The Independent Market Observer

10/24/13 – Money Velocity and the Recovery

Posted by Brad McMillan, CFA®, CFP®

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This entry was posted on Oct 24, 2013 7:52:21 AM

and tagged Market Updates, Economics Lessons

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While rushing between planes yesterday, I had a good conversation with one of our advisors, who was preparing a talk for his clients about whether the recovery is real. Specifically, he was concerned about the fact that money velocity is so low.

Velocity is how fast money circulates, or how much economic activity is created by a certain amount of base cash. It usually runs at rates several times where it is right now.

The advisor’s concern—that low money velocity means the recovery isn’t real—is reasonable, and I think there’s some truth to it. More broadly, however, I believe the decline in velocity reflects systemic changes in the financial system that are acting (in ways not fully understood) to impair the visibility of significant sections of the economy.

In short, I think the recovery is real, and that money velocity is a less useful indicator now than it has been in the past.

As for why, let’s start with the banking system. As part of the general retrenchment of the financial services industry, banks have pulled back from commercial and business lending for the past several years. While that is starting to change, there has been a real shift in where lending is done, away from the banking system and toward other sources.

One example is the private nonbank business development companies that have sprung up to lend to companies too small, or not creditworthy enough, to work with the banks or the bond markets. The lending is still happening, but it’s not being mediated through the traditional fractional reserve banking system, and therefore isn’t showing up in the usual way in the tracking mechanisms. The details aren’t clear, but this seems to be a contributory factor to the decline in velocity.

The second component of the decline, and probably the major one, is that the Federal Reserve has simply pushed too much cash into the system. To put it in concrete terms, if you give a starving man three turkeys, he can still only eat so much. Even a healthy man probably couldn’t eat all that much more. The extra turkey—or, in this case, money—isn’t an indicator that the man is starving. It’s just too much turkey. The decline in velocity, in this case, reflects too much supply, not insufficient demand.

The third possible piece, which is even more nebulous, is the rising role of alternative currencies and the underground economy. The poster child for alternative currencies, bitcoins are digital money of obscure origins that have attracted a growing amount of attention and economic activity. The government hates them, as they represent a way to transact business that is completely obscure to the traditional tracking mechanisms—and hard or impossible to tax. The rise of a widely used currency outside of government control is a new factor in the modern era, and the consequences will play out for some time.

Closely related to this is the rise of the underground economy. Traditionally, in higher-taxed and more regulated economies, the underground economy has grown as a proportion of the whole, as we have seen in many countries in Europe and Asia. As a historically lightly taxed and regulated country, the U.S. has had a relatively small informal sector, as it is called, although there has always been one. The risks of operating underground made sense for criminal businesses but generally weren’t worth it for legitimate ones.

With the rise in taxes and regulation, however, this has started to change. We’re not Europe, but change always begins at the margin, and the rise of alternative financial venues outside the traditional banking system, like bitcoins and computer-mediated cash transfers, has made going underground much easier and safer at the same time that the tax and regulatory environment has made it more desirable.

Of these factors, the excess turkey is, I think, the principal one, but the banking and underground economy component is also significant. I suspect the banks will reassert their primacy in lending over the next couple of years as they recover, and the Fed will ultimately dial back the stimulus. Digital currencies and the underground economy, however, will be with us for a long time.

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