Flourishing and the Velocity of Money

Hae-Joo led me to a stylish cafe platform. He bought a styro of starbuck for himself and an aqua for me. He explained that under Enrichment Laws, consumers have to spend a fixed quota of dollars every month, depending on their strata. Hoarding is an anti-corruption crime.

-David Mitchell¹⁾David Mitchell, “An Orison of Sonmi – 451,” in Cloud Atlas (New York: Random House, 2004).

Let’s face it. Flourishing takes money. By its nature, Flourishing requires being out there and active, both succeeding and taking pleasure in work, as well as participating in activities such as travel, music, sports (diving in the Maldives is expensive) and socializing with friends and family (I am in the camp that says in a civilized society pretty much everyone should be able to enjoy a pint with their mates at the pub).

And, of course, working means receiving money and Flourishing; if you are involuntarily unemployed, it is not easy. So in the Flourishing world, money is pretty important – perhaps not as important as in a world where money equals status, but important nonetheless.

There is no economic activity without someone deciding to spend. And having lived in Lagos, Hong Kong, and London, I have consistently seen – indeed felt – the energy of highly concentrated commercial centres. Money just seems to circulate. There is what I will call a rapid economic metabolism.

And this high economic metabolism isn’t restricted to high population centres. Anyone visiting Fort McMurray, Alberta (the centre of the oil sands industry), will have the same sense of economic vitality and, unsurprisingly when you think about it, Fort McMurray is Canada’s wealthiest place per capita.²⁾Daniel Tencer, “The Richest Cities and Towns in Canada,”  The Huffington Post, June 27, 2012. Accessed on December 13, 2013. Huffington Post on Canada’s Wealthiest Cities. None of this is meant to imply Nevinomics endorses oil sands exploitation; that is a topic for another day.

In other places, you can see that the economic metabolism is much lower. Whether we are in the US, Cambodia, or South Africa, we all sense immediately a small population centre that has seen its best days. Young people with no reason to stay leave, and economic strength goes elsewhere.

Of course, one person’s spending is another person’s income. So where there is high economic metabolism, money must be moving quickly from hand to hand. Economists have a word for this – the velocity of money: The rate at which money is exchanged from one transaction to another, and how much a unit of currency is used in a given period of time.³⁾From “Investopedia,” accessed December 13, 2013. Velocity of Money Definition While Velocity of Money is a concept I learned in graduate school, it does not really seem to play much of a role in contemporary economic discussions. But if we think about it for the moment, it should: economic metabolism is high only if the velocity of money is high. The GFC has brought this concept a little more into the light. Figure 1 shows a 60-year history of the Velocity of Money in the US. The gray shading indicates recession.

Figure 1: Velocity of M2 Money Stock (M2V)⁴⁾Butter, Andre. “The New Dumb Economic Idea: Velocity of Money Was Driven by Securitization.” (2010). – Shaded Area Indicates US Recessions

So what does this graph tell us? Well, the Velocity of Money was pretty stable from 1959 to 1989, with a slight upward trend. But starting in 1990, it has experienced two massive boom and busts in the 2001 internet bubble and popping and the 2002-2007 housing bubble and GFC.

What does it mean when the velocity of money declines? Basically, hoarding – the crime David Mitchell alludes to in the quotation opening this article. I hold onto my money because, rather than spending it today, I want the option to spend it in the future.

And this has not gone unnoticed. Mark Carney – now Governor of the Bank of England and (always) fellow Canadian – commented on the hoarding behaviour when he was Governor of the Bank of Canada, chastising Canadian business leaders for sitting on piles of “dead money,” doing the economy no good. If companies can’t think of what to do with that cash, they should “give it back to shareholders and they’ll figure out what to do with it.”⁵⁾McKenna, Barrie. “‘Dead Money’ a Missed Opportunity for Cash-Hoarding Companies.” The Global and Mail. Accessed on January 3, 2014. McKenna: Dead Money.

If we all decided to spend 10% more in the current month than the previous month, like some type of alchemy, our economy would be much bigger (of course, not quite so simple, because if everyone in Canada decided to spend 10% more, our trade with other nations would cause the increased economic activity to spill over to other economies).

Similarly, if we all decided to spend 10% less, we would see economic activity decrease. And the GFC has popularized the term for this – we call it depressed aggregate demand.

So what causes changes in the Velocity of Money? Without doing a scientific study, it seems pretty obvious that in times of high economic uncertainty, velocity decreases. If one is not sure he can put his hands on money in the future, then he is a lot less likely to spend today. Hoarding follows fear. And Figure 1 shows this – the velocity drops during a recession: that is, when one is fearful about the future.

And when the future is certain (or at least I believe it is certain), spending can precede earning, at least in places with advanced (for better or worse) consumer credit systems such as the US, UK, and Australia. And in every society, there are complex forms of debt to dissociate the time you earn from the time you consume (as well as to establish hierarchical relations – but let’s leave that aside for the moment⁶⁾See David Graeber. Debt: The First 5000 Years (New York: Melville House Publishing, 2011).). But if I am pretty certain I can get a reasonably well-paying job, then I am OK to take on some debt for consumption now. And if I know my retirement is secure, when I am 50 or 55 I am prepared to take that cruise I’d always dreamed of to Alaska or Nordkapp.

Indeed, in 2001, after 9/11, George W Bush urged Americans to go shopping. At the time, I thought it was an inappropriate response to an incredible tragedy. But in retrospect, it may have been GWB’s greatest contribution to economic thinking. Fear causes people to stop spending. And if people stop spending, the economy collapses.

So how do we retain the high rate of economic metabolism that is necessary for Flourishing? China has done it for 30 years, with spectacular results. But they have relied on other people buying things, particularly Americans. In exchange, Americans have given the Chinese pieces of paper, which the Chinese have been content to accept and hold. We call these pieces of pieces of paper USD. Figure 2 shows this very clearly. For virtually the entire decade of the 00s, the percentage of Chinese GDP made up of consumer spending declined, bottoming out at 34% according to these numbers in 2009 (in contrast to c.70% in the US).

Figure 2. Consumer Spending as a Percentage of the Economy in China⁷⁾World Bank. Household final consumption expenditure, etc. (% of GDP).

The reason for this is pretty clear – in an economy with no safety net and a high degree of uncertainty, it makes perfect sense to delay consumption to create greater certainty in the future. And this strategy has at one level been been enormously successful. By staying busy making things for others, China has maintained a remarkable economic metabolism for over 3 decades. However, as successful as this strategy has been, there are at least 2 major problems.

First, China’s solution is not universalizable, as not every country can be a net exporter (since net exports sum to zero, of course). Germany chides its PIIGS neighbours for having current account deficits and points to its own economic export power. But of course if the PIIGS did not import a substantial amount of Germany’s output, then Germany would not be a net exporter.

Secondly, maybe Chinese people might enjoy consuming the fruits of their labour. In a Flourishing society, people are actually meant to have some fun. Consuming is not so bad.

So what does reduced economic metabolism (as expressed by the reduction in the velocity of money) imply for public policy? Well, there is the obvious Keynesian mechanism of increased public spending to counterbalance the depressed aggregate demand. Krugman is the most visible proponent of this strategy today, and there is a lot to recommend his thinking, particularly if we do useful things with this spending that increase productivity in the future. Infrastructure and education obviously come to mind. I would suggest that spending on public health (including mental health) would also pay off handsomely in terms of increased productivity (but that is an empirical question).

However, Nevinomics believes this is only part of the story and that if all we do is increase state spending, even if we do so in high productivity ways, it will not completely solve the problem. Aggregate demand is too low not only because of the current state of the economy, but also because in times of high uncertainty, people do a rational thing, which is to decrease current consumption. They seek to find a way to guarantee the ability to consume in the future, which is perfectly sensible. And this means they consume less now, reducing economic metabolism. So simply spending more now through stimulus is not enough if the the individual still believes his future prospects are highly uncertain. Unfortunately, if too many people decrease their current consumption because of high uncertainty, the end result is perfectly predictable.

The implication of this is that in addition to stimulus (stimulus, one hopes, that increases future productivity), restoring aggregate demand and getting our economic metabolism back to a high level will require bold policies that change the uncertainty equation for individuals. The previous uncertainty equation held from the end of WWII to 2008 for advanced economies. This uncertainty equation basically said that the economy would continue to expand, jobs would be available for those who wanted to work, housing and asset prices would rise. These conditions of low uncertainty allowed people to spend (and invest) freely – as evidenced by the the fact that debt increased at a much faster rate than GDP during this period.

But as many commentators have noted, any trend that cannot continue won’t. And these conditions of high personal certainty that allowed for high economic metabolism during the post WWII period no longer apply. Nevinomics is suggesting that high economic metabolism can be restored only by reducing individual uncertainty, which requires restructuring the labour market and pension/income support systems to reduce uncertainty (while maintaining strong incentives).

This is Systems Thinking.

Photo: El Neill (Castello Aragonese, Italy)