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Reply #85: Velocity of Money Comes to a Standstill [View All]

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DemReadingDU Donating Member (1000+ posts) Send PM | Profile | Ignore Sun Jun-14-09 10:02 AM
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85. Velocity of Money Comes to a Standstill

6/12/09 Velocity of Money Comes to a Standstill by Mr Practical

Gross Domestic Product is the standard measure, in dollars, of the level of production in the economy. Production is essential, as it's wealth creation (when measured properly); more efficient production creates wealth and raises the standard of living. Every other economic variable is only important as it relates to production. For example, we only care about price inflation insofar as it affects our wealth. Lower prices can actually be the result of more efficient production; our Federal Reserve tries to convince us that lower prices are bad only when an economy is over-levered, as any good central bank left alone will eventually accomplish.

The objective of capitalism is to ruthlessly increase production. The objective of socialism is to take the current standard of living and spread it equally among an economy's population. GDP is the sum of consumption, investment, government spending, and net exports. in valuing assets such as stocks, we need to understand not just whether or not the economy is currently expanding, as indicated by GDP, but how and why. Current GDP has been shrinking and is currently $11.5 trillion.

Current consumption, which at $8.2 trillion is around 70% of GDP, has fallen $150 billion from last year. If you exclude gasoline purchases from todays numbers, retail sales fell by a record amount over last year. Consumers are spending more of their disposable income on non-discretionary goods and trying to save more money: the savings rate bottomed last year and has been rising. It will continue to rise as consumers must mend their balance sheets. If you take consumer debt divided by disposable income, it's still 130% (reported today), an all-time high. Consumers are in shabby shape.

Investment, which represents things like building factories, is $1.3 trillion or 11% of GDP, and down 23.3% from last year. We all know the status of net exports, which is and has been negative to the current tune of $350 billion a year or a drag of 3% on GDP. In order to compensate, the government has stepped in with massive spending of $2.2 trillion or almost 20% of GDP. Where they get the money for this I've discussed many times. Our public debt could one day soon surpass those kings of inflation -- the Japanese. In addition to stimulus, the government has also borrowed to bailout directly or indirectly the financial system. This adds nothing to GDP but probably saves it from nose-diving via consumption and investment. Not many people know that if you add up all the bailouts, direct and indirect, it comes to $30 trillion. Truly mind-boggling numbers.

Government spending becoming such a large part of GDP is not good because it is the least productive of the other processes that drive production. The other processes are based on capitalism that have several stages where production is made more efficient. When a computer is made it is the culmination of many processes and parts, all of which are produced by specialists who make their processes the most efficient possible. They're rewarded with profit for doing so. The government doesn't have specialists and spends money mostly based on political considerations.

The "capital" it spends is very inefficient towards production. Government taking over the economy will lower productivity dramatically. Berries (bureaucrats) dont seem to understand this. It takes more and more government spending to marginally grow GDP; thus the huge sums being spent to merely slow down the decline. We are fast reaching the point, because of immense debt levels that take capital away from productive uses (crowding out), where infinite spending by government is not adding to GDP.

All this massive spending has stabilized the economy and with some natural and base level of economy, people have perceived this to be the beginning of improvement. This is flawed logic. Getting worse at a declining rate is natural. Some are buying stocks because they fear inflation. Inflation is a falling dollar. When the dollar falls it tends to drive prices up. But we can see that prices of necessities are going up while prices of discretionary things are going down. This is natural as disposable income falls and the savings rate rises. Additionally, I think they don't quite understand how "inflation" is created. To "inflate" or devalue the dollar precipitously, you need a fractional banking system to lend money and consumers to borrow it. Without that you have no multiplier effect.

With mortgage rates up 100 basis points in 2 weeks (as a result of trying desperately to print enough money to reflate), and with a now required 20% down, few people can afford a mortgage given their negative equity and high debt. The money "supply" is egregious (the government bailing out banks and stuffing them with cash), but the velocity of money has come to a standstill (people aren't in any shape to borrow it). I heard a Fed official say that a jobless recovery is possible. I suppose it is, but I will tell you it can only occur if productivity is rising. So while not lying, he isn't telling the truth, or he doesnt understand it. Berries call productivity higher when it is driven by leverage.

For example, a company can make more money per employee if they lever their balance sheet, at least temporarily. But leverage creates risk -- or havent we learned that lesson yet? Real productivity is driven by technology and system advancement, not by more leverage. That may or may not come but it is not a function of leverage and government spending, which in fact tends to reduce, not increase it. The US economy has a serious problem, one which I've talked about many times: too much debt. The government is merely trying to shift financial debt (forget consumer debt) to public debt. They're merely shifting the costs from us to our children. Todays politician seeks short-term solutions at the expense of the long term. Shouldnt it be the other way around? Risk is very high.
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