The Indexer has, on more than one occasion, asked why the federal government’s massive infusion of liquidity–$3 trillion, a 19 percent increase in the M-2 money supply—has not juiced the economy more. Yes, retail sales are up, but not by $3 trillion.
The answer involves cautious consumers. And there is a measure of that caution that was recently updated for the second quarter: the “velocity of money.” This refers to the rate at which a dollar circulates within the economy during a given time period. Does a dollar travel from your paycheck to a tip jar, to a grocery store, to a daycare, and so on? Or does it plunk into a bank or investment account and not budge?
The indispensable website Fred, managed by the Federal Reserve Bank of St. Louis, calculates the velocity of money simply as the ratio of nominal GDP (on an annualized basis) to the money supply. Since GDP is a measure of transactions, the more transactions, the faster the money is flying around and the higher the numerator in the ratio. Figure 1 shows the velocity of money for the past five years. The M-1 money supply consists of cash and checking accounts, so it tends to circulate much faster with day-to-day transactions. M-2 includes everything in M-1 plus savings accounts, the money in which tends to circulate much less.
The velocity of money has been on a slow decline for years, but plunged dramatically this year. The combination of a smaller numerator (pandemic-induced decline in GDP) and a much larger denominator (huge federal injection into the money supply) gives us the sharp drop in the velocity of money.
So what is happening? The short answer is that households are saving money and paying down debt. The savings rate stood at 19 percent in June and outstanding credit card balances are down 12 percent since March—not exactly what one expects during a recession.
The slow velocity of money raises some interesting questions:
- Will new “money for everyone” payments make any difference, or will it just get socked away like much of the last batch?
- Should more effort go into increasing consumer confidence, on both the financial and health levels, so that people feel good about spending?
- Should we be working harder to find clever ways to open and retool businesses that are still shuttered to give people more places to spend?
- Should we be looking at old fashioned Keynesian fiscal strategies: government as the consumer of last resort?
As the Indexer has pointed out repeatedly, there is lots of money out there—household incomes are higher than ever, even with high unemployment. 90 percent of the workforce is employed. Getting the rest of the workforce employed means speeding up money by giving consumers who are otherwise financially secure reasons to spend the dollars they are sitting on.
[…] we have noted before, the velocity of money—the rate at which money circulates in the economy—has plunged, so all that cash is heading to […]