Velocity “Magic”, Tax Receipts, and GDP
Velocity is defined as (prices * transactions) / (money supply). Economists substitute GDP for (prices * transactions).
Real GDP is a flawed measure of output because it ignores asset bubbles, even home prices in its measure of pricing.
Moreover, there is no universal agreement whether to use M1, M2, MZM, Austrian Money Supply or something else as the denominator. This leads to numerous measurements of velocity.
M2 velocity is shown in these charts.
Velocity vs GDP
It’s possible for GDP to rise or fall with velocity either rising or falling.
Tax receipts can fluctuate independently as well thanks to tax policy changes and capital gains collected on rising asset prices.
Austrian economist, Frank Shostak, took apart conventional wisdom years ago with his column Is Velocity Like Magic?
"The Mainstream View of Velocity
According to popular thinking, the idea of velocity is straightforward. It is held that over any interval of time, such as a year, a given amount of money can be used again and again to finance people’s purchases of goods and services. The money one person spends for goods and services at any given moment can be used later by the recipient of that money to purchase yet other goods and services.
For example, during a year, a particular $10 bill might have been used as following: a baker, John, pays the $10 to a tomato farmer, George. The tomato farmer uses the $10 bill to buy potatoes from Bob, who uses the $10 bill to buy sugar from Tom. The $10 here served in three transactions. This means that the $10 bill was used three times during the year; its velocity is therefore 3.
From this it is established that: Velocity = Value of transactions/supply of money. This expression can be summarized as: V = P(T/M) , where V stands for velocity, P stands for average prices, T stands for volume of transactions, and M stands for the supply of money.
This expression can be further rearranged by multiplying both sides of the equation by M. This in turn will give the famous equation of exchange: M(V) = P(T).
Many economists employ GDP instead of P(T), thereby concluding that: M(V) = GDP = P x (real GDP).
Most economists take the equation of exchange very seriously.
Velocity Does Not Have an Independent Existence
Contrary to mainstream economics, velocity does not have a “life of its own.” It is not an independent entity–it is always value of transactions P(T) divided into money M, i.e., P(T/M). On this Rothbard wrote: “But it is absurd to dignify any quantity with a place in an equation unless it can be defined independently of the other terms in the equation.” (Man, Economy, and State, p. 735)
Since V is P(T/M), it follows that the equation of exchange is reduced to M(PxT)/M = P(T), which is reduced to P(T) = P(T), and this is not a very interesting truism. It is like stating that $10=$10, and this tautology conveys no new knowledge of economic facts.
What matters right now is the fact that money is growing at an alarming rate, which sets in motion an exchange of nothing for something and, hence, economic impoverishment and consequent boom-bust cycles. Furthermore, since velocity is not an independent entity, it as such causes nothing and hence cannot offset effects from money supply growth."
Boom and Bust
Shostak wrote that in 2002. A housing boom and a housing bust followed.
We are now in an everything bubble with money supply rising like mad. Another bust is guaranteed.
Velocity will not cause the next bust no matter what it does (although I do expect velocity will decline for the simple reason I expect massive amounts of further monetary stimulus).
The cause of the next major decline will be the same as the cause of the last major decline: excess monetary and fiscal stimulus by the Fed, ECB, other central banks, and various government bodies.
One irony in the velocity debate is that money does not even “circulate” as widely believed.
“Money can be in the process of transportation, it can travel in trains, ships, or planes from one place to another. But it is in this case, too, always subject to somebody’s control, is somebody’s property. “(Human Action, Mises p. 403)
Garbage In = Garbage Out
Starting with flawed measures of money and flawed measures of GDP, a good summation of velocity is “garbage in = garbage out”.
Velocity itself does not predict anything, nor cause anything! It’s not an independent variable.
However, we can say that falling velocity now is a result of massive monetary printing.
It’s taken amazing amounts of central bank stimulus, junk bond offerings, and government spending to keep GDP rising.
For a detailed look at the stock market bubble, with thanks to John Hussman, please see Median Price-to-Revenue Ratio Higher in All Deciles vs 2007, 90% vs Dot-Com Bubble: THE Choice
Pater Tenebrarum sent links to two more recent articles by Shostak on his blog:
I love this chart from the first.
Mike “Mish” Shedlock