Velocity Of Money: A Flawed Model

``Economics is a social science. Econometric models spit out results that lack the accuracy of chemistry experiments and the precision of mathematical equations. Central bankers are forced to deal in the realm of the touchy-feely all the time. If their work could be reduced to an equation, we wouldn’t a) need them or b) find ourselves in the mess we’re in now.” Caroline Baum Central Banks Can Do Better Than Just Mopping Up

Zero Hedge’s Mr. Tyler Durden comment of ``And instead of this excess money hitting broader aggregates such as M2 or MZM, it is held by the banks, who proceed to buy securities outright on their own, either Treasuries or Equities. Apply the proper "money multiplier" to get the monetary impact on the S&P 500, as a result of the banks not lending these excess reserves, and instead simply speculating with it, and you will likely get the increase in the market cap of the S&P since the launch of QE” provoked my inquisition to mainstream’s allure to use money velocity as benchmark for arguing the case for deflation.

Velocity of money is the turnover (circulation) rate of money in terms of transactions.

It is assumed that a low money velocity, which means lower rate of circulation, can only support lower prices.

Yet if US banks have indeed been directly speculating, and if such activities haven’t been registering in money aggregates, as postulated by Mr. Durden, then the whole premise built around the inefficacy of monetary policies seems tenuous because statistics have not accurately captured such bank speculations in the asset markets.

Besides, Velocity of Money is a statistical measure based on the Keynesian consumption model, where spending equates to income.

The idea is more spending would result to higher prices and higher national income and or higher economic growth.

This is an example from wikipedia.org,

``If, for example, in a very small economy, a farmer and a mechanic, with just $50 between them, buy goods and services from each other in just three transactions over the course of a year

Mechanic buys $40 of corn from farmer.

Farmer spends $50 on tractor repair from mechanic.

Mechanic spends $10 on barn cats from farmer

``then $100 changed hands in course of a year, even though there is only $50 in this little economy. That $100 level is possible because each dollar was spent an average of twice a year, which is to say that the velocity was 2 / yr.”

In short, velocity of money measures transactions only and not of real economic output.

Moreover, it is also implies that money printing or increasing systemic leverage as the key driver to an increased velocity of money.

From the Austrian economic perspective, this concept is pure flimflam.

Henry Hazlitt wrote ``What the mathematical quantity theorists seem to forget is that money is not exchanged against a vacuum, nor against other money (except in bank clearings and foreign exchange), but against goods. Hence 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.” (bold emphasis mine)

Similarly Ludwig von Mises scoffs at the concept, ``They introduce instead the spurious notion of velocity of circulation fashioned according to the patterns of mechanics.” (bold emphasis mine)

Figure 5: Hoisington Management: Velocity of Money

Some deflation exponents say that the two major forces, which drove up the velocity of money, which has characterized the previous boom (see figure 5), particularly financial innovation and leveraging, will be materially less a factor in the post boom era.

The general notion is that the collapse of the shadow banking system and the deleveraging in the US households and its banking system would lead to deflationary pressures from which the government or the central bank inflationary policies won’t be able to offset.

That is from a mathematical standpoint, from which presumes to capture all the variables of human actions. Unfortunately, these macro based math models don’t reflect on reality, because it can’t impute the cause and effect, before and after outcomes of human decisions.

Other reasons why I think velocity of money is a flawed model?

One, such outlook depends on the accuracy of each and every variable that constitutes the equation, such as money supply. If Mr. Durden is correct, then velocity of money model automatically crumbles.

Two, it disregards the impact of pricing dynamics on the marketplace, e.g. how will lower prices impact demand?

Three, it discounts man’s adoptability in acquiring technology [see earlier post, Technology's Early Adoptor Disproves Deflation]

Fourth, such measure focuses entirely on the leveraging of the financial sector and leaves out the contributions from the real economy.

Fifth, it treats the economy as a homogeneous constant (single form of capital, labor and output), from which excludes the evolving phases of the interlinkages of the marketplace, governments and technology.

Lastly, it oversimplistically omits the transmission mechanism from the interactions of the US (policies and economic activities) with the world.

As Professor Arnold Kling observed, ``Structural models do not extract information from data. Instead, they are a method for creating and calibrating simulation models that embody the beliefs of the macroeconomist about how the economy works. Unless one shares those beliefs to begin with, there is no reason for any other economist to take seriously the results that are calculated.” (bold emphasis mine)

Or as Warren Buffett on warned on depending on models, ``Our advice: Beware of geeks bearing formulas.”