The velocity of money measures how many GDP dollars are generated by $1 of money supply. The Velocity of Money is therefore simply nominal GDP divided by M2 Money Supply. M2 money supply is the amount of money in the economy that is in cash (checking accounts) and cash equivalents (savings accounts, money markets, CDs, line of credit).
Ideally, the Velocity of Money should be as high as possible, meaning each dollar of Money Supply is generating multiple dollars of GDP (economic activity). For example, a machine in a factory that costs $1 Million, produces product that is valued at $3 Million dollars. The velocity of the money used to buy that machine is there 3.0.
The above chart shows the Velocity of Money in the US (blue line) versus the M2 Money Supply in the US. Pretty shocking chart!
What we see is that since the mid 1990’s, the velocity of money has crashed, and the most significant slow down occurred during and after the financial crisis.
What the above chart means is that we are doing less with more as a country. We have a productivity crisis. Somehow, money is very stagnant. It’s being held in long term investments, illiquid investments, such as real estate, or long term bonds, or stocks. Business investment is just not there.
The above chart explains somewhat the rally in financial assets, a rally that has NOT been accompanied by business investment and strong economic growth. How?
Money is simply not being invested in innovation, or new ways of increasing productivity. What’s even more shocking is that we are seeing this even with a technology boom in the US that has seen technology stocks soar in value since the financial crisis.
The weakness in velocity of money, not seen since at least the 1960s, is definitely a bad sign, and is reason to be concerned for overvaluation in financial assets. Recall the issue of stock buybacks; stock buybacks are when companies, rather than invest in their businesses, go out and buy back their own stock as a way of returning money to shareholders (driving up the value of their stock by buying their stock with profits generated by the business).
An uncharacteristically large amount of national income is coming from financial assets (stocks, bonds, real estate) and not from economic productivity (development of technology, machinery to make more with less).
The above graph expands a bit more on the conundrum of tumbling money velocity. The blue line is the the percentage of GDP that is paid out to people, in total. It is the total National Income as a percentage of GDP.
The red line is the total National Income paid out in wages and salaries, as a percentage of GDP. The red line is therefore the total of all wages and salaries paid to workers, as a percentage of GDP (economic output).
Notice that total National Income as a percentage of GDP has been fairly stable since 1950 (when this chart begins). It is hovering between 52.5% and 57.5%. Now, look at the Red Line. Notice how it has been on a downward trajectory since 1970.
Remember, 1970 saw the end of the Gold Standard. It saw the US Dollar become unhinged from Gold. It also saw the beginning of globalization caused by the removal of the Gold Standard, and, as we mentioned earlier, the Opening of China.
What the graph shows is that globalization has increased competition in labor, thereby lowering wages. Therefore, the only Americans who have seen their incomes rise are the ones who make money in other ways, not just by working. These are the Americans that own financial assets (stocks, bonds, real estate). An example would be Americans who own apartment buildings and make money on rental income. They have seen their incomes rise, and at the very least, stay stable. This line of thought conforms with the weakness in the velocity of money. Money is not being put to work in producing economic value. It is being put to work in financial assets, which is the only way income has been able to stay stable or increase since the 1970s.