During all of the economic turmoil that has occurred since the dotcom bubble bursting in 2000 and the housing bubble bursting in 2008, an obscure measure of economic reality has gone largely unnoticed.

This measure, the velocity of money, while obscure, is one of the most incredibly potent measures of economic health and vitality. It provides extraordinary guidance into an economy’s health and well-being.

The velocity of money is, according to the Federal Reserve, “the ratio of nominal GDP (gross domestic product) to a measure of the money supply (M1 or M2). It can be thought of as the rate of turnover of the money supply -- that is, the number of times one dollar is used to purchase final goods and services in GDP”.

I am an economist and that definition even bored me. Unfortunately, failing to understand the significance of the velocity of money and how to improve it to stimulate economic growth may lead to further economic stagnation and perhaps a depression.

The velocity of money has declined to 1.49, the lowest level ever recorded. From 1960 to 1990, the velocity of money average between 1.7 and 1.9. It reached a peak of approximately 2.2 in 1997 and has, for the most part, plummeted since then.

A declining velocity of money means people are hoarding cash and not spending it!

This precipitous decline in the velocity of money, in spite of a massive expansion in the money supply by the Federal Reserve, is one of the reasons why inflation or in many cases deflation has set in.

In an article by an analyst at the Federal Reserve two reasons were given for this decline:

“And why then would people suddenly decide to hoard money instead of spend it? A possible answer lies in the combination of two issues:

• A glooming economy after the financial crisis
• The dramatic decrease in interest rates that has forced investors to readjust their portfolios toward liquid money and away from interest-bearing assets such as government bonds

In this regard, the unconventional monetary policy has reinforced the recession by stimulating the private sector’s money demand through pursuing an excessively low interest rate policy (i.e., the zero-interest rate policy).”

The implications of these two potential causal factors are that the Federal Reserve is in fact perpetuating the financial crisis and not solving it. The very low velocity of money which the Federal Reserve has reported for over 10 years reflects people hoarding money and not spending it.

Additionally, to stimulate demand, the federal government has been using deficit spending but, one again, to very limited effect. 

Expansionary fiscal and monetary policy therefore have had little to no real effect on the economy because all other participants in the market are offsetting these expansionary efforts as reflected in the declining velocity of money.

While some may argue, that the unemployment rate has declined, and some other measures of economic activity have expanded, signs of deflation abound indicating that government measures of economic progress are ineffective and not reflective of what is really happening.

In particular the unemployment rate is mitigated by the very low labor force participation rate. The inflation rate is mitigated by those items not included in the calculation of inflation. Real disposable income has been declining or stagnant at best which provides a contrary indicator to the unemployment rate and inflation rate.

The net effect of all of these issues is that federal government efforts at stimulating the economy through deficit spending, and the Federal Reserve’s efforts at stimulating the economy through low interest rates have been largely ineffective and perhaps counterproductive.

The velocity of money and its precipitous decline indicate that the consumer and businesses are not comfortable with the risks that they see in the economy and are not spending. This insufficiency of demand is triggering a worldwide crisis and will lead to a depression if it is not resolved.

Monetary policy has become completely paralyzed. Should the Federal Reserve increase interest rates, the impact on the federal debt and deficit will destroy the federal budget due to increasing interest expense on the federal budget. 

Both the federal government and the Federal Reserve have made the housing bubble crisis even worse because of their efforts to stimulate the economy.

The velocity of money can be increased with the resultant improvement in economic activity and the economy into a growth mode with meaningful jobs only when government and Federal Reserve remove the uncertainty which is paralyzing economic growth.

Government regulations and their stranglehold on economic activity make economic expansion painful at best. The frustration that the consumer has over what government will do next to the family budget paralyzes many consumers.

The solution to this problem is for government to curtail its regulatory overreach, get federal spending under control, reduce taxes for individuals and corporations, and allow free economic activity to return.

Should the nation continue on its current path, a worldwide depression is possible. The economic downward spiral has already started. Time is no longer on our side.

Col. Frank Ryan, CPA, USMCR (Ret) and served in Iraq and briefly in Afghanistan and specializes in corporate restructuring and lectures on ethics for the state CPA societies.  He has served on numerous boards of publicly traded and non-profit organizations.  He can be reached at FRYAN1951@aol.com and twitter at @fryan1951.