From: The Automatic Earth
Stoneleigh: The velocity of money is an important concept underpinning the liquidity trap we are entering. John Mauldin has a good explanation as to how it interacts with the money supply in this article, and I suggest that everyone reads the whole piece.
What is happening is something we have touched on here before – hoarding. The hoarding mentality is a psychological shift in response to perceived shortage. Hoarding represents a lack a trust that the supply of something will be adequate, or the price reasonable, in the future. The response is to stock up, even though this compounds the problem for everyone. People are currently hoarding food in many places, which acts to drive the price up further due to the increase in demand (see comment below with accompanying article).
Similarly, even if the money supply is increasing, a lack of trust results in banks hoarding cash, which sends the price of cash (in the form of interest rates on inter-bank lending) sharply higher and the availability lower. This decrease in the velocity of money makes it increasingly difficult to keep the market supplied, even though central banks are intervening in more and more aggressive ways. Combined with the on-going destruction of credit (which has acted as a money equivalent during the long expansion), the failure of the securitization model (which has acted to increase the velocity of money), the need for banks to rebuild reserves and the need for individuals and businesses to both cut spending and build savings, the liquidity trap becomes inevitable.
Now, let’s introduce the concept of velocity of money. Basically, this is speaking of the average frequency with which a unit of money is spent. Let’s assume a very small economy of just you and me, which has a money supply of $100. I have the $100 and spend it to buy $100 of flowers from you. You in turn spend $100 to buy books from me. We have created $200 of our “gross domestic product” from a money supply of just $100. If we do that transaction every month, we would have $2400 of “GDP” from our $100 monetary base.
So, what that means is that gross domestic product is a function of not just the money supply but how fast the money supply moves through the economy. Stated as an equation, it is P=MV, where P is the Nominal Gross Domestic Product (not inflation adjusted here), M is the money supply and V is the velocity of money. You can solve for V by dividing P by M.
Now, let’s complicate our illustration just a bit, but not too much at first. This is very basic, and for those of you who will complain that I am being too simple, wait a few pages, please. Let’s assume an island economy with ten businesses and a money supply of $1,000,000. If each business does approximately $100,000 of business a quarter, then the Gross Domestic Product for the island would be $4,000,000 (4 times the $1,000,000 quarterly production). The velocity of money in that economy is 4.
But what if our businesses got more productive? We introduce all sorts of interesting financial instruments, banking, new production capacity, computers, etc., and now everyone is doing $100,000 per month. Now our GDP is $12,000,000 and the velocity of money is 12. But we have not increased the money supply. Again, we assume that all businesses are static. They buy and sell the same amount every month. There are no winners and losers as of yet.
Now let’s complicate matters. Two of the kids of the owners of the businesses decide to go into business for themselves. Having learned from their parents, they immediately become successful and start doing $100,000 a month themselves. GDP potentially goes to $14,000,000. In order for everyone to stay at the same level of gross income, the velocity of money must increase to 14.
Now, this is important. If the velocity of money does not increase, that means that (in our simple island world) on average each business is now going to buy and sell less each month. Remember, nominal GDP is money supply times velocity. If velocity does not increase, GDP will stay the same. The average business (there are now 12) goes from doing $1,200,000 a year down to $1,000,000.
Each business now is doing around $80,000 per month. Overall production is the same, but divided up among more businesses. For each of the businesses, it feels like a recession. They have fewer dollars so they buy less and prices fall. So, in that world, the local central bank recognizes that the money supply needs to grow at some rate in order to make the demand for money “neutral.”
It is basic supply and demand. If the demand for corn increases, the price will go up. If Congress decides to remove the ethanol subsidy, the demand for corn will go down as will the price. If the central bank increases the money supply too much, you would have too much money chasing too few goods and inflation would manifest its ugly head. (Remember, this is a very simplistic example. We assume static production from each business, running at full capacity.)
Let’s say the central bank doubles the money supply to $2,000,000. If the velocity of money is still 12, then the GDP would grow to $24,000,000. That would be a good thing, wouldn’t it? No, because we only produce 20% more goods from the two new businesses. There is a relationship between production and price. Each business would now sell $200,000 per month or double their previous sales, which they would spend on goods and services which only grew by 20%.
They would start to bid up the price of the goods they want and inflation sets in. Think of the 1970’s. So, our mythical bank decides to boost the money supply by only 20%, which allows the economy to grow and prices to stay the same. Smart. And if only it were that simple.
Let’s assume 10 million businesses, from the size of Exxon down to the local dry cleaners and a population which grows by 1% a year. Hundreds of thousands of new businesses are being started every month and another hundred thousand fail. Productivity over time increases, so that we are producing more “stuff” with fewer costly resources.
Now, there is no exact way to determine the right size of the money supply. It definitely needs to grow each year by at least the growth in the size of the economy, new population and productivity or deflation will appear. But if money supply grows too much then you would have inflation….
….Now, why is the velocity of money slowing down? Notice the real rise in V from 1990 through about 1997. Growth in M2 (see the above chart) was falling during most of that period, yet the economy was growing. That means that velocity had to rise faster than normal. Why? Primarily because of the financial innovations introduced in the early 90’s like securitizations, CDOs, etc. It is financial innovation that spurs above trend growth in velocity.
And now we are watching the Great Unwind of financial innovations, as they went to excess and caused a credit crisis. In principle, a CDO or subprime asset backed security should be a good thing. And in the beginning they were. But then standards got loose, greed kicked in and Wall Street began to game the system. End of game.
What drove velocity to new highs is no longer part of the equation. Its absence is slowing things down. If the money supply did not rise significantly to offset that slowdown in velocity the economy would already be in a much deeper recession.
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Good info will come back again soon.