Velocity Is An Accounting Identity
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).