Debunking the Velocity of Money Myth


The markets got off to a bad start Wednesday following the news that some members of the Federal Open Market Committee slipped the word “deflation” into the minutes of its last meeting, in December.

Thus, the media jumped all over the deflation theme. Although there was only one mention of “deflation” in the entire 6,000-plus word release, it prompted headlines like this one from MarketWatch: “FOMC Members Discussed Mounting Risks of Deflation, Depression at Mid-December Meeting.”

The stock markets crumbled. Most commodities fell. And even though the dollar fell, gold prices fell $24 on the Comex in response to all this noise Wednesday, while the gold stocks were among the worst performing sectors on the board. Recovery sentiment halted in its tracks as the deflation trade came back with a vengeance. Of course, I’ve been more cautiously bullish with gold prices approaching the resistance points controlling their intermediate downtrend. But my reasoning is that the reflation trade will win out and drive up both stocks and commodities broadly, at gold’s expense, but only short term.

The bulk of the evidence supports this trade, but it has ebbed a little this week because of the news flow – none of which says anything new about the prospects of “deflation” in the Fisherine sense of a liquidation of debts and contraction in deposits. It was just more of the same drivel about falling prices and the shrinking economy, profits and employment, with commentators dragging in long-discredited concepts like velocity of money, the multiplier or even Japan’s alleged deflation during the ’90s.

Of course, as with any other “bubble” – if I am right to call it that – it implies an extent of irrational exuberance or popular delusion, and then there is the sustainability feature… bubbles simply don’t last.

In the reader comment section in response to the MarketWatch report on the minutes of the FOMC, there were example after example illustrating that people believe deflation is caused by a slowing in the economy; rising unemployment; or falling wages and prices, including asset prices… or that deflation is bad; or saving is bad; or deflation existed throughout the ’30s, despite the Fed’s efforts.

I have already dealt with most of these misunderstandings in past issues. My influence must be waning, because they’re not fading away!

Now let me take this opportunity to emphasize something. I do not mean to seem stubbornly fixed to the inflation paradigm. I’m not, in fact. I worry about the deflation possibility. I am always considering new facts and old premises as part of an analytical check to my evolving outlook. My recent tirade is not against the “possibility” of deflation – which cannot be denied. It is a reaction to the nonsense that underlies the great many bad arguments for deflation, which are either littered with factual errors about history or rely on theoretical concepts that are outdated, obsolete and have been long discredited.

The best argument for deflation, given the current monetary system, is if central banks decide that they want to take liquidity out of the system one day (i.e., run a deliberate deflation policy) or be serious enough about fighting inflation, they might overshoot. But no one is making this case.

Unlike the period 1929-33, central banks today can print “reserves” up. You can see this yourself.

There is nothing much to check this process but the will of the populace or the prudence exercised by politicians. The original deflationist, Irving Fisher, made sure of that. He scared America off the gold standard much like the deflation calls of the day have scared the Fed into ballooning its balance sheet!

Speaking of Fisher, I want to deal with one of the most ancient nonsensical theories about money that underpins the deflation scare today: the “velocity of money,” a concept that Fisher himself resurrected.

According to proponents, an increase in money supply doesn’t necessarily mean that money will lose its purchasing power if the velocity of circulation slows down, which happens if people don’t spend.

David Rosenberg, Merrill Lynch’s chief economist, recently put it this way:

“Money supply will increase, but money velocity will not. We are getting asked repeatedly these days how it is that the government debt creation we are about to see is not going to be inflationary. After all, aren’t we going to see a boom in the money supply? Well, we’re sure that the money supply is going to increase, but at the same time, we are going to see the turnover rate of that money, or what is called money velocity, decline.” [Emphasis added.]

And in a segment on CNBC Wednesday discussing the grave threat of deflation, Art Cashin said:

“Even if you walked over and gave somebody a trillion dollars and they either put it in the mattress or just in their pocket, it doesn’t help the economy. You need the velocity of money to move. You gonna give people money, they gotta go out and begin to use it. And we’re seeing some of that worry coming home to roost here in the market today. We saw Intel…” [Emphasis added.]

With people like this, big credentials and all, promoting such ideas, it’s no wonder the deflation scare has teeth, even though it can’t bite through the flesh. Contrast their words with those of former Wall Street Journal reporter and economist Henry Hazlitt, who brought the Austrian School to America:

“Monetary theory would gain immensely if the concept of an independent or causal velocity of circulation were completely abandoned. The valuation approach, and the cash holdings approach, are sufficient to explain the problems involved.”

Hazlitt wrote that in 1968 in an essay in which he demolished the velocity of money notion.

Simply put, the idea “refers to the rate at which money circulates, changes hands or turns over.” It is a very old idea, harking back to the days when the “mechanistic quantity theory” of money predominated. That is, before we understood how individual judgments determined value, this concept of velocity explained variations in the value of money that were out of proportion with the variations in its supply. Under the mechanistic quantity theory, such changes were to be proportional.

Fisher adopted the idea of velocity in his dubious formulation MV=PT (where M is the supply of money, V is its velocity of circulation, P is the general price level and T is the volume of trade).

Both the mechanistic quantity theory and Fisher’s equation have long since been refuted. No credible economist takes either of them seriously. But the idea of the velocity of money has survived, nevertheless, and today it’s a pain in the neck. Hazlitt’s insights were as follows.

First, as far as Fisher’s equation goes, velocity (V) is not an independent variable. It is always exactly equal to the volume of trade T, and is driven by trade, not vice versa – it does not drive trade:

“What we have to deal with, in the so-called circulation of money, is the exchange of money against goods. Therefore, V and T cannot be separated. Insofar as there is a causal relation, it is the volume of trade which determines the velocity of circulation of money, rather than the other way around… the velocity of circulation of money is, so to speak, merely the velocity of circulation of goods and services looked at from the other side. If the volume of trade increases, the velocity of circulation of money, other things being equal, must increase, and vice versa.”

Changes in the velocity of circulation are thus the effect, and not the cause, of changes in the demand for money and/or goods. The concept is a makeshift explanation for the factors affecting the demand for money. For example, if the price level did not change in direct proportion to the money supply, the “Fisherine quantity theorists” would explain it with reference to changes in the velocity of circulation.

Yet the statistic has no more bearing on the value of money (its purchasing power) than the concept of “inventory turnover” has on the price of the individual units of inventory. It cannot cause anything.

Second, as Ludwig von Mises explained, money doesn’t really circulate at all. Nor is it idle. It is always in someone’s possession, but ready to be exchanged (or used). It only spends a fraction of the time changing hands – i.e., without an owner. And when it is exchanged, someone else wants it for the same reason: to keep on hand for future use. It does not simply circulate on its own, as if by some unexplained force, and especially not independent of human judgments of value or expressions of the demand for money, as von Mises pointed out in his famous treatise Human Action:

“The service that money renders does not consist in its turnover. It consists in its being ready in cash holdings for any future use. The main deficiency of the velocity of circulation concept is that it does not start from the actions of individuals, but looks at the problem from the angle of the whole economic system. This concept in itself is a vicious mode of approaching the problem of prices and purchasing power. It is assumed that, other things being equal, prices must change in proportion to the changes occurring in the total supply of money available.”

Third, neither does velocity measure the willingness of people to hold or get rid of their cash, because for everyone who is rendering their cash, someone is taking it, so that at all times, Hazlitt tells us:

“Average individual cash holding must always be the total supply of money outstanding divided by the population… People who are more eager to buy goods, or more eager to get rid of money, will buy faster or sooner. But this will mean that V increases, when it does increase, because the relative value of money is falling or is expected to fall. It will not mean that the value of money is falling, or prices of goods rising, because V has increased… It is the changed valuation by individuals of either goods or money or both that causes the increased velocity of circulation as well as the price rise. The increased velocity of circulation, in other words, is largely a passive factor in the situation.”

He did find, however, that increases in money velocity corresponded with periods of intensifying speculation, whether that speculation was a bullish or bearish extreme. That is, this velocity has no directional significance even as a byproduct – it was just as likely to rise with too much speculation on the bearish side as on the bullish side. Consequently, since it is tied to the volume of speculation and trade, “velocity of circulation cannot fluctuate for long beyond a comparatively narrow range.”

In summary, I am not saying deflation is impossible – only that if the Fed is inflating, we’ll have inflation.

This truth is so simple that it is bewildering to see so many people take the other side of that bet. It is a testament to the effectiveness of the Fed’s propaganda campaign that the deflation argument tends to recruit some of its otherwise potentially most ardent critics.

Keep your eye on the ball, and in the end, you will see that the deflation bogeyman is just that – a myth – used by politicians and central bankers to fear monger the masses into allowing them to inflate.

It has never been anything more.

Irving Fisher was one of its earliest authors, and it was he who lobbied for creation of the Fed, and advised the subsequent abandonment of the gold standard. Certainly, there is no precedent for what the Fed is doing today, but that by itself is no reason to summon the deflation bogeyman.

As for why the reserves the Fed is creating have not been multiplied, the answer is simple: Interest rates are too low! If you fixed the price of oil at 50 cents per barrel, supply would run out quick too.

Ed Bugos
for The Daily Reckoning Australia



  1. Ed…Why is deflation (in the shorter term)such a myth when the banks and financial institutions are using the government”handouts” to try to improve their balance sheets and basically are not lending but acting in their own survival interests as expected. Further whilst this is all happening( and money not being lent)the asset values underpinning the banks are still in freefall and there is no guarantee that additional TARP money (or heaps more green paper)will put a floor under it or keep a lot of the banks any more solvent than they were 6 months ago. The velocity of money may be discredited in an economic theory sense, but all this created money is not out there chasing goods, commodities or assets but trying to put a floor under the banking system. Again why are you so sure that “the deflation bogeyman is just that -a myth”. I dont doubt inflation will come (some goods and taxes rise everyday)if other actions are not taken at appropriate time but the financial system may be a little different when it does, as someone has to pay the piper….any comments.

  2. Ed: You debunk the velocity of money myth, and I like what you have written there. But I agree with Gerry in that I don’t see how you debunk deflation at all.

    If the banks won’t lend or people won’t trade for fear of not having enough cash tomorrow, does that not imply that there will be deflation?

    And if you are really going to talk about deflation, surely you would start by defining what you mean by deflation, eg- deflation of the money base, deflation of prices, deflation of credit. What do you mean!?

    Anyway, for those who couldn’t be bothered wading through that article, the two useful points debunking velocity are:

    – “Changes in the velocity of circulation are thus the effect, and not the cause, of changes in the demand for money and/or goods.”

    – “money doesn’t really circulate at all. Nor is it idle. It is always in someone’s possession, but ready to be exchanged (or used). It only spends a fraction of the time changing hands – i.e., without an owner. And when it is exchanged, someone else wants it for the same reason: to keep on hand for future use.”

  3. Ed. Your post is insightful. I take the velocity to mean the transaction rate (applied by individuals, companies and governments) to the amount of money which is out there in circulation.
    I refer to money’s velocity(V) x volume (or mass) as it’s MOMENTUM. Indeed I have never taken any notice of the T part of this formula (because I hate looking at economic formulas I don’t understand and becasue I only ever did enough to aviod failing exams on the subject).

    Money printing won’t make a difference at the formula level if you are using it to consider real purchasing power terms rather than a nominal value (which could be interpreted as nothing more than a purchasing power index).

    People are paid in fiat currency and most often hold their savings in fiat currency. Money printing (quantitative easing) must clearly drop the purchasing power of what they have. In plain language we all in for a massive WAGES CUT! This will far out weigh the cheques that are being sent by politicians to consumers in the mail.

    My current conclusion is that we are in for a significant bout of real PURCHASING POWER DEFLATION against a backdrop of money printing that results in NOMINAL PRICE INFLATION.

    There is a common misconception that one will automatically balance out the other. Why should they? Why should quantitative easing cure purchasing power deflation? The two phenomena are not mutually exclusive and in my view we are likely to end up with the worst of both.

    Coffee Addict
    January 16, 2009
  4. Reduced trade and as an outcome reduced velocity do matter. When cash is sucked up into what are already well understood as phoney balance sheets at banks and reserves you have to worry about the deflationary effect on trade in the general economy.

    But as far as asset deflation goes, liquidate-radically restructure-nationalise the banks before refloating them asap and publicly fund only the bail out of a large chunk of an underwater mortgage borrowers’ interest payments compensated by a quarantined specific purpose death duty for the life of the mortgages. Fund nothing else than the expenses of committees delivering cuts to public expenditure or improving balance sheet risk accounting rules and audit.

  5. I think of currency as either dynamic or non dynamic capital…….currency in circulation is dynamic energy … the inflationary bail out funds currently hoarded by the big banks is only potental energy right now. Less available currency circulating must bring down assett values that rose due to a massive debt binge.
    In my opinion,the big banks are waiting to buy up everything for a fraction of their true values and then start lending to the people who will then buy the produce of those companies.

    nic meredith
    January 17, 2009
  6. Velocity of Money is not a myth, it is a fact of life based on observations. You cannot deny the fact that bank reservs have gone up in the last 6 months from a few billion to almost 500 billion. That is money sitting at the FED, the money that FED pumped into the banking system in the first place. Check our facts first.

  7. Your bebunking only works in a world that has no banks.

    Do you understand how money is created? Loans! I make a deposit in a bank and the deposit gets loaned out by the bank. That new loan gets spend and RE-DEPOSITED at a bank and the process starts all over. So the velocity of money doesn’t pertain to actual cash changing hands but to money going in and coming out of banks. If I fill a mattress with cash I’m depriving someone of a loan. If I’m a banker and I’ve got mounting loan losses and I’m hoarding cash to protect my bank from those losses I am depriving some one of a loan. If loans aren’t getting made, then deposits aren’t getting made and trade can’t happen even if their is demand for it.

    While consumers are probably not yet filling matresses with money, banks are for surely depriving the economy of loans as they hoard cash. Add as consumers reduce demand for loans they also impact the rate of money creation.

    So YES there is a velocity of money.

  8. So Adam, are you suggesting that a system without banks would have zero velocity?

    Or that if people stop using loans and credit that money would have less velocity?

    I’m not sure what your point is…

  9. Hazlitt’s describes money’s role as being benign in an economic transaction as cash is transfered from one economic agent to another. Hence its only purpose is to act as an accounting tool. The demand for goods in the economy determine the volume of transactions and therefore the velocity of money needed to appropriate these transactions. But in the short run the stock of money does effect the volume of economic activity, just like if I forgot my wallet when going to the grocery. I would at least have to postpone my purchase. The problem the Fed is trying to grapple is if everyone forgets their wallet will the grocery store go bust, and to what extent can the very short run have a feed back effect into the economy for the long term.

  10. “It is the changed valuation by individuals of either goods or money or both that causes the increased velocity of circulation as well as the price rise. The increased velocity of circulation, in other words, is largely a passive factor in the situation.”

    I understand this argument but if the idea is to place “valuation by individuals” into a state of being an unsolvable enigma it is both right and wrong. In the case of, for example, a fad or willingness to pay more for aesthetics combined with function such as apple computers there is definitely a point that it depends on the “valuation by individuals”.

    Then there is another case such as a much faster than normal increase or decrease in the year to year percentage change of the inflation adjusted money supply which always originates from the banking sector. Money supply that increases much faster than the average year to year percentage change, which is due to the profit motivations of banks during boom periods, can have a sudden impact on prices as the supply of money grows faster than the supply of goods and services. The reason banks are responsible for the money supply is that they are the only variable in money supply and demand. The non bank sectors pull for money is essentially unlimited, as long as currency has value, absent bank rules and regulations which are under government and bank control, therefore the amount of money that is pulled from the banking sector depends on the the only variable which is the rules and regulations set by government and the bank sector. If there is a rapid increase in money supply the money velocity will generally increase while savings decrease due to speculative distortions when individuals rationally try to find investments due to both the individuals motivation for profit and as his/her counter to nominal profit loss due to inflation. The other reason a bank driven increase in money supply, which is due to profit motivations of banks in boom cycles increasing their willingness to give loans, has to increase velocity is because bank loans come with pre-conditions and business plans that necessitates the spending of money in order for customers to retain their credit rating, get future loans and succeed in their business. Individual Self interest dictates that overall these incentives will increase money velocity in boom cycles due to expanding credit and the framework of bank loans. In this case money velocity is not passive but is directly related to an increasing money supply combined with rational actors who want to gain profits, retain the ability to get bank loans and at the same time avoid inflationary losses and bad credit ratings. On the other hand the widespread realization that money supply has for example rapidly doubled making it worth half as much relative to a constant or constant percentage increase in the supply of goods necessarily depends on that money circulating. If half the doubled money supply was put under mattresses and remained there the money supply in the economy would not increase relative to goods and so money would not lose half of its worth resulting in the doubling of the price of goods and services with wages generally trailing. The process of borrowing money from banks combined with individual self interest that motivates repaying bank loans is the reason this does not happen. The rising prices due to the results of bank loans and money supply growing faster than productivity and the supply of goods and services draws out savings as inflationary pressure motivates investment and spending because of profit motivation and an aversion to the loss of spending power.

    The exact opposite situation would be the money supply quickly contracting, for example %50, as old loans were repaid at the same time as new loans were not forthcoming. The motivation banks generally have to stop lending money is to unwind leverage and enact recapitalization measures with an eye to gaining liquidity and decreasing liabilities in order to counteract the chance of bankruptcy. The motivations of banks is a fear of insolvency and future bankruptcy due to a high and increasing debt to equity ratio in recessionary periods. Bank leverage, which is a counterpoint to the broad money supply, increases in boom cycles, eg 1920’s, as banks liabilities increase due to their high willingness to give loans or make risky investments to increase profits and continues to increase in recessionary or depressionary periods, eg 1930’s, as an increasing debt to equity ratio as equity and collateral lose market value and loan defaults accrue. Under these deflationary circumstances money velocity would tend to decrease and savings would increase as rational actors realize prices are going down relative to money equaling a nominal profit from saving. This exacerbates deflation as long as some type of intervention such as banks lending again or money being injected into the economy does not occur.

    This puts the speed of money velocity as a result of both enigmatic individual choices dependent on changing wants and desires creating unpredictable demand for goods and services in some circumstances and as rational individual actions dependent upon whether the broad money supply change is constant or is rapidly fluctuating upwards or downwards relative to the average broad money supply change, which in turn is based on the actions of the banking sector driving money supply increases or decreases based on the increase or decrease of loans.

    John Williams
    February 20, 2010
  11. Your article, notwithstanding a variety of confusing and opaque ideas, has not convinced me to side with your argument. And here is a simple reason why.

    What is the point of the FED lowering interest rates? To get people to SPEND money via borrowing, which leads to starting new businesses which leads to sales, which leads to hiring etc. They also do it so that people borrow at a lower rate and invest at a higher rate, ie stock market. Why would they lower interest rates if they didn’t have the idea to spur spending? In other words, the whole meaning behind lowering interest rates is to get people to spend- hence the positive effect on “the velocity of money.”

    You state:

    it is the volume of trade which determines the velocity of circulation of money, rather than the other way around.

    The chicken before the egg argument. Is it? Or is it more about “people will spend when they feel that things are good and/or they have the money or extra money to spend.”? I think the latter. It seems as though you’re trying to debunk a valuable tool or theory for some reason other than what we are to believe (perhaps because you just don’t like Fisher???) and base your arguments on abstract ideas that I really don’t buy. When you think about it, it really is a simple theory laid out by Fisher in a more quantitative equation applicable to text books. The more people spend the more the economy thrives and spending is a result of many things- the biggest being “availability of money” and “attitudes toward the economy in general.” Seems simple enough to me unless I’m missing something.


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