The Velocity Squared Bellwether: How V^2 Correlates with Economic Crises

In a previous analysis, we explored the relationship between the velocity of money (V), its squared form (V^2), and economic output, expressed in the equation pQ = MV^2. This equation, analogous to Einstein's E = mc^2, posits that just as energy is amplified by the square of the speed of light, economic output might be significantly influenced by the squared velocity of money. This follow-up essay delves deeper into the empirical evidence, suggesting that V^2 could indeed act as a bellwether for impending economic crises by reflecting various economic distortions that precede these crises.

Revisiting the Correlation Between V^2 and Economic Output (pQ)

We've calculated the correlation between MV (interpreted here as pQ) and V^2 by examining different economic periods over the past six decades. The results reveal a compelling pattern: high correlations between V^2 and pQ tend to precede economic crises, suggesting that V^2 could be a critical indicator of underlying economic issues that eventually lead to instability.

Periods of High Correlation: Harbingers of Crises

1. 1974-1982: Stagflation and Recession

   - Correlation: 0.832

   - Interpretation: During this period, the high correlation between V^2 and pQ coincides with a time of severe economic stress marked by stagflation—simultaneously high inflation and unemployment—culminating in a deep recession. The strong correlation suggests that as the economy became more volatile, changes in money velocity had an amplified impact on economic output, signalling the underlying instability that led to the early 1980s recession. This recession was driven by:

    - Asset Bubbles and Speculative Behavior: In the 1970s, speculative investments, particularly in real estate and commodities, led to inflated asset prices. This inflated pQ without a corresponding increase in economic productivity. The oil shocks of the 1970s and resulting speculation in energy markets further destabilized the economy, contributing to high inflation and reduced consumer confidence.

    - Inflationary Pressures: The inflationary spiral during the 1970s was fueled by high energy costs and loose monetary policies, leading to stagflation—a rare and difficult economic condition where inflation remains high despite stagnating growth. Persistent inflation led to wage-price spirals, further exacerbating economic instability and pushing pQ higher.

2. 1983-1990: Recovery and Expansion

   - Correlation: 0.730

   - Interpretation: Although this period is labelled as one of recovery and expansion, it was also characterized by significant economic restructuring and the aftereffects of the stagflation era. The high correlation between V^2 and pQ suggests that even in recovery periods, underlying economic vulnerabilities could be exposed, setting the stage for future instability and eventually leading to the early 1990s recession. This recession was influenced by:

    - Credit Expansion and Leverage: The 1980s saw a significant credit expansion, fueled by deregulation and the growth of the financial services industry. This led to increased borrowing and speculative investments, particularly in real estate. The increased use of leverage in corporate and personal finances magnified economic activity and heightened the risk of financial instability when economic conditions changed.

    - Misallocation of Resources: The real estate bubble of the late 1980s is a prime example of resource misallocation, where excessive investment in property development eventually led to a market collapse. While substantial, the growth observed during the 1980s was unsustainable due to the over-reliance on debt and speculative investments. When these bubbles burst, the economy contracted sharply, leading to the recession of the early 1990s.

3. 2001-2007: Pre-Financial Crisis

   - Correlation: 0.682

   - Interpretation: Leading up to the 2008 financial crisis, the economy experienced rapid growth fueled by credit expansion and speculative investments, particularly in the housing market. The strong correlation between V^2 and pQ during this period suggests that the economy was becoming increasingly sensitive to changes in money velocity, foreshadowing the eventual collapse of the financial system. The Lehman crisis of 2008 was a direct consequence of the underlying instability indicated by this high correlation, driven by:

    - Asset Bubbles and Speculative Behavior: The housing market bubble, characterized by soaring real estate prices, was a key driver of pQ during this period. The rapid increase in home prices was not matched by fundamental economic growth, creating a disconnect that eventually led to the crisis. Financial instruments such as mortgage-backed securities (MBS) and collateralized debt obligations (CDOs) became highly speculative, further inflating the bubble and increasing the economic system's fragility.

    - Credit Expansion and Leverage: The availability of easy credit, often to subprime borrowers, fueled a surge in home purchases and speculative investments. The proliferation of adjustable-rate mortgages (ARMs) and other risky lending practices amplified this trend. The use of leverage by financial institutions to maximize returns on speculative investments further heightened systemic risk. When the housing bubble burst, the excessive leverage led to a cascading failure in the financial system.

Periods of Low or Negative Correlation: Indicators of Stability

In contrast, periods with low or negative correlations between V^2 and pQ tend to coincide with times of economic stability or recovery:

1. 1964-1973: Post-war Boom and Stability

   - Correlation: 0.151

   - Interpretation: During this period of steady economic growth, the low correlation between V^2 and pQ indicates that the economy was not highly sensitive to changes in money velocity, reflecting a stable and balanced economic environment. This stability was underpinned by strong industrial growth, a healthy labour market, and relatively low inflation.

2. 1991-2000: Tech Boom and Stability

   - Correlation: -0.207

   - Interpretation: Despite the speculative nature of the tech bubble, the negative correlation suggests that the relationship between money velocity and economic output was decoupled, likely due to the specific dynamics of the tech sector that didn't broadly affect the entire economy until the bubble burst. The economy was generally stable, supported by technological innovation and productivity gains, although speculative investments in the tech sector eventually led to the dot-com bust in 2000.

3. 2008-2013: Financial Crisis and Recovery

   - Correlation: -0.227

   - Interpretation: In the aftermath of the financial crisis, the negative correlation reflects the economic dislocation and the decoupling of money supply dynamics from real economic activity during the recovery phase. This period was marked by significant monetary intervention (e.g., quantitative easing) and structural adjustments within the financial sector.

4. 2014-2020: Post-Crisis Recovery and Stability

   - Correlation: 0.294

   - Interpretation: The weak positive correlation during this period suggests a return to more stable economic conditions, with less sensitivity to changes in money velocity. Economic growth was driven by moderate inflation, low interest rates, and a stable labour market, contributing to a prolonged recovery from the financial crisis.

5. 2021-2024: Post-Pandemic Recovery

   - Correlation: 0.400

   - Interpretation: The moderate correlation during this recovery period from the COVID-19 pandemic suggests some alignment between V^2 and pQ, but not enough to indicate immediate economic instability. This period has been characterized by unprecedented fiscal and monetary interventions, supply chain disruptions, and shifting consumer behaviour, all of which have influenced the dynamics of money velocity and economic output.

The Empirical Evidence: V^2 as a Bellwether for Crises

The empirical evidence strongly supports the notion that V^2, or the squared velocity of money, correlates significantly with pQ during periods leading up to economic crises. The periods of 1974-1982, 1983-1990, and 2001-2007—all followed by significant economic downturns—show high correlations between V^2 and economic output. This suggests that when V^2 closely tracks pQ, it could be signalling underlying economic vulnerabilities that may culminate in a crisis. These vulnerabilities include inflated asset prices, speculative investments, excessive credit expansion, leverage, inflationary pressures, and the misallocation of resources.

Conclusion: The Role of V^2 in Economic Forecasting

The data supports the idea that V^2 is not just a theoretical construct but a practical tool for anticipating economic crises. High correlations between V^2 and pQ are reliable indicators of economic instability, making V^2 a potential bellwether for forecasting future crises. These periods of high correlation are often characterized by underlying economic vulnerabilities, such as inflated asset prices, speculative investments, credit expansion, leverage, inflationary pressures, and misallocation of resources.

Conversely, periods of low or negative correlation correspond to times of economic stability or recovery, where the economy is less sensitive to fluctuations in money velocity. During these times, the economy tends to function more predictably, with less susceptibility to shocks and crises.

As we look ahead, monitoring the relationship between V^2 and pQ could provide valuable insights into the health of the economy, helping policymakers and investors anticipate and respond to potential economic disruptions before they fully materialize. The historical data proves that V^2 can indeed signal when the economy is on a precarious footing, offering a new perspective on economic forecasting.

In particular, the high correlations observed in the periods leading up to the early 1980s recession, the early 1990s recession, and the 2008 financial crisis suggest that when V^2 tracks pQ closely, it could be a warning sign of an impending economic downturn. By paying close attention to these correlations, it may be possible to identify and mitigate the risks before they escalate into full-blown crises.

Moreover, the consistency of this pattern across multiple decades and different types of economic environments reinforces the utility of V^2 as an analytical tool. Whether the economy is experiencing stagflation, a credit-fueled boom, or a speculative bubble, the correlation between V^2 and pQ appears to offer valuable foresight into potential disruptions.

In summary, the squared velocity of money, V^2, is a powerful indicator that can help us better understand the complexities of economic cycles. It provides a unique lens through which we can view the relationship between money velocity and economic output, offering valuable insights into the conditions that precede economic instability. As we refine our understanding of these dynamics, V^2 could become an essential tool in the toolkit of economists, policymakers, and investors alike, helping to navigate the uncertainties of the global economy with greater foresight and precision.

Recognizing the patterns and understanding the correlations in historical data allow us to approach future economic challenges with informed strategies. This is especially crucial as we look toward the post-pandemic era and beyond, where past lessons can help us anticipate and mitigate the economic risks that lie ahead.