Tuesday, June 16, 2009

Money velocity is likely stabilizing

A reader's comment made me realize I have not addressed the velocity question directly, so here is a chart of what is arguably the best measure of velocity, which is calculated by dividing nominal GDP by M2. The last datapoint uses my estimate of nominal GDP and M2 for the second quarter. I might be off by a little, but even considering a decent margin of error it is clear that the decline in velocity has really tapered off in recent months. Velocity fell by 7.6% last year, with the drop being the greatest in the fourth quarter: -5.6%. Velocity then fell 3.1% in the first quarter, and my guess is that it will fall only 0.5% in the current quarter.

The big drop in velocity is simply the result of consumers and businesses deciding to hang on to their money instead of spending it; a natural reaction to the sudden onset of the financial crisis which followed in the wake of the Lehman bankruptcy last September. The turnover of money (velocity) slowed dramatically as everyone sought to either increase their money holdings or pay down debt.

It's not unreasonable to assume that as the level of fear declines, people will resume spending their money. As everyone attempts to reduce their money balances, money will turn over faster, and nominal GDP will rise at a faster rate than money balances. Velocity, in other words, will rise. For the time being it looks more like velocity is stabilizing, but it will rise by the end of the year if the economy picks up speed.

One reason that M2 velocity is arguably the best measure is that it is the only velocity measure that has proven to be relatively stable over long periods. Note how today's velocity is back to the levels that prevailed from 1959-1989. Looks like one more thing that is "returning to normal."


alstry said...

The big drop in velocity is simply the result of consumers and businesses deciding to hang on to their money instead of spending it.

You and I agree completely on this one!!!!

The problem is most of that savings is going to pay down DEBT.

The even BIGGER problem is that there is MUCH MORE DEBT than savings...so as the economy continues to contract....we will reach a point where DEBT reduction and servicing debt consumes most of the dollars that would have gone to goods and services.

Until you restructure debt....DOWN DOWN we go until practially all are bankrupt!!!!

It really is pretty simple to see where we are heading at this point....

All planes eventually hit the ground when the run out of gas.....you may find Vikram Pandit's comments last night insightful.

Bill said...

Translation: "We're all going to die!!"

alstry said...


It is not death...think of it as a rebirth.

I am aware of a number of people in my circle who have declared bankrupty and made a few hundred million relatively shortly thereafter.

von Mises said...

I would argue, based on your graph, that M2 Velocity is anything but stable. Look at those swings, if you analyze the data points I am guessing the STD Dev.'s are huge. Just because a graph is created where the start point and end point are similar does not make what the graph is measuring stable.

I am with you however in seeing this graph as a positive. Regardless of whether or not the money is being saved or used to pay down debt, it is a good thing.

alstry said...


There is NOT enough money in
America to pay off debt....as a matter of fact America is running out of money trying to pay down debt.....

As people are forced to liquidate assets to pay off debt....expect asset values to implode...especially house values.

As house values implode, expect tax revenues to the state, especially California, to evaporate forcing MASSIVE JOB CUTS.

Here is a snipit from today's SacBee:

Deep cuts in state spending in the past two years will translate to the loss of more than 60,000 public-sector jobs by the middle of 2010, a UCLA economist estimated in a report released today

60,000 jobs lost BEFORE the upcoming cuts from the $24 Billion shortfall.......imagine the additional cuts in the pipeline!!!!

The ecnomist went on to say:

The 60,000-job loss - which Nickelsburg said would reflect reduced spending in the 2007-08, 2008-09 and 2009-10 fiscal year budgets -- would represent a sizeable portion of the 430,000-plus Californians whose jobs or wholly or partly funded by state government.

The California mess could get MUCH WORSE!!!!!

In the end, most of the country will be forced into bankruptcy but it will be a new beginning to get very optimistic about.

Scott Grannis said...

Matthew: Thanks for the comment, as I realize I really should have explained some of the big swings in velocity. M2 velocity surged in the early and mid-1990s as a result of FIRREA legislation which produced profound changes in the way the banking and S&L industries operated. S&Ls virtually disappeared, and their role was effectively taken over by the institutional bond market. This meant that the economy needed much less in the way of deposits in order to function; M2 thus grew much more slowly than nominal GDP.

M2 velocity then plunged in the early 2000s. I think this happened because of the strong deflationary forces that were set in motion by tight monetary policy from 1996 to 2000. As deflationary pressures increased, the demand for money rose. The economy wanted more M2 money because money was perceived as holding its value very well. It is not a coincidence that the dollar reached a peak in early 2002 as velocity was falling. In effect there was a shortage of money in the world given very strong demand for money.

The Fed finally responded to these pressures and relaxed monetary policy from 2003 through 2005. Velocity rose as money increased and the demand for money fell and the dollar fell; people wanted houses and commodities more than they wanted money or the dollar.

With the Fed now in the midst of a massively aggressive easing campaign, we could possibly see a big increase in velocity, should the demand for money again start to fall at the same time the Fed is willing to oversupply the system with money. This would yield a big increase in the growth rate of nominal GDP, with inflation comprising a bigger and bigger portion of that growth.

So in a sense policy volatility is the driving force behind the volatility of velocity. Unfortunately we will probably have more volatility in coming years.

Finally, let me add that the velocity of M1 has been less volatile, but not stable at all. It has increased steadily, from 5 to 9, since 1970. Huge growth in currency, most of it used outside the U.S., is one factor that has caused this.

alstry said...


Can you provide some basis for your statement:

With the Fed now in the midst of a massively aggressive easing campaign, we could possibly see a big increase in velocity, should the demand for money again start to fall at the same time the Fed is willing to oversupply the system with money.

Credit card companies are scaling credit way back....way way back.

Last night Vikram Pandit told us the world is going to have to get used to much lower credit.

Tonight MarketWatch reports:

WASHINGTON -- The Obama administration on Wednesday will propose the establishment of the Federal Reserve as a consolidated supervisor of large, systemically significant financial institutions that will require higher capital standards...

Higher Capital Standards????

Does any of this sound like massive easing to you????

Scott Grannis said...

The Fed is engaged in the biggest quantitative easing campaign in the history of the world, having almost doubled its balance sheet since September, and with the monetary base having grown 125% over the same period.

As I have explained in many prior posts, that massive easing has for the most part been necessary to offset the huge increase in money demand. That's why inflation has not yet picked up. I've also posted frequently on the subject "there is no shortage of money."

The things you mention are all symptomatic of a big increase in money demand. They are all a response to the panic of last year. They won't go on forever. The Fed is likely to end up oversupply money to the system at some point, and I think we're already there.

You make the mistake of extrapolating recent trends, and you miss the big changes on the margin that suggest those trends will not continue.

Unknown said...


I'd be curious how this looks over the past 2-3 years. Specifically, I'd be looking for a significant change around the beginning of the banking crisis last fall.

Consumers are obviously de-leveraging as well, which will probably slow the reversal of the decline in velocity. Once this slowing reverses, we'll be well on our way to GDP growth again.

von Mises said...


Look at some of the graphs posted by Scott(http://scottgrannis.blogspot.com/2009/06/households-balance-sheet-update.html) Our ratio of debt to wealth has not changed all that much in recent years.

I could quote economists who have extremely positive views on our economic futures, too. Quoting an article is not as impressive as quoting statistics.


I agree with a lot of your explanations wit the reasoning for M2 fluctuations but again, that does not make it stable. Thanks for all the time you put in.

Scott Grannis said...

Matthew: perhaps my choice of "stable" was not a good description. But I'm tempted to think that M2 velocity is mean-reverting over long periods. That would give it some measure of "stability," would it not? Surely as compared to the behavior of M1.

von Mises said...


We can test whether or not M2 is "mean reverting" and or stable. If you give me the data points (I am a statistical geneticist) I can run some analyses. Do you have data beyond 1959?

Also, full disclosure: I don't believe much, if any, parts of the financial system are normally distributed. Making most statistical analyses moot, but its fun to look at the numbers anyway.

Scott Grannis said...

Matthew: The question is whether the ratio of nominal GDP to M2 is mean-reverting. I don't have the data at hand that goes back before 1952. I'm not sure what it looks like. I'm not sure this is important anyway. But the fact that the ratio has not changed much on balance over many decades is a good reason to believe that there is some kind of stable relationship over time between M2 and GDP. Whereas the same cannot be said about other money supply measures. Bottom line: I think M2 is the best measure of money to pay attention to.

von Mises said...


I think we have taken this conversation as far as it can go. I have my questions about whether or not M2 is mean reverting-- it very well might be. I will leave you with a question, though. While M2 might be the best measure of money does that necessarily make it a GOOD measure.

Thanks again for your responses.

Scott Grannis said...

I think M2 is the best of the money supply measures to watch, but no measure is perfect. I've been reading the monetary tea leaves for 29 years and I can tell you that nothing is ever black or white. But knowing what M2 is doing can help in fleshing out a picture of the macro forces at work in the economy.