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What the Number Crunchers Get Wrong about the “Velocity of Money” – Alasdair Macleod (06/25/2019)

The idea of “velocity of circulation” arose from the quantity theory of money, which links changes in the quantity of money to changes in the general level of prices. This is set out in the equation of exchange. The basic elements are money, velocity and total spending, or GDP. The following is the simplest of a number of ways it has been expressed:

Money x Velocity of Circulation = Total Spending (or GDP)

Assuming we can quantify both money and total spending, we end up with velocity. But this does not tell us why velocity might vary. All we know is that it must vary in order to balance the equation. You could equally state that two completely unrelated quantities can be put into a mathematical equation, so long as a variable is included whose only function is to always make the equation balance. In other words, the equation of exchange actually tells us nothing.

This gives analysts a problem, not resolved by the modern reliance on statistics and computer models. The dubious gift to us from statisticians is their so-called progress made in quantifying the economy, so much so that at the London School of Economics a machine called MONIAC (monetary national income analogue computer) used fluid mechanics to model the UK’s economy. This and other more recent computer models give unwarranted credence to the idea that the economy can be modelled, derivations such as velocity explained, and valid conclusions drawn.

Ludwig von Mises criticized these notions in Human Action when he wrote:

The mathematical economists refuse to start from the various individuals’ demand for and supply of money. They introduce instead the spurious notion of velocity of circulation according to the pattern of mechanics.

Mises’s criticism is based on the philosopher’s logic that economics is a social and not a physical science. Therefore, mathematical relationships must be strictly confined to accounting and not be confused with economics, or as he put it, human action. Unfortunately, we now have the concept of velocity so ingrained in our thinking that this vital point usually escapes us. Indeed, the same is true of GDP, or the right-hand side of the equation of exchange.

GDP is only an accounting identity: no more than that. It ranks gin with golf-balls by reducing them both to a monetary value. Statisticians select what’s included so it is biased in favor of consumer goods and against capital investment. Crucially, it does not tell us about an ever-changing economy comprised of successes, failures, and hard-to-predict human needs and wants, which taken all together is economic progress. And because it is biased in its composition and says nothing about progress the value of this statistic is grossly exaggerated. 

The only apparent certainty in the equation of exchange is the quantity of money, assuming it is all recorded. No one seems to allow for unrecorded money such as shadow banking, but we shall let that pass. If the money is sound, as it was when the quantity theory of money was devised, one could assume that an increase in its quantity would tend to raise prices. This was experienced following Spain’s importation of gold and silver from the new world in the sixteenth century and following the gold mining booms in California and South Africa. But relating an increase in the quantity of gold to prices in general is at best a summary of a number of various factors that drive the price relationship between money and goods.

[RELATED: “The Role of Shadow Banking in the Business Cycle” by Arkadiusz Sieroń]

But with both sound money and fiat money, the only way to understand the relationship between money and prices is in a human framework. The quantity of a fiat currency is first expanded without the public noticing, other than the prices of certain commodities rise, or prices in and near financial centers increase as bankers and allied trades have more money to spend. As people see prices starting to rise more generally, they begin to buy more goods than they need in the knowledge that prices are rising. 

In the current fiat money system, people have been doing this for years, to the point where most of the population in most countries have abandoned savings altogether and now borrow to spend. It is a situation that can persist for many years, moderated by cycles of varying credit expansion, before a final flight into goods and out of money altogether takes place. During that final collapse of purchasing power, in von Mises’s own words, “The mathematical economists are at a loss to comprehend the causal relation between the increase in the quantity of money and what they call velocity of circulation.”1

According to the equation of exchange, this is not how things should work. The order of events is first you have an increase in the quantity of money and then prices rise, because monetarist logic states that prices rise as a result of the extra money being spent, not as a result of money yet to be spent (the condition when people anticipate rising prices). With a mechanical theory there can be no room for subjectivity.

It is therefore nonsense to conclude that velocity is a vital signal of some sort. Monetarism is at the very least still work-in-progress until monetarists finally discover velocity is no more than a factor to make their equation balance. The broker’s analyst quoted above would have been better to confine his statement to the easy money regimes of the past 20 years being responsible for the substantial misallocation of capital, leaving out the bit about velocity entirely.

A small slip perhaps on the way to a sensible conclusion; but it is indicative of the false mechanization of human behavior by modern macro-economists. However, it should also be noted that is impossible to square the concept of velocity of circulation with one simple fact of everyday life: we earn our salaries once and we dispose of it. That’s a constant velocity, give or take, of one.

  • 1. Ludwig von Mises; Human Action, Chapter 17.8 “The anticipation of expected changes in purchasing power.”

Alasdair Macleod is the Head of Research at GoldMoney.