It is time to stop using the “velocity” of money to explain (away) inflation.
It amazes me how commentators and professional economists alike keep referring to a concept that has no existence of its own as the cause for the absence (or presence) of inflation.
If the title did not already give it away, I am talking about the so-called “velocity” of money. As Mises pointed out, money does not circulate, it is never “on its way”; money is always part of someone’s cash balance. The concept of velocity was used by economist Irving Fisher to close his famous identity, the often misused and misinterpreted Fisher equation. Read into it what you will, just don’t let it be a causal relationship.
Money velocity
I have previously shared some thoughts on the Fisher equation here. To reiterate the identity is written as
M∙V=P∙TR,
where M is the (broad) money supply, V the velocity of money, TR a matrix of economic transactions during a certain time period, and P the matrix of corresponding prices. The matrix of transactions comprises all possible transactions, including financial transactions, asset purchases, real estate investments, etc.
In practical applications, P and TR are represented by the Consumer Price Index (CPI) and GDP, respectively. Using the CPI and GDP may make it seem as if a change in the “velocity” of money can somehow “cause” a change in the price level for we see CPI and GDP as “externally” given. But this is only an illusion. The “velocity” can never change by itself because it does not independently exist. It is a concept introduced to balance the original identity.
Even forgetting about the illusory concept of velocity for an instant, let’s consider the absurdity of multiplying CPI and GDP. The latter consists of consumption, investment, government expenditures, and net exports (exports minus imports). Multiplying an index of consumer prices — dubious in and of itself — with GDP implies multiplying the entire Gross Domestic Product with the prices of only one of its components. And yet, it is so ingrained that people using it and drawing conclusions from it, don’t even recognize the false assumptions they are basing their analysis on.
Restricting GDP to consumption only attenuates the aforementioned shortcomings, but does not eliminate them entirely, not even when the money supply is similarly restricted. The “velocity” of money is not a causal factor of inflation, never can be, and never will be. Making it seem as though it is, is a sign of ignorance or deception.
As stated above, the prices in the original Fisher identity, are the individual prices of all transactions during a certain time period; that is, all the individual prices of each and every individual transaction that has taken place.
It is not “velocity” that drives those transactions. In fact, it is the other way around, velocity is entirely determined by the number of transactions. Defining velocity as the number of times a unit of money changes hands makes this even clearer. Money changes hands only as a result of transactions. Thus, an increase in the number of times money changes hands — the “velocity” — can only occur if the number of transactions increases.
Transactions are initiated through the demand for certain goods and services, all possible goods and services. Changes in prices can only come about through changes in demand and supply. These changes, however, do not affect the “general price level”, all else equal. Only relative prices change. (The “general price level” would increase if all or some prices would increase without offsetting decreases in other prices.) With a constant money supply changes in certain prices must be offset by opposite changes elsewhere in the economy, through changes in demand and supply. From this, it should also be clear that the only way the “general price level” can increase is through an increase in the money supply.
Moreover, an increase in the number of transactions — and hence in the velocity — implies that there is sufficient supply to accommodate demand. If this were not the case then the number of possible transactions would decrease and so would the velocity, while the price increases. Again, it is clear that it is not a higher “velocity” that causes higher prices. Only when the money supply outgrows the growth in transactions, i.e. production, will there be a (visible) rise in prices; while any increase in the money supply is inflation.
The asymmetric use of the CPI as an indication of inflation
Pundits have us believe that we should not be worried about inflation and they point to the absence of any significant increase in the Consumer Price Index as validation. But we have seen above that the absence of an increase in a general price level — an index in this case — does not necessarily mean that prices of individual goods and services have remained unchanged. It may very well be that certain categories of goods and services have seen increases while others have seen their prices drop. Which categories have had price increases will determine how different socio-economic groups are affected, if at all.
But why would we restrict the definition of inflation to changes in the Consumer Price Index? And even if we do, we should recognize that relative prices within the index may very well change considerably without affecting the overall level of the index, hurting some socio-economic groups more than others.
Fearing someday inflation will raise its ugly head, people try to safeguard their money by buying assets such as gold, silver, Bitcoin, etc. that they consider stores of value. What they don’t seem to recognize is that those assets’ “values” are inflated just as much, if not more. But even ignoring that, if inflation is measured only through increases in the CPI, then why not invest in companies that sell consumer products? If the prices of consumer products rise that can only be good for the companies selling them, right?
That does not seem to be what the majority of people think. When consumer prices increase, so the argument goes, companies also have to pay more for their inputs, i.e. “inflation” also affects the cost of doing business. Now, that is what is puzzling to me. When inflation as measured by an increase in the CPI increases rapidly and extensively then it becomes an economy-wide problem affecting not only consumer goods but all goods and services. But when the Consumer Price Index does not change — or not much anyway — despite considerable increases in the money supply, we are told not to worry about inflation at all as there simply is none, nowhere.
Conclusion
Many commentators seem to misunderstand what really causes prices to change and how it affects the overall price “level” — if that could ever be measured. From a correct interpretation of the Fisher equation, we saw that an increase in the general price level — an increase in prices without offsetting decreases — can only come about through an increase in the money supply. As Milton Friedman pointed out, inflation is a monetary phenomenon.
With a constant money supply, there can be no inflation, only changes in relative prices. And yes, an economy can still grow and society prosper with a constant money supply. Resources will be allocated more efficiently and prices would decline when the economy grows. But that is exactly what central banks — and many others with them — want to avoid. They believe — and they want us to believe it with them — that declining prices, i.e. deflation, is bad for the economy and that inflation is a sign, a consequence even, of a growing economy. That could not be further from the truth. Inflation, defined as a rise in prices across the board, is a sign that the money supply grows faster than the economy does. The natural tendency, without intervention, is for prices to decline in a growing economy. Even without an increase in the CPI, inflation is still present whenever the money supply increases.
The reason deflation is feared is that we are accustomed to thinking in absolute levels rather than in relative levels, especially when it comes to money. But when prices decline the same amount of money can buy more goods and services, making the holder of money better off.
We have been made to believe that expectations of future inflation increase consumption now and help the economy thrive, while declining prices lead consumers to postpone their purchases, ultimately leading to a recession. Such fallacies and the accompanying beliefs can be self-fulfilling for a while, but not indefinitely. First of all, consumption cannot be postponed indefinitely, and secondly, the argument relies on the false assumption that consumption is the driving force of economic growth.
Another side effect of the perpetual increase in money supply is that it exacerbates inequality. We have derived that money supply is the only factor driving inflation — as measured by a rise in the general level of prices. Now, new money does not get distributed equally. The early receivers can still profit from the relatively low prices, but once the money has reached all echelons of society prices have generally already increased, making the last in line actually worse off. And that is the kind of inequality we cannot and should not tolerate.
