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Why Milton Friedman Is Still Right

Thursday, October 8, 2009

Inflation is always and everywhere a monetary phenomenon.

The easy-money advocates had a tough summer. In August alone, the price level increased almost half a percent, raising the average annual rate of inflation for the past three months to almost 5 percent. Wholesale prices, especially of raw materials, have also been moving upwards, as has the “prices paid” index of the Institute for Supply Management's survey of the manufacturing sector (the service sector has had more mixed recent results). Across the board, the stats show a broad consensus that we have switched from a deflationary trend to an inflationary one.

When the facts are against you, you can either change your mind, or switch the argument from facts to theory. The easy-money guys have chosen the latter course.

Recently, a client sent me an article written by economics blogger John Mauldin (see his chart below). Mauldin has written some of the best work arguing that America is far more likely to see deflation than inflation. His argument revolves around the concept of monetary “velocity,” that is, the rate of money turnover. If each dollar is spent and re-spent many times over, that is a high velocity. If the money is spent only a very few times, then the velocity is low.

Chart 10.7.09

Others are advancing the velocity view. For example, the New York Times’s Paul Krugman has dusted off the Keynesian liquidity trap theory in order to convince America that deflation is the more worrisome threat. In Krugman’s case, it seems as though politics are in charge, and the economics seem to be there for no more reason than to provide an elaborate justification for more stimulus spending. I have been taught that the best way to uncover truth is to debate against the opposing views in their clearest and best forms: and the clearest and best form of the case for deflation is not Krugman’s political polemics but Mauldin’s economic theory. Mauldin is a truth-seeker, not a propagandist.

Originally, the strong focus on the velocity of money goes back to John Maynard Keynes, who used it as part of his general effort to overthrow the Victorian classical consensus that a stable supply of money is the source of stable prices. Keynes argued that inflation was as much a matter of the velocity of money as of its supply. Hence, the government had an obligation to manipulate the economy in such a way as to stimulate velocity in order to overcome deflationary recessions. In essence, Keynes said do not worry about debasing the currency, because that is not a likely source of inflation.

It did not take long before the classical camp corrected the record. Financial journalist Henry Hazlitt accurately identified the theoretical problems with this view:

I have said nothing above about the much-discussed “velocity-of-circulation” of money, and its supposed effect on prices. This is because I believe the term “velocity-of-circulation” involves numerous irrelevancies and confusions. Strictly speaking, money does not “circulate”; it is exchanged against goods. A house that frequently changes hands does not “circulate.” A man can only spend his monetary income once. Other things remaining equal, “velocity-of-circulation” of money can increase only if the number of times that goods also change hands (say stocks or bonds or speculative commodities) increases correspondingly …

An increase in the “velocity-of-circulation” of money, therefore, does not necessarily mean (other things remaining unchanged) a corresponding or proportionate increase in “the price-level.” An increased “velocity-of-circulation” of money is not a cause [emphasis Hazlitt’s] of an increase in commodity prices; it is itself a result of changing valuations on the part of buyers and sellers. It is usually a sign merely of an increase in speculative activity. An increased “velocity-of-circulation” of money may even accompany, especially in a crisis at the peak of a boom, a fall in prices of stocks or bonds or commodities.
---The Failure of the ‘New Economics,’ by Henry Hazlitt, 1959

Later, Milton Friedman’s monumental Monetary History of the United States empirically crushed the Keynesian model with page after page of data. Friedman concluded that “inflation is always and everywhere a monetary phenomenon.” And that has been that ever since.

But the trauma of recent history has convinced some, and pro-stimulus special pleading has convinced others, to abandon the classical model once again and declare that the monetary and fiscal spigots should remain open for a long time; commodity, dollar, and bond investors have been using their mouse clicks to vote early and often for the opposite. Others are arguing that we need not worry about inflation because inflation cannot occur without an increase in monetary velocity. Therefore the various market indicators should be ignored and the Fed should keep the money flowing.

Mauldin, in particular, argues that Friedman’s views are obsolete because Friedman did his inflationary work in the time before changes in monetary velocity were measured. So, Friedman (and by implication all of the classical free-market crowd) were stuck focusing on money supply when it was velocity that was caused inflation. But the problem is that the velocity argument was wrong from the beginning. It put money in the center of the analysis, rather than the production and exchange of goods and services. Money is the means, not the ends of economics. Transactions are what count. For a time they were conducted by barter, then later facilitated by money, but money is ancillary. In classical logic terms, it is accidental to the transaction, not essential to it. The transaction causes money exchange, not the other way around.

If we are buying and selling at the same rate as we were before, then the only way to change prices is to change the supply of money.

This points in a powerful way to an extremely important flaw that Keynes introduced into modern economic reasoning. Keynes repeatedly argued that certain variables were “functions” of other variables. Since function theory was all the rage in mathematical reasoning at the time, this gave Keynesianism a veneer of scientific sophistication. It did add precision to economic calculation and that was an advance. But it also took something away. It took away the notion of causality. Classical economics was built on the foundation of classical philosophy and formal logic. Logic taught that there are three acts of the mind which were needed to derive a valid inference. First there was apprehension, that is the mind had to understand the terms involved. Second, there was judgment, the action in which the mind assents to the truth of a statement. Finally, there is reasoning, by which the mind uses premises to draw a valid conclusion. Apprehension answers the question “what.” Judgment answers the question “whether” and reasoning answers the question “why.”

When Keynes began to declare that, say, output, was a function of, say, velocity. He was actually destroying insight, because functions are silent on the question of cause and effect. Equations do not flow in one direction or another, they make no distinction between Y=MV on the one hand and MV=Y on the other, so they take causality out of the thought process. Once that was done, economics became at once more confused and at the same time more confident in its newfound scientific rigor.

One of the ways to guard yourself against this confusion is to translate ideas back from mathematical expression into plain English prose with concrete subjects, verbs, and predicates. Once that is done the fallacies are far more easily detected and dealt with. Once you have grasped the true cause-and-effect relationships between various ideas, you can go back to the formula and know where and how to use it.

For example, Mauldin (brace yourself for a bit of algebra, or skip this paragraph) argues that

if M and Q are held constant, then
V varies with P

In quasi-English:

Output (basically GDP) is a multiple of the amount of money (M) and the velocity of money (V). Then he argues that Y=PQ, that is output is a multiple of the price of goods (P) and the quantity of goods sold (Q). If Y equals MV and Y also equals PQ, then it follows mathematically that MV=PQ. So if M stays the same and Q stays the same, and V goes up then P must go up too. Hence, velocity causes inflation!

Except that in the real world velocity doesn’t cause inflation. The attached chart which Mauldin himself produced shows that sometimes velocity and inflation coincide and sometimes they do not.

The problems become apparent once the algebra is translated into plain English. Yes, output is composed of the number of new goods and services purchased times the average price. Yes output also equals the number of dollars circulating times the number of times each dollar circulates. Both things have to be true, but it is the causes that matter. Dollars circulate because people are buying and selling things. The more cars and houses and cab rides and computer programs we produce and sell, the more turnover of money there is, but the money does not cause the transactions. It is the other way around: the transactions cause the money flows. Once you understand this, the whole velocity argument falls into ruins. Because if you translate the math into plain English, you are really saying that if we increase the number of times people pay for things, but do not increase the number of times people sell things, then the price will go up. But this is insanity. In the real world, velocity of money and quantity of sales go up and down together: you cannot possibly increase V without increasing Q. Money changes hands precisely so that goods can change hands.

Once we get that notion, we can never be fooled by Keynes again. Taking into account the way the real world of cause and effect operates, we see that you should hold velocity and quantity the same. This means that as money goes up, so does price. In English, if we are buying and selling at the same rate as we were before, then the only way to change prices is to change the supply of money.

In other words, “inflation is always and everywhere a monetary phenomenon.”

Jerry Bowyer is an economist, columnist, and CNBC contributor, and blogs at

Image by Darren Wamboldt/Bergman Group.

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