The deterioration in demographics is a symptom, and it’s caused by over-indebtedness that weakens growth. It’s said that correlation does not imply causation. Let’s walk through some data and move onto the Velocity of Money (VOM).
The U.S. debt clock as of today…
For an overview of the explosive debt issue this country faces, go to my most recent article, Household and Corporate Debt Through the Roof. Here are a couple charts.
As overall debt has risen, the U.S. population growth has reached an 80-year low, at 0.6%. That is the lowest since 1936 and the Great Depression.
We also have a household formation bust. Babies are EXPENSIVE, and the households they create are conducive to overall economic growth.
The deterioration in productivity is also a symptom of over-indebtedness.
“Leading up to The Great Recession, the U.S. economy experienced a massive expansion of credit, a slowdown in productivity growth, and a rapid increase in income inequality… Previous research showed that credit growth is a robust predictor of financial fragility. I find that changes in top income shares and productivity growth are strong early warning indicators as well. In fact, changes in top income shares outperform credit as crises predictors.” – Federal Reserve Bank of San Francisco Working Paper, Sep. 2017
Velocity of Money (VOM) “is 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… Velocity is important for measuring the rate at which money in circulation is used for purchasing goods and services, as this helps investors gauge how robust the economy is, and is a key input in the determination of an economy’s inflation calculation. Economies that exhibit a higher velocity of money relative to others tend to be further along in the business cycle and should have a higher rate of inflation, all things held constant. Simply put, the velocity of money can be thought of as the turnover of the money supply. For this application, economists use broad measures of money supply: M1 or M2. M1 is defined by the Federal Reserve as the sum of all currency held by the public and transaction deposits at depository institutions. M2 adds in savings deposits, time deposits, and real money market mutual funds.” – Investopedia
With extreme over-indebtedness and too much of the wrong type of debt, a positive income stream is not generated. This is causing a decline in the VOM, which is now at the lowest level since 1949. How VOM is measured is not really important to making any sense of it. VOM is complicated, and it’s determined by many factors. The equation of exchange formula says that nominal GDP is equal to money supply x VOM. VOM rises over time if you are generating positive income flow to repay principal and interest. The most important variable is the productivity of debt, which indicates how much additional GDP is added for each newly-borrowed dollar of debt. As seen in the following chart, there has been a secular decline over many decades, and the Great Recession stimulus packages have only produced a large — but transitory — spike in the downtrend.
From the OECD…
VOM also picks up the shadow banking system. Between what is happening to the rate of growth in money supply, along with the rate of growth in VOM, you cover all the bases.
If there are major innovations taking place, such as new ideas and types of financial transactions that transform an economy, it’s all captured in the VOM. Despite the innovations and ideas that have moved into the economy over time, the VOM has fallen. When the VOM peaked in 1997, $1 in M2 growth resulted in $2.12 of GDP growth. In 3Q17, $1 of M2 growth only generated $1.43 of GDP growth. When extremely over-indebted, the money multiplier falls. It fell during the 1920s and 1930s and continued to fall before and after the Great Recession of 2008.
Going back to 1900, debt levels went much higher after 1918 due in part to WW1, but the VOM fell for nearly a decade before the Great Depression. In comparison, the VOM had fallen from 1997 until 2008, and it has continued falling further, despite all the financial stimuli. Once the VOM is undermined with debt, monetary policy becomes asymmetric. When the Fed tightens in a highly-leveraged economy, a little bit of tightening can go a long way. But when the Fed eases in a highly-leveraged economy and the VOM is declining with interest rates near zero, a lot of Fed action (like QE) produces very little benefit to an economy. We are now Pushing on a String. If core demand does not exist that encourages people to part with their money, it cannot be forced to happen through monetary policy alone. Only structural changes with legislative policy and allowing the ebb and flow business cycle recessions can balance the imbalances.
Fast-forward to today. We’ve only had a small rise in the Fed funds rate since Dec. 2015, the monetary base is contracting, the rate of growth in monetary and credit aggregates is slowing, and the yield curve is flattening, possibly to an inversion.
This market indicator has predicted the past 7 recessions. Here’s where it may be headed next… “An inverted yield curve will lead to market disorder as it did in 2000 and 2006. But this next recession starts with our national debt over $20 trillion dollars and the Fed’s balance sheet at $4.5 trillion. Therefore, when the yield curve inverts for the third time this century, you can expect unprecedented chaos in markets and the economy to follow shortly after. This is because the yield curve will not only invert at a much lower starting point than at any other time in history but also with the Fed and Treasury’s balance sheets already severely impaired.” – CNBC, June 2017
That all points to monetary restraint already making itself known within the financial system, and it’s indicative of a coming recession that is overdue, as we’re in the advanced stage of a poor expansion that has lasted over 100 months. Late-stage expansions are very different because pent-up demand is already near exhaustion. One example is the overall rise in domestic auto inventory, with a recent drawdown primarily due to post-hurricane disaster demand.
The Fed appears to be very focused on the Phillips Curve (as unemployment goes down, wages rise and inflation rises) in making their current monetary policy decisions, but they’re ignoring all the other data (such as VOM) that is available to them. The Fed has admitted that they don’t understand why the Phillips Curve is not working. Many of their models are not working. And by enabling extreme indebtedness, along with QE, the Fed has basically put themselves out of business. What they have done is enabled financial assets in the stock market, and housing values to shoot to all-time highs, and perpetrated a psychological wealth effect that all is well for the average Joe.
But the average Joe doesn’t own stocks and doesn’t necessarily own a house in a renter nation, or have a mortgage in the black. By encouraging the business community to move into financial assets instead of real capital investment, the Fed encouraged a bad behavior environment where corporate business debt has risen exponentially, but there’s no evidence of a wealth effect moving down the pipeline to alleviate the financial repression of main street. Ever since the crash in 1987, The Greenspan Put has given corporate America a signal that financial investment is better than real investment. QE along the way has only enforced that perception and stretched the moral dilemma of debt, as it relates to the lack of prosperity for our future children.
Look, honey. We can print as many of these pretty things as we want, but let’s not have any more children, okay? It is getting expensive.
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