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Why Low Velocity Is Our Fundamental Economic Problem

09 Jul 2010
Posted by Bruce Bartlett

In my Fiscal Times column today I try to explain why our economic problem results primarily from a decline in velocity (the ratio of GDP to the money supply), which impacts on the economy exactly the same way as a decline in the money supply. The following table illustrates my point.


Monetary Velocity and GDP
( billions of dollars )
Year/QuarterGDPM2VelocityLost GDP*
2006 III13,4536,9281.94
2006 IV13,6117,0721.92
2007 I13,7967,1601.93
2007 II13,9977,2711.92
2007 III14,1807,4031.91108
2007 IV14,3387,5011.91139
2008 I14,3747,6841.87456
2008 II14,4987,7451.87450
2008 III14,5477,8921.84684
2008 IV14,3478,2401.741,556
2009 I14,1788,3901.692,015
2009 II14,1518,4421.682,142
2009 III14,2428,4551.682,076
2009 IV14,4548,5441.692,036
2010 I14,6018,5121.711,827
*If velocity were 1.93; 
quarterly figures at annual rates
 Source: Commerce Department, Federal Reserve and author’s calculations


Can you extend that chart

Can you extend that chart back further in time? How does our current situation relate to pre-bubble conditions? I mean, you don't really expect that we're going to start spending again like we were at the peak of the credit bubble?

Low velocity is not our fundamental economic problem

Our fundamental economic problem is that we have had an uncompetitive economy for a long time primarily due to globalization and arbitrage of skilled and unskilled labor. The only way to solve this problem of uncompetitiveness is to let wages fall to international levels. Falling wages is hard for politicians and voters to stomach because it leads to falling standards of living and falling asset prices. To avoid that, the politicians and central bankers made it easy to borrow money so that standards of living could be maintained. The markets helped because there was no demand for money for real economic activity. Because of the flood of borrowed money, at first the asset prices kept climbing giving an illussion of free lunch but once the available cash flow could not support the amount of money borrowed, the assets had to be sold to keep making payments on the debt. This led to price discovery and the asset prices started coming down. Meanwhile all the businesses that had thrived on this flood of borrowed money started collapsing. Addressing money supply or velocity etc. misses the real problem. Fed interest rate cuts and asset purchases just pushes the day of reckoning by promoting more borrowing. The real solution is to let the ponzi economy based on borrowed money collapse and then to let the real economy heal with deflation and falling wages.


Excellent column.

Largely agree with your analysis, but just one tiny quibble: low velocity is just an accounting identity (MV=PQ). It's like Irving Fisher saying GD1 happened because real interest rates were negative. Anyway, the causal factor for low v is lack of aggregate demand, so ... lack of aggregate demand is our fundamental economic problem.

It seems like a lot of years' past AD was predicated on borrowing. So, I'm not sure how we increase AD now that borrowing has reached an inflection point. Maybe East Asia can help.


Agreed, but what explains the

Agreed, but what explains the persistence of low velocity? It's like saying that the problem with floods is too much water.

You need to add a column

You need to add a column indicating the tax revenues that weren't collected because of the decline of money velocity.

In other words, the plane

In other words, the plane barely wants to fly! I believe that aggregate demand continues to exist, albeit in largely unrecognizable form, as what people actually need in the present was never presented as effectively as production based goods. Until recent history, much of what people needed on a daily basis was actually provided by people who were not getting paid (family) or ownership (slaves). Service-based economies (excluding finance) that are efficient for everyone today include restaurants. Not so efficient service markets include healthcare. People occasionally buy actual products. But people every day of their lives depend upon services, and this is the focus of the future if economies are to be healthy again. Services are what people need, and they have to become part of a new equation, for they cannot be provided in the same manner as production based goods. The solution? Voluntary structuring for the services that people need, so that people will not be forced into servitude for such services again.

Great column

Great summary of the situation.
Under current conditions, increasing the money supply decreases velocity more than it increases GDP. There is plenty of unmet demand for goods and services. Unfortunately, those with the most unmet demand have suffered the greatest percentage loss of wealth and income. The monetary policy channels for transferring money to this population is clogged because they have too little savings, too little income and too few jobs so they are not a good credit risk.

Because the channels that were open before the crash are now dysfunctional, new channels must be created that bypass the blocked channels. The key is transfer payments either directly by BigG providing payments for workforce training, health care and other investments in workforce and infrastructure. There is plenty that needs to be done, but we lack the political will to do what needs to be done.

Thanks for the link. So, in

Thanks for the link. So, in fact, the current velocity is relatively normal, and the bubble was an aberration. Which would seem to contradict your headline.

Historical Data- 4 years????

This would be an interesting topic to examine from a long term historical perspective, but only going back 4 years to the height of the speculative bubble in housing and credit and assuming that is a reasonable historical norm is not realistic. It would be much more helpful to go back a few decades and see what a real historically "average" level should be. I would guess that we still have a ways to go in deleveraging the economy , which would mean that the velocity of money has further to fall.

More Analysis

I wrote this column hopes that people who are smarter than me will do some analysis of the velocity issue and hopefully come up with some ideas about what to do.

What to do about it?

Drop in velocity and weak private sector demand has created an output gap between current GDP and potential GDP. The sooner the output gap is closed, the less costly it will be to the long term economy. The focus must be on economic growth and closing the gap. This is where economic policy disputes are taking us into the weeds. However, it is not in the interest of business to expand under the current situation. Businesses closely monitor demand for their goods and services and while they have plenty of money on the sidelines, they are not jumping in (just in time practices reduce business inventory costs) until the demand is there.

The ONLY player that can take up the slack is the BigG. BigG needs to close the output gap by increasing demand. How the BigG should increase demand is a big political fight. It means winning a major battle against forces that have spent the last half century trying to roll back BigG spending on domestic programs. There are a lot of ways to increase BigG spending, but leadership and vision is required. Obama has provided to timid leadership and does not seem to have a good grasp of the economics. Many of the Obama opponents want to dismantle all government and inflict as much pain on the economy and American people as possible in an effort to purge the system. This is not a good idea and has never worked.

During the Great Depression, FDR increased and decreased BigG. It is clear that increasing BigG stimulated the economy and withdrawing BigG (1937) depressed the economy. It wasn't until the US entered WWII that the BigG demand was large enough to finally close the output gap. Post WWII, the US faced the problem of GIs returning to the old labor market with not enough jobs. The BigG created the GI Bill which was far more money per decade than all the other New Deal spending combined. The GI bill stimulated housing construction and invested massively in workforce training in a way that expanded our University system. The GI Bill guaranteed over 53,000 business loans. The money invested in workforce training increased the productivity of the workforce and created new sectors of the economy that did not previously exist. However, the GI Bill was only passed after massive political pressure by the American Legion bolstered the political will to act. That type of political support will not be found in our current situation.

The Federal Government needs to do what the states are doing and identify areas of economic growth and provide the appropriate climate for those businesses to establish in the US (states entice them into the state). We are competing on a global scale with other countries who have government that are providing aid and incentives to businesses that they don't get in the US. Whatever we do has to be sufficiently large. With unemployment at 10 percent, it will take several years of BigG jobs before private sector jobs can close the unemployment gap.

We know that BigG spending would work. We lack the political will to do that. Obama is too timid and his do nothing opponents, too numerous. That leaves Option B with a decade of high unemployment, slow economic growth, and a persistent output gap while Congress tilts at half-measures and tries to deny blame. There is no easy solution.

The Communists never worried about the velocity of money

Remember the great advantages of communism touted during every recession prior to the collapse of the Soviet Union and its empire? There was always full employment in the Warsaw Bloc. No slack resources. They didn't have recessions. They didn't have to worry about monetary policy and the velocity of M2. Was that a good thing?

All that the absence of recessions in the Warsaw Bloc proved was that there was no independent economic power to counter the Communist Party and assert that mistakes were being made. Was that a good thing?

Recessions and depressions are a signal that huge set of simultaneous mistakes are being made by market participants, and that the direction of activities must change. Even in growing economies, firms go bankrupt and make mistakes, and we accept that's OK. Recessions are just a highly correlated series of mistakes that market forces require a reallocation of resources in response. Isn't that a good thing?

From 2001 to 2007 the G-7 economies were headed in the wrong direction. Whatever was happening was unsustainable. Did excessive Chinese savings cause this? Did Greenspan's loose monetary policy cause this? Was it all the fault of greedy mortgage brokers peddling Alt-A mortgages? Was Goldman Sachs the culprit? How about the public school teachers' unions raising a generation of academically deficient students at higher costs per pupil than ever before? Who knows?

All I know is that the Keynesians and the stimulus advocates and money velocity analysts focus on aggregate spending as if general equilibrium theory and microeconomics are irrelevant. Does it makes sense to enact stimulus policies that are trying to stimulate the very same sectors of the economy that cratered?

It's as if the government can defy the market's signals and say, "We don't care what markets are saying. They're wrong, and we'll do what we've always done. Let's boost housing starts and make mortgages more affordable."

It's like saying that fevers are bad so let's put the sick into a cold bath or put ice on the thermometer to bring the temperature down.

I think Krugman, stimulus advocates, and Keynesians in general need more humility and less hubris. They're shooting in the dark at targets they can't see, and the debt grows bigger.

Here is a chart of money

Here is a chart of money velocity dating back to 1900.

What is unusual about velocity is not the present. It is the extremely high velocity of money from the early 1990's to 2007 - peaking in 1997 just before the Asian crisis. We are currently at the exact average money velocity (1.67 average from 1900-2007)

Good comments

Like the Depression generation, this "Great Recession" has reshaped spending behaviors. The younger generations fully expect to have a lower standard of living, limited pensions, no social security, high health care costs, etc., etc. Every penny screams as it comes out of their tight pockets.

From the Pew survey you mention in an earlier post: "The survey also finds that the recession has led to a new frugality in Americans' spending and borrowing habits; a diminished set of expectations about their retirements and their children's future; and a concern that it will take several years, at a minimum, for their family finances and house values to recover."

Low Velocity Could Be Offset

Yes, velocity is low. Yes, if velocity were higher, then GDP would be higher. That does not mean that low velocity per se is the problem. There are three important quantities, and two important linkages. The quantities are:
Monetary Base
Money Supply
Real Gross Domestic Product.

The linkage between the monetary base and the money supply is the most unusual. A huge jump in the base resulted in only a moderate increase in the money supply; and in the past six months, there has been virtually no further increase in the money supply. (see my blog post about the Fed's quantitative tightening,

The linkage between Money Supply and real GDP, called velocity, is also lower than we would have expected.

The solution is not to worry about velocity per se, but simply to goose the money supply. Over the past 12 months, money has increased about in pace with inflation, leaving no room for real GDP to grow. Money supply has to rise at least by five percent annually; and with the current slack in the economy, something more like eight to ten percent for a year or two would be good.

Would this be inflationary? Only if carried on too long. But no major economist I'm aware of is forecasting enough GDP growth in 2010 and 2011 to bring us any close to potential GDP. So goose the money supply today, and then be ready to dial back if (1) real GDP accelerates rapidly, or (2) either of the key monetary linkages rebound.


I earned an A+ in b-school analyzing velocity in money & banking, but the problem with this now is ... ALL stats are b.s. Where in God's name can you get the truth in data? The Fed! Sure...

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Help me out, please

Bruce, I am not an economist but I do work with numbers. Either I am missing something basic in your column, or something is not quite right.

The table indicates that velocity = GDP/M2. If so, then a decrease in money supply (M2) should lead to an increase in velocity. Or, a decrease in velocity is comparable to an increase in money supply. That is with GDP held constant, which it is not. But if GDP is also a variable then this is an equation with three variables. On it's own, such an equation provides little insight.

What am I missing?

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