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Money supply and the velocity myth
Dr Frank Shostak
In 1988 two members of the Federal Open Market Committee (FOMC), Jerry Jordan and William Poole, expressed concern regarding the strong momentum of the money supply. Year-on-year in July money M3 increased by 9.2 per cent. These two men feared that the strong monetary momentum was likely to lift the rate of inflation in months to come.
Consequently they advocated that the Fed adopt a tighter monetary stance to prevent the acceleration in the rate of inflation. Many noted Wall Street economists regarded this fear as totally misplaced. It was held, that this thinking ignored the fact that the velocity of money was currently falling. This fall in money’s velocity, it was argued, neutralised the rising monetary momentum, thereby preventing a future increase in the rate of inflation.
What do they mean by velocity? The idea that there is such a thing as velocity is based on a view that money circulates. It is alleged that when the velocity of money rises all other things being equal, the buying power of money falls, i.e., prices of goods and services rise. The opposite occurs when velocity declines. If for example it was found that the quantity of money had increased by 10 per cent in a given year, while the price level as measured by the consumer price index, had remained unchanged, it would mean that there must have been a slowing down of about 10 per cent in the velocity of circulation.
If the quantity of money has remained unchanged, but there has been a 10 per cent increase in the price level in a given period, it would mean that there must have been an increase in the velocity of circulation of money of 10 per cent in that period. According to this way of thinking it would appear that velocity is an important determinant of the value of money. Does it all make sense?
Individuals demand for various goods and services is not set arbitrary but rather consciously and purposefully. Thus people demand food because it offers nourishment which is required to support their lives and well being. Individuals demand for housing stems from the need of having a shelter. In other words for a good to be demanded by human beings it must have certain features or characteristics which will contribute to human's well being. So if the main feature of money would have been that it circulates, how would it have been useful to humans?
How money velocity would promote people's well being? The main feature of money is that people can employ it as the medium of the exchange. According to Ludwig von Mises, the service that money renders does not consist in its turnover. It consists in its being ready in cash holdings for any further use. The introduction of money into human lives enables them to expand the production of goods and services by allowing them to specialise.
With the existence of money a product of one specialist can be exchanged for the product of another specialist. Now, once an individual has exchanged his product for money he can now hold the money until he will decide to exchange it for goods that he requires. Note that by exchanging his goods for money he has exercised a demand for money. In this regard a decision by individuals to buy a certain amount of goods and services means that they have decided to lower their holdings of money. Conversely a decision to sell goods and services implies that they want to raise their holdings of money.
As with all goods it is changes in the relation between demand and supply of money that determines the purchasing power of money and not some mysterious velocity. In his writings Ludwig von Mises showed that the whole concept of velocity is hollow. According to Mises money never circulates. It is always under someone's ownership. The only time money is on the move is when it is physically carried by someone. However, this movement has nothing to do with velocity since money is still owned by someone.
The popular thinking doesn’t deny that money is always under someone’s ownership. However, it is argued, this doesn’t preclude it from being circulated. According to this way of thinking velocity means how fast money changes hands. Consequently, it is held, that all other things being equal, a rise in the speed of change in money’s ownership leads to higher prices. A fall in the speed leads to lower prices. In other words it would appear that velocity of money is an existent entity which influences my purchasing power.
A careful analysis of this will show that it is erroneous. For money cannot change hands without its owner’s decision. Implying that it is individuals demand versus supply that determines the value of money. The velocity in this case, or how fast money changes hands, is the result of individuals exercising their demands. This in turn means that the so called velocity cannot have any input in the setting of the purchasing power of money for it is not an independent entity.
By regarding velocity of money as an independent entity, most economists also conclude that its increase must be regarded as an effective rise in means of funding. This in turn, it is held, permits more economic activities. However, this way of thinking confuses funding with money. Funding consists of real goods and services i.e., means of sustenance.
The role of money is just to represent these means of sustenance, so to speak. What permits the expansion in means of sustenance is the increase in capital goods. Consequently economists who maintain that a rise in velocity of money raises the pool of funding imply that velocity can replace capital goods.
So if velocity is a hollow concept obviously it cannot neutralize the strong momentum of money as suggested by Wall Street economists. Therefore, the concern expressed by Jordan and Poole is well justified. They however, regard the rising momentum of money as a threat to the so called price stability. The harm from the rising money momentum however, is not because of a possible increase in the price level, but on account of the damage that this rising money momentum inflicts on the process of wealth generation. (Mises and other Austrian economists have shown that there is no such thing as the price level. There are only prices of goods and services. It seems therefore, that the central bank is trying to stabilise a non existent entity).
Pool of funding and money what is the relation?
At any point in time, individuals are engaging in variety of activities. Some activities are confined to the production of consumer goods and services while other activities are confined to production of tools and machinery and various intermediary products. What makes these activities possible is the fact that various individuals who are engaged in these activities are supplied with goods and services necessary to sustain their lives and well being. In other words, these individuals are supplied with the means of sustenance. So regardless of the technology imbedded in the production structure, without the means of sustenance and therefore the pool of funding, no economic activity can emerge.
The increase in the pool of funding permits the lengthening of the production structure. The lengthening amounts to the introduction of new stages of production which permits increases in the output of consumer goods. Also, new stages permit production of goods that previously could not be produced at all. Any lengthening of the production structure must be in accordance with what the pool of funding permits.
Thus if the size of the pool of funding is sufficient to sustain a production structure of a one year length, any attempt to lengthen the structure beyond the one year period must fail. The reason being, because there is only a one year supply of the means of sustenance. (Bear in mind that during the period of building new stages, all the individuals engaged must be sustained. It is only once the construction of the new stages is completed that more goods can be generated.) The pool of funding therefore sets a brake on the use of the more productive but longer stages of production.
Individual’s time preferences, as manifested by the natural rate of interest, determines how much out of a given flow of real wealth is allocated towards consumption and how much towards savings, and hence towards the pool of funding. Lowering of time preferences i.e., lowering of the natural rate of interest, implies that people are now more willing to wait for any given amount of future output. Implying that they are ready to allocate means of sustenance towards longer stages of production.
A rise in the time preferences and in the natural rate of interest means that people are less willing to wait. This means that they will allocate proportionately more of the means of sustenance towards the production of consumer goods and less towards the longer production stages. In this regard the natural rate of interest fulfils the crucial role of co-ordinating between the length of the production structure and the pool of funding.
The introduction of money will not alter the essence of the analysis we have presented so far. Money now, will offer not only the services of the medium of the exchange but also the means of savings. In the world without money individuals would encounter difficulties to save. For instance, there will be a problem with perishable goods. The introduction of money resolves these difficulties. However, to fulfil the role of the medium of the exchange and the means of savings, the money stock must remain unchanged.
This will guarantee that production will precede consumption. It will also guarantee that money is fully backed up by means of sustenance. Thus whenever a producer exchanges his goods and services for money he acquires a permit to access the pool of funding whenever he requires. By exchanging his goods for money, he enables the buyer of his goods to engage in production, thereby allowing the overall production flow to stay intact. It is this uninterrupted flow of produced goods that provides full backup to money, meaning that whenever a producer will decide to realize his money he will be able to find the means of sustenance.
Pay attention that while the pool of funding consists of real goods and services i.e., means of sustenance it is expressed or denoted in terms of money. The existence of money so to speak, enables us to grasp the existence of the pool of funding. Money however, does not create this pool. Trouble however, erupts whenever the banking system expands the money stock i.e., creates money out of ‘thin air’. For this increase in the money stock gives rise to the consumption of goods which is not preceded by production. It generates exactly the same results as the counterfeit money does.
For under these conditions the buyer of goods does not use them to support his own production. In fact he only consumes and produces nothing. Consequently the buyer of the money –– the seller of goods –– can never realize his money, for the means of sustenance to support these newly created money was never produced. Any attempt then, to lengthen the production structure by means of an expansion in the money stock must always fail. Money, therefore, cannot be a substitute to non-existent means of sustenance, and therefore its increase cannot cause economic growth. Without the backup of the means of sustenance money is just an empty concep).
Professor Friedman comments on the role of monetary policy
In an interview with the Barron’s, 24 August 1998, economics editor famous Nobel Laureate Milton Friedman argued that what was needed to fix the economic crisis in Asia was for Japan to start pulling itself out of a recession. Friedman suggested that this could be accomplished by means of the monetary pumping. According to Friedman:
The answer is that the central bank can buy up government securities. It can keep on buying them. It doesn’t matter whether the interest rate is 1.2 per cent, 1.1 per cent or 1 per cent. If it buys those securities it will increase the monetary base. It will do more in the short run to help Japan resolve its banking crisis than any short-term reforms.
In other words Milton Friedman holds that by means of monetary pumping Japan could revive its economy. How does the increase in the money stock cause economic growth? Friedman and his followers hold that all other things being equal, a loose central bank monetary policy raises people’s money balances. This increase in turn lifts their spending which in turn sets in motion an economic expansion. Further to this, the monetary pumping raises people’s demand for financial assets thereby raising their prices and lowering their yields. The fall in yields further reinforces the economic growth through the expansion in capital goods projects.
Notwithstanding the appeal of this way of thinking it is nevertheless erroneous. Neither monetary pumping and nor the artificial lowering of interest rates can grow the economy. What do we mean by the economic growth? By this we mean the expansion in goods and services that people require to sustain their lives and well beings. Goods and services, i.e., the means of sustenance are produced by various individuals with the help of tools and machinery. With better tools and machinery workers can accomplish much more than with a lesser quality tool. These tools however, do not spring out of ‘thin air’, somebody must produce them.
What makes this production possible is the fact that various individuals that are engaged in this are supplied with goods and services necessary to sustain their lives and well being. In other words these individuals are supplied with the means of sustenance. However, at any point in time the amount of the stock of the means of sustenance, i.e., the size of the pool of funding is finite. This implies that a given pool of funding sets the limit to the expansion in tools and machinery, i.e., the infrastructure, and in turn limits the economic growth.
What then causes the expansion in the pool of funding? The answer is savings. The more people save out of their production of goods and services the more they contribute to the overall pool of funding. Pay attention that money is not involved as such in economic growth. Money’s main function is to fulfil he role of the medium of exchange. This role however, cannot be improved by printing more money. On the contrary it will result in the fall of money’s purchasing power, thereby making money less marketable.
It is true that the monetary pumping is likely to boost consumer spending. However, the increase in consumption doesn’t cause economic growth, this increase only weakens the flow of savings thereby undermining the process of wealth formation. Also, the reduction in interest rates as a result of the monetary pumping cannot add anything to economic growth. Interest rates are the manifestation of the demand versus the supply of savings.
In this capacity they guide businessmen in the allocation of funding in the most profitable way. In other words interest rates are just an indicator as it were. Obviously if this indicator is falsified by means of the monetary pumping, it only causes the misallocation of funding which ultimately results in an economic recession.
During the interview Milton Friedman expressed strong misgivings about the Austrian school economic framework regarding the role of the government during a recession. The Austrian school recommends that during a recession the government should do nothing. According to Friedman this way of thinking has done the world a great deal of harm. To Milton Friedman the main source of the boom-bust cycles is volatile money supply growth.
He holds that by setting the money supply growth at a particular percentage and sticking to it, the economy would stabilise and the boom-bust cycles would disappear. For Friedman then, a fall in economic activity could only occur if the money growth falls below the percentage which supposedly generates economic stability. To do nothing then, during a recession, for Friedman means allowing the instability to perpetuate.
For Austrians however, the source of instability is the monetary pumping and the artificial lowering of interest rates. Contrary to Friedman, Austrians, in particular Ludwig von Mises, have shown that even if the money growth will be fixed at a particular percentage, it will give rise to boom-bust cycles because the increase in money always causes consumption that is not preceded by production. This in turn always weakens the process of wealth formation. Further, stable monetary pumping produces artificial lowering of interest rates which in turn causes the misallocation of funding.
The emergence of a recession in the Austrian framework is always the beginning of the healing process. During a recession the pool of funding is redirected from non-wealth generating activities towards wealth generating activities. This implies that various non-wealth generating activities, which sprang on the back of the monetary pumping at the expense of wealth producers, must disappear.
Obviously pumping money will only arrest the process of adjustment and enforce misery. So doing nothing as far as the central bank and the government are concerned is the best policy. For it is active governments and central banks that cause the boom-bust cycle.
Dr Frank Shostak is a former professor of economics who now works in the private sector
BrookesNews.Com
Monday 26 September 2005