Sluggish Money
By: Prof. Shlomo Maital

"Pull over!" the traffic cop said to the 100-shekel banknote.  

"But officer," said the note. "I was not speeding. I was barely doing 10 kilometers per hour (6 mph)."  

“Sure," said the officer. He was tough and grizzled and had heard it all. "That's exactly the problem, buddy. You were going too slow!"

"Too slow?!" said the note.  

The stunned note fell silent, then recovered.

"Officer, believe me. I want to be a Ferrari. But these bankers, these people. They turn me into a turtle. They hang on to me. They used to spend and lend me like there was no tomorrow. Now? I can sit in a pocket or a vault for days! Weeks! I can't get no… momentum!"

***

Money talks, the saying goes. If it could, perhaps it would say what the imaginary banknote says to the cop. 

Central banks all over the world, including the Bank of Israel, are facing a common problem. And none have found a solution.  

They are all pumping vast amounts of money into the banking system in order to restore lending, reliquify a frozen capital market and get the wheels of commerce moving again.

But to their sorrow, the banks are reluctant to lend the money and prefer to hold on to it. And even when they lend, people and businesses are also holding on to the money rather than spending it. In times of deflation, when prices fall, the value of money increases over time rather than decreases, as it does during inflation (rising prices). So why spend the money when it will be worth more tomorrow? And why spend it when everyone speaks of the coming hard times when we may need it? 

The result is that the money in circulation grows in quantity, but moves around far more slowly and hence overall, economic momentum slumps. Central banks control the amount of money. But they do not, and cannot, control whether we spend it or how fast. Only we control that. And that is the heart of the problem.

Let us review some basic theory -- theory that is over 260 years old, dating back to David Hume's essay of Interest published in England in 1748. 

In physics, high school students learn that the momentum of a moving body is the product of its mass (M) multiplied its velocity (V). Momentum equals M*V. You get high momentum either by having a heavy body move slowly, or a light body move rapidly. A tiny elementary particle like an electron has infinite mass, theoretically, when it moves at the speed of light. A scrawny American football linebacker weighing in at a mere 220 pounds (100 kg) hits with great force if he tackles a 280-lb fullback while he is moving at top speed. 

The same holds true, according to David Hume, in economics. The economic momentum of a nation, such as Israel, measured by its Gross Domestic Product, is the product of its money (M) multiplied the velocity of money (V), or the number of times a unit of money changes hand during a year. GDP equals M*V. 

That is why central banks everywhere are struggling to combat the ongoing economic downturn. If they could, they would legislate a minimum speed limit for money. But they cannot. M is rising. V is falling even faster than M rises. So the product of M times V is falling. 

In his book on the Great Depression, The Great Contraction, 1929-1933, University of Chicago Professor Milton Friedman notes that between 1929 and 1933, the stock of money in America fell by a third, as many banks closed their doors. But, he notes, the velocity of money also fell by almost a third. As a result, America's GDP declined by more than half.  

Here are the numbers for Israel. Israel's money supply last December (M) was 17.5% bigger than a year earlier. Yet the velocity of money was less than 10 (i.e. a shekel changed hands every 37 days), compared with 11 the same time the previous year. And this is before the full economic storm hit. Money will slow down even more this year.

When we citizens decide things are looking up and that we can spend our money rather than hoard it, money will speed up, economic momentum will improve, the economy will grow and unemployment will decline. 

Until that time, the hard times will continue, whatever governments and central banks choose to do. 
         
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*This article originally appeared in the Jerusalem Report's Marketplace column, February 24, 2009.