Tuesday, December 30, 2008

The Velocity of Money…

How fast is she doing? Let’s just say that we aren’t driving a Ferrari here, okay? More like an old VW Beattle whose transmission just dropped out!

What is M1? It’s the measure of the U.S. money stock that consists of currency held by the public, travelers checks, demand deposits and other checkable deposits including NOW (negotiable order of withdrawal) and ATS (automatic transfer service) account balances. In other words, it’s what most people would consider to be readily available/ spendable cash.

Here’s a current chart of M1 courtesy of our Fed (note the newly shaded recession area they finally confessed to). Also note the dramatic upward climb as more cash is thrown at our economy in an attempt to “provide liquidity.”

M1 Money Supply:


The problem is that too little liquidity is not the problem and never has been. In fact, the problem has been, and still is, too much liquidity in the form of cheap and easy credit. Our economy has reached what I call “macro debt saturation,” that is that the income from all earnings is unable to pay principal and interest on all debts. We’re there – please read “Death by Numbers” if you haven’t already - Death by Numbers.

Debt destroys the VELOCITY of money.

Normally a dollar that enters the economic system gets spent more than once. Let’s say that you take out a loan to buy a new house and that money is given to your contractor. He then takes that money and pays the plumber, the mason, the electrician and so on – and then they in turn go out and spend that same money on down the line. That’s velocity.

Now imagine that you get a loan and the check goes to your contractor who is in massive trouble with his debts. To avoid bankruptcy, he takes that check and makes a payment on his debts, thus returning that money back to the bank before it can ripple through the economy. See? Debt brings velocity down.

So to get our economy going, what’s the Fed trying to do? They are trying to inject money in hopes to spur spending. Will it work? Let’s look at the next chart:

M1 Money Multiplier:


As you can see, the M1 Money Multiplier has fallen below 1. That means that for every dollar placed into the economy, less than a dollar makes it to the second person! Would that be good? Ahhhh, NO! It is proof positive of macro debt saturation – end of discussion.

Take a look at that chart! Normal velocities run upwards towards 3. Less than one means that the Fed has lost control with another tool. Below is a close up view of velocity over the past four months:

M1 Money Multiplier (close up):


Remember that they already lowered interest rates to zero – that gun is now empty. Now that the velocity of money is less than one, they have lost control of that gun also. What gun is left? You tell me, I don’t see it, because it doesn’t exist.

This ties into my earlier article Setser’s “The Collapse of Financial Globalization”, as the entire globe is debt saturated. The velocity of money has gone to less than one because every dollar put into the system is being used to pay back debt.

In regards to world wide capital flows, the same velocity problem is occurring. The problem is that we've been relying on foreigners to finance our debts, and that's worked as long as they are able to. That has already ended as shown by the private capital flows; it is the government capital flows that are the only thing keeping the game going.

The "experts" in teevee land believe that it doesn't matter, that we can continue to print our way out since we are the reserve currency. That is only true as long as the foreigners continue to return our worthless paper to us. That will end, too, because of macro debt saturation and because the velocity of the money they print no longer has a stimulus effect. Bet you don’t want to know what the velocity of money looks like in Zimbabwe, Iceland, or Argentina right now! Those who believe that being the reserve currency will allow us to magically escape the laws of economics are living in an Alice in Wonderland world but they will eventually awaken from their dreams to find that reality is a lot more like a nightmare.

Sorry to be negative, that’s not me, it’s the data – I’m just a messenger who would like to see a better long term system put in place so that we never have to be in this situation again.

Nate

PS – Karl Denninger did an excellent piece on this as well: Uh Oh Monetary Flat Spin

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