Velocity of money

The quantity theory of money and measuring money:  Econobrowser.

I wanted to follow up on Menzie's recent observations about what's been happening to the supply and demand for money.

These discussions are sometimes conducted in terms of the following equation:

MV = PY.
Here M is a measure of the money supply, V its velocity, and nominal GDP is written as the product of the overall price level (P) with real GDP (Y). We have direct measurements on nominal GDP. And once we agree on a definition of the money supply (no trivial matter), we have a number for M. But where do we come up with data on this concept of the velocity of money, V?
The answer is, we don't have independent measures of the velocity of money. So if people talk about velocity as something they could measure, they're just referring to the value of V that makes the above equation true. That is, we measure the velocity of money from

V = PY/M.
As alluded to above, different people come up with different answers for how we should measure the money supply. One measure is M1, whose key components include currency held by the public and checkable deposits. Another measure is the monetary base, which is currency held by both banks and the public plus deposits banks hold in their accounts with the Federal Reserve. So we could use M1 as the value for M in the above equation, and call the resulting value for V the "velocity of M1". Or we could put the monetary base in for M, and call the resulting V the "velocity of the monetary base". You get the idea-- use your favorite M to get your favorite V.
Arnold Kling, for example, proposed that we might use for M the quantity of marbles.
Which perhaps sounds a little silly. Even if there's no particular relation between the quantity of marbles and the stuff we care about (inflation and real GDP), you could still go ahead and use the equation above to define the velocity of marbles. But what you'd find is that when marbles go up, the marble velocity goes down, and it makes no difference for output or inflation.
OK, so let's look at the velocity of M1. It turns out to look a lot like you'd expect the velocity of marbles to behave-- when M1 goes up, the velocity of M1 goes down by an almost exactly offsetting amount. Here's an update of a graph that I presented a year ago:

Top panel: annual growth rate of M1, 1980:Q1 to 2010:Q3. Bottom panel: annual growth rate of the ratio of M1 to nominal GDP. Horizontal line in each figure is drawn at the historical average for that series.

So maybe we'd be better off using the monetary base as our value for "M"? I don't think so.

Top panel: level of monetary base, 1980:Q1 to 2010:Q3. Bottom panel: velocity of base.

Obviously the interest in an equation like MV = PY comes not from using it as a definition of V for some arbitrary choice of M. Instead there must be some kind of behavioral idea, such as that there is some desired value of M1, or monetary base, or marbles, that people want to hold. Suppose it was the case that to a first approximation, this desired quantity was essentially proportional to nominal GDP. If that were true, we would see the graphs of V above behaving roughly as constants instead of simply tracking the inverse of whatever happens to M.
Now, I think it is true that, in normal times, nominal GDP is one of the most important determinants of the demand for M1 or the monetary base. In the absence of other factors changing these demands, there certainly is a connection between money growth and inflation, and you do find a correlation if you look at much longer horizons than the quarterly changes plotted above.
But conditions at the moment are far from normal. In particular, something quite remarkable has happened to the demand for the monetary base. In the current environment, banks have shown themselves to be indifferent between holding reserves (a risk-free way to earn a modest interest rate from the Fed) and making other uses of overnight funds. For this reason, the demand for reserves, and with it the demand for the monetary base, has ballooned without any corresponding changes in output or inflation.
Some people felt I was making a sophistic distinction in emphasizing that the Fed is creating reserves as opposed to printing money ([1], [2]). But I maintain this is a critical distinction. The demand for reserves has increased by a trillion dollars since 2008. The demand for currency held by the public has not. The supply of reserves could therefore increase a trillion dollars without causing inflation. The quantity of currency held by the public could not.
Now, the time will come when banks do see something better to do with these reserves, at which point the Fed will need to take appropriate measures in response, namely a combination of raising the interest rate paid on reserves and selling off some of the assets the Fed has been accumulating. This is of course a key long-term story that we will all be following with interest.
But someone who insists that inflation (P) must go up just because the monetary base (M) has risen may have lost their marbles.

Source: FRED.

There Is No National Sock Shortage

Yglesias:

This USA Today story about kids asking santa for basic necessities is actually more tragic than most people recognize:

Santa Claus and his elves are seeing more heartbreaking letters this year as children cite their parents’ economic troubles in their wish lists. U.S. Postal Service workers who handle letters addressed to Santa at the North Pole say more letters ask for basics — coats, socks and shoes — rather than Barbie dolls, video games and computers.

Something important to note here is that this is not only sad, but fundamentally avoidable. The world is not suffering from a shortage of socks. If the government tried to give an iPad to everyone who writes in asking for one, we’d swiftly run out of iPads. The supply is constrained. But we have lots of socks. There’s nothing stopping the government from buying socks and giving them to everyone. What about the money? Doesn’t the money have to come from somewhere? Not really. As Ben Bernanke says “[t]he U.S. government has a technology, called a printing press (or today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at no cost.”
Now of course having the Post Office initiate a big sock-purchasing program would be pretty goofy. But the point is that we have in this country right now lots of factories running below capacity. Lots of workers doing no work. Lots of trucks not delivering anything. We’re not short on ability to produce more things, or on ability to transport, and distribute more things. We have citizens who would buy more things if they had more money. The real shortfall we’re facing, in other words, is a shortage of money. This is a good kind of problem to have, since it’s actually really easy to fix: Just print more. But it’s also an extremely frustrating problem to have, since it’s so easy to fix. The shortage of money isn’t the only problem America has. We also have, for example, a shortage of really excellent teachers and it’s hard to know what to do with that. But our money shortage is very solvable.

Yglesias » Monetary Policy and Asset Prices

Yglesias » Monetary Policy and Asset Prices:

I was arguing yesterday that 25 years worth of wage stagnation, occasional recessions, and no episodes of inflation together constitute a powerful prima facie argument that monetary policy has been systematically too tight. That doesn’t necessarily mean it’s been dramatically too tight or anything. Maybe it’s just that interest rates should have been 0.25 percentage points lower from 1985 onwards. That would still make a big difference over time.

Something some people said in response is that we may not have had CPI inflation, but loose money might drive asset price bubbles. People say this fairly frequently, but I don’t understand how it’s supposed to work. I’ve seen several efforts to debunk the loose money = bubbles hypothesis via empirical work (PDF, for example), but I also think it’s very problematic as a theory. After all, what does it mean to say there’s a “bubble” in the price of houses or the price of tech stocks? It means, I think, that current prices are based on overestimating the long-run demand for homes or for the goods sold by tech firms.

Clearly, things like that do happen from time to time. But how would higher interest rates avoid those occurrences? It’s easy to see how tighter money could lead to lower asset prices via slower growth and reduced demand and expectations of demand. But that doesn’t eliminate the “bubble,” the mismatch between anticipated demand and actual demand, instead it lowers the price of the asset by actually lowering demand.

Bubbles, it seems to me, have to do with the fact that (a) making correct estimates is hard, (b) frailties of human psychology, (c) certain “the market can stay rational longer than you can stay liquid” asymmetries, and (d) to an extent bad regulatory incentives. Making money tighter or looser should alter the average price of assets but there’s no reason to think it would change the basic social and psychological dynamics that sometimes lead to large-scale mis-pricing.

What Is Money? - NYTimes.com

What Is Money? - NYTimes.com:

...the evils of increasing the money supply.

You hear it all the time: the Fed is printing money! Danger, Will Robinson! In some comments on this blog I see assertions that the true measure of inflation isn’t prices, it’s what happens to the quantity of money.

Now, one thing you might immediately say is that for those who care about, know, actually buying things — you can’t eat money — it’s prices of goods that matter; and for the past three decades, as shown above, there has been remarkably little relationship between the standard monetary aggregates and the inflation rate.

But here’s an even more basic question: what is money, anyway? It’s not a new question, but I think it has become even more pressing in recent years.

Surely we don’t mean to identify money with pieces of green paper bearing portraits of dead presidents. Even Milton Friedman rejected that, more than half a century ago. For one thing, a lot of those pieces of green paper are pretty much inert — sitting outside the United States, in the hoards of drug dealers and such. For another, checking accounts are clearly a close substitute for cash in hand.

Friedman and Schwartz dealt with this by proposing broader aggregates –M1, which adds checking accounts, and M2, which adds a broader range of deposits. And circa 1960 you could argue that those aggregates were good enough.

But now we have a large shadow banking system, in which things like repo serve much the same function as deposits; M3 used to capture some of that, but the Fed discontinued it, in part I think because it wasn’t clear which repo belonged there, and data on repo not involving primary dealers is scattered. Whatever.

The truth is that these days — with credit cards, electronic money, repo, and more all serving the purpose of medium of exchange — it’s not clear that any single number deserves to be called “the” money supply. Intellectually, this isn’t a problem; nor is there necessarily a problem maintaining monetary policy even if there isn’t any single thing you’re willing to call money. Mike Woodford has been writing about this stuff for years.

But if you’re determined to view economic affairs through a sort of paleo-monetarist lens, focused on the evils of “printing money”, you’re going to have a hard time in the modern world, where the definition of money is increasingly vague.

The SPECTRE of Inequality - NYTimes.com

The SPECTRE of Inequality - NYTimes.com:
there’s a scene early in [the old Bond film Thunderball] when the minions of SPECTRE, the evil conspiracy, are shown reporting on their profits from dastardly activities. ...

Even the big one — demanding a ransom for two stolen nuclear warheads — is 100 million pounds, $280 million. Adjusted for inflation, that’s about $2 billion — or one-eighth of the Goldman Sachs bonus pool.

It’s just an indicator of how huge top incomes have become that what were once viewed as impressive numbers, the kind of thing only arch-villains might demand, now look trivial. Or maybe the other way to look at it is that we have a lot more arch-villains around than we used to.

PS: Prices haven risen roughly sevenfold since the movie was made. So $280 million is, as I said, around $2 billion in today’s dollars — still a trivial sum by modern Wall Street standards.

Moral Hazard and Modern Finance

The Inequality That Matters - Tyler Cowen - The American Interest Magazine:

some investors opt for a strategy of betting against big, unexpected moves in market prices. Most of the time investors will do well by this strategy, since big, unexpected moves are outliers by definition. Traders will earn above-average returns in good times. In bad times they won’t suffer fully when catastrophic returns come in, as sooner or later is bound to happen, because the downside of these bets is partly socialized onto the Treasury, the Federal Reserve and, of course, the taxpayers and the unemployed.

To understand how this strategy works, consider an example from sports betting. The NBA’s Washington Wizards are a perennially hapless team that rarely gets beyond the first round of the playoffs, if they make the playoffs at all. This year the odds of the Wizards winning the NBA title will likely clock in at longer than a hundred to one. I could, as a gambling strategy, bet against the Wizards and other low-quality teams each year. Most years I would earn a decent profit, and it would feel like I was earning money for virtually nothing. The Los Angeles Lakers or Boston Celtics or some other quality team would win the title again and I would collect some surplus from my bets. For many years I would earn excess returns relative to the market as a whole.

Yet such bets are not wise over the long run. Every now and then a surprise team does win the title and in those years I would lose a huge amount of money. Even the Washington Wizards (under their previous name, the Capital Bullets) won the title in 1977–78 despite compiling a so-so 44–38 record during the regular season, by marching through the playoffs in spectacular fashion. So if you bet against unlikely events, most of the time you will look smart and have the money to validate the appearance. Periodically, however, you will look very bad. Does that kind of pattern sound familiar? It happens in finance, too. Betting against a big decline in home prices is analogous to betting against the Wizards. Every now and then such a bet will blow up in your face, though in most years that trading activity will generate above-average profits and big bonuses for the traders and CEOs.

To this mix we can add the fact that many money managers are investing other people’s money. If you plan to stay with an investment bank for ten years or less, most of the people playing this investing strategy will make out very well most of the time. Everyone’s time horizon is a bit limited and you will bring in some nice years of extra returns and reap nice bonuses. And let’s say the whole thing does blow up in your face? What’s the worst that can happen? Your bosses fire you, but you will still have millions in the bank and that MBA from Harvard or Wharton. For the people actually investing the money, there’s barely any downside risk other than having to quit the party early. Furthermore, if everyone else made more or less the same mistake (very surprising major events, such as a busted housing market, affect virtually everybody), you’re hardly disgraced. You might even get rehired at another investment bank, or maybe a hedge fund, within months or even weeks.

Moreover, smart shareholders will acquiesce to or even encourage these gambles. They gain on the upside, while the downside, past the point of bankruptcy, is borne by the firm’s creditors. And will the bondholders object? Well, they might have a difficult time monitoring the internal trading operations of financial institutions. Of course, the firm’s trading book cannot be open to competitors, and that means it cannot be open to bondholders (or even most shareholders) either. So what, exactly, will they have in hand to object to?

Why bubbles are structurally likely

Grasping Reality with Both Hands: "Sixth, the market will go wrong whenever its prices function as forecasting mechanisms. A proper forecasting mechanism would weigh each individual's opinion by the precision of his or her knowledge. A market tends on the contrary to weigh each individual's opinion by his or her wealth. This means that whenever economic processes tend to revert to seem average level that the market is likely to get things wrong, for when prices rise above average those who are optimistic become richer and their opinions carry more weight and so prices tend to rise further above their likely long-run fundamental values. Bubbles and crashes, manias and panics, are thus built into the system.