The real problem? Money is stuck, not multiplying

On the Money
From the October 7, 2011 print edition

Stimulus, recovery. Stimulus, recovery.

The theory is that there’s a relationship between the two.

But something just isn’t working.

Inject more money into the economic system, and there’s supposed to be growth, liberty and more time to pursue happiness. But it seems that no matter how much money is injected, it’s not enough. A little like, “One dollar is too many, 10,000 not enough.”

So what’s missing? Velocity.

Most of the time, we talk about money in terms of static amounts. Such as, “I have $10,000 in savings,” or “I need $35,000 to buy that car.” However, underneath those statements is the most important characteristic of our money.

It represents control over goods and services. The $10,000 in savings is meaningless unless it’s connected to some item or service that we desire. It’s really not the $35,000 we want; it’s the car. Money has no value at all if it doesn’t move from one person to another. The rate at which it moves is called “velocity.”

What makes an economy thrive isn’t how much money there is, but rather the rate at which it travels between people and organizations.

We’ve all heard the phrase, “money is tight.” It means that of the $2.11 trillion in the money supply as of August, not enough of it is moving around.

During the third quarter of 2010, the money supply turned over 10 times. But this year, it turned over only seven times in the same quarter, an approximately $6 trillion decrease in economic activity.

When people feel threatened or fearful, they tighten their grip on what they have and velocity decreases. When they feel good about life, they buy everyone a beer and speed increases.

The way velocity affects the economy is explained by two sophisticated-sounding terms: “propensity to save” and “propensity to spend” — or, just say “keep” and “give.”

As the same money moves from person to person in transactions, this repetition is called the “multiplier effect.”

That is, person A gets $10, keeps a dollar and gives $9 away in exchange for something useful from Person B. Person B gets $9, keeps 90 cents and gives the rest away, and so forth. Continuing this give/keep ratio of 10 percent, 50 exchanges will multiply the initial $10 into almost $90 in economic activity. It’s the 50 transactions, not the $10 that makes the economy thrive.

Stimulus means pump more money into the system. But no recovery? Then pump more money into the system.

Why isn’t it working? Because the money (both old and new) is stuck. The velocity hasn’t changed, and there’s no multiplier.
In order to stimulate a faster velocity of money — to motivate people to give rather than keep — a variety of fiscal and monetary tools usually are employed. The Federal Reserve Board uses interest rates as a tool to stimulate or slow the velocity of money. Fiscal policy includes tax rates and credits. However, the success or failure of the policies ultimately falls to those individuals who are either keeping or spending the money.

A recent phenomenon in business is that many of the same services are being performed, and at the same rate as two years ago. But service providers aren’t being paid.

For example, a consultant provides services to a client and also hires an attorney to provide services to him. The client doesn’t pay the consultant and the consultant doesn’t pay the attorney. The same services were rendered between the parties and the work was performed, but the only thing created were accounts receivable and accounts payable. No money changed hands.

Removing the monetizing layer reveals that the real measure of economic activity may reside in accounts receivable/payable growth, which reflects just how much work actually is being performed.

If stimulating fiscal and monetary policies are having no effect, and recovery isn’t working, then we ask, “Where is all the money going?” It’s stuck. It’s stuck with people and institutions for emotional reasons that have little to do with traditional financial evaluation. Interest rates could be virtually zero, but unless someone makes an intentional decision to spend based upon both intellectual and emotional confidence, the money will stay stuck.

© C. Stephen Guyer for American City Business Journals Inc. All rights reserved.