How the Declining Velocity of Money Could Show a Stalling Economy

As the Velocity of Money Plummets, It Implies a Recession Is on the Way

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The more times a single dollar gets spent as it cycles through the economy, the greater the velocity of that money. It is almost as if currency has a life of its own, and can be very "energetic," or quite "sleepy."

The amount of activity tells many things about the health and future direction of a nation. Healthy economies typically have a higher velocity, while a decreasing level of activity generally demonstrates that a nation is cooling off, or even approaching recession.

For example, a single dollar can be spent, (and then re-spent again, and again, and again...), dozens of times in a single year, which represents a high velocity. Alternatively, each dollar could just sit in someone's bank account or wallet for months at a time (which would be a very low velocity).

If a customer pays at a restaurant, then the establishment's owner uses that dollar to purchase menus from a printer, then the printer buys some clothes, that represents a velocity of three (restaurant patron-to-owner, owner-to-printer, printer-to-clothing store). Any time frame can be used to check the velocity over any period (weeks, six months, several years), but the most common time frame is one full year.

In that sense, if you hear the velocity is 11, you can assume that on average each dollar is being spent 11 times as it passes through the economy, over the course of a year. You can easily check the current and recent data at the online portal of the St. Louis Federal Reserve.

On that portal, you can see the velocity of the M1 Money Stock, as well as the M2 Money Stock. The former is the better metric to use for tracking velocity, as it represents the actual physical supply of money; cash; coins; traveler's checks; demand deposits.

The M1 supply can easily and quickly be converted into something you could hold in your hand if needed.

On the other hand, the M2 metric also includes things like savings deposits, less liquid investments, and money market mutual funds. To spend any of the M2 Money Stock, you generally would first need to convert some of it into one of the M1 forms of cash.

A declining velocity implies a few issues. It suggests that individuals are holding on to their money for longer before spending it, or are choosing to save or pay down debts, rather than spending the money.

In some cases, it can be argued that a dropping velocity of money demonstrates that consumers are more worried about the economy, or are less optimistic, or maybe even face more difficult times from a financial perspective. This, in turn, results in them being more discerning or cautious with their typical purchases.

This situation also suggests that governments and municipalities will be seeing less incoming tax revenue, which is typically derived through consumer purchases. As velocity falls, it also warns of a slowing economy, or one that is cooling off.

In general, higher activity levels are superior (from the standpoint of any and all metrics used to assess the economy). The busier money is over time, and the more the activity level, the (theoretically) stronger the underlying nation from a financial perspective.

However, even more important than the exact number, is the speed and direction of any changes. Consider that the velocity of money had peaked at 10.68 in the fourth quarter of 2007, immediately before the mortgage crisis hit us.

Since then, the value has been in free-fall, most recently hitting 5.65. That has thus far capped off what has been a steep, consistent decline, with an end result being that the velocity has been cut in half, without even brief periods of any recovery.

As mentioned above, the 5.65 value matters, but not as much as the speed of the drop. Yes, the overall economic activity (as measured by the velocity of money) is about half what it used to be — however, to see the value slide so strongly and steeply lower will probably have some significant effects.

For example, when the change moves too fast to the upside, it typically is involved with very high levels of inflation. Businesses perform better, sales rise, and most aspects of the economy help the whole system grow.

On the other hand, when that change is too fast to the downside (as it has been in our situation discussed above), it arrives with, or exacerbates all the things which can be bad for an economy. That would be the closest thing we have to a quantifiable metric to display the underlying health of a country.

A rapid decline in velocity may mean lower revenues for the government, which arrives so quickly that the municipalities and Federal departments are unprepared, or do not have enough time to adapt or adjust to the new reality. The same situation would also imply that as consumers spend less or more cautiously, most businesses will face harder times; declining sales; purchase mix leans towards lower price items; ballooning inventories of unsold items; sales and discounts are more necessary.

The final result is typically that small businesses (and even large businesses, as a matter of fact) see their profit margins declining. If they used to sell 10 items for $50 to generate $4 profit on each, they now sell only 6 items for $35, and claim only $1 profit on each.

Businesses can usually adapt to a low velocity of money given enough time. However, they have a much worse track record of evolving well when that collapse is swift.

The actual slide in the metric we have seen since the peak in late 2007 has NEVER been more pronounced. The rapid decline may test the health and resiliency of just about every American small business.

Of course, in response businesses will do what they always do. Besides finding various ways to conserve funds, they will lay off workers. In other words, they will spend less, and they will pay less.

This results in unemployed individuals, who then have to conserve money, or have less to spend. That, in turn, adds to the vicious cycle — declining velocity of money manifests as an even greater decline.

To skip all the way to the end of this story, it culminates with a nation-wide recession. In fact, nothing is more directly responsible for any recession than a swift drop in economic activity, as displayed by the velocity value.

There is also the other side of the chicken-and-egg argument. Perhaps velocity declines in response to entering a recessionary period. Is it a cause or a symptom.

Well, the sad fact is that economic weakness and dropping velocity often go hand in hand. They are so closely intertwined that it is often nearly impossible to isolate which underlying force or trend is causing the other.

At the end of the day, does it even really matter? While it may be interesting to know exactly where and how you caught a cold or flu, it does not change the illness in any way.

Maybe the knowledge could enable you to avoid getting sick next time, but maybe not. Either way, you know that you will catch a cold from time to time.

This is no different from shifts in the velocity of money. There will be increases and decreases over time, this you already know. The most important aspect of it would be to be aware of the velocity of money, watch the current level, and prepare to adapt to any dramatic shifts. Kind of like the significant slide we have been watching lately!