Canadians didn’t experience the Great Recession, not to the extent that the rest of the world did. Sure, we logged a few quarters of Gross Domestic Product (GDP) declines, but there aren’t all that many heartbreaking stories of loss in Canada. This is often credited to the shrewd moves the Bank of Canada made. Rather than a recession correcting any misallocation of human and financial capital, we slashed rates and made rapid expansions to our monetary supply. Many Canadian experts say we “skipped” the recession, but that’s because they’re looking at the wrong data. Looking at the Velocity of M2 Money Stock, it can be argued that we only delayed it. Now we’re going to have a lot of catching up to do.

You’ll Need To Know These Two Things

This is actually a really complicated topic, based around very simple concepts. There’s only two things you’ll need to know to understand this – M2 money supply and capital velocity. The M2 money supply is how central banks measure the amount of money, and near money instruments available in the local economy. Just to cover all of our bases, money are those multi-colored pieces of plastic you pretend you don’t have when you see homeless people. Near money are things that are as good as money, like short term deposits and government bonds. The M2 money supply is sometimes referred to as a measure of “broad” money, because it measures more than cash.

Capital velocity is the rate at which a dollar travels through the economy. For example, let’s say you bought $10 worth of cannabis. Your government endorsed dealer takes $5 out of that, and buys a couple of seeds. The seed dealer takes $2, and gets a double-double from Tim Hortons. There were $17 worth of transactions, but only $10 traded hands. If only $10 existed, this would mean there was a capital velocity of 1.7. Each dollar in existence, traded 1.7 times. Now imagine those ten dollars is over $1.5 trillion, and that’s the Velocity of M2 Money Stock. Got it? Now you’re practically a f–king genius.

When an economy has a high rate of capital velocity, things are awesome. It means consumers are so comfortable with their financial situation, they don’t feel the need to stash away for a rainy day. Money exits their pockets, as quickly as it enters it. This is where the saying money “burnt a hole through their pocket” comes from. The capital velocity was so high it “burns” right through. Conversely, the opposite is also true. If velocity falls, it means people aren’t spending the money they earned. This generally happens because people begin hoarding cash. Well, those with cash begin hoarding, anyway. They’re either making so much and don’t think there’s a good way to use it, or they’re worried that things will go south soon. There’s some more to it, but those are the basics of it.

Canada’s Velocity of M2 Money Stock

Now that we have a broad understanding, let’s take a look at the velocity of M2 money stock, a.k.a capital velocity, in Canada. Fund managers and traders have most likely started to try to map out historic market events in their mind. For the rest of you, look for the relation of velocity around the marked recessions in the early 1980s, early 1990s, and 2008 to 2009 (the Great Recession). Shortly after a recession, we see healthy increases in velocity. It never quite gets to the point where it was before (it never will in Keynesian economics), but it should improve. Once the decline occurs in 2008, we don’t see any rise at all, and that’s not great.

Source: St. Louis Federal Reserve, Better Dwelling.

In the most recent period, we see a rapid decline in the velocity of M2 stock. From Q3 2008 to Q3 2009, we the velocity fall 20% – a lot for a 12 month period. After the recession, it continues to decline to today. Currently we’re at 1.36, which is 31.91% lower than it was before the Great Recession. If you talk to any old timers (people aged 40+), they’ll tell you that business in Canada doesn’t feel like it did before the recession. This has to do with the declining capital velocity. People aren’t spending like they did in the good old days. It’s not necessarily a bad thing, but why velocity falls can often be an indicator of that.

Deflation, Recession, and Debt

The rate of velocity falls for three main reasons – deflation, recession, or debt. The first, deflation, is when the cost of goods start to slide. People spending less to consume the same goods, it’s pretty self explanatory. The second, recession, causes consumers and businesses to spend less. Spending less (a.k.a. cash hoarding), results in a lower velocity, and slows the rate of economic growth. The third, debt accumulation, either consumer or debt. More money that goes to debt servicing, means less money rippling through the economy and stimulating growth.

There’s a lot of takeaways, and fun and exciting things we can take learn with our new understanding of capital velocity. Today, we’re just going to focus on two of them however – high home prices, and the creation of liquidity traps. The former we’ve talked about a few times, the latter is going to help explain why rising interest rates likely won’t be able to rise for as long as the Bank of Canada expects it to.

High Home Prices Lead To Low Velocity a.k.a Slow Growth

Let’s chart the percentage of median household income required to service the mortgage of a median home, beside velocity. Periods of rising velocity, when everyone is out spending, correlate with a low cost of home prices. Periods of declining velocity also correlate with periods of high home prices. Why? Most likely, when people are making money in the real economy, they don’t feel the need to speculate on non-productive assets. Not to knock housing, but the physical location of it doesn’t generate new income. Afterall, you ideally only move once every few years.

Source: National Bank of Canada, Better Dwelling.

The Bank of Canada Set A Liquidity Trap

Rather than facing the full brunt of the Great Recession, we took a theoretically painless route – rapid expansion of our monetary supply. In order to stimulate buying of goods, we slashed interest rates, and basically dropped bags of cash from a helicopter. Low interest rates were designed to increase the demand of goods, and it kind of worked. However, each dollar added to the supply becomes less effective at driving growth. We can see this in the velocity, when you realize how much money we added to the supply.

Source: St. Louis Federal Reserve, Better Dwelling.

In 2011, the former Bank of Canada governor noted “Cheap credit has been used to bid up the price of Canadian houses, a non-tradable good, rather than invest in expanding the productive capacity and export competitiveness of our businesses.” Nonetheless, we continued down that path, until we finally started to hike rates last year. Except we never saw an uptick in the Velocity of M2 Money Stock. After rapid expansion of the monetary supply, we still haven’t convinced businesses to go out and spend on tradable goods. Consumers are still mostly just using the excess money supply to buy houses. After 10 years of trying to avoid a recession, we still haven’t addressed the initial problem. We’ve only driven up individual household debt levels.

Now the Bank of Canada has two options, they can continue to expand the supply or start to shrink it. Continuing the expansion, i.e. keeping rates low, will cause further asset inflation with a minimal contribution to the GDP. If they raise rates, the supply will shrink, likely triggering a recession. People fear the consequences of a recession, but it actually addresses a very useful purpose. It corrects misallocation of capital, whether human or financial. Our ten year experiment of trying to avoid correcting the misallocation, has only made it worse.

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