The current economic policy has hinged upon the following equation:
Where P is the amount of productivity in the economy measured by GDP; M is the supply of money often measured by the M2 money supply, and V is the velocity if money (M2) or how often a dollar turns over each year.
In the simplest definition this equation represents the amount of value created by our economy (GDP) is equal to the amount of money in the system (M2) multiplied by how frequently that money “turns over” (V).
The faithful logic is that you can offset a decline in V by raising M to support P. Mathematically this makes sense and would be true if the equation followed only the rules of linear mathematics.
However, the problem is twofold: while M is the only lever that the Federal Reserve has any real control over; V is a value rooted in physics more than math and subject to inertia and indirect responses.
While M follows a linear progression (a $ in = a $ in and a $ out = a $ out) V is subject momentum where the rate of change is neither controllable or linear. The velocity of money tends to follow a trend which is partially fed by the supply of money but which is also fed by human behavior.
Consumption patterns are not linear and we don’t all necessarily start and stop consuming at the same time and the same rates. Moreover, the actions of one group can affect another and positive and negative momentum can drive how much of our paychecks we choose to spend. If our peers appear to be cutting spending we may choose to follow their lead if we presume their caution is correct. Vice versa in the hay days of the late 1980’s/early 1990’s our consumption patterns were heavily influenced by “keeping up with the jones'”. The chart below illustrates the velocity of M2 in the US since 1950.
In theory if V is falling faster and faster, neither a linear increase in nor an imaginable amount of M is going to support P for very long. At some point the attention needs to move from how we support economic growth to how we arrest the falling velocity of money.
Solving for V, the equation turns to V=P/M.
Turning the equation around, the only method the Fed would have to arrest the current rapid continue decline in money velocity by attempting to make V larger, is actually to reduce M which in the new equation is now in the denominator.
While reducing the supply of money in anathema to growth, the problem is that the issue is no longer solvable until V is stabilized and the only way to stabilize money velocity is to effectively make cash more scarce so that more of the cash available gets used or put to work. A dogmatic and long term agenda focused on increasing Velocity likely would have its own negative effects, but its clear that focusing on adding more liquidity to an economy awash in liquidity is no longer boosting output and is showing signs of growing impotence. The best solution would probably at least be to pause on the quantitative easing and let interest rates rise modestly, if nothing else but to give some time for current cash to be circulated more effectively without the anticipation that more is on its way which creates a perception of falling prices.
As interest rates rise the cost of sitting (cost of waiting) on large piles of cash increases as depositors begin to feel the lost opportunity cost of at higher rates or simply consuming the cash. At the very least it gets people out of the mindset that prices will continually be lower tomorrow and that there is no better alternative to cash.
What the right interest rate would be us as unknown as the grand experiment we are currently in the midst of, nonetheless it seems that our current path beyond being unsustainable may simply be wrong.