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Re-examining the Money Velocity Myth and What it May Tell 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.

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