UNDERSTANDING FEAR THROUGH EXAMINING MONEY VELOCITY

As people saw the recession taking hold and the risk that the financial bubble posed on the economy as a whole, they became afraid and began pulling their money out.  Bankruptcies at Lehman, failures at AIG, Washington Mutual, and others slowed the speed at which the money circulated in the economy, thus money velocity came to a halt.  This shock put pressure on the other side of the monetary equation, causing downward pushes in both prices and output, and deepening the recession.

By the time the fear had reached the government, the damage was done.  Velocity, by some accounts had fallen 30% and the money supply was also dropping.  Even if the pressure on growth could be reduced by drops in prices, a massive decline in prices would have naturally reduced output (as suppliers aren’t going to produce more of something if it is worth 30% less).  The prospects of a depression had become real.

The Government’s Action

The government stepped in and bailed out many of our large institutions, not only to avoid collapse, but to restore confidence.  With confidence restored, money velocity could return to normal and push the monetary equation back up.  Unfortunately, once the panic had set in, the damage had been done.  The government turned its attention to the money supply.  By increasing the money supply by 10% or more than a trillion dollars, they hoped this would prop up the other side of the equation, prices and output. 

Once again, I think most of (not all) the bailouts and the money creation was a mistake.  I believe the government should have focused on a quick restoration of money velocity and set a fixed target (instead of none) on money supply growth.  So, let’s examine money velocity on an individual level to try and determine an appropriate policy response.

You see a crisis coming.  You obviously don’t want to buy large consumer products (homes, goods, etc) if you might not have a job in the coming year.  Your employer is also afraid.  They are cutting labor, their orders are falling, and they are cutting other costs that have the same effects on vendors/suppliers.  Consumers and producers are scared (along with the banks) and money moves to a halt.  So what would get you to spend again?

1)      Set capital gains taxes to 0% for up to $100,000 in gains for individuals for a period of one year.  Maybe create an increasing scale for the next four years after that (bringing the tax back to 15% after that). 

Analysis- People now have incentives to invest their money in the stock market, which at the peak of the crisis was down 60%.  More participants in a market that went up 40% (like it did in 2009) create wealth and push the markets higher.  This would have been helpful to money velocity (and naturally increased the money supply without the printing press).  According to the Fed, citizens bought $650 billion of the new debt issued in 2009.  I believe and I hope this was not true.

By getting only 2% of their money returned instead of 40% or more (in the stock market), wealth grows at a slower pace.  Plus, the flight to safety by buying treasuries maintains that fear and keeps money either on the sideline or in the hands of the government to waste.

A 0% cap gains tax also encourages more self-employment as the costs and barriers to starting your own business are slowly being reduced.  This would in return decrease the burden of social program costs on some people.  Again, a 0% cap gains tax could not do any greater damage to our economy (unless it is strung out).

2)      Keep the capital gains taxes at 15% for the big guys and don’t let them go to 27% when the Bush tax cuts expire.

a.       Analysis- The big guys want to invest in labor as well, but by raising their taxes in a time of uncertainty, you are essentially creating uneasiness and again fear.  These elements do not encourage a return to money velocity.  To get the big guys to circulate and spend their money in this economic environment, we have to show them a little love too.

3)      A temporary tax holiday on equipment purchases.

a.       Analysis- Equipment creates jobs.  Whether it is through the fact that it has to be produced by someone, sold by someone, installed by someone, and used by someone.  The making of one piece of equipment can easily generate four or five jobs.  By eliminated sales and capital gains taxes on equipment, businesses will be more encouraged into acquiring up-to-date technologies at a discount.  These moves will encourage entrepreneurs to also create the best technology when it comes to all types of equipment. 

While there is nothing here that can guarantee increased sales of the final product, increased efficiency, lower costs, and higher supply all point to the product’s prices falling which help consumers buy more and help normalize the economy into recovery.

4)      Permanent tax cuts that create more “hoopla” than they cause problems.

a.       Analysis- A tax cut that is small, but publicly made to sound bigger can also help the economy.  The government should focus on small areas where it costs more to collect certain taxes than the revenue benefits of having them at all.  By doing this, investors, consumers, and entrepreneurs can all be drawn into certain places where these tax cuts apply. 

While the cuts may have little effect on government or the economy, creating the perception that it does will increase confidence.  This confidence will allow people to consumer, invest, and invent (because they will see the opportunities as well).  All of these activities increases money velocity and by much more than the few billions lost in tax revenues from cosmetic tax cuts.

5)       Massive reductions in public spending in areas where it clearly isn’t working.

a.       Analysis- The left may get angry, but let’s take a hypothetical industry that the government has dominated over the past 50 years, Industry A.  Industry A is providing subsidized services to the taxpayers.  The taxpayers pay 50% of the cost by consuming the service and the other 50% through their taxes.  Now, the public sector leaves this industry.

While the government may be gone, the NEED for the service is still there.  Entrepreneurs, quick to re-invent processes and create efficiency, will see this need, storm this industry and begin creating businesses that provide the same services.  Combined with favorable capital gains taxes, this now “private” sector will create jobs in order to account for the increased demand for it to provide this service.

The end result is a newly privatized industry with less government spending and a lower taxpayer burden.

On Friday, we will examine what the monetarist equation tells us about the future.