Although Milton Friedman and Monetarism became less chic as the Reagan-Thatcher era faded, the Fed continues to act as if the money supply is the main lever for managing the economy. Actually, though, the theory is fine. The problem is that policymakers and the financial markets have been turning blind eyes to 25 percent of a key four-factor model: They’re not paying attention to V, Velocity of money. They’d better start soon or we could be in for some serious turbulence.

The Not-So-Secret Sauce

Monetarism is based on the Quantity Theory of Money traceable back at least to Francisco de Vitoria the 16th Century philosopher and theologian from the School of Salamanca. It’s summarized in the following equation:

  • MV = PT
  • M is Money supply
  • V is Velocity of money (See below)
  • P is Prices (think CPI)
  • T is Transactions (think Real GDP)
  • Reagan-Thatcher era policymakers thought that they could control inflation by controlling the money supply. As we know from basic algebra, if M goes up, so, too, does P and vice versa. (In other words, as money supply rises, so, too does the CPI).

    There’s a Catch

    Actually, in many walks of life including financial and economic research, you can’t simply say if such and such does this, then this other thing will do that. It’s always essential to add and important caveat: “all else being equal.”

    The all-else caveat is vital. That, however, may be the problem. It’s so vital, we often take it for granted and forget to say it out loud. And if we stay silent for too long, it becomes easy to lull ourselves into completely forgetting about it. One well-known example is the PEG (PE-to-Growth) ratio, which presumes PEs are influenced by the level of growth. It’s not just that. Cost of equity capital is an important all-else.

    Vintage 1980s monetarism faded as it became apparent that the Fed could not control inflation simply by controlling the money supply. And that conclusion was inevitable. P is not purely related to M just as PE is not purely related to G.

    The Crucial All-Else Item, V (Velocity)

    Velocity of money is the topic that seems least discussed. The Federal Reserve defines it as follows in connection with its data collection and presentation: “The velocity of money is the frequency at which one unit of currency is used to purchase domestically-produced goods and services within a given time period. In other words, it is the number of times one dollar is spent to buy goods and services per unit of time. If the velocity of money is increasing, then more transactions are occurring between individuals in an economy.”

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