Republicans Should Focus on Monetary Velocity

Friday, 22 Feb 2013 07:45 AM

By Barry Elias

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My previous column suggested the Republican Party is positioning itself for a third consecutive loss in 2016 at the presidential level.

In order to combat the devastating global financial collapse, the Federal Reserve has increased the money supply significantly over the past few years. This may be useful in the very short term, but it could be devastating in the long term.

Going forward, in lieu of the money supply, I highly recommend that Republicans (and Democrats) turn their attention toward monetary velocity.

Monetary velocity measures the turnover of the money supply in a given year. It is directly proportional to the quantity of available, high-value, cost-competitive goods and services in the economy. As this quantity rises, so does income, without a significant increase in the money supply and inflation.

Simply increasing the money supply can be inflationary if the quantity of goods and services remains relatively constant.

The algebraic representation of this dynamic is as follows:

GDP = MS * MV = P * Q

Where,

GDP = Gross Domestic Product (Income)
MS = Money Supply
MV = Monetary Velocity
P = Average Price Level
Q = Quantity of goods and services produced

Since 1980, the monetary velocity for the most liquid form of money (MZM, or zero maturity money), has declined by 56 percent, from 3.2 to 1.4

This dramatic fall was the result of falling investment relative to consumption. Investment as a percentage of GDP fell nearly one-third, while consumption approached 70 percent of the economy. This depressed the growth of income and employment, while exploding the level of public and private debt.

The principal reason for this decline in investment was the 1986 tax reform legislation signed by President Ronald Reagan, which was described in a recent column. That law permitted personal tax rates to fall significantly below corporate tax rates for all levels of net income (maximum: 28 percent personal versus 39 percent corporate). Consequently, there was great disincentive to develop long-term, sustainable business models.

Since the financial collapse of 2007-08, the Fed has been increasing the money supply to support the economy in the short term. However, this rate of monetary formation is unsustainable. Without a significant increase in the quantity of high-quality goods and services, upward pressure on prices will prevail (“too many dollars chasing too few goods”).

Therefore, the first order of business is to reduce the corporate tax rate significantly in order to promote direct business investment.

Additional policy measures will be discussed in my next column.

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