Expert Commentary

Deflation Makes Money (Not) Go Around (a mark, a yen, a buck or a pound…)

The velocity of money is slowing. What is that and what does it mean?

Money makes the world go around, as the famous cabaret song goes. But when money stops going around it can be a sign of a weak economy. U.S. M2 Money Stock is now expanding at its highest annual rate in at least the last 40 years and that causes many people to scream "INFLATION!" at the top of their voices. But whilst it's true that increasing money supply is inflation, the nuanced components of M2 are worth considering. Much of the increase in M2 since the start of March has been caused by a surge in retail money market funds. When you think about it, that's a sign of a defensive mindset and, therefore, could actually be thought of as Deflationary. An increase in M2 money could, ironically, reflect cash hoarding.

The most important aspect to money supply numbers is whether the money is actually being used. It's all very well having a big stash of money but if it's not being used, then it's as much use as a chocolate teapot. When I lived and worked in Abu Dhabi, I learned about this great story of the ruler when oil started being extracted back in the 1960s. When the money started rolling in, he had it stacked up in his residence in physical piles upon piles of U.S. dollar bills. Hundreds of millions of dollars! Frustration over this caused his brother to replace him in a bloodless coup, and his brother, Sheikh Zayed, went on to distribute the oil revenue, making Abu Dhabi what it is today and earning him the highest respect from his people.

In the U.S., M2 Velocity is an indicator that is used to determine whether money is being circulated. As the chart shows, it has been declining since the late-1990s and is now accelerating lower. In this respect, it's worth looking at how M2 Velocity is calculated. It's actually a very simple equation, being the ratio of nominal Gross Domestic Product to M2 Money Stock. In general, the economy's output divided by how much money there is. So, the fact that it has been declining since the late 1990s reflects a situation whereby U.S. national output has been declining relative to the amount of money in the economy. That's a reflection of a weak underlying economy which is consistent with the fact that the Dow Jones Industrial Average topped out in terms of Gold back in 1999 and is still almost 70% below that peak.

With GDP now tanking and M2 Money Stock soaring, the technical downward pressure on M2 Velocity will continue. And that's even before we talk about the evaporation of confidence and its effect on money velocity. That's coming soon, so stay tuned!

200501 - MGD