M2 has increased by over a 14% annual rate over the past six months, which is in the vicinity of past record growth rates. Liquidity creation or destruction, in the broadest sense, has two components. The first is influenced by the Fed and its allies in the banking system, and the second is outside the banking system in what is often referred to as the shadow banking system. The equation of exchange (GDP equals M2 multiplied by the velocity of money or V) captures this relationship. The statement that all the Fed has to do is print money in order to restore prosperity is not substantiated by history or theory. An increase in the stock of money will only lead to a higher GDP if V, or velocity, is stable. V should be thought of conceptually rather than mechanically. If the stock of money is $1 trillion and total spending is $2 trillion, then V is 2. If spending rises to $3 trillion and M2 is unchanged, velocity then jumps to 3. While V cannot be observed without utilizing GDP and M, this does not mean that the properties of V cannot be understood and analyzed.
The historical record indicates that V may be likened to a symbiotic relationship of two variables. One is financial innovation and the other is the degree of leverage in the economy. Financial innovation and greater leverage go hand in hand, and during those times velocity is generally above its long-term average of 1.67 (Chart 4). Velocity was generally below this average when there was a reversal of failed financial innovation and deleveraging occurred. When innovation and increased leveraging transpired early in the 20th century, velocity was generally above the long-term average. After 1928 velocity collapsed, and remained below the average until the early 1950s as the economy deleveraged. From the early 1950s through 1980 velocity was relatively stable and never far from 1.67 since leverage was generally stable in an environment of tight financial regulation. Since 1980, velocity was well above 1.67, reflecting rapid financial innovation and substantially greater leverage. With those innovations having failed miserably, and with the burdensome side of leverage (i.e. falling asset prices and income streams, but debt remaining) so apparent, velocity is likely to fall well below 1.67 in the years to come, compared with a still high 1.77 in the fourth quarter of 2008. Thus, as the shadow banking system continues to collapse, velocity should move well below its mean, greatly impairing the efficacy of monetary policy. This means that M2 growth will not necessarily be transferred into higher GDP. For example, in Q4 of 2008 annualized GDP fell 5.8% while M2 expanded by 15.7%. The same pattern appears likely in Q1 of this year.
The highly ingenious monetary policy devices developed by the Bernanke Fed may prevent the calamitous events associated with the debt deflation of the Great Depression, but they do not restore the economy to health quickly or easily. The problem for the Fed is that it does not control velocity or the money created outside the banking system.
Washington policy makers are now moving to increase regulation of the banks and nonbank entities as well. This is seen as necessary as a result of the excessive and unwise innovations of the past ten or more years. Thus, the lesson of history offers a perverse twist to the conventional wisdom. Regulation should be the tightest when leverage is increasing rapidly, but lax in the face of deleveraging.
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