Where Did The Money Go?

Did the Corona Virus cause money to disappear? No. So, if there is the same amount of money available, why is it necessary to create and distribute zillions more dollars to individuals and businesses?

Author: John B. Moore, Professor Emeritus, Management Sciences,
University of Waterloo

Where Did The Money Go?

Did the Corona Virus cause money to disappear? No. So, if there is the same amount of money available, why is it necessary to create and distribute zillions more dollars to individuals and businesses?

The answer is simple. The first sentence in preceding paragraph does not include the phrase “in circulation”.

People that stay home don’t spend money on restaurant meals or travel or haircuts or at bookstores. Individuals that are laid off have reduced incomes and have to limit their spending to necessities like shelter and food. Businesses that shutter their doors see their revenues disappear while many of their expenses continue. Financial institutions become reluctant to loan money because of increased risks of loan defaults.

On the other hand, there are many people who have not lost any income. These include those working for “essential businesses” in the private sector, suppliers of products and services needed to combat the pandemic, and people on government payrolls. Unlike retail workers for example, teachers continue to receive their salaries and benefits even though schools are closed. Although the spending of this not-been-financially-hurt group is significant, the total spending in society has decreased significantly because of the pandemic.

Why does this matter?

The reason is that the “Velocity of Money” has gone down. In its simplest terms, the velocity of money refers to the number of times the same dollar is spent in a given period of time. For example, when you buy a coffee at a cafe, that money may go the same day to pay a worker. If the worker purchases a loaf of bread on the way home, your money has been involved in three financial transactions — the coffee, the pay and the loaf of bread. The velocity of money involved is 3. The money supply has not increased, but its frequency of use in one day is 3. More generally, the velocity of money in an economy is the amount of spending on goods and services in a given time period divided by the money supply. In an expanding economy, the velocity of money is relatively high because people spend on increasing their standard of living or investing in assets such as real estate or stocks. When spending decreases, the velocity goes down and the economy contracts because people and businesses act to preserve their financial assets.

Governments and the Velocity of Money

Businesses obviously lose money when spending goes down. But governments at all levels are big losers too. Why? Again, the reason is simple. Government revenues depend on taxing financial transactions. A big source of government income is of course generated by taxes on personal incomes and corporate profits. Consider the taxes on spending. There are many government taxes on purchases — no purchases, no taxes. As well, there are thousands of national, state/provincial and municipal fees of every kind. These taxes and fees are necessary to fund not only basic services for health, education and security but citizens’ ever-expanding demands for government-provided social benefits.

Consequently, when the velocity of money decreases, government revenues decrease significantly. And, at the same time, individuals and businesses are financially distressed and demand that governments “do more”.

What Should The Government Do?

Clearly, to get the economy growing again, governments at all levels want to increase the velocity of money.

Options at the state/provincial and local level are limited because of the inability of these bodies to increase the money supply by “printing money” and distributing it in the form of relief payments and friendly loan contracts.

At the national level, the situation is different. The national government has unlimited power to increase the money supply. It can do this by reducing taxes, printing money or by buying assets such as mortgages and bonds from the private sector. (This latter strategy is known as Quantitative Easing.) By distributing this new money to individuals, businesses and lower levels of government, it is hoped that the recipients will, in turn, either spend or loan the money received. Theoretically, the subsequent increase in the total dollar value of goods and services would be greater than the increase in the money supply. This would mean the velocity of money would increase which in turn, would raise government revenues.

Will It Work?

There are three concerns. One is short term; two are longer term.

First, a question. While the pandemic lasts, will the expansion of money prevent an economic recession or possible depression? The answer depends on the confidence individuals and businesses have that there are better days ahead. If the confidence level is low, families will not spend, and businesses will not rehire laid off workers. There will be an increase in bartering when exchanging goods and services. Banks will not relax loan-approval criteria and corporations will use funds to buy their own shares in order to increase its stock price and therefore rationalize increases in executive compensation.

Second. Government deficits and debts will increase significantly. Government deficits imply a public obligation to be repay debts in the future. The current near-zero interest rates mean that borrowing costs are not a consideration. Furthermore, a relatively new theory called Modern Monetary Theory (MMT) is gaining support among some but not all economic gurus. MMT argues that countries having sole control of their national currency (U.S.A, China, Japan and Canada for example) are justified in expanding the money supply indefinitely to provide services to their citizens — no worries about ever balancing the budget. Critics counter that this is based on voodoo accounting and that large continual increases in the money supply will lead to rampant inflation and economic disaster.

Third is inflation itself. Inflation can be defined as too much money chasing too few goods. High inflation has many negative consequences. The fiscal stimulus expands the money supply and unless it results in increasing the availability of goods and services, inflation (rapidly rising prices) is inevitable. That is a simple manifestation of the law of supply and demand. The are many examples of catastrophic consequences of unfettered inflation in the last hundred years. There is no reason to think that this could not happen again.

Summary and Conclusions

• The money didn’t go anywhere. Because it hasn’t gone anywhere is the root of the economic malaise caused by the pandemic.
• Government revenues depend greatly on the frequency of financial transactions (the velocity of money).
• The fiscal stimulus measures undertaken by national governments distribute large increases in the money supply to individuals and organizations. The objective is to restore economic activity to pre-pandemic levels.
• The infusion of large amounts of new money may or may not achieve the primary economic objective but will temporarily relieve severe economic hardships caused by the pandemic.
• Government responses to the Corona Virus pandemic increase both the likelihood of implementing a Universal Basic Income and, in the worst case, direct government control over the production of goods and services.