Salmon P. Chase was the U.S. Secretary of the Treasury in the early 1860s. He was the one person Abraham Lincoln relied on to finance the U.S. Civil War. It wasn’t easy. The war was expensive. The U.S. government had lousy credit. Chase instituted the country’s first ever income tax in 1861, but that tax proved difficult to collect. In the end, Chase turned to the one form of finance that nearly every government relies on in times of desperation: he issued paper money.
Chase’s currency used black ink on the front and green ink on the back. He issued three tranches of the so-called greenbacks, two in 1862 and a third in 1863. Each tranche consisted of $150 million of newly-created currency. Economists today estimate the Northern States spent about $800 million on the war. Chase’s greenbacks, $450 million in total, financed over half of that figure. The total circulation of U.S. Dollars prior to the issue of the greenbacks was about $300 million. Unlike the currency from before the war, the new greenbacks were not exchangeable for gold or silver. Greenbacks were literally just paper.
Economists will occasionally refer to a concept called money velocity when describing inflationary periods. Some economists have noted the correlation between money velocity and inflation. Money velocity tends to increase during periods of high inflation and decrease during periods of low inflation.
Money velocity is the frequency that one unit of a currency is used to purchase goods and services over a certain period. Money velocity is typically expressed as the sum of all transactions in an economy in a year divided by the total stock of money in that economy. If an economy has total cash transactions of $1.5 million during a year and $1 million in money, its money velocity is 1.5x.
If we could magically go back in time and witness how the issue of greenbacks affected money velocity during the war, we would have seen a reduction in money velocity immediately after Chase issued the first tranche. The new money once created would have added to the denominator of the ratio and, before the new money began circulating in the economy, the numerator in the ratio would stay the same.
When the recipients of the new money started spending it, transactions (the numerator) would increase, which would cause the ratio to go back up.
Issuing money drives the ratio down; spending the newly-created money drives the ratio back up.
In The Bizarre Parallel World of Hibernation, we described how and why newly-created money affects prices not when it is created, but when the newly-created money is spent. People hoarding newly-created money cause a lag between the creation of the money and its effect on prices.
The hoarding of newly-created money creates a similar lag with the velocity of money. Since the creation of money sends the ratio down and the spending of the new money sends it back up, the hoarding of the new money after it is created causes an extended trough in the ratio. The hoarding of new money creates a lag in the rise of the ratio. Money velocity remains low as long as people hoard the new money. When the recipients of the new money decide to spend it, money velocity increases.
The general price level and money velocity are therefore positively correlated not because one causes the other, but because they share a common cause. It is the propensity to hold cash that coordinates the two. When people hoard newly-created money, they are in effect increasing their propensity to hold cash relative to their spending, which reduces money velocity and keeps inflation subdued. When the recipients decide to spend the new money, they in effect decrease their propensity to hold cash relative to their spending, which increases both money velocity and the general price level.
That time gap between money creation and its effect on prices can sometimes lead to complacency. Lots of money has just been created, people are flush with cash, and the flood of new money has yet to affect prices. The money creators look like heroes during that period. They see a clear path to the basket. Easy score.
But that clear path is an illusion. The economy and the people in it have benefited from the issue of new money, but have yet to incur the costs. The costs will come in due course, but they have not yet arrived. The clear path will vaporize in time as people begin to spend the money they now hoard. At that point, money velocity and inflation will each move higher.
We believe the United States is in that period of illusion at the moment, between the creation of new money and its effect on prices. The Federal Reserve’s balance sheet has increased over eight-fold since the Global Financial Crisis. We don’t think a few months of ten percent inflation is the extent of the costs to be paid. Many people see a clear path to the basket in today’s economy. We think it is an illusion. We think the U.S. is experiencing some lingering benefits from massive money creation and has not yet experienced the full extent of the costs.
Money velocity is an indication of where an economy is on the spectrum between money creation and its effect on prices. Low and declining money velocity results from the hoarding of new money after it is created and before it is spent. It is a sign that an economy has already experienced the benefits of money creation but has yet to experience the costs.
During the U.S. Civil War, the recipients of the greenbacks - mostly soldiers and arms suppliers - were very quick to spend the new money. A broad-based price increase commenced almost immediately after the government printed the greenbacks. The gap between money creation and a general price increase was almost non-existent. Prices shot up 21% in 1862, the year the government first issued the paper currency, another 19% in 1863, and 33% in 1864. Prices nearly doubled before the war was even over. A clear path illusion was brief if it existed at all.
When the U.S. Government and U.S. Federal Reserve again turned to money creation to fund government deficits in the 1960s (Vietnam War, new social programs), the recipients of the new money elected to save it. That hoarding of new money created a clear path illusion in the mid-to-late 1960s as the government continued to spend newly-created money with no apparent cost. The cost eventually came in the early 1970s as people started reducing cash balances to maintain their lifestyles in the face of escalating oil prices. Money velocity almost perfectly tracked episodes of inflationary spikes in the 1970s.
Money velocity dipped to its lowest point on record in 2020 as the government created new money to battle one crisis after another and people elected to save the new money rather than spend it. The velocity of money has only marginally increased since 2020.
We believe today’s depressed money velocity is a sign of the clear path illusion. We do not believe we have a clear path to the basket. We are merely waiting. We have experienced the benefits of the money creation. The costs will come. They always do.
