02 April 2014
The velocity of money has a way of frustrating the best-laid plans of central banks. For instance, when the Fed wants to squeeze the growth of money it often finds that velocity increases sharply, so that the same amount of money does much more work than before, thus rendering the constriction of money ineffective. Similarly, when the Fed wants to expand the amount of money, it often finds that the velocity of money falls sharply.
The unpredictability of money velocity was a key factor in hastening the demise of monetarism in the eighties. Economics, the textbook by Paul Samuelson and William Nordhaus, said in the 2005 edition: "As the velocity of money became increasingly unstable, the Federal Reserve gradually stopped using it as a guide for monetary policy... Indeed, in 1999, the minutes of the Federal Open Market Committee contain not a single mention of the term 'velocity' to describe the state of the economy or to explain the reasons for the committee's short-run policy actions."
Economists since Milton Friedman have sought to relate velocity to a number of factors and have been unsuccessful. The graph below will therefore come as an utter surprise to many. It plots the velocity of money against Moody's Seasoned AAA Corporate Bond Yield. For the entire period of five decades, 1960 to 2011 it shows that velocity runs a course exactly parallel to corporate bond yield. No one can be more surprised than I am. The velocity of money graph occurs in my book "The General Theory of Money" published in May 2012 but until now I had never thought of connecting it with interest rates if only because all the papers I had read never spoke of any relation between the two.
The monetary aggregate used in the graph is what I have called Corrected Money Supply in my book. A brief explanation is in order. Assume that you receive a salary of $1000 at the start of every month into your demand deposit. During the course of the month you spend 95% of this and save 5%. So the demand deposit would start at $1000 and run down to $50. However, you choose to keep a little extra in your demand deposit to allow for exigencies, say $500, roughly the value of your demand deposit at the middle of the month. If you add all the funds in all demand deposits in the economy there would thus be a certain amount of money that is never spent. Corrected Money Supply is M1 reduced by this money that is not a medium of exchange but is held purely with a precautionary motive.
One economist who came close to identifying the relation between money velocity and interest rates was John Tatom. In a 1983 paper called "Was the 1982 velocity decline unusual?" published by the Federal Reserve Bank of St Louis he observed that during numerous recessions after 1947 the velocity of money fell. He was, however, puzzled by the fact that in the 1970 and 1973-75 recessions the velocity rose. After some analysis he concluded: "Explanations that focus on declining interest rates also do not match up well with the recent pattern of velocity declines. In the first quarter of 1982, corporate Aaa bond yields averaged 15.01 percent and had risen from 14,62 percent one quarter earlier or 14.92 percent two quarters earlier. During the remaining quarters of 1982, the bond yield declined to 14.51 percent, 13.75 percent and 11.88 percent.9 The pattern in the second half of 1982 is consistent with a decline in velocity. What remains unexplained, however, is the largest decline in velocity, which occurred in the first quarter."
If Tatom had had the right monetary aggregate he would have reached different conclusions. He would also have realised that if money velocity falls during most recessions it is because usually interest rates fall during recessions.
The mechanism relating a rise in interest rate to a rise in velocity (or as it has been sometimes called, the case of the missing money), is quite simple. But for economists who have been brought up to view money in a particular way it is very difficult to grasp.
17 December 2013
On 31 July 2013 the Bureau of Economic Analysis of the USA released the initial results of the 14th comprehensive revision of the National Income and Product Accounts.
Many of the revisions were marginal. For example, the average annual GDP growth rate for 1929-2012 was 3.3 per cent, which was just 0.1 percentage point higher than in previous published estimates. Similarly, the average annual increase in the price index for gross domestic purchases for the period 1929-2012 was lowered from 3 per cent to 2.9 percent.
However, the estimates for personal income, disposable personal income and personal saving have undergone huge revisions. These revisions are mainly the result of using an "accrual approach for measuring defined benefit pension plans".
Under the new system, the sum of employers' actual and imputed contributions is the accrual-basis measure of the compensation income that employees receive from their participation in defined benefit pension plans. According to the BEA, "accrual accounting is preferred over cash accounting for compiling national accounts because it aligns production with the incomes earned from that production and records both in the same period; cash accounting, on the other hand, reflects incomes when paid, regardless of when they were earned". If you don't understand this, don't worry.
The Figure below shows the estimates for personal saving in June 2013 and then again in December 2013 for the period from 2001 to 2013. The new estimates are higher than the older estimates for 2001 to 2007, lower for 2008, and higher again from 2009 onwards. For October 2001, the new estimate is nearly 200% higher than the old one. For November 2001 it is nearly 100% higher. For April 2005 it is again nearly 100% higher.
When a mere accounting change results in such gargantuan revisions it is of course necessary to take a closer look.
On juxtaposing the old and new estimates for personal saving with the S&P 500 for the same period, as in the figure below, some patterns emerge. It is only during 2008 that the old estimates are higher than the new estimates. This also happens to be a period when the S&P 500 was falling. What this suggests is that much of the change is the result of the stocks being held by pension funds. It is true that in 2001 and 2002 when the S&P 500 was falling the new estimates were higher than the old ones, but again this can be explained by the fact that pension funds also held mortgage and mortgage-related bonds that were rising during the period.
During periods when the S&P 500 or the real estate market was rising rapidly employers needed to make little or no contribution to defined benefit pension funds. The rising value of the funds' assets accounted for the employers's "imputed contribution". The BEA's error is of course in adding the rise in value of DB pension fund assets to employees' income, disposable income, and personal saving, although the increase in no way adds to employees' current income and of course it adds nothing to employees' disposable income because they never get to lay their hands on it. What the BEA likes to call higher personal income is contributed neither by production during the period nor by employers but is simply a reflection of higher markets. After 2008 one could say without much exaggeration that it is a direct result of QE.
The BEA justifies its new definition of personal income by saying it is consistent with business accounting. But a commonplace of business accounting is that the difference between the recorded value of available-for-sale securities and their fair market value is added to the equity section (or comprehensive income) of the balance sheet, and not to the current year's net income. The latter is of course what the BEA's change in accounting policy amounts to.
Whatever the faults of the old cash-accounting method it related sensibly to reality unlike the new accrual method.
20 October 2013
The 2013 Nobel Prize for Economics has been awarded to Eugene Fama, Lars Hansen and Robert Shiller for laying "the foundation for the current understanding of asset prices".
On a lark I have drawn graphs showing the relation between Corrected Money Supply (for the benefit of those who haven't read my book it is Seasonally Adjusted M1 plus Sweeps minus Seasonally Adjusted Personal Savings) and the S&P 500 for 1961-70, 1971-80, 1981-90, 1991-2000 and 2001-August 2013 (the latest month for which data are available). The amazing correlation surprised even me. There are periods e.g. 2001 and 2002 when Corrected Money Supply rises but the S&P falls. But as the last graph shows that was the period during which the Case Shiller 20 City Home Price Index kept rising. Conversely, this index fell from 2010 to 2012 when the S&P kept rising in tune with increasing money.
Readers may notice that the Corrected Money Supply graphs differ from those in the past. That is because the Fed has reworked a lot of data series right back to 1929.
17 July 2013
Below is a graph showing GDP growth rates of major countries around the world in 2012. The data is from Wikipedia
Mauni Baba does not seem to have done too badly after all.
03 July 2013
Below are graphs for Corrected Money Supply (explained in my book) and a newer one, Seasonally adjusted M1 + Sweeps - Business Loans of all commercial banks in the US.