Why bailouts are not working?

With governments all around the world announcing bailout packages totaling trillions of dollars, the questions remains - why is the global economy not recovering? The answer lies in understanding the concept of ‘velocity of money’.

Let us take a simple case in which there are only two people in a given country - Mr. A, who sells clothes and Mr. B, who sells food. Suppose Mr. A has $100 and buys food worth $100 from Mr. B every month. Mr. B then spends the $100 buying clothes from Mr. A every month. Thus the total value of transactions each month is $200. Hence the annual GDP (gross domestic product) for the country is $2,400.

As can be seen, with just $100 worth of money in the economy, the GDP can be as high as $2,400. The reason is - velocity of money - or in simple terms how fast does money flow from one person to the other. In this case the velocity of money is 24.

Now let us consider another case in which both Mr. A and B suddenly have a millions of dollars each. However, they decide to keep all their extra money in mattresses and still carry out transactions like they were doing before. Consequently the GDP for the country will still be $2,400. Even though there is millions of dollars worth of money in the economy, the GDP is still $2,400!

As can be seen, the amount of money does not really matter if it is idle. The money in the mattress is non-existent for all practical economic purposes. If people decide not to spend money, the velocity of money goes down.

This is exactly what is happening right now. Even though governments all over the world are pumping in huge amounts of money into the economy, people and companies are taking in the money and not spending it. As in the above example, the money is going into the ‘mattress’ and hence is not having any material impact on the economy.

As can be seen from the graph below, the velocity of money goes down significantly during recessions (years highlighted in grey). This is the reason why the numerous bailouts all over the world do not seem to be having any effect.

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This post presents a point of view which differs from conventional wisdom. Apart from being a good read (hopefully), it can also be a good starting point to help readers, preparing for CAT (IIM) or other MBA interviews, think differently. Since the data / facts for these posts are derived from a host of sources and websites, readers are advised to cross-check the authenticity before using them anywhere.