economy – dubbing it the Money Velocity Myth. Is this true? Perhaps not. Let’s re-examine this index from a different perspective and then speculate what it may portray for the future.

For those that may not be familiar with this index, here is a simple definition. The velocity of money (or the velocity of circulation of money) is a measure of the number of times that the average unit of currency is used to purchase goods and services within a given time period. One can define the Money Velocity formula as follows:

Money Velocity = (Prices * Transactions) / Money Supply

It should be noted that Money Velocity is a derived indicator, and in and of itself is not useful without understanding the detailed parameters that drive the indicator. Any more than the temperature can tell you what the weather will be the next day – it can give us a view of coming weather by using trend data and other events, such as cloud cover and seasons. Hence, when a derived indicator changes, one can then better understand the underlying parameters and their relationships, driving the index changes.

So let’s examine these underlying components of the Money Velocity Index. For example, when using this Money Velocity formula, if Transactions are constant and the ratio of Money Supply to Prices are constant, would not Money Veolicty also remain constant? And yet Money Velocity keeps going down – why?

Looking at the ratio of CPI (Prices) and Money Supply in the chart above, up until COVID19, the ratio has remained fairly constant. Hence, the change must have come in the declining Transaction rates. Is this true? One common way we can see Transaction rates is the Baltic Dry Index.

The Baltic Dry Index in the chart below is reported daily by the Baltic Exchange in London. The index provides a benchmark for the price of moving the major raw materials by sea. The index tracks rates for capesize, panamax, and supramax vessels that ferry dry bulk commodities. The Baltic Dry Index is not restricted to Baltic Sea countries or a few commodities like crude oil. Instead, the Baltic Dry Index takes into account 23 different shipping routes carrying coal, iron ore, grains, and many other commodities.

Certainly, this is not an exact measure of Transactions due to the changing supply of shipping capacity and the subsequent efficiencies in the shipping industry. Nevertheless, this clearly shows that since the “Great Recessions,” trading Transactions have yet to recover to pre-2008 levels fully. When factoring in inflation, one can argue that, though the index has been flat since 2008, in a sense, Transactions are in a steady decline – consistent with the decline of Money Velocity.

Despite the Money Velocity indicating the long term macroeconomy has weakened since 2008, GDP growth levels and stock markets keep powering ahead. This gives the impression that the Money Velocity index is meaningless and a myth. On an aggregated basis, this may be true. The disconnect between main street and wall street has long been talked about. Perhaps Money Velocity may be telling us what is happening on the main street, not wall street.

Take a look at Money Velocity juxtaposed against social-economic class net worth in the chart below (note offset formulas used to display it properly). As Money Velocity declined, the gap between the top wealthy people and the bottom 50% has widened. The idea is quite simple. If you have ten people in an economy, and nine are going now where (even declining), but the one wealthy guy is experiencing huge wealth growth – the economy on an aggregate level is growing nicely, but not for the majority of people. Financial markets really don’t delineate by the social-economic classes … the total aggregate numbers to the financial analysts are all that matters. 

But can wall street from a political perspective continue an economy like this without consequences? In time, no. The rise of the masses will demand change via a demand for different policies – and if that doesn’t work, revolution. Hence the rise of Marxist socialism driven by the far left of the political spectrum. Regardless of your view of envy politics of the Left, it is real, and it sells. Wealth inequality does matter as it is the fuel that enables Marxism – see here (Is the Federal Reserve Sowing Seeds of Marxism?).

Even the Fed has taken notice and is quick to note that income inequality has improved in the first three years of the Trump administration. But is it enough to satisfy the Leftist masses before they draw their pitchforks? It took us decades to get into our current situation. It will not recover in a few short years. But clearly, the Trump administration for main street is heading in a “good” direction. Whether it is fast enough for the masses, we shall see in the November elections despite COVID19.

The economic central planners (sorry for the snark) at the Fed have an interesting job ahead of them. Though managing wealth inequality is not part of their dual mandate, it may become a third mandate if they want to keep their jobs. And they will need to act quickly. The quantitative easing policies may become passé, and a new tool of “Fed Free Money to the Masses” may become their new state of play. Can it work?

The Fed’s idea is to put money into the hands of the masses, to increase Transactions, in the Money Velocity equation – reversing the growing wealth inequality. The obvious fear is that too much “Free Money” in the masses’ hands may spark inflation – even hyperinflation, given the amount of Money Supply already in the system. The Fed will try to thread the needle with the right amount. What could go wrong?

What the Fed may be missing is the social aspects of giving “Free Money” to the masses. Human nature is such that people would get use to the “Free Money” and adapt living standards to the new reality of “Free Money,” thereby making the “Free Money” of little effect. As in the case of quantitative easing, ever-increasing amounts would be required to have the same effect over time – leading to even more currency debasement and even more wealth inequality. The scourge of currency debasement from Central economic planners are one policy program away from creating a utopia for us all.

Will anyone listen to “sound money,” “real free trade,” or “balanced budget” policies to actually help the lower social-economic classes in this highly charged political environment?

The bottom line here is that the Money Velocity index does matter if you are on main street – and it may become increasingly more important. To wall street, one better keep an eye on this Money Velocity index to stave off the masses coming for them.

 RWR original article syndication source.

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Written by Tom Williams

Born down on the farm in America's Midwest, my early life was spent climbing the ladder via a long career in information technology. Starting as a technician, and after earning a degree going to night school, I eventually found a place working at ATT Bell Laboratories as a software engineer.

Later moving into management and then a long stint in a major management consulting firm working with major banking, telecommunications, and retail companies. Working in various states in America, I also spent considerable time living and working in several European countries - currently expat in France. As a side career, I was heavily involved in real estate development and an avid futures trader. This experience can give one a unique view of the world.

The storm clouds of dark change are near. Today America is at a crossroads. Will it maintain its prowess as a national leader in the free modern advancing world, or will it backtrack in the abyss of the envy identity politics of tyrannical socialism, and the loss of individual freedoms. The 2020 election may have decided this. Join the Right Wire Report team and make a stand.

8 Comments

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  1. The velocity of money does not increase significantly when the preponderance of money is held in few hands. Not easy to spend great amounts of money unless you are in congress. Tax cuts should go to the Middle Class. These are the folks that spend on home improvements,
    dental work, clothing vacations etc. This fires up velocity and gets the entire economy in high gear., not just the luxury car segment or Yachts.
    When government takes the money we see little improvement. Wealthy donors wind up with much of this government largesse.
    TRUMP 2020 TRUMP 2020 TRUMP 2020 TRUMP 2020!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!

    • @Terrance Dugan: re: “held in few hands”

      Frictionless financial perpetual motion requires that, income not spent (monetary savings, commercial bank-held savings, $15 trillion dollars) is quickly reintroduced into the economy, completing the circuit income and transactions’ velocity of funds (*circular flow*), thereby sustaining and promoting economic momentum. The utilization of savings via targeted real investment outlets has a positive economic multiplier (increases productivity, real wages, as well as the real rate of interest).

      Unfortunately the complete deregulation of interest rates for the commercial bankers results in a negative economic multiplier, where it takes increasing infusions of reserve bank credit to generate the same inflation adjusted dollar amounts of GDP thereby decreasing the real rate of interest.

  2. Income velocity is a contrived figure. It is the transactions velocity of money, money actually exchanging counterparties that is telling. It is the transactions velocity of money that American Yale Professor Irving Fisher used in his truistic “equation of exchange”. What Milton Friedman had printed on his license plate was wrong. Dr. Philip George’s definition of velocity is apropos: “Changes in velocity have nothing to do with the speed at which money moves from hand to hand but are entirely the result of movements between demand deposits and other kinds of deposits.” Unfortunately the FED discontinued publishing the Debit and Demand Deposit Turnover G.6 release in Sept. 1996.

    Nevertheless we know why Vt has fallen since 1981. Banks are “Black Holes”. Banks are credit creators – not credit transmitters. All bank-held savings are un-used and un-spent, lost to both consumption and investment, indeed to any type of payment or expenditure. Banks pay for their earning assets with new money – not existing deposits. From the standpoint of the entire payment’s system, the monetary savings practices of the public are reflected in the velocity of their deposits and not in their volume.

    Thus as the volume and proportion of bank-held savings increases, velocity decreases. The FDIC’s increase in deposit insurance levels, from $100,000 to $250,000 decimated money velocity. The remuneration of interbank demand deposits decimated money velocity (inverted the short-end segment of money market funding rates for the nonbanks). The impoundment and ensconcing of monetary savings is responsible for the rival of Alvin Hansen’s 1938 secular stagnation thesis – not demographics, not globalization, not robotics, not monopolization, etc.

    • Can you explain why -> “Changes in velocity have nothing to do with the speed at which money moves from hand to hand but are entirely the result of movements between demand deposits and other kinds of deposits.” And why Velocity has declined since 2008.

      • To ignore the aggregate effect of money flows on prices (using the transactions velocity (Vt) of money, i.e., with bank debits being the proxy), is to ignore the inflation process. To dismiss the concept of Vt by saying it is meaningless (that people can only spend their income once, as defined in Keynesian economics), is to ignore the fact that Vt is a function of three factors:

        (1) the number of transactions;
        (2) the prices of goods and services;
        (3) the volume of M.

        Inflation analysis cannot be limited to the volume of wages and salaries spent (as income velocity by definition does). To do so is to overlook the principal “engine” of inflation – which is of course, the volume of credit (new money) created by the Reserve & the commercial banks, plus the expenditure rate (velocity) of these funds. Also, e.g., overlooked is the effect of the expenditure of the savings of the non-bank public on prices (dis-savings). The (MVt) figure encompasses the total effect of all these monetary flows (MVt).

      • The decline in Vt since 2008 was due to the remuneration of interbank demand deposits. Bankrupt-u-Bernanke initially destroyed the nonbanks by inducing nonbank disintermediation, where the remuneration rate inverted the short-term retail and wholesale funding of the money market yield curve. Disintermediation is a term that only applies to the nonbanks since 1933.

        The remuneration rate acts like old Reg. Q ceilings for the commercial banks. Raise the rate and nonbank lending is destroyed. The 1966 Savings and Loan Association crisis is the antecedent and paradigm (where the term credit crunch originated).

        That plus the FDIC raised deposit insurance limits from $100,000 to unlimited. In 2013 it reduced it from unlimited to $250,000. This caused the taper tantrum (as I predicted).

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