The Wall Street Journal reported somewhat breathlessly on June 10 that nonfinancial businesses in the U.S. are sitting on $1.84 trillion in liquid assets, or 12.6 percent of the gross domestic product (GDP). The implication is that this money could immediately be mobilized to invest and create jobs. This isn’t quite so, but excessive cash holdings by households, businesses and banks are symptomatic of a fundamental problem plaguing the economy: the low level of monetary velocity.
The $1.84 trillion figure is a bit misleading because businesses always have a lot of liquid assets. At the end of 2007, before the financial crisis hit, they were sitting on $1.53 trillion in liquid assets, which represented 11.1 percent of all their financial assets. At present, liquid assets represent 12.9 percent of financial assets, roughly comparable to the 12.5 percent share in 2005.
It’s difficult to say what would be a normal percentage for liquid assets, but it’s doubtful that businesses are sitting on much more than $150 billion or so of precautionary liquid assets . If they were to spend these funds on hiring or investment or even dividend payments to shareholders, it would help the economic situation, but not by all that much.
However, to the extent that businesses and households are hoarding cash it reduces the rate of turnover of money in the economy—the number of times dollars are spent in the aggregate—which economists call velocity. In the simplest terms, velocity is the ratio of the money supply to GDP in nominal (money) terms.
For many years, economists treated velocity as if it was a constant like pi (π), the ratio of the diameter of a wheel to its circumference. Throughout the 1960s and 1980s, velocity was fairly stable at around 1.6/1.7. But in the 1990s, it began to rise due to financial innovations, such as debit cards, that allowed people and businesses to use their cash more efficiently. Throughout the 1990s, the velocity ratio was more than two, meaning that if you multiplied the money supply by two, that would approximately equal GDP.
In the 2000s, velocity fell to the 1.8/1.9 range. On the eve of the financial crisis it was about 1.93, as shown in the table. But in mid-2007, it began to fall, hitting a low of 1.68 in the middle of last year, a level not seen since the 1980s.
|Monetary Velocity and GDP|
( billions of dollars )
|*If velocity were 1.93; |
quarterly figures at annual rates
Source: Commerce Department, Federal Reserve and author’s
A decline in velocity has the same economic effect as a decline in the money supply, which creates deflation—falling prices. This is what happened during the Great Depression. At that time the money supply fell because there was no deposit insurance, so when banks failed, their deposits literally disappeared. (Most of the money supply is in the form of checking accounts or demand deposits that exist only in an accounting sense.) Between 1929 and 1933, the money supply shrank by 30 percent. Since the price level is a function of the quantity of money times the goods and services available for sale, this caused the Consumer Price Index to fall by about 25 percent.
The problem then and now is that prices and wages don’t adjust very quickly, so businesses lose money and are forced to lay off workers in order to reduce costs. Laid-off workers cut back on their purchases, businesses stop investing and banks stop lending, creating a vicious downward spiral. Eventually, workers accept pay cuts and the system adjusts and GDP stabilizes, but until that happens there will be a decline in both prices and output.
As the table shows, velocity has fallen by more than 11 percent as spending in the economy has fallen, which has the same effect as an 11 percent reduction in the money supply. Although the Federal Reserve has increased the money supply substantially—M2 is a broad measure of the money supply that includes cash, checking accounts, money market accounts and so on—it has not been able to offset the fall in spending that has reduced velocity. The result has been stagnation of GDP since the end of 2007.
To illustrate the importance of velocity, I have shown how much higher GDP would be if it were still at its pre-recession level. For the past year, GDP has been about $2 trillion less than it would be if people and businesses were still spending their money as rapidly as they did previously. That’s almost $7,000 in lost income for every man, woman and child in the U.S.
So why did people stop spending? The key reason is that the collapse of the housing bubble and the stock market caused the net worth of households to fall by $15 trillion between the first quarter of 2007 and the first quarter of 2009, according to the Federal Reserve. This reduced spending because research shows that people spend between $5 and $10 of each $100 increase in their wealth. Thus the decline in net worth took between $750 billion and $1.5 trillion in spending out of the economy on an annual basis.
Because people and businesses are not spending, they have built up saving and cash balances. Banks are also sitting on vast quantities of money that they could lend. According to the Federal Reserve, excess reserves—liquid assets over and above what banks are required to hold to pay depositors—have risen from about $2 billion before the crisis to a current level of more than $1 trillion.
Just to be clear, excess reserves are funds that banks have available for lending on which they would earn interest, but that they have not lent and thus earn almost nothing. (The Fed pays them a very small amount of interest.) It would be as if an individual kept all of his or her financial assets in cash stuffed under a mattress rather than investing them in stocks or bonds that would earn interest, dividends and capital gains.
Thus we have a giant chick-and-egg problem. If people and businesses would spend and invest it would raise velocity, which would raise output, prices, profits and employment, which would further raise velocity and create a virtuous circle leading to prosperity. The question that policymakers have been wrestling with since the beginning of the crisis is how to get the ball rolling.
The Federal Reserve has tried to increase the money supply to compensate for the fall in velocity, but the money just piles up in the banks and is unlent and unspent. It is, as economists say, pushing on a string; something needs to pull money into the economy and get people to buy, businesses to invest and banks to lend for monetary policy to be effective. But with the Fed lending reserves to banks at essentially a zero percent interest rate, the impetus has to come from elsewhere.
Most economists had hoped that the federal government could fill the gap, which was the purpose of last year’s $787 billion fiscal stimulus package. The idea was that government spending would compensate for the fall in consumer and business spending, get the economy off dead center and, hopefully, kick-start the engine of growth. That would raise velocity and get growth on a self-sustaining track.
It now appears that the stimulus package was both too small and too poorly designed to have the impact that was hoped. Moreover, the stimulus is running out and it is probably impossible to do much more, if only for political reasons. The challenge for policymakers is to find some other way of raising consumption and investment spending, get idle funds mobilized and thereby raise growth and employment. Unfortunately, at this moment no one knows exactly how to do that.