Thursday, March 18, 2010

Chart of the Week: P=MV, Who Cares?


You should.  Close readers of this cyberspace have seen this formula before. It explains the relationship between a country's gross domestic product, P, to the money supply, M, and the velocity of money, V. {1.26.09} V is slightly arcane, but easy to understand since it basically measures the rate at which a given money supply is exchanged. The chart from the Federal Reserve shows that the velocity is reverting to the historic mean of 1.67 (blue line). That is the basic reason the Fed is pumping money into the economy by deficit spending to new heights, increasing M, to prevent P from contracting severely (depression).  18% of personal income in the US is now provided by the federal government. According to the White House, the financial crisis has caused more than 8 million Americans to loose their jobs. The P=MV relationship also explains why during the 90's when M2 was falling the total economy expanded because financial wizardry in the form of derivatives and collateralized debt obligations of all types increased the velocity of money by enhancing liquidity. In 1997 it reached 2.12 the highest point in the last century. We know now to our great regret that the explosive, even fraudulent growth, in unregulated financial instruments proved to be toxic to the economy. As John Mauldin says, the "Great Unwind" is upon us.