Money Velocity Is Crashing–Here’s Why

That the velocity of money has been crashing while the money supply has been exploding doesn’t seem to bother the mainstream pundits. There is always a fancy-footwork explanation of why whatever is crashing no longer matters.

Take a look at these two charts and tell me money velocity doesn’t matter. First, here’s money supply: notice how money supply leaped from 2001 to 2008 as the Federal Reserve pumped liquidity and credit into the economy, and then how it exploded higher as the Fed went all in after the Global Financial Meltdown.

Now look at a brief history of the velocity of money. There are various measures of money supply and various interpretations of velocity, but let’s set those quibbles aside and compare money velocity in the “golden era” of the 1950s/1960s and the stagflationary 1970s to the present era from 2008 to 2015–the era of “growth”:

Notice how the velocity of money remained in a mild uptrend during both good times and not so good times. The inflationary peak of 1979-1982 (Treasury yields were 16% and mortgages were 18%) generated a spike, but velocity soon returned to its uptrending channel.

The speculative excesses of the dot-com era pushed velocity to unprecedented heights. Given the extremes in velocity, it is unsurprising that it quickly fell in the dot-com bust.

The Federal Reserve launched an unprecedented expansion of money, credit and liquidity that again pushed velocity up in the speculative frenzy of the housing bubble. But note that despite the vast expansion of money supply, the peak in the velocity of money was considerably lower than the dot-com peak.

Since the collapse of that speculative bubble, the Fed’s all-in expansion of money, credit and liquidity has failed to stem the absolutely unprecedented collapse of money velocity. Clearly, expanding money, credit and liquidity no longer generates any velocity.

Rather, the inescapable conclusion is that Fed policies have effectively crashed the velocity of money. How is this possible?

Longtime correspondent Eric A. proposed an insightful explanation. Here is Eric’s commentary:

“You know how you say that the economy is locked up in fiefdoms, and they’re picking winners and losers, as part of colluding the prices? Well this adjustment of prices locks out certain people, like say, the young from housing. So houses don’t sell, they stagnate.

But what are we really looking at? Velocity.

Velocity is an indicator that buyers and sellers agree on a price, that the price is “right” and not an outlier. That’s why you see a stock move on high volume “confirming” the move, because it means the prices wasn’t “right” at the previous level, while more people agree the new price is fair.

If prices are allowed to go where they need to without pressure and manipulation, you will always have velocity, as the most buyers and sellers will always agree at some price. Because this is true, low velocity cannot happen in a free market. Which means the only reason for low velocity (in this or the previous Depressions) is that someone has somehow managed to get an edge that prevents them from selling, from liquidating, at the true price, i.e. the one the buyers will agree to.

This has another corollary, that the measure of velocity on the Fed’s own chart is the measure of the level of unnatural price manipulation on the market. We can watch this aggregate indicator of their failure in real time, by the Fed’s own hand, and we can know the manipulation is ending when it rises.

So yes, the Fed, the governments, the insiders can manipulate to their heart’s content, as they’ve been doing, but that unnatural pressure goes somewhere. And the pressure diverts into velocity. As we saw in the Great Depression, or the Roman Empire, velocity can stagnate for 10, 20, or 1,000 years until the manipulation ends, property rights are restored, and we have a free market.

History has shown that may be a bargain they’re willing to make, but it won’t do the rest of us a lot of good.”

Thank you, Eric, for an explanation that intuitively rings true. Manipulating the PR optics (i.e. perception management) as a substitute for an open market doesn’t make you omnipotent, it makes you a hubris-soaked fool.

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  • December 16, 2015 What Does Today’s “Rate Hike” Mean?

    The Federal Reserve raised the interbank borrowing rate today by one quarter of one percent or 25 basis points. Readers are asking, “what does that mean?” It means that the Fed has had time to figure out that the effect of the small “rate hike” would essentially be zero. In other words, the small increase in the target rate from a range of 0 to 0.25% to 0.25 to 0.50% is insufficient to set off problems in the interest-rate derivatives market or to send stock and bond prices into decline.

  • jadan

    Several problems with this analysis. Expansion of the money supply has meant more money in fewer hands. QE didn’t trickle down to the lumpen proletariat and the so-called recovery didn’t raise all ships, as indicated by the increased demand for food aid. The velocity of money refers to a quantity of money in motion. Few people spending generate less velocity than many people spending. The tens of millions create demand and money motion, not the 1%, the handful of fat pigs at the top playing with paper. There is no free market in nature. Such a thing does not exist without a government, however informal or imposing, creating a market place in which trade can occur and money to facilitate that trade.. If the market is well regulated and managed, the velocity of money is whatever the millions determine it will be. The failure of money velocity that Smith notes, free market ideology aside, is a result of the failure of the private Fed system to properly manage the people’s money. They fail to understand that it is the people’s money they play with. The rich never understand this. Very quickly people will come to realize that giving rich people monopoly control of the nation’s money is a truly stupid idea! That little white-haired and very arrogant minion of the rich who just raised rates will go down in infamy along with her private system of financial corruption and mismanagement.

  • Don Robertson

    The two preceding commenters have part of the story right, and part of it wrong.

    Over the preceding century the credit economy has driven inflation into the stratosphere at an increasing rate. This is why so many people at the bottom are so poor, and why the economy is in such deep trouble, and the velocity of money is so low. The FED has seized the reins of interest rates and in so doing, the FED has destroyed the free market that determines the value of cash-money, YOUR CASH-MONEY!

    The banks are paying almost literally nothing on deposits. That says, YOUR money is worth essentially nothing. Your money has been made worth essentially nothing because the FED adopted ZIRP, a zero interest rate policy, a policy that gives to banks what is essentially free money to lend.

    The economy is not driven by the financialization of assets. The economy is driven by increases in wealth, real wealth, not an inflated money supply.

    So, the result of ZIRP is that, all your money is good for is buying things at ever higher prices, things that are being taxed higher and higher because credit economy inflation is destroying the value of the currency forcing all government entities to raise taxes.

    Today the Wall Street scoundrels are trying to crash the market today. Their free money has been taken away by one quarter of a percent. The truth is, the FED is printing money -TODAY- and loaning it out at .5% to banks, and these same banks want that free money to cost them no more than .25%

    THIS MAKES YOUR CASH MONEY WORTHLESS! Interest rates should be set by the market. And money expansion should be limited to the actual increase in the wealth being created by the economy.

    Inflation should be held at ZERO PERCENT!

    Otherwise, all of us are being ripped-off for they value of our money.

    There is no real positive wealth gain in hurrying the economy along toward the next recession. And that is really all the FED has proven itself capable of doing by manipulating interest rates. The free market should set interest rates, the value of your money on deposit at a bank, not the FED.