The Velocity of Money

by Larry Levin


I received an interesting question from a reader of my blog last Friday. Since it is probably on your minds as well, I thought I would write about the subject today: Velocity of money.

“Yesterday, I was trying to explain to my wife of the oncoming super inflation. I explained that the government can’t just create 100s of $billions out of thin air without creating inflation. She responded with; ‘Well didn’t the big investment banks just wipe out 100s of $billions out of thin air? And what about the $trillions wiped out of thin air in the stock market collapse?’ I didn’t know how to respond. Maybe you could help with the explanation.”

My short answer was - “Well, you’re actually BOTH correct. Your wife points out the main reason why there is absolutely no inflation now: the government’s printed money is just filling in the hole left by the banks. Moreover, since there isn’t any real demand for money now, there is no inflation either. Said another way, the VELOCITY of money has come to a stand still. Once the market works its way through this mess, however, if the FED doesn’t remove all of the pumped-money, it will cause inflation. Until then, we have debt deflation in the air.”

So what is the velocity of money anyway? It is the average frequency with which a dollar is spent in a specific period of time given a certain amount of money.

It’s best to describe this using a very small economy of just two people. Let’s say there are a one baker (we’ll call him Frank Schmoltz) and one shoemaker (we’ll call him Al Bundy) in our small economy. In the small economy of Frank and Al there is just a $100 money supply.

- During the year Frank the baker buys a pair of $50 boots from Al Bundy.

- Al Bundy then buys $70 worth of cakes and bread from Frank Schmoltz.

- Frank the baker then buys his daughter a new pair of shoes for $80.

- All of this occurs within the year.

In this simplistic example we have a $100 money supply generating $200 worth of activity because the money is being spent back and forth, making its velocity 2. The important point is that the greater the transactions, the greater the velocity, which increases GDP and could eventually lead to inflation. Moreover, the velocity must be driven by demand for goods, services and loans, which happens during economic expansion - not recessions.

If the Fed pumps trillions of dollars into the economy but there are no demands for loans, some money will be saved, while many loans go belly-up. If the government spends hundreds of billions of dollars on roads and health care but there is no demand in the general economy for goods and services, much/most of the government spending will be wasted. It will NOT stimulate the economy.

This Keynesian thesis (read: rubbish) has been proven bankrupt for many decades, but like a bad penny it keeps turning up. This so-called “stimulation” is actually just a nicer word for leverage. After all, 100% of the “stimulation” is via DEBT so we should start calling it what it is: leveraging a sub-prime economy. And isn’t leveraging a huge part of today’s problems on Wall Street? Yes. More of the same is insane and why I say - Keynesian economics is a pox on all societies.

Without the demand for money, goods, and services, the velocity of money will be low and therefore one shouldn’t worry about inflation. If by some miracle, however, there is a radical change in the public’s mood about job prospects and the future in general, there could be a bidding war over this new money that has been pumped into the system thereby causing inflation.
Given the massive losses in the stock market, housing values, and banking system, just printing money won’t solve the problem. These losses have changed the psyche of Americans and thrift is now “in.” Printing money out of thin air can’t solve the velocity problem. Said another way, money itself is not the problem - demand for goods and services are down as Americans grapple with colossal amounts of debt.

Hopefully many of you now are wondering - What is money anyway if it can just be printed out of thin-are? Sure there are many explanations, but it all boils down to one answer.

Let’s start by describing what is not money. Money is not; pieces of paper with green ink on it, gold and silver, IOUs, government debt, etc. Money is and always has been SAVINGS!

In the example above, Al Bundy and Frank Schmoltz could have bartered IF what they were exchanging were of exactly the same worth. Over time, however, this is impossible. For example, what if Al Bundy the shoemaker wanted to buy just a few pastries from Frank the baker? First, Al Bundy needs to pay with something, which are the extra shoes he has made that he can’t currently use. And since Frank would have made more pastries and bread than he can eat, he will have extra to sell. Both of these men have SAVINGS with which they can transact.

So how can Al Bundy the shoemaker buy just a few pastries? Can Al pay with ?-shoe? No, he can’t. And this is the dilemma our ancestors faced millennia ago, so a medium of exchange was devised to fill in the gap: money. Of course, the money was originally 100% backed by savings - then the banker was born and the fit hit the shan.

Whatever form money does take, whether it is indeed just pieces of paper with green ink on it or gold, money is in fact SAVINGS.

So how could our current economy have gone on for so long without little to any savings? In a word: debt. There is no credit crisis folks; it is a DEBT crisis! And until the debt is paid down, the debt deflationary spiral will live on and there is nothing the government can do to stop it. What it can do, however, is make it much worse and longer - just like FDR did in the 30’s.

Eventually the velocity of money will improve and when it does, so will the economy.

Previous Day's Trading Room Results:

Trade Date: 1/16/09

E-Mini S&P Trades*
(before fees and commissions):

1) Engf sell @ 9:00am at 853.00 = +2.00 (1 lot)

2) VA buy @ 1:10pm at 840.50 = -2.00 (1 lot)

3) Algorithm positions (4)...combined SofT and Algo total...+0.50

ZB (30 Year Bond) Trades*
(before fees and commissions):


1) No trades today.



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