Casting economic theory aside, I would argue that monetary policy effectively boils down to the use of debt as a tool to generate nominal economic growth. Yet, in the wake of the financial crisis, monetary policy has failed to restore economies to the rates of nominal growth that were seen before the crisis. Why is this so?

As can be seen in the chart below, the growth intensity of debt – the increase in nominal GDP per dollar increase of non-financial debt – has been in structural decline for decades. In other words, the US economy has required progressively more dollars of debt in order to generate the same dollar increase in nominal GDP.

Given that the growth intensity of debt has been less than one for 50 years, the use of monetary policy in pursuit of nominal GDP growth has meant that an increase in the ratio of debt to GDP has been a mathematical inevitability.



Source: Thomson Reuters Datastream, September 2016


A waste of funding

But why has the growth intensity of debt fallen? In order to understand such a decline, which indicates that debt has increasingly been used to fund unproductive spending, one need look no further than the velocity of money, as shown in the chart below:


US economy – velocity of money

Brendan chart2

Source: Thomson Reuters Datastream, September 2016


The velocity of money is defined as the number of times a unit of currency (in this case the US dollar) is spent to buy domestically produced goods and services per unit of time. It is calculated as the ratio of nominal GDP to the average of the money stock. The velocity of money provides some insight into whether consumers and businesses in aggregate are saving or borrowing. As such, it has historically fluctuated in sympathy with the economic cycle as can be seen in the chart above.

The velocity of money peaks at or just before the onset of a recession/slowdown. As consumers and businesses increase the proportion of income being saved or used to pay down debt (or hoarded as cash), the number of transactions in the economy declines along with the velocity of money, reflecting the fact that each dollar earned is less likely to be spent.

Slowing down

Conversely, as households and businesses reduce saving/increase borrowing, the velocity of money begins to increase. This explains the observed cyclical dynamic of the velocity of money. It does not, however, explain why, since the late 1990s peak, it has been in structural decline. It also raises the question of why, eight years into the current cycle, the velocity of money continues to fall.

With this decline continuing, an ever-larger increase in debt is required to realise a given rate of nominal growth. So far, the private sector has proven unwilling or unable to take on the scale of debt needed to return economies to rates of growth seen before the financial crisis. The reality is that economies do not have an infinite capacity for debt, and so relying on ever-increasing debt to generate economic growth could not go on indefinitely.

I suspect that the ongoing central bank experiment is the most conspicuous evidence that the monetary policy regime of the last 30-plus years is nearing its conclusion.

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