Where Do Central Banks Need To Focus Their Attention? 2
Compounding matters is that all of these deep seated economic problems combine to adversely affect money velocity.
The falling labor force participation rate means that a growing portion of the American population do not have an income, at least not a formal one, and as a result struggle to obtain bank lending.
Naturally, this poor access to credit, combined with these folks not having an income, negatively impacts both their ability and willingness to spend.
These folks are almost always hoarding whatever amounts of money they have, simply because of how uncertain their economic situations are.
Put another way, if someone does not know when, where, or how they will next obtain a paycheck, they will tend to be a lot more conservative with how they spend their money in order to make sure they can afford to eat and pay the bills.
While this is a dire situation for anyone to be in, their plight isn’t often reflected in aggregate macroeconomic data.
This is simply due to the fact that people who have less or make less, spend less. Which means that when viewed from the perspective of the entire economy, their actions are miniscule to the point of being negligible.
But, should the number of people in this, or similarly tough economic situations grow large enough, then their economic plight can become visible enough to be inferred in some data sets.
A good example of this is money velocity, as you can see from the chart below, M1 velocity peaked just before the Great Financial Crisis in 2008, and has been falling ever since.
M2 velocity, which takes a broader view of what constitutes money in the economy, topped out sometime in the mid 1990’s, and started to accelerate downwards after the Dot Com bubble burst.
In other words, money has been changing hands at a decreasing rate for almost 30 years for M2, and 13 years for M1.
This decreasing rate is what allows us to infer the consequences of falling labor participation and credit availability. Money velocity slows in response to individuals deciding to spend more carefully, and in extreme cases, hoard their cash.
Considering that the labor force participation rate, as shown below, began to accelerate lower in the wake of the ‘08 crisis, and topped out just before the Dot Com bubble, we have cause to suspect that its decline is somehow linked to the decline in money velocity.
However, it is very important not to look at both charts trending the same way, with similar inflection points, and jump to the conclusion that one definitely caused the other.
As we like to point out, correlation does not equal causation, and the truth is that we simply do not know, and will never know with full certainty if one caused the other.
Putting aside the psychological need to attribute cause, what we can say with a fair degree of certainty is that declines in both share a common denominator – income.
Or rather, the lack of income that leads to reduced spending and even outright hoarding.
Considering that both these data sets have declined strongly even as the Fed has pumped trillions of bank reserves into the banking system over the last 13 years, we know that current monetary policy really isn’t solving the problem(s).
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