Terminal Velocity 2013

Written by , KeySignals.com

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Having done science at school, we have always had problems with what an economist calls the Velocity of Money. By their definition, it’s the GDP divided by the Money Supply. As far as we can see, when you do the division there are no units left, so it’s an index number that relates two quantities of money. As a scientist, it can’t be a velocity to us; unless this quantity is related to time. So if you plot it each year, then it’s the gradient of the slope that is the actual velocity. But even then it’s only an Index Number per Year in unit terms; and has no real Monetary Value per Year basis. The measurement seems a bit pointless.

So what’s the point of all this?

Velocity of Money has two drivers (1) the GDP numerator and (2) the Money Supply denominator.

Changes in velocity therefore depend upon (1) and (2) above. Since 1980, the Velocity of Money has been decelerating (slowing).

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Looking at the GDP numerator, we can see that growth began in the US around 1950,then got boosted in 1970; and has been growing ever since, with the short blip attributable to the Credit Crunch. One can therefore say that the Velocity of Money has been accelerated by the economic growth of the US Economy.

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Looking at the Money Supply denominator, we can see that the Money Supply (in our case M2) has been growing over the same period.

The fact that the Velocity of Money has been declining since 1980, even as the GDP numerator grows, suggests that the Money Supply was growing the faster of the two over this period. This conclusion is counter-intuitive since it shows that, even though more credit was being created and economic activity was occurring, the Velocity of Money was falling. Some Monetarists are at a loss to explain why there has been no hyperinflation; and others will tell you it is because the Velocity of Money has been falling. We think Monetarists don’t know what they mean by Velocity of Money. If they understood what they were implying when they talk about the Velocity of Money, they should actually divide Money Supply by GDP. This would then at least correlate inflation with movements in the Money Supply, which is their Holy Grail; but also what they have failed to prove conclusively. If anyone has ever heard or read an economist (not even a Monetarist) explicitly say that it is the gradient of the Velocity of Money graph that counts, please let us know. We suspect that most of them just look at the direction of the line and assume that this is the Velocity.

All that is really being said is that the excess of money was being used for other purposes from 1980 onwards. So what are these other purposes? Clearly they are capital market transactions. The fall in Velocity of Money corresponds with the growth of debt and equity markets since 1980. When the size of these capital markets is in excess of the ability of real economic activity to pay dividends, coupon and bond maturities after taxes have been paid, the size of these capital markets must shrink. It is the growth in capital markets that has stopped the Money Supply from creating inflation. This implies that to avoid inflation, central bankers must save capital markets; but more of this later.

The most interesting observation to be made, is the steep decline in the Velocity of Money during the last recession and then during the period of QE after this recession. This is clearly a point where the GDP numerator is increasing slowly and the Money Supply denominator is increasing much faster. Monetarists will look at this and say that the falling Velocity of Money is signalling a depression; in fact they will then look back to the previous trough during the Great Depression and say that this is what is portended. At the same time however, Monetarists will also tell you that all this money is hyperinflationary. Once again, they don’t know what they mean and can’t give a straight answer. As President Truman opined, economists are two-handed; on the one hand they say this and on the other hand they say that.

Ben Bernanke is very much a one-handed economist. He is now in the process of creating the credit in the banking system in order to pay the dividends, interest and redemptions net after tax in the capital markets. Even though he says that he is targeting growth, it can be seen that the real economy is far less in size than the capital markets and doesn’t need all his QE. It is the debt pyramid that has been created since 1980, that needs all this credit. He is not however printing money as his critics opine. He is holding down the term structure of interest rates, so that all the debt can be carried at a low rate of interest through refinancing. The new low rate of interest will thus be closer to the rate of normal GDP growth of the real economy; so that debts will be able to be paid out of the proceeds of economic activity. His real intended purpose is to keep the size of the capital markets higher than the real economy. Since the real economy is growing slowly, he must therefore put in the credit to sustain the capital markets.

A liberal would ask why Bernanke wishes to preserve the size of the capital markets above the size of the real economy. He has no choice; since this is what he inherited. Looking at Exter’s Pyramid, if he allowed the capital markets to shrink in size, then all the layers above Gold would vanish and we would be back to primitive times. There would be no credit, no growth, no assets, no savings and we would all be fighting each other to accumulate Gold. Worse still, once holders of paper assets saw that the Fed had abandoned them, they would take their money out and drive up the price of real assets in a period hyperinflation. The Fed and QE are a necessity to avoid both depression and hyperinflation in a modern civilization. Exter’s Pyramid is built to create economic growth without hyperinflation; its functioning is its own Dual Mandate.

He wasn’t always one-handed though. The little acceleration in Velocity of Money after 9/11 suggests that the US Economy might actually have been growing at a genuine above trend clip. Bernanke however read this as inflation and started tightening. It was this tightening, which pushed interest rates to levels that real economic growth could not generate the profits to pay the interest on; and so killed the Banksters. Instead of lending against sub-optimal return businesses, they started to lend against property speculation that led to a massive oversupply of commercial and residential real estate, beyond what was needed for an economy that only grows organically at 2% to 3% at best. Bernanke and the Banksters have since learned that real bankers can only lend against American businesses that grow in the 2% to 3% range (unless you take real risk and find the next Microsoft or Apple) in America (hardly the kind of lending that creates the big bonuses), so they have raced around the world to emerging markets looking for better returns. American banking now needs a business (and compensation) model which reflects the low pace of American GDP growth. Lending against the riskier assets now requires more capital; and also now means that the Banksters or at least their shareholders must take the full loss.

Looked at very simply, once everyone in America has refinanced and borrowed in single digits of say 2% to 3%, which is where the US economy really grows at, then the financial system will be stable again. Deleverage, is simply a new name for refinancing at a lower rate of interest. At the new lower rate of interest, the Money Supply denominator will then start to grow at a slower rate than the growth in the GDP numerator. By targeting higher inflation, the higher GDP numerator is guaranteed. At this point, the Velocity of Money will appear to be accelerating again, as it did after WWII (and 9/11). The Fed is simply engineering interest rates that are lower than inflation and GDP growth rates. The key is however that the inflation and growth rates are low and falling during this period, as we see today. As inflation and growth rates keep falling, so the Fed can do more bond buying to lower interest rates. The last thing that the Fed wants now is economic growth during this period, although Bernanke would never admit this. Growth can’t be tolerated, until the whole of the USA has refinanced all of its debt at between 2% and 3%, or lower if possible. Those who predict a collapse in economic activity should understand that the real economy is moving under its own steam; and that the Fed is giving it the opportunity to accelerate, by making the burden of debts on consumers and companies lower. Those who predict hyperinflation, should understand that the money is being locked up at low rates of interest for long periods of time via refinancing and other layers in the Pyramid. Hyperinflation only occurs when the money is compounding rapidly in short-term debt instruments, or in systems where there are no layers in the Pyramid.

As a guide, this is what Japan has done. It can now go for growth and take apparently crazy economic and commercial risks, because it has rolled over all its long-term debts at interest rates below 0% and 1%. Japan also has a massive currency reserve, so there is no limit to what it can do to the Yen. America however is not quite there yet, and the bad news is that it took Japan twenty years to get back to lift-off mode. In getting there, America must tolerate having a stronger currency and consuming fewer imports; just as Japan did. It will not take America as long to refinance, since the Fed has embraced the process aggressively; and bond investors have been fool enough to participate in the great refinancing, so that the Fed has not had to do all the work. Because the Dollar is the Global Reserve Currency, the Fed has been able to accelerate this refinancing process and not scare away the bond investors.

And then there is Good Old Blighty; which may perhaps be a better model for the Fed than Japan. Britain created Five Pounds of Debt for every One Pound of GDP. Gordon Brown sold nearly all of its Gold. Exter’s Pyramid for Britain has a tiny Golden Base and many Wide Layers that are crushing it. It is therefore in dire straits compared to America. It tried QE and it nationalised the banks, so the Pyramid is still standing but it’s very unstable. Britain has therefore started tinkering with the inflation picture, so that incomes and profits (The GDP numerator) appear to grow faster than liabilities (The Layers of the Pyramid). It will also start to target the GDP numerator through Nominal GDP Targeting; which in practice means that the Bank of England will expand the Money Supply denominator because GDP is deemed to be below potential. The Velocity of Money in the UK will thus fall like a stone; and the Monetarists will call for the creation of more money, whilst remaining ignorant of the fact that it is this money creation that is reducing the Velocity of Money. The Bank of England will be happy to comply and will print even more. Britain however has neither Gold nor a reserve surplus like Japan, to make good on the cheques that Mark Carney is going to be writing. Neither is it linked to the constrained monetary orthodoxy of the ECB. If one is looking for a hyperinflation candidate in the Developed Markets, the UK is it. Britain is betting that once it moves first, that everyone else will follow. Given that Britain has an open economy and there will be more liquidity in the global economy, if all follow suit, Britain can then leverage off everyone else having first encouraged them to provide the leverage. It’s a massive wager, which will require the skilful manipulation of domestic and international public opinion to carry off. Hats off to David Cameron though; he has started his road show in Brussels and North Africa pretty well so far and observers are falling for it.

And then there is Germany. It created less Debt for every Euro of GDP and is on track to reach a balanced budget in 2014. It has recently taken back most of its Gold into custody. Germany therefore has a robust Pyramid, with a wide Gold Base and fewer stronger Layers. Its surplus in Euros is immense, because of safe haven flows within the Eurozone. Germany can therefore match Japan and America if it needs to play the devaluation game, if the Eurozone breaks up and its own currency becomes too strong.

And then there is the Eurozone ex-Germany. It has substantial Gold reserves, but no surplus. In fact it has a deficit with Germany. If Germany were to realize its surplus, it would presumably go after the Gold. The Eurozone has numerous Layers of the Pyramid which are weak. The ECB therefore is playing a game similar to the Fed to maintain the Pyramid structure. The EU politicians hold the knife of the unrealised surplus at Germany’s throat, so that Germany thinks twice about going it alone. Germany would ask for Gold to settle its surplus, but the EU would give it Euros. If Germany has exited the Eurozone, the value of this Euro surplus would presumably shrink. Germany knows it can’t leave, so it must try and get as much control politically and financially to safeguard this unsettled surplus.

All the Developed Market central banks must maintain their Pyramids. It makes more sense for them to coordinate the maintenance plan, to avoid one maintenance job eroding someone else’s. If they get this right then money flows out of Gold into the higher layers of the Pyramid. The one thing keeping this from happening, right now, is the markets fear of Trade and Currency Wars, as they see the picture of beggar thy neighbour devaluations. It looks like they will have to see the Euro stop rallying versus the Dollar, before they become secure and think about selling Gold. Signs of coordination across Developed Market central banks, even if only remaining quiet whilst Japan cracks on with its QE process, would however be enough for us to start turning against Gold.

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