Danger: Velocity of Money

Consider the usual identity formula:

Most western economies are experiencing little growth in real output and little pricing changes so the ‘PY’ has been basically flat. Consequently the massive change of quantity of money (x6 in US) has been accompanied by a corresponding reduction in money velocity. Whereas this formula is usually used in discussions of inflation it can also be used to confirm the falling money velocity.

The quantity of money was increased through cheap debt that caused financial capital to be cheaper than other forms of capital. Consequently financial capital dominated initiatives were favoured thereby reducing demand for the other factors of production. For labour, this resulted in downward pressure on real wages contributing to both cost reduction and curbing of aggregate demand.

Cheap financial capital increases debt; leading to asset inflation and increased servicing costs. Both these reduce velocity of money as they both reduce incomes with expenditure that does not result in additional economic activity.

So if wages decline and an increasing % is going to debt servicing, then economic activity stagnates and perhaps declines. Government reaction has been make more money and debt available making the money velocity decline further.

With all the money provided to the economy, and the government continuingly trying to accelerate the economy then one day the continual decline in velocity may stop and slightly reverse. This may be due to a change in sentiment, external factor, currency devaluation, fiscal stimulation, tax cuts, increasing interest rates and so forth,

Looking back at the formula when the velocity of money rises, the quantity of money and production will be mostly static leading to price rises. As there is so much money and debt then a small change in velocity will be magnified in price rises. When the population has a sense that money is losing its value then this will spark additional expenditure creating an inflationary spiral.

Government action to raise interest rates will cause defaults that will reduce money supply and employment. The delays between spiralling inflation, interest rate changes, defaults and unemployment will in a mixture of inflation, stagnation and stagflation.

The low velocity of money with so much debt and money supply is like unlit explosives.