|
|
 |
September 2011
You Can Lead a Horse to Water...
As the saying goes, you can lead a horse to water, but you can't make it drink. In the case of the U.S. economy, the Federal Reserve can lower interest rates and print lots of money, but they can't make individuals and corporations borrow, invest or spend more if they don't want to.
Traditionally, a country's nominal GDP or gross domestic product is a function of the total amount of money in circulation multiplied by the velocity of the money. In other words, economic growth is dependent on the amount of money that is available to spend (for example, funds in checking, savings and money market accounts) and how many times the same dollar is spent throughout the year (the "velocity" of money).
This "velocity of money" concept is important and needs to be understood. If you borrow money from the bank to buy a car, some of the dollars you spend on the car will end up in the pocket of the factory worker who helped build that car. She might then, in turn, spend the extra income on a new fishing boat. The person that built the boat might then decide to buy a new home. A carpenter who helps construct the home might then replace his old stove and refrigerator with new appliances - and so on. You see how the same dollar is spent several times. The money you borrowed and spent on a car started a chain reaction - the longer the chain, the higher the "velocity" of money.
But, if you decided not to buy the car, or if the auto worker opted not to spend the extra money she earned on a new boat, the chain reaction would stop and the "velocity" of the money would be lower. Then the carpenter would not be employed to build the home and probably would not buy new appliances. When many individuals and companies behave in this manner, it has the effect of slowing down economic growth. That's the problem with the U.S. economy today. The Fed has created a lot of money, but it can't seem to get people and corporations to spend enough of it.
It makes sense that if the amount of money people and businesses have (the money supply) is somehow increased; it should result in increased spending and investment (economic growth). However, that is not enough. The velocity of money must also increase or at least remain stable. If the velocity of money declines, the increased money supply will not sufficiently stimulate economic growth.
What the Fed calls "M2" (the total value of cash in circulation, checking accounts, savings accounts, money market funds and other similar liquid investments) has grown 78% during the last ten years. In fact, M2 has increased 8.1% the past year and now totals $9.5 trillion dollars. However, the "velocity" of M2 has declined 17% the past ten years, with most of that decline occurring since the latest recession.
What does all this mean in plain English? The Federal Reserve has done its best to increase the amount of money that is available to spend by lowering interest rates and printing hundreds of billions of extra dollars. The problem is that not enough spending and borrowing is taking place to materially grow the economy - despite all the extra cash. The Fed has created a big lake and walked the horse to the water, but it can't get the horse to drink.
So what can be done to encourage more borrowing, capital investment and spending? Of course, like many challenges in life, that's a complex problem with several dimensions. However, a big part of any potential solution could include providing incentives for individuals, and, especially, corporations (which have considerable cash) to spend and invest more. This might be done by creating tax incentives that promote spending and investment. Make the horse thirsty and it will drink the water.
So the problem is not that we don't have money - rather, it's that we just don't want to spend it. The "velocity" of money is too low. And the most effective solution would be for Washington to get its act together and draft legislation that would create a more enticing business environment to encourage spending and investment. The Fed has done all that it can do. Europe has its own challenges addressing the fiscal problems of several European Union members. The EU has learned that it's not enough to have a common currency -there must also be coordinated fiscal policy as well. The economy is barely moving forward and the probability of slipping into another recession has increased. It's time for Congress and the President to act. Otherwise, it is likely we will be stuck at this water hole for a long time.
|
|
Estate, Tax and Financial Planning
Newsletters