22 August 2016

M2 Money Velocity Began Dying in 1997 And What That Means For Us

It is correct to say that money velocity does not do anything.  It does not do anything in the way that the speedometer on your car does not do anything.    But it is an important measurement, a ratio of the amount of money being created and it relationship to productive, organic growth in the economy.

And it is well known that money velocity peaked in 1997, and has been in a steady decline since then.  It is now at lows never seen before in the US economy.  It, like the implications of the long term stagnation of median household income, remains largely unremarked, and if noticed, excused away as unimportant.

Why is this?

Below is a recent article from Anthony Sanders of George Mason University that makes a good case that it has to do with the 'bubble economy' which began with the expansion of the money supply to promote housing ownership.

Tony is an expert on financial aspects of housing, among other things, and as you know I follow what he writes closely.  He knows more about these things than anyone that I know.  And he says what he means and means what he says, which is a sometimes neglected principle among mainstream economists these days.

But as I have a slightly different perspective on that period of time,  I would take this a step further and draw a admittedly broader, less specialized conclusion.   The article does not account for the massive tech bubble, which at the time was covered by the fig leaf of a 'new era internet economy,' giving it the name of the dot-com bubble, with which I happened to be intimately familiar.

Who can forget Chairman Greenspan's irrational exuberance speech which shanked the stock market in December of 1996.
Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past.

But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?

Alan Greenspan, The Challenge of Central Banking in a Democratic Society, 1996-12-05
As it turned out, Chairman Greenspan was blinded by ideology, as he himself admits years afterwards, never seeing a bubble that he didn't like.  But his successors have followed the same sorry route of feeding the financiers to the detriment of the broader economy.

The problem was not the mortgage credit bubble per se, but rather the policy bias towards managing and regulating the economy itself, with an aggressive expansion of the money supply under Alan Greenspan (remember the Y2K scare) and Treasury Secretary Robert Rubin, along with bubbles in the usual suspects, in this case the financialization of housing and the tremendous bubble in the equity markets.

Do you recall the Time Magazine cover from 15 February 1999?   The Committee To Save the World?

And how can we forget the Rubin doctrine of propping up the financial markets using the SP 500 futures before the fact, which he thought was cheaper than cleaning up the mess of a market crash after the fact.  Remember The Working Group, aka The Plunge Protection Team, housed within the Exchange Stabilization Act, that came out of the scarring experience of the Crash of 1987, which itself was a precursor to the woes created by weakly regulated, artificially exotic financial instruments and mispriced risks?

A crisis is a very effective mechanism for enabling the abuse of power.

And let us not forget the overturning of Glass-Steagall in a decades long campaign richly underwritten by the Wall Street Banks, and the infamous Gramm-Leach-Bliley Financial Services Modernization Act of 1999.
In 1999, on signing Gramm-Leach-Bliley into law, Clinton said, 'This is a day we can celebrate as an American day' and that 'the Glass-Steagall law is no longer appropriate for the economy in which we live' and 'today what we are doing is modernizing the financial services industry, tearing down these antiquated laws and granting banks significant new authority' and 'This is a very good day for the United States.'

Columbia Journalism Review, Bill Clinton on Deregulation
One might say by way of analogy that Reagan made the nest, and Clinton laid the egg.  But both Bush II and Obama have nurtured this chimera economy along.  And we can have every expectation that the political establishment will continue to do so in the next presidency.
"It comes as a surprise to many people that, despite the fiasco at Citigroup and his role in causing the subprime mess, Rubin remains inside the circle at the White House. Nearly two decades after first migrating to Washington, he apparently is still calling the shots of U.S. financial and economic policy with the full support of President Barrack Obama.

Working through his favorite marionettes, Treasury Secretary Tim Geithner and Economic Policy Czar Larry Summers, most recently Rubin managed the defense of Wall Street following the great crisis. No matter what Secretary Geithner says or when he says it in public, you can be sure that those utterances have the full knowledge and approval of his handler Larry Summers and their common political owner and sponsor, Robert Rubin.

Chris Whalen, The Institutional Risk Analyst, 29 June 2010
The causes for this are debatable and many, and I have considered it here many times as the credibility trap,

What we have now, an economy based on artificial support market resulting in a series of asset bubbles and crashes, with a growing inequality in income distribution.  This is the natural outcome when a policy body decides to manage or 'stimulate' the economy by shoving freshly minted dollars top down through a weakly regulated, increasingly corrupt financial system whose outsized and largely unproductive profits act like a private tax on the real economy.  It enriches a few, and enervates the productive working class.

This is why I have said that until there is financial and political reform, there will be no sustainable recovery.  And the longer this continues, the more that the organic productivity of the economy will decline.  And the more socially explosive the situation may become.
"Over the last thirty years, the United States has been taken over by an amoral financial oligarchy, and the American dream of opportunity, education, and upward mobility is now largely confined to the top few percent of the population.   Federal policy is increasingly dictated by the wealthy, by the financial sector, and by powerful (though sometimes badly mismanaged) industries such as telecommunications, health care, automobiles, and energy.   These policies are implemented and praised by these groups’ willing servants, namely the increasingly bought-and-paid-for leadership of America’s political parties, academia, and lobbying industry.

If allowed to continue, this process will turn the United States into a declining, unfair society with an impoverished, angry, uneducated population under the control of a small, ultrawealthy elite. Such a society would be not only immoral but also eventually unstable, dangerously ripe for religious and political extremism.

Charles Ferguson, Predator Nation
I have little expectation now that reform will come from within.  The power of the status quo is too great, and too prone to rewarding those who serve it, and silencing and impeding those who oppose it by progressive reform.
"'After dinner, 'Larry [Summers] leaned back in his chair and offered me some advice,' Ms. Warren writes. 'I had a choice. I could be an insider or I could be an outsider. Outsiders can say whatever they want.  But people on the inside don’t listen to them. Insiders, however, get lots of access and a chance to push their ideas.  People — powerful people — listen to what they have to say.  But insiders also understand one unbreakable rule: They don’t criticize other insiders.'

I had been warned."

Elizabeth Warren, A Fighting Chance
How can we have missed this element of self-serving preservation of the status quo so broadly on display in the run up to our recent presidential election?

'Stimulus' in itself is no panacea.  It must be productive and targeted towards increasing aggregate demand within a healthy economy which distributes the rewards for productive efforts broadly amongst its participants.

Whether it is affordable housing, infrastructure project such as roads, bridges, and modern power grids, the general improvement of the environment,  or the expansion and improvement of those basic elements of a culture than lend value to peoples' lives, any project which can be considered stimulative can and will be turned into an unproductive boondoggle by a corrupt financial and political system.  They contaminate everything that they touch.

And so I continue to make the observation that significant financial and political reform are the sine qua non for a genuine economic recovery.

Doing more of the same may make no sense, may even seem neurotic. And if it seems to defy common sense, that is because it does.

But it has one very special thing going for it. It has been and still is richly rewarding to a small group of very powerful people, something which we have seen repeatedly throughout the developing world, and even in the gilded, boom and bust eras of this country before.
"The crash has laid bare many unpleasant truths about the United States...

Recovery will fail unless we break the financial oligarchy that is blocking essential reform."

Simon Johnson, The Quiet Coup, May 2009

Confounded Interest
Dying Money Velocity Began in 1995 with Massive Mortgage Credit Expansion

M2 Money Velocity (GDP/M2 Money Stock) peaked back in Q3 of 1997. And it has mostly gone down hill from there.  As of Q2 2016, M2 Money Velocity is at the lowest point in history.
One explanation for the decline in velocity is the decline in labor force participation since early 2000 when labor force participation peaked.  Fewer people participating in the labor force (as a percentage of the population) makes it more and more difficult to maintain velocity since GDP is lower despite the expansion of money.
Why is labor force participation declining? First, our population is aging and more and more people are retiring. Second, more and more students decided to attend and/or stay in school given the lousy jobs market.  Third, some people have just given up trying to find a job and would prefer to rely on the state for food, housing, healthcare, etc.
A closer look reveals some bad AND good news. Labor force participation for ages 25-54 has been declining since 2007 (but showing some improvement in 2016). On the other hand, LFP for ages 65 and above (many of whom were pushed back into the labor force as a result of the financial crisis and housing bubble burst) has been growing steadily since 2008.
Actually, the economic world turned before labor force participation peaked in early 2000 and M2 Money Velocity peaked in 1997.  A key economic indicator, core personal consumption expenditures YoY,  was above 4% in the early 1990s only to fall to around 2% around 1995 prompting the Clinton Administration to enact policies leading to a dramatic increase in mortgage credit (creating a credit bubble) as a stimulative measure. This was the Clinton National Homeownership Strategy: Partners in the American “Dream.” nhsdream2 That turned into a nightmare for millions of American families.
1995 was the beginning of the incredible housing credit bubble that catastrophically exploded in 2008.
Core personal consumption expenditures (cPCE) YoY sagged after 1989 and hit 2% by mid 1990s and has struggled to reach 2% on a consistent basis ever since. As a result, GDP has been compromised and the massive expansion of mortgage credit helped created a massive house price bubble which burst … and things have never been the same since.
And with the fall of the House of Usher cards, mortgage equity withdrawal has fallen as well (putting a damper on personal consumption expenditures.
Remember, housing is a consumption good (to serve as shelter), not a productive asset like a factory. Trying to create economic growth through housing is a poor choice. So much so that The Federal Reserve is left blowing asset bubbles instead of stimulating actual economic growth.