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Velocity of Money

Since 2008, the Federal Reserve has more or less printed over $1.6 Trillion in two rounds of “Quantitative Easing”.  Many have speculated that this has to result in inflation for the simple reason that there are more US Dollars out there than ever before.  That’s based on the most fundamental principle of any market, supply and demand –more of these things called “Dollars” around and the value has to drop, meaning it takes more of them to make a reasonable exchange with something real.

It hasn’t worked out that way.  Inflation remains at around 2% per year as it has throughout the worst part of the Managed Depression, the financial crisis that started in 2007.  How on earth can that be?

The answer is that the number of US Dollars in the world is only one part of the equation.  The “velocity of money”, or the number of times they turn over in the economy, is equally important.  Data since 2007 shows what every freelancer and job seeker knows – it’s a tough world out there, and people are pretty slow to let go of the dough they have.

Before we can talk about the “velocity” of money, we have to define what we mean by “money” and how much of it is out there.  The broadest measure we have good data on these days is called MZM – a measure of the bucks printed and in coin, plus all bank accounts and money market accounts.  It’s not a complete measure, since it does not include stocks and other investments that people can both borrow against or otherwise use to make themselves feel rich.  It’s “demand money”, the stuff that is accessible right now.

How much of that is there?  About $11T in total, and it grows all the time (red line on the graph below).  But it has been turning over less frequently, as shown in the graph of velocity (GDP/MZM, the blue line):

You can take the “velocity” as roughly the number of times a buck turns over in one year through the economy.  The chart above shows that coming into the current Depression in 2001 it was over twice a year, falling to 1.75 times by 2002.  It never recovered to more than 1.92 times (April, 2006) before it fell off a cliff in 2007 (before the “official” recession even began!) where it hovers today, about 1.4 times.

What this means is that for all the money out there in the world, it feels as though there is considerably less than there has been.  The velocity today is only 75% of what it was in 2006, the last time anyone felt remotely flush with cash.

This suggests that if you wanted to have the same effect on the economy with the money you have, there is room for about one third more of it around, or about $3.7T.  If the Fed wants to go in for one Hell of a lot more “Quantitative Easing”, it could print upwards of that much before we can reasonably expect a heavy dose of inflation.

That number is shocking for many reasons.  It suggests that the shortfall in our economy is far more than anyone has even tried grapple with so far.  It also demonstrates the key characteristic of a Depression over an ordinary Recession, two terms that have always seemed a bit murky.  In a Depression the supply of money falls so hard that there simply is not enough to go around, representing a failure of the general money supply rather than an oversupply of any given product or service.

An argument could easily be made that the velocity of money is a function of far more than economics – that the rate at which people spend is not just what they have on hand, but how much they think they might have in the future.  That’s why the we use the term “Depression”, a psychological term, to describe the situation.  It also goes to the heart of FDR’s famous 1933 speech proclaiming that “The only thing we have to fear is fear itself.”  Much of what is going on is a matter of attitude and anxiety.

So can the Fed step up and print $3.7T tomorrow?  Sure, why not?  It can print that much and cancel loans all over the place, getting that money into circulation and generally opening up wallets and convincing the world that tomorrow will be a better day.  The problem is that if it over shoots and the velocity jumps up again, there are suddenly way more US Dollars than anyone needs and inflation erupts.

It’s all a balancing act.  Right now, it looks like more money might be coming soon.  We will see if there is, in fact, a QE3 in the works.

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19 thoughts on “Velocity of Money

  1. Very good. But what goes into velocity of money? I bet there are many factors that cause people to spend more / turn it over more. Psychology may play a big part but there has to be more. Any thoughts? What did it look like before 2001?

    • I’ve never seen anything on velocity that was not mostly psychology based. Expansion of credit makes people spend more, for example, but most of the effect has to do with the feeling that you have money to spend.

  2. Thanks for the explanation, Erik. My simple brain needs to understand the relationship (ratio?) between the *quantity* of money and the *value* of the actual goods and services represented by the money. Is it possible to calculate this? I intuit that velocity has something to do with the *perception* of money, but can’t quite connect the dots. Can you explain that a little more?

    • Thanks. It is all about perception of value – and, as Adam Smith said, “All money is a matter of belief.” Velocity is a derivative of money itself, more about the change in money, and so it apparently is entirely about perception of how well people are doing. I’m not finding anything more technical than that, sadly. I’ll keep trying – and if you come up with anything please let us all know.

  3. Yes, there has to be a lot more to say on this. What drives money to turn over in the economy and how can we get it back up?

    • Historically, it has been 2.5-3.0 in good times – such as in the 90s. When we talk about controlling the economy with loosening/tightening credit that’s what we’re really talking about. I won’t share graphs going back into the 1960s because the different definitions of “money supply” produce very different peaks, and the details are pretty sketchy. I think this only works over one definition of “money” and only over a short time, to be honest.

  4. i always wonder why there was a distaste for the inflation level of the late 1960s through the 1970s. If you had debt you could repay with dollars worth less. A lot of people were enjoying buying houses, salivating at the price increases they were seeing. Wages were going up quite a bit too. Government tax revenues were up.

    • Inflation is interesting, isn’t it? A little bit is a good thing, but a lot is horrible. What is the right amount? The Fed did announce that they have a target of 2% (which we have been hitting square on lately!).
      I am very confident that the way out of this Depression is going to include debt forgiveness and a whole lot of inflation at some point, ideally coupled with serious productivity gains. It’s either that or we become slaves to someone, and I don’t see that holding up well, either.

  5. The inflation of the 1970s was the reason for President Ronald Reagan. What I liked best about Reagan is that he was anti-communist, more so than liberals. I remember hearing about how Jane Fonda went to Hanoi. The Soviet Union was a one party state. They didn’t think their was a marketplace of ideas.They thought they could base their ideas on Marx, Engels, Lenin, Trotsky and Stalin. Those thinkers brought so much suffering into the world. They didn’t believe in capitalism. They didn’t even want to reform capitalism.They didn’t even believe in democracy.

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