Here's yet another look at the issue of money (in this case M2 money) and nominal GDP. Velocity is a measure of how many times a dollar of M2 changes hands in order to produce a given level of output (i.e., nominal GDP divided by M2). As this chart makes clear, money growth surged in Q4/08 and Q1/09, while nominal GDP fell. That means velocity collapsed as people suddenly decided to boost their holdings of cash, CDs and money market funds instead of spending the money. This was a prime example of a sudden shock to confidence.
In recent months, however, M2 growth has slowed quite a bit, and my estimate of nominal GDP in the second quarter (-1% real growth and 2.5% inflation) shows that in nominal terms the economy is once again growing. This same estimate of growth coupled with recent data on M2 suggests that velocity essentially stopped falling in the second quarter. Going forward, spending habits will continue to revert to more normal relationships. Confidence is returning. The recession has essentially ended, as the economy is very likely to register positive real growth in the third quarter.
As I've mentioned before, there is a strong positive feedback relationship at work now. As confidence rises, money that was stored up in M2 is released, and that supports stronger growth and stronger cash flows. That in turn boosts confidence, etc. With cash yielding almost zero, the demand to hold that cash will decline since a growing economy offers a lot of more attractive alternatives.
I remain steadfastly and viscerally opposed to the spend-and-tax policies of the Obama administration, but for the moment they can't do as much damage as the good that is now coming from the simple fact that the economy is no longer shrinking and confidence is rising. The economy was able to heal itself without any meaningful help from the stimulus bill (indeed, I should say in spite of the stimulus bill, since it was essentially a massive negative shock to confidence since it telegraphed a huge increase in future tax burdens), and there is every reason to think we will see modest growth (on the order of 3% a year) going forward.
That's probably not enough to boost corporate profits much, but even if they don't grow at all for the next year, that doesn't rule out a rise in equity prices, since PE ratios are relatively low.