Tuesday, December 30, 2008

A Response to a Reader About the Velocity of Money...

A reader has asked some good questions regarding the velocity of money and we have been conversing between two places. I just sat down and hammered out a response that I believe is the key to understanding the fundamental situation of our current economy. So here it is, I hope it helps make clear what's happening - comments are always welcome:

One of the problems with those in academia is that they know how to take a relatively simple matter and obscure it with formula and reasoning until it no longer appears simple (kind of a central banker trick, also). The key to passing on real knowledge is the ability to take a complex matter and make it simple and understandable.

What I mean by debt saturation is that there is so much debt that the aggregate (total) income of non-government earners is not enough to support the aggregate debt that has already been created. Of course certain individuals still have the capacity for more debt, but as a whole, the people of the United States of America do not – the people and country are bankrupt.

Before anyone starts throwing debt to GDP comparisons at me, I would ask that you first read my article “Death by Numbers” if you have not already and pay attention to what I said about debt to income versus debt to GDP (Death by Numbers). In a nutshell, the private, corporate, and governmental debts are all owed by the same 305 million people, and when those debts and obligations are added upon one another, they exceed $300,000 for every man, woman, and child. A family of four is responsible for more than $1.2 million of this, while the average family income cannot pay the interest much less feed and cloth themselves (6% interest is more than $66,000 per year – no principal). Now, you say that half of that is unfunded future liabilities and that we can end the entitlement programs and that we can reduce government and military spending? Yes, we can, but I ask will we, or will the debt continue to progress on a parabolic curve even longer? And even if you do reduce the total debt and future obligations in half, debt service combined with REAL growth is still not possible.

That’s what I mean by debt saturation. It creates the “pushing on a string” situation when yet more “stimulus” is introduced. The Fed simply cannot ram more debt into the hands of those who cannot already the support the debt they have. When new money is introduced into this environment, as soon as it reaches the hands of debtors, that money is used to either pay back the current debt or is hoarded. That’s exactly what the banks are doing now. This is what drives velocity down in THIS environment. Yes, any reason that drags aggregate demand down will drag velocity with it. And, yes, there are many reasons that demand is falling now, BUT the UNDERLYING reason is DEBT.

For growth to continue, each year’s credit creation must be larger than the last. The shadow banking system allowed so much debt creation that the numbers to recreate it at this parabolic juncture are many times larger than the numbers being tossed around now. But even if they could create that much credit, who will service it and with what income?

And that’s the root policy mistake that has been made by our government. The debt needed to be defaulted upon to make it go away permanently. Instead of forcing the debt holders to eat it, the bag is simply being transferred from one bag holder to the next. The debt did not go away, it simply changed hands. At this juncture, if you want velocity to increase, you need to clear out the debts, not make new debt.

And to take it a step further, it is our monetary system that is the root cause of the unserviceable debt that we already have. More articles are coming on this subject soon.