Economists use many tools to quantify economic activity. Some are better than others, but all are useful to some degree.
But one of the most useful, yet underutilized, tools is a relatively obscure measure of economic health and vitality called M2 Velocity. M2 Velocity is a ratio of nominal gross domestic product (GDP) to the money supply (M2). Pretty boring, I know, but think of it as the number of times one dollar is used to purchase final goods and services in the economy.
Now, despite this gauge’s superb value in measuring the health of an economy, very few people outside of the field of economics grasp the importance of M2 Velocity. Instead, most pundits prefer to discuss more widely understood economic measurements, such as GDP.
And that’s exactly what happened this morning when the government revised its fourth quarter GDP estimates from 0.7% growth to a 1.0% (both are terrible numbers, by the way). Many pundits breathed a sigh of relief to see some evidence that the U.S. didn’t fall into recession late last year as some economists feared.
But M2 Velocity indicates we’re not out of the woods yet – not by a long shot…
As you will see in the chart below, the velocity of money ebbs and flows like many economic indicators. When the gauge rises, it indicates greater levels of economic activity as a dollar changes hands much more frequently. On the other hand, when the gauge declines, it indicates that fewer goods and services are being purchased with that same dollar.
Since 1958, the M2 Velocity has roughly channeled between 1.7 and 1.9. The gauge rose above its historic average in the 1980s and 1990s as the economy experienced healthy expansion rates. On the few occasions that M2 Velocity fell below the bottom of the channel of 1.7, it was a relatively short-lived occurrence.
But even a casual glance at the gauge will tell you there is a problem. The M2 Velocity has been falling for more than a decade and now sits at 1.482, the lowest level ever recorded.
So what does this mean?
A declining velocity of money means people are spending less disposable cash than ever despite a massive expansion in the money supply by the Federal Reserve. More importantly, it’s an indication that the economy is being pulled down by cyclical deflation.
Now, I’m not given to apoplithohorismosphobia (love that word!). For the uninitiated, apoplithohorismosphobia is the fear of falling prices leading to uncontrolled deflation. So, while falling prices isn’t the bogeyman many people think it is, to Keynesian economists, it is to be avoided at all costs.
That’s why the Federal Reserve constantly tries to drive inflation in the economy.
And it’s the reason this graph unsettles the Federal Reserve. After more than 5-years of zero interest rates and three rounds of quantitative easing, the Fed’s monetary policy has had no real effect on inflation – or in slowing the descent of M2 Velocity.
The continuing decline in the velocity of money indicates that consumers remain uncomfortable with the status quo. More importantly, if the low levels of demand continue unabated, central banks around the world risk a global depression if it isn’t resolved soon.
But to reverse the downward trend in money velocity, the federal government must shift into growth mode by removing the uncertainty that comes with excessive control and regulation of the economy. Even in the best times, government regulations make economic expansion difficult. But the sheer volume of regulations in today’s anemic economy threatens our very way of life.
The moral solution is for the federal (and state) governments to curtail their regulatory overreach, get spending under control, reduce taxes for individuals and corporations, and allow free economic activity to return.
It may be a pipe dream, especially listening to each party’s presidential candidates, but a downward economic spiral continues unabated, and time is no longer on our side.