Economic Impacts of Income Inequality & Money Velocity

Economic Impacts of Income Inequality & Money Velocity

During the run up to the 2016 Presidential election in, perhaps, the only superpower of today’s world, the result of which will have huge impact all over the world, we saw something totally unexpected happen. It was Bernie Sanders, a socialist, out-polling the eventual Democratic presidential candidate Hillary Clinton and Republican presidential candidate Donald Trump in almost all the national polls in hypothetical match-ups. Well, eventually he was unable to win the candidacy for next president on the Democratic side, whatever the reason that was for. The question here is, how a self-proclaimed socialist, like Sanders, was able to win the hearts of a majority of this capitalist country who, because of the weight of history, religiously believe socialism is something evil?

One of the major reasons behind this paradigm shift was the ground reality of income inequality. To quote Sanders himself, “It is not moral, not acceptable and not sustainable that the top one-tenth of one percent now owns almost as much wealth as the bottom 90 percent, or that the top 1 percent, in recent years, has earned 85 percent of all new income. That is unacceptable. That must change.” According to world wealth report, US comes in at 4th spot in wealth inequality out of 141 countries. This is a direct result of following a capitalist economic structure which drove their growth for decades. If this is the case with one of the most prosperous country on the planet, how does India fair in income inequality, considering the fact that it follows a pseudo socialist economic structure? Well, India comes in at 13th place on the list and the divide between rich and poor is on the rise at a very significant rate. With a population four times that of US, this leaves India with a much larger number of poor people. Some say capitalism makes people unequally rich and socialism makes everyone equally poor. Here we have two vastly different economic success stories, but this success doesn’t seem to resonate through all levels of the economic ladder. The income inequality and money velocity are entwined, so knowing the concept of money velocity is very important to understand its impacts on economy.

Money Velocity is the rate at which money is exchanged from one transaction to another and how much a unit of currency is used in a given period of time. Simply, it is how quickly money changes hands in an economy. Ideally, an economy with faster velocity is healthier than an economy with slower velocity. Also faster velocity means businesses are further along in the business cycle which increases price and hence, inflation. For example, consider a small economy with just a builder, a farmer and a mechanic. Suppose the builder pays the farmer Rs. 1000 for some farm goods. The farmer pays the mechanic Rs. 600 for tractor maintenance and the mechanic pays the builder Rs. 400 for some housing repairs. In this case, the original Rs. 1000 was used to pay for Rs. 2000 worth of goods and services over a given period of time and hence the velocity for this case is 2x. Velocity is important for measuring the rate at which money in circulation is used for purchasing goods and services and this, in turn, helps the investors to gauge how robust the economy.

The US economic growth was driven by a high money velocity averaging 1.86x from 1959 to 2007. During the first quarter of 2016, velocity dropped to 1.46x. This is a record low since 1.66x in 1964. During the great depression, it bottomed out at 1.15x. Is this low money velocity a problem just in US? No, the situation is no different in India, China or even in Europe. To curb this problem of lack of money flow in the economy, the central banks across the world have been putting out money to grease the wheels of the economy, but it is not gaining traction. So where does the money go?

That is where the skewed economic structure comes into the picture. Logically, the more concentrated money is in a system, the more should be the velocity of money. But it depends upon the monetary activities of the holders of money. Famous American financier Asher Edelman explained it very clearly. He said, “when you have the top 1 percent getting money, they spend 5…10 percent of what they earn. When you have the lower end of the economy getting money, they spend 100…110 percent of what they earn. As you have a transfer of wealth to the top and a transfer of income to the top, you have a shrinking consumer base, basically, and a shrinking velocity of money…”. In other words, the poor or middle class tend to spend on the basic needs and hence the money is left to circulate through the economy with minimal savings, while the rich tend to take the money out of circulation as savings or illiquid or less liquid assets. This decreases the velocity. Several studies have indeed shown a strong positive relationship between saving rates and income. You should remember that what is saved today is spent in the future; or whatever illiquid assets cash is converted into today, may be liquidized in the future. Therefore, the effect on the velocity of money is not static, but it fluctuates through time. But when time value of money is considered, income inequality does seem to logically decrease the velocity of money and hence, negatively affects the economy.

According to Organization for Economic Cooperation and Development, certain types of income redistribution — specifically, high-value services like good education and healthcare — increase, and not decrease, economic growth if effectively targeted without inefficiency and waste. Also it’s about time government policies regulate income inequality and laws to encourage banks to lend money, rather than speculate on the market to be put in place in order to maintain the robustness of the economy.