Economic Challenges in 3 Charts

Economic Challenges in 3 Charts

I subscribe to John Mauldin's weekly newsletter "Thoughts From The Frontline". It is, without fail, thoughtful and challenging. And it is FREE. I highly recommend subscribing to it.

In his March 31 issue he delved into some charts presented in the recent conference that he hosts annually. Three of the charts caught my eye and I thought I would post them here. You can read the full letter at your leisure.

1. Velocity of Money

The Velocity of Money is a very cool concept that is a simple way to gauge overall economic activity. It basically measures how many times a Dollar moves through the economy. Greater velocity = More Economic Activity.  Let me explain:

The basic calculation is easy to understand. The amount of money in circulation is known, and the size of the economy is known via the GDP, so divide the GDP by the amount of money and you get the velocity of money. Or put another way, you will calculate the number of times a dollar in circulation changes hands in order to create the total GDP. Here is a nice explanation:

Imagine that a farmer, a grocer, a doctor, and a scientist live in the world’s smallest country.  Between all of them, they have $1,000 in money supply.  Over the course of a month, the following transactions take place:

  • The farmer sells $500 worth of food to the grocer.
  • The grocer marks up the price and sells $700 worth of food, split among the doctor and scientist who are his two customers.
  • The grocer falls and hurts his knee.  He goes to the doctor and pays $200 to the physician.
  • The scientist needs fertilizer for an experiment.  He goes to the farmer and pays him $300.
  • The physician is working on a liquid band-aid product with the scientist.  He pays him $300.

The total value of the transactions in our time period is $2,000.  We have $1,000 in money in our economy, so the velocity of money is 2.

Now look at the chart above. You can see that the velocity of money is falling. It has been falling steadily since the late 1990's and is now at the lowest point since 1949.

What does this mean? It means the underlying economic activity in the economy is slowing down. There are less transactions than 10 years ago and 20 years ago. In fact, it hasn't been this low since right after WWII. And this is in the face of the action by The Fed, which has helicoptered money into the economy post 2008 and increased the money supply in unprecedented fashion.

One positive thing in this graph is that for Inflation to become an issue the velocity of money needs to increase. Given the way this chart looks it seems that Price Inflation is not an immediate concern.

2. GDP per Dollar of Business Debt

The chart above visualizes another simple concept. For every dollar that businesses borrow there is a resulting increase in overall economic activity. One hopes that businesses are borrowing money to grow their business, and as a result the overall economy. As you can see in the chart, back in the 50's there was over $3 of GDP increase for every dollar borrowed but currently there is just a little over $1 of value created.

Why is this an issue? Well, the cumulative debt in the global economy is at historic proportions. But the returns on that debt are diminishing. At $1 GDP per $1 of Debt (which we are close to) we are borrowing $1 to make $1 (which falls into the category of 'What's the point?'). As Mauldin puts it:

People compare debt to addictive drugs, and as with some of those drugs, the dose needed to achieve the desired effect tends to rise over time.

3. USA Budget Deficit/Surplus as a % of GDP

Speaking of Debt, the Federal Government has become a Debt Junkie.

The traditional paradigm for increasing government debt is as a stimulus to a declining economy. Basically the knee jerk action is that when the economy is in recession the government will go further into debt to try and stimulate the economy back into growth mode. The idea is that the government can borrow during a slow down and pay it back during the good times.

Over the last half-century, higher deficits have been associated with recessions. After recessions end, the deficit shrinks, and occasionally (e.g., after Clinton and Gingrich cut their deal) we get a surplus. That’s not happening this time. Deficits are growing even without a recession.

We have thrown that out the window in the last couple of years. We are now in a mode of increasing the government debt while the economy is growing. This has never been done before. If we are increasing our budget deficit during good economic times what will the budget deficit look like when the next recession hits. And there will be a next recession.

On the positive side, today’s annual deficits are nowhere near 2009–2012 levels. That’s encouraging, but in the next recession tax revenues will fall, and spending will increase enough to not only swell the annual deficit but also to add north of $2 trillion to the national debt each year. We’re using up our breathing room, and that will be a problem – sooner or later.

What are these charts important?

The Economy is driven by, what I call, Big Moving Parts. In an economy the size of ours, it takes a very long time for the forces at play to have an effect that is felt by us as individuals. These charts visualize some of the symptoms of the Big Moving Parts that don't point to Strength, but rather to Weakness:

  1. Slower economic activity
  2. Lower returns for business debt
  3. Higher government deficits for the foreseeable future

These are tea leaves to be read, for sure. Nothing is certain. But it seems to me that any minor shock to the system can bring on a recession.

These are just things to keep in mind as you read the news of the day.

Clouds lifting over the North Fork Valley

The Beach Boys "Wouldn't It Be Nice" (Vocals Only)

The Beach Boys "Wouldn't It Be Nice" (Vocals Only)