Velocity Is An Accounting Identity
Jeffrey Hummel and David Henderson continues to insist that Greenspan had nothing to do with the bubble. Since they use the same arguments that they used before and since they don't even try to reply to the criticism they've received from me and others, there's no real point in me specifically replying to any of their arguments, then there is no point in me writing anything new. Instead I simply link to my old post criticizing their original report.
However, there was one point I did not address, since it wasn't directly related to the issue of Greenspan's guilt. However, Henderson and Hummel also argues that the Fed under Greenspan created free market conditions in the monetary area, using a very strange argument:
"Combined with subsequent administrative deregulation under Greenspan through January 1994, these changes left all the financial liabilities that M2 adds to M1--savings deposits, small time deposits, money market deposit accounts, and retail money market mutual fund shares--utterly free of reserve requirements and allowed banks to sweep a large portion of M1 checking accounts into M2 money market deposit accounts. M2 and the broader measures became quasi-deregulated aggregates with no legal link to the size of the monetary base.
One result, which the late Milton Friedman noted in 2003, is that fluctuations in the velocity of M2 were automatically offset by fluctuations in the amount of M2. Interestingly, this is exactly what monetary economists George A. Selgin and Lawrence H. White predict would happen under free banking, that is, a market-determined monetary system without any government involvement.
They argue that free banking would automatically adjust the quantity of money to changes in velocity. If velocity rises, signaling a fall in money demand, market mechanisms would cause banks to reduce the quantity of money they created. And if velocity falls, signaling a rise in money demand, banks would enlarge the quantity of money."
But what needs to be understood here is that velocity is an accounting identity.
Using the classical formula MV=PY, where M stands for money supply, V for velocity, P stands for price level and Y for real output, and PY thus stands for nominal output it should be noted that V is defined as PY/M. If say, nominal GDP is $12 trillion and M2 is $5 trillion, that means that velocity is 2.4. If M2 is $6 trillion, then velocity is 2, and so on.
While velocity represents an indirect indicator of non transaction demand for money, it is thus not something which really exists as an independent phenomenon. It is simply a name given for the quotient you get by dividing nominal GDP with money supply.
There are two possible interpretations of what Henderson & Hummel wrote about fluctuations in M2 growth offsetting fluctuations in velocity. Taken literally, the assertion is simply false since there have been significant fluctuations in nominal GDP growth. If it is instead held to be true in a ceteris paribus sense (given a certain level of nominal GDP), then it is true that fluctuations in money supply has offsett changes in velocity since 1994, but then again it did so before 1994 too and must always do so in all countries at all times. Crediting Greenspan's monetary policy with the fact that fluctuations in velocity will ceteris paribus be offset by fluctuations in money supply is about as silly as crediting him with the fact that total assets in bank balance sheets were equal to total liabilities (including equity).
However, there was one point I did not address, since it wasn't directly related to the issue of Greenspan's guilt. However, Henderson and Hummel also argues that the Fed under Greenspan created free market conditions in the monetary area, using a very strange argument:
"Combined with subsequent administrative deregulation under Greenspan through January 1994, these changes left all the financial liabilities that M2 adds to M1--savings deposits, small time deposits, money market deposit accounts, and retail money market mutual fund shares--utterly free of reserve requirements and allowed banks to sweep a large portion of M1 checking accounts into M2 money market deposit accounts. M2 and the broader measures became quasi-deregulated aggregates with no legal link to the size of the monetary base.
One result, which the late Milton Friedman noted in 2003, is that fluctuations in the velocity of M2 were automatically offset by fluctuations in the amount of M2. Interestingly, this is exactly what monetary economists George A. Selgin and Lawrence H. White predict would happen under free banking, that is, a market-determined monetary system without any government involvement.
They argue that free banking would automatically adjust the quantity of money to changes in velocity. If velocity rises, signaling a fall in money demand, market mechanisms would cause banks to reduce the quantity of money they created. And if velocity falls, signaling a rise in money demand, banks would enlarge the quantity of money."
But what needs to be understood here is that velocity is an accounting identity.
Using the classical formula MV=PY, where M stands for money supply, V for velocity, P stands for price level and Y for real output, and PY thus stands for nominal output it should be noted that V is defined as PY/M. If say, nominal GDP is $12 trillion and M2 is $5 trillion, that means that velocity is 2.4. If M2 is $6 trillion, then velocity is 2, and so on.
While velocity represents an indirect indicator of non transaction demand for money, it is thus not something which really exists as an independent phenomenon. It is simply a name given for the quotient you get by dividing nominal GDP with money supply.
There are two possible interpretations of what Henderson & Hummel wrote about fluctuations in M2 growth offsetting fluctuations in velocity. Taken literally, the assertion is simply false since there have been significant fluctuations in nominal GDP growth. If it is instead held to be true in a ceteris paribus sense (given a certain level of nominal GDP), then it is true that fluctuations in money supply has offsett changes in velocity since 1994, but then again it did so before 1994 too and must always do so in all countries at all times. Crediting Greenspan's monetary policy with the fact that fluctuations in velocity will ceteris paribus be offset by fluctuations in money supply is about as silly as crediting him with the fact that total assets in bank balance sheets were equal to total liabilities (including equity).
posted by stefankarlsson at 7:34 AM
3 Comments:
Hello Stefan ....
I haven't read the origonal piece by Hummel & Henderson.
But, just going from the portion you quoted, i was wondering if it would make their argument more sensible if we take it that they mean the velocity of money (not generally) but velocity going from M1 to M2 and vice versa.
Does that improve their argument ?
On another side point, I have started but not yet finished reading Rothbard's book on the Great Depression.
What is mentioned here i.e. making savings "utterly free of reserve requirements" was very similar to what happened before the Great Depression, according to Rohbard.
Moreover, Rothbard cites it as having inflated the bubble which led to the Great Depression.
I find it, therefore, astonishing that these authors mention this particular feat of "deregulation" under Greenspan in almost an approving manner!
It think H&H meant something slightly different re: M and V, though I may just be misreading your argument.
Specifically, H&H are comparing the Greenspan Fed to free banking with fractional reserves.
Under a free banking system, when the demand for money increases - i.e. there is a recession - banks will print more money to meet demand. As the economy begins to recover and demand drops, banks will suck up this liquidity.
Thus via a market mechanism, the system avoids the mistakes of the Great Depression as pointed out by Friedman and Schwarz, but at the same time helps protect against a post-crisis inflationary spiral.
Celal, no, I don't see how moves from M1 to M2 and vice versa would improve their argument (Since M1 is a part of M2, that would BTW mean shifts from M1 accounts to non-M1 M2 accounts).
And considering the problematic aspects of fractional reserve banking (especially in the context of governments bailing out failed fractional reserve banks), I do not think that lowering reserve requirements really represents a genuine pro-market reform.
Econ: I don't see why a private fractional reserve banking system would increase liquidity during a recession. Indeed, because of the likely bank failures, and the increased fear of bank runs, money supply will more likely contract during recessions under a private fractional reserve banking system.
The Fed didn't actively try to deflate during the Depression. Instead the reason for monetary deflation was the widespread bank failures, something which will always happen in fractional reserve systems unless the government or the central bank bails out the banks.
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