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Sunday, August 24, 2008

The Velocity of Money

I was browsing the mises.org forums and saw a flamewar about what velocity of money means. The velocity of money is the speed with which people spend money after receiving it. If people start losing confidence in a currency, then they will rush to spend it. This increases the velocity of money and increases price inflation. If people have confidence in a currency, then they will be willing to save it. This decreases the velocity of money and decreases price inflation.

The CPI understates the true inflation rate. The average person doesn't realize how much his purchasing power is eroded by inflation. The average person thinks that money in their checking account is safe, while its value is being eroded at a rate of 0.5%-3% per month, depending on what measure of inflation you use. If people realized how bad inflation actually is, they would rush to spend their dollars immediately after acquiring them, which would cause even more inflation. During a hyperinflationary collapse, the people who spend their dollars first receive the most benefit.

Suppose that people started panicking that the rate of inflation for the US dollar was too high. Suppose stores started noticeably raising their prices by 5%-10% or more per week. At this point, people would start losing confidence in the dollar. Immediately after getting paid, they would rush to the store to convert their salary into tangible goods. This would cause even more price inflation. Pretty soon, everyone would be spending their dollars immediately after acquiring them, and hyperinflation would spiral out of control.

In 1932-1933, people were concerned that the US government and Federal Reserve would default on the dollar. The number of outstanding Federal Reserve Notes was far greater than the amount of gold in the US Treasury. Anticipating a default, people started hoarding gold. This was not greed; it was their rational self-interest, defending themselves against a default on the dollar. People were hoarding gold and spending their Federal Reserve Notes. The velocity of gold dropped to practically zero, and the velocity of Federal Reserve Notes was skyrocketing. President Roosevelt frustrated this prudent behavior by illegally seizing all gold in 1933. If you held gold in a bank safe deposit box, bank management was required to seize the contents of the box.

Instead of seizing all the gold, President Roosevelt should have forced the Federal Reserve into bankruptcy; the holders of Federal Reserve Notes would have been creditors for the remaining gold in bankruptcy court. This would have screwed over the owners of large financial institutions and benefited individuals who had prudently hoarded gold. Instead, Present Roosevelt screwed over individuals and bailed out owners of large banks. Individuals lost their savings via inflation, and the proceeds went to the owners of large financial institutions. This pattern continues in the present; individuals lose purchasing power to inflation, and owners/management of large banks are the beneficiaries of money supply inflation.

In the present, gold is not legally recognized as money. Hoarding gold is a prudent way to protect your savings. If you invest in gold, your inflation-adjusted return will be 0% minus expenses, but that may really be the best investment out there! The Federal Reserve credit monopoly distorts the lending market. It isn't practical to make a gold-denominated loan, because it's cheaper to borrow from the Federal Reserve via a bank; real interest rates are negative. It isn't practical to operate a gold warehouse receipt bank, because taxes and regulations make such a business unprofitable.

There is no evidence that the velocity of money in the USA is increasing or decreasing. There is no official government report for velocity of money, so I don't know how a valid comparison should be made. When I do inflation calculations, I assume the velocity of money is constant; if it were increasing or decreasing, that would affect price inflation. If the velocity of money is constant and the size of the economy is constant, then money supply inflation and price inflation should occur at the same rate. If foreign countries become reluctant to hold dollar reserves, that would increase the velocity of dollars.

Does anybody know what the "velocity of money" in the USA is right now? It can't be calculated from any of the publicly available government statistics. The velocity of money is the average time that a person holds onto a dollar before spending it. For example, suppose my salary were $60k/year and I keep an average of $5k in my checking account. The velocity of my money is 1 month. Using FIFO accounting (first-in first-out), money stays in my checking account for an average of 1 month. During hyperinflation, the velocity of my money would drop to 1 day or less, causing 30x more price inflation. During hyperinflation, I would be reluctant to keep any money in my checking account at all. In the present, I keep money in my checking account to meet my short-term spending needs; I accept the loss to inflation as a necessary expense. I keep the bulk of my savings in inflation-hedged investments.

If I invest in gold, I'd be holding it as a long-term investment. The velocity of my gold would be practically zero, unless I sold some for some short-term needs, or I found some trading partners that accepted payment in gold. In a free market, the velocity of gold would be greater than zero. Interest payments are a disincentive against gold hoarding. If I trust my trading partner, I'd make a gold-denominated loan. In the present, you would be foolish to borrow a gold-denominated loan, because of the Federal Reserve credit monopoly; a negative real interest rate Federal Reserve Point-denominated loan would be cheaper than a gold-denominated loan. The price of gold is rising at a rate of 20%-30% per year, so a gold-denominated loan has an implied interest rate of 20%-30%. I can't profitably loan/invest gold savings while the Federal Reserve has its credit monopoly, because the Federal Reserve and financial industry can lend/invest much cheaper than me.

For example, it doesn't pay for me to spend gold to invest in real estate, because I can't get full allodial title to that real estate. Real estate isn't a safe investment, because property tax rates are arbitrary and eminent domain could be used to seize my property. In a free market, people wouldn't hoard gold; they would prefer to invest in income-producing assets like real estate. In the present, gold and silver are the *ONLY* investments where I can get full allodial title!

People hoard gold when they anticipate that the government is going to default on the gold-redeemability of its paper money. People hoard gold when State regulations prevent them from profitably investing/loaning it.

When the velocity of money is increasing, that increases price inflation. When the velocity of money is decreasing, that decreases price inflation. The CPI understates the true inflation rate. By spreading the propaganda "Inflation is low", people can be persuaded to hold onto dollars, keeping the velocity of money low.

8 comments:

Thomas Blair said...

It's typically calculated indirectly as:

velocity = national product / money supply

anarcho-mercantilist said...

FSK already calculated the velocity of money from this post. GDP is inaccurate.

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Thomas Blair said...

anarcho-mercantilist:

Of course. GDP is a nearly useless figure. GDP increases in the face of expanded government spending (theft), increasing inefficiency of corporations, with disaster reconstruction (broken window fallacy, anyone?), yet decreases for increasing private efficiency, and for increasing off-the-books private activity.

There are also questions about which measure of the money supply to use. Broad? Narrow? Gold?

FSK wrote: "Does anybody know what the "velocity of money" in the USA is right now? It can't be calculated from any of the publicly available government statistics."

I was just supplying the answer.

Nick said...

The manipulation of inflation rates is another good reason not to trust anything the government says, and in fact probably to believe the opposite.

Government laws are almost always judged in favor of increasing government power over every aspect of a person's life. Anyone who believes the government can accurate judge the value of the money the government itself prints is entirely too gullible.

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