The Great Myth of Money Velocity

June 13, 2014

The missing variable in the great monetary equation is money velocity. We hear it over and over again, "There is no money velocity." And therefore, inflation cannot be a problem and is not.

Yet, there is a great divergence between the conventional financial media and the public who goes to the supermarket. The financial media swallows whole the official artifice that inflation is near-zero while ‘J.Q. Public’ sees his/her grocery costs, health insurance, etc. rising by leaps and bounds

Banks are not loaning, money growth is declining, and demographic headwinds are the predominant forces.

The third central bank in U.S. history is bound and determined to get its inflation.

And like those that went before, it will get its hyperinflation via the secondary economy it has created from toxic intervention.

The quantity theory of money states that there is a direct relationship between the quantity of money in an economy and the level of prices of goods and services sold.

If the amount of money in an economy doubles, price levels also double, causing inflation (the percentage rate at which the level of prices is rising in an economy). The consumer therefore pays twice as much for the same amount of the good or service.

P = M * V / Q

Where the variables are:
P = Price level
M = Money supply
V = Velocity of money, how many times money turns over in a year
Q = Real GNP

In hyperinflation the money supply is going up, the velocity of money is going up, and the real GNP is going down - all at the same time.  It is a triple whammy that drives prices up really fast.

One of the problems with this equation is that it doesn't measure potential velocity. Nor does it measure the exchange of money that happens in the gray or under the table economy.

Velocity's cousin (the money supply) is an even more nebulous concept. No one knows the true definition, which should come as no real surprise in a system that is completely free of anchor or fiat.

Money velocity is an incomplete concept at best.

Very simply, it's the rate in which money is exchanged between parties in an economy or monetary system.

Critics believe that the equation ignores the psychological effects in terms of valuating a currency. For example, the incremental addition to the money supply has disproportionate effects on price. In other words, it is not simply a non-linear relationship.

Hazlitt believed that it is the sum of individuals' value of the currency that determines the velocity of money. And von Mises took this one step further by noting that the measurement has no bearing on purchasing power because it looks at the issue from the perspective of the entire system.

Money is changing hands quickly, but it's a hidden transfer mechanism.

The rise of equities causes another expansion in velocity, as shares and dividends act as yet another source of transfer mechanism.

The internet has created a gray market mechanism. Transfers are happening, whether by Craigslist or Bitcoin. Cash is moving through the underground economy.

The welfare state adds to this.

Much of the working class has been indirectly encouraged to stay at home. To take cash payment or any opportunity off the grid to keep the guaranteed monthly checks coming.

And the Fed faces a same dilemma.

Sure, it can manipulate interest rates and equity prices. That works out in the interest of the elites. But there is a natural limit and unpredictable reaction to intervention.

Of course, admitting to direct intervention of monetary assets is a dangerous game.

It is a massive unregulated world. Not only would already steady demand surge, but it would morph into a violent uprising.

A secondary economy is developing. It’s underground; and yet is has been here all along.

Government transfer payments + other government dollars being handed out are not included in wages.

So even if wage growth is flat - there is still velocity.

A flood of cash - social security checks, food stamps, student loans, and automobile loans are some of the big ones.

There are more people working "off the books" so they can keep their food stamps and unemployment "compensation".

It used to be people worked off the books to avoid paying taxes - now they must do it to keep their welfare.

Fixation on money velocity serves only in the aftermath. Those who constantly point out this measure as proof that inflation is not alive and well are misguided. Confidence is much like bankruptcy - its loss happens slowly, then all at once.


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