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Tuesday, March 16, 2010 5:10 AM

Misconceptions about Money and Velocity

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Inquiring minds are interested in velocity and money. John Mauldin discusses both in The Implications of Velocity. Unfortunately, Mauldin perpetuates three widely believed myths in his article.

Misconception #1: Money Supply Needs To Grow

"Now, there is no exact way to determine the right size of the money supply. It definitely needs to grow each year by at least the growth in the size of the economy, the population, and productivity, or deflation will appear. But if money supply grows too much then you have inflation."

Reality #1:

Money supply most assuredly does not need to grow each year by the size of the economy, by increases in population, or anything else as is widely believed.

An increase in money supply confers no overall economic benefit whatsoever. Over time, money simply buys less and less.

Please consider a few re-ordered sentences of Rothbard's classic text: What Has Government Done to Our Money?

Money is a commodity used as a medium of exchange.

Like all commodities, it has an existing stock, it faces demands by people to buy and hold it. Like all commodities, its “price” in terms of other goods is determined by the interaction of its total supply, or stock, and the total demand by people to buy and hold it. People “buy” money by selling their goods and services for it, just as they “sell” money when they buy goods and services.

Money is not an abstract unit of account. It is not a useless token only good for exchanging. It is not a “claim on society”. It is not a guarantee of a fixed price level. It is simply a commodity.
What Is The Proper Supply Of Money?

Continuing from the book ...
Now we may ask: what is the supply of money in society and how is that supply used? In particular, we may raise the perennial question, how much money “do we need”?

Must the money supply be regulated by some sort of “criterion,” or can it be left alone to the free market?

All sorts of criteria have been put forward: that money should move in accordance with population, with the “volume of trade,” with the “amounts of goods produced,” so as to keep the “price level” constant, etc.

But money differs from other commodities in one essential fact. And grasping this difference furnishes a key to understanding monetary matters.

When the supply of any other good increases, this increase confers a social benefit; it is a matter for general rejoicing. More consumer goods mean a higher standard of living for the public; more capital goods mean sustained and increased living standards in the future.

[Yet] an increase in money supply, unlike other goods, [does not] confer a social benefit. The public at large is not made richer. Whereas new consumer or capital goods add to standards of living, new money only raises prices—i.e., dilutes its own purchasing power. The reason for this puzzle is that money is only useful for its exchange value.

[Thus] we come to the startling truth that it doesn’t matter what the supply of money is. Any supply will do as well as any other supply. The free market will simply adjust by changing the purchasing power, or effectiveness of the [monetary-unit] gold-unit .
The online book is a great read and I highly recommend reading it in entirety.

Misconception #2: Falling Velocity Causes Economic Activity to Decrease, Requiring an Increase in Money Supply to Maintain the Status Quo

"If velocity does slow by another 10%, then money supply (M) would have to rise by 10% just to maintain a static economy."

Reality #2:

Falling velocity is a result of an increased demand to hold money as opposed to a desire to expand productive capacity or borrow to make purchases. In other words, banks do not want to lend and consumers and businesses do not want to borrow. The Fed can print, but it cannot determine where the money goes, or indeed if it goes anywhere at all.

If the Fed increased money supply by 10%, the most likely consequence would be for money to sit or perhaps make its way into non-GDP producing financial speculation. Thus, GDP would not rise by 10%, instead velocity would plunge.

Congress can get into the act by giving away money, as it does with various stimulus plans but that has encouraged little lasting economic activity. Unemployment checks maintain spending on food and essentials but those are low-velocity activities. And as boomers head into retirement, peak spending behind them, velocity is highly likely to continue its downward slide.

By the way, when figuring velocity is it correct to use M1, M2, MZM, Base Money Supply, Austrian Money Supply, or True Money Supply? Obviously the measure of velocity differs widely depending on what definition of money one uses. In general, the broader the measure of money, the lower the resultant velocity.

Misconception #3: In a normal scenario, banks take money and lend it out 9-10 times over.

"And now we come to the policy conundrum for the Fed. They have pumped a great deal of money (liquidity) into the economy. Normally, banks would take that money and multiply it by lending it out (through fractional reserve banking at a potential 9-times factor), increasing velocity and the overall money supply."

Reality #3: Lending Comes First, Reserves Come Second

Australian economist Steve Keen and I have emphasized reality number 3 on numerous occasions. Please consider Fictional Reserve Lending And The Myth Of Excess Reserves for a lengthy rebuttal to the idea that the Fed expands money supply then banks lend it 10 times over.

Those are three widely believed misconceptions. Unfortunately they continually make the rounds. By the way, John Mauldin is a friend of mine and his columns are usually worth a look.

Mike "Mish" Shedlock
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