Meaningless statistics: The Velocity Of Money

1. AC1 reminded me about this 'velocity of money' nonsense, which he, along with a lot of other people seem to believe in, so I might as well tick that one off my 'blogging to do list.

2. The accepted method of calculating the velocity of money appears to be dividing annual GDP by the amount of money in circulation, and you can make up your own mind which measure of money supply you want to use.

3. It is quite clear that we can measure GDP in a barter economy as the sum total of the value all goods and services produced or provided. Using one currency to express the value makes the figures much more manageable. If last year output was 1,000 sheep and 5,000 tonnes of wheat and this year output is 2,000 sheep and 4,000 tonnes of wheat, has the value of output gone up or down? We can only say for sure if we know the prices, i.e. relative values, of sheep and wheat.

4. Whether you include the value of own-consumption is a fundamental flaw in measuring real GDP, which "falls when a man marries his housekeeper" as the old saying goes, and applies as much whether it's a barter economy or whether most exchanges are goods/services for cash. There are plenty of other made up figures or missing figures, so GDP in absolute terms is no more than a rough guide, although changes from year to year and comparisons between countries are relevant.

5. Then we have a bewildering array of measures of money supply, which go from M0 (coins and notes in circulation, easy to understand but basically meaningless as most transactions are between bank accounts) up to MZM. While relative changes from year to year in any of these measures might be mildly interesting, in isolation they are all meaningless as well. If everybody took the cash from under the mattress and paid it into the bank, then M0 would fall, but MB stays the same.

Not only that, the whole concept of "supply" is misleading anyway, as you could just as well look at total debts. Remember that total financial liabilities always equal total financial assets, and the two net off to precisely zero. So if a politician says "money supply increasing" that sounds like A Good Thing (unless you worried about inflation) but if he says "debt is increasing" that sounds like A Bad Thing. In fact they are two sides of exactly the same thing. Remember also: the assets could be fictitious but the debts are real.

6. Logic says that GDP is a fairly stable figure and that most people live from month to month, so in a pure cash economy (i.e. using M0 as the measure), we'd only need enough coins and notes to cover one month's income/expenditure and velocity would be twelve. If some people hoard cash under the mattress, then the government has to print some more, so velocity goes down a bit, but cash under the mattress is not part of GDP. If everybody has enough cash under the mattress to cover themselves for one month's expenditure, then velocity goes down from twelve to six. This is neither A Good Thing nor A Bad Thing.

7. Yes, the reader shouts, but what if everybody decides that the good times will never end, takes that cash from under the mattress and goes on an almighty spending spree? Well, some people might respond by opening their shop for longer hours, and factories might increase their output and so on, but this boost to GDP would be very short lived (and would suck in imports and lead to short lived inflation), this level of spending is only sustainable if everybody also works double the hours and so on, so the chances are, a month later, all that cash would be back under the mattress (minus what was spent abroad on imports).

8. By this stage, the cunning reader might have noticed that if the top part of the fraction (GDP) is fairly fixed and the bottom part (the money supply) is a made up number. The resulting 'velocity' is merely the inverse of a made up number.

9. Quite correct. From an article at Seeking Alpha headed "Money velocity continues to plunge":

The US Federal Reserve is engaged in an historic liquidity operation intended to support economic recovery. Since the recession in 2008, M1 money supply has surged an astonishing 60 percent [from $1.4 trillion to] the $2.2 trillion level in January, with no end in sight to the extreme move higher. However, during that time, the velocity of M1 money has plunged from a high of 10.37 in late 2007 to 7.09 in late 2011.

Here are his supposedly terrifying charts:10. Well, duh.

Working backwards, at the start of the three-year period, nominal GDP was $14,500 trillion (10.37 x $1.4 trillion) and at the end it was $15,600 trillion (7.09 x $2.2 trillion), knock off 2.5% a year for inflation and we come to the amazing conclusion that, er, US GDP flat lined over the three years, which we knew already, having already worked out GDP in order to be able to calculate money velocity in the first place.

It just so happens that the US government had done all the Quantitative Easing over there to keep their mates the bankers afloat, but that extra $0.8 trillion just stayed in the bank, it was just numbers on bits of paper with no impact on the real world.

11. Here endeth.