Content provided by Scott Kubie, CLS Chief Investment Strategist

With all the effort central banks have made to revive economic growth, why hasn’t it increased? While not the culprit, the velocity of money is the statistic that shows why the efforts aren’t being met with proportionate success. According to Investopedia, the velocity of money measures is, “the rate at which money is exchanged from one transaction to another, and how much of the currency is used in a given period of time.” As can be seen in the graph below, the speed of money exchange has been on a steady downturn and continues to grind lower.

This concept was a struggle for me in my first economics course. Money is money right? Well, no. The faster it moves, the more there is. So, high velocity is spending and low velocity is investing and saving? Again, no. It may be easier to think of the opposite of the velocity of money, the holding period of cash.

The chart below shows the decline in velocity, but it also shows the ratios by which it is measured. If the velocity of money is 2.0, then the holding period of cash is 6 months, since a 2.0 ratio means money moves twice a year. That holding period only ends when the cash is exchanged for something. It doesn’t change when given or invested, but only when the entity who receives the cash puts it to use.

Velocity

In part, the decline in the velocity of money reflects fear about the future and the desire to hold cash as a buffer against uncertainty. If the economy starts getting better, then people are likely to be less fearful, and velocity will increase. One important concept is that fear is expressed in two ways: a desire not to spend money and a desire to hold cash rather than invest. The desire not to spend or invest can be held by individuals and institutions. To make this easier to understand, I thought a few examples might help.

Things that slow the velocity of money

  • Someone keeping a lot of cash on hand for an emergency
  • Someone putting a lot of cash in a bank and the bank not loaning the money
  • Corporations making a profit or borrowing money, but keeping a large cash balance for emergencies

Things that increase the velocity of money:

  • Taking the cash hoard and putting it in the bank
  • Banks starting to loan money
  • Corporations remodeling a plant to increase production

While central banks have done a great job of increasing the supply of money, governments in general haven’t done particularly well at reducing the fear and uncertainty. But time and somewhat better policies are starting to take hold. If the economy starts moving people will become more confident and the cycle has the potential to become self-reinforcing.

The next question is whether the central banks will be able to keep up should a cycle of self-reinforcing growth take off?

 

1189-CLS-6/10/2014