The speed of money

These are the notes for a talk given at the Occupy University sessions at Occupy Dame Street last October (2011).


Money’s been around for a long time, since the days of the mythical King Croesus. Certainly far longer than capitalism. So we should surely understand all about it by now?

Surprisingly not. I’m not an expert, still less a “proper” economist (whatever one of them is). But I think I can show you, in a short space of time, that some of the basic ideas about money accepted by most mainstream economics are demonstrably silly.

First of all, let’s consider a thought experiment. Suppose the ECB print a new batch of 10 billion euros. They then stack them on a palette in a warehouse and they don’t move from there. What effect on the economy does that extra 10 billion euros have?

[Trick question - depends if someone is made to pay for them having been printed. But pari passu]. No effect, basically. The mere existence of money, hidden in a cave somewhere, doesn’t do anything. That seems a trivial observation, hardly worth mentioning.

The reason I mention it though, is one of the themes of this talk, which is that there is a common sense way of looking at the world which I call the Legoland view. With Lego you have so many bricks to play with. There’s a whole variety of different bricks and Lego pieces, but what you have is what you got. If you only have a hundred bricks or pieces that limits the things you can build. You get another 200 bricks and pieces you can build bigger and more elaborate things. It stands to reason. Speed has nothing to do with it. Whether you build your Lego fast or slow, there’s no difference in the limit to the end result. The limit is what you can count if you take a snapshot of how many pieces you have. It would be pointless to have a talk about the speed of Lego.

One more primer story before we get into it. The Knights Templar and the mystery of their missing gold. Since they were established in 1129 as an order of poor christian soldiers to wage crusades into the holy land, the Templars had built a very profitable side business in a kind of banking. The voyage from France or Britain to the Holy land was lengthy and dangerous for knights making their pilgrimage, and there was always the chance of getting robbed along the way. But as the Templars had “branches” both locally and in Jerusalem, wealthy pilgrims, say Lord Muck, could go to his local branch of the Templars and deposit say 500 gold pieces with them in return for a coded document which he could then exchange back for the money when he fought his way through the pirates and the bandits (or perhaps I should say the other bandits and pirates, let’s not have any illusions about Lord Muck and his fellow crusaders) and staggered into Jerusalem.

Pretty soon all the feudal lords were using the Templars “Travellers Cheques” system. Plus then they started lending money as well. Sir Roger the penniless knight would come along after Lord Muck had deposited his 500 gold pieces in preparation for his 5 or 6 month voyage to Jerusalem, and ask whether he could borrow, say 300 gold pieces for 3 months until his peasants got the harvest in. Sure the Templars could oblige him, so long as he promised to pay back well before Lord Muck got to Jerusalem (if he got there at all). And of course, the Templars would never ask for something so un-Christian as interest, because that would be usury, but a suitable charitable donation to keep up the good work or the Order would naturally be appreciated.

A century or so later, the Templars were the richest organisation in Western Christendom. Which inspired Philip IV, King of France with a Baldrick-esque cunning plan. In 1307 he arrested the leaders of the Templars in France, tortured them until they confessed to some hokum heresy (complete with salacious sexual details, without which no smear has that gossip X factor), burned them at the stake and then went to get his hands on all that lovely gold the Templars were holding. Except he couldn’t find it. Everybody who was anybody had gold on deposit with the Templars, that should have added up to a huge amount (far too big to be spirited away by a couple of men on horseback in dead of night) - where the hell was it? To this day there are still some deluded fools hunting for that lost Templar treasure. In fact, as we’ll find out in a bit, the answer to the mystery is much more mundane than you might expect. But I’m getting ahead of myself.

So, let’s talk about money supply - which is what the topic of this talk is mainly about. We all know about supply and demand. So if money supply exceeds demand for money then we get inflation (Zimbabwe) and if money supply is less than demand we get? Deflation.

But what is the relationship between transactions in the “real” economy and prices of tradable goods and services and amount of money available and the rate at which it circulates?

In mainstream economics this relationship is commonly expressed in the so-called “equation of exchange

M . V = P . Q

for a given period, where M = nominal money, V = velocity of money, P = prices, Q = transactions for newly produced stuff. (and P.Q is total spends)

So-called “equation” as we associate that term with laws of science, like K = ½ mv2 , that tell us useful things about how the world works. This is just a re-arrangement of the definition of the velocity of money (V = PQ / M), that is, it is a tautology.

To turn that tautology into a relationship that tells us something useful about the world, further assumptions are needed. The quantity theory of money adds the assumptions that, in the short term, two factors stay constant. The velocity of money V and the index of transactions Q. So if both V and Q are fixed, then we can simplify the equation to tell us that changes in prices are proportional to changes in the mass of money. If the mass of money increases so do prices and, conversely, if it decreases, so does prices. These two “imbalance” conditions occur then we get inflation and deflation respectively.

Inflation means that the price of each good goes up (which is to say that the value of money goes down) and deflation means that the prices go down (and the value of money goes up) in classic supply and demand dynamic.

But there is a real-world problem with the assumption that the speed of money is constant. Lets think of what happens in an economic crash. The 1% who control a very large proportion of the money in circulation see that investment in productive enterprises that employ people, and put money into circulation by means of wages and purchase of supplies for them to work on, is unlikely to be profitable in the next period. So they take their money out of circulation and put in in safe stores of value like US treasury bonds. This is called the “flight to safety”. What does that do to the velocity of that money? It was going round from hand to hand via wages and consumer spending, now its sat in a 5 or 10 year treasury bond. Clearly, if the speed of money is how often it changes hands as part of economic transactions, then this money has slowed drastically, even almost stopped.

Of course the control of the 1% over “their” money is only one part of the story. Most employment is by SME’s who are not generally run by the 1%, but they also rely on bank lending. If the banks are in trouble they will stop lending to SMEs and they also suffer the double-whammy of losing sales as falling employment and wage cuts means most people have less money to spend. But the money they can no longer borrow is also not not going into circulation and is slowing down.

Now, not to be too one-sided, there is also a simultaneous counter-tendency that while this is happening, also the reduction in the creation of money through new loans and the increase in the destruction of money through those who can afford to repaying loans, is also reducing the mass of money. But here we’ve got ahead of ourselves again, - we’ve created our own little crisis, although of the narrative rather than economic sort - so we need to pause and go back to how banking and lending creates (and destroys) money.

let’s imagine that we have a Toytown economy where there are 100 people who get paid every 4 weeks in beans. They get paid four beans a month - taking the month to be four weeks. Each week they take a bean out of their account and that is spent on all their consumables for the week. The bean gets paid to the company that makes all that stuff and goes into their company account, which is where the wages come from again at every start of the month. Now let’s imagine that each of the four beans each person receives is invisibly labelled A, B, C or D. And let’s say that the first week everybody takes the A bean out for the week’s spends, the next week the B bean, and so on.

So what happens. At the start of the month, the company pays out 400 beans in wages. Each person takes out their A bean, which ends up in the company’s income account. During the first week the B, C, and D beans are all sat in the bank, doing nothing. (I think you can see where I’m going with this, but bear with me). In the second week everybody takes their B bean out and that eventually ends up in the company account. Meanwhile all the A beans are sat in the company account, doing nothing, as are the C and D beans in the workers accounts. And so on.

Until one day the bank thinks, “Hang on, what happens if instead of leaving the A beans in the company account at the end of the first week, we just put them back in the workers accounts to be used for the second, third and fourth week?”. The we’ll have a reserve of all the B,C & D beans in case the company wants some money before the next wage round or someone wants a loan or what have you.

What just happened? Simple, the A beans were just speeded up to four times their original velocity, to do the work of all of the B, C & D beans as well. The number of transactions every week is unchanged, there should be no net effect on prices either way, the company still has the money it needs to pay wages and so on.

Now in practice, this doesn’t even have to be pre-meditated. If you have a bank branch where people deposit large sums infrequently and withdraw small sums frequently, in dribs and drabs. You will eventually end up with a front of house float that covers the average daily withdrawals and an accumulated stash of cash in the storeroom at the back.

It’s a feature of the different time profiles of deposits and withdrawals and the fact that money, unlike cheese or milk, doesn’t go off, so you don’t operate a first-in first-out queue system. If a customer deposits 50 euro and the next customer wants to take out 50 euro, you don’t go “Hold on, I can’t give you this 50 euro, we’ve only just got this, I’m going to have to go back into the storeroom and find that 50 euro that Mrs Higgins deposited 4 weeks ago”. In terms of the speed of money banks are accelerators. Not quite Large Hadron Colliders, but you get the picture.


And now we understand why Philip IV of France couldn’t find all that Templar gold. It wasn’t there. (And NB this is back in the 14th century when gold was money and no-one had heard of “fractional reserve banking”)

So having taken that detour, lets return to what happens to the speed of money in a financial crash. As all the investors flee from risky investments in production into supposedly safe stores of value, is it credible that the speed of money stays constant? Clearly not. In fact many, if not most, economists accept that a crash like that the lead to the Great Depression in the 1930s and the one we are in now, risks creating deflation. The obvious way to understand this is a very rapid deceleration of money.

So why do the majority of conventional economists (and many not-so-conventional ones) still accept the quantity theory of money?

If we see that a commonly-held belief is in fact wrong we can answer why this might be so in two ways. The first is to think that most people are dumb or easily-fooled “sheeple” who believe wrong ideas because they are told to. The second is to look at what the context of surrounding ideas is, that might make a wrong idea appear to “fit in” with other commonly accepted ideas.

I propose that the quantity theory of money fits with most people’s “common sense” because we’re used to a Legoland world of static things. If there’s 4 bicycles going round the cycle track of a Velodrome, if they go faster that doesn’t make them into 5 or 6 bicycles, right? That violates our common sense. And though we can easily see that it doesn’t make sense to talk about the speed of Lego, yet it is perfectly natural to talk about the speed of bicycles. And the common sense of bicycle logic tells us that an increase or decrease of speed does not mean an increase or decrease of bicycles. So the same common sense would tell us that if the central bank has already printed X amount of base money, then if they print the same amount of money again, the money supply must have doubled. Surely?

Not necessarily. If the speed of money has decreased by half, then doubling the mass of money would not increase the money supply. And if the speed of money has actually dropped to 40%  or 30% of its original speed, the money supply has actually fallen, even if you have printed double the amount of currency.

Now I’m aware here that I’m relying on an equation here against the workings of common sense (or what’s sometimes called a cognitive bias or frame, following George Lakoff & co), so forgive me for labouring the point just a little more.

There is one part of our world in which we’re more used to speed becoming quantity, which is the microscopic world. We remember from science or physics classes at school that most solids and gases expand if they are heated and that this is because the microscopic molecules (or atoms for pure elemental materials) are absorbing heat energy and moving faster with more energy. So a balloon of gas, if heated, will grow bigger. But that’s the microscopic world and we understand that, like the past, it’s “another country, they do things differently there”. But money, like this coin say, is not part of that world, its part of our human-scale world, so it should behave more like Lego and bicycles when it comes to speed and volume or surface area, surely?

Well, there is a third level, on top of the microscopic and the human-scale ones, which is the macroscopic level. That is the level of whole societies, of hundreds of thousands or many millions of people. Money, I’m going to propose, as an integral part of the economic system, even though we can hold it in our hand or have it in our pocket, is also part of that macroscopic world as well as our human-scale one, in a way that Lego and bicycles are not.

And in fact most of the difficult or counter-intuitive things about not only money, but most economic questions, are to do with this conjunction of the human-scale and the macroscopic scale. A well known economics example of this is Keynes’ paradox of thrift.

At the individual human scale, being thrifty and saving your pennies rather than drinking it all down the pub, is sound economics that will improve your individual welfare. But at a macroscopic level, if everyone in society decides to spend less and save more at the same time, we get a drop of demand for goods and services, the economy tanks, businesses close (and not just the pubs) and people lose their jobs and everybody’s welfare gets worse, not better.

This mismatch between the individual level logic and the macro-scale logic is related to something called the “fallacy of composition” and also ideas like general systems theory and emergence which has been one of the big intellectual and conceptual stories of the 20th century and you can read all about it on Wikipedia, because I’m in danger of going off on a massive tangent here.

So back to the situation of a crash where the increase in the mass of base money being printed by the Treasury and Central bank is being outweighed by the rapid drop in the speed of money. Here we are running the risk of a debt-deflation scenario.

What is debt-deflation? Well the classic case is the Great Depression of the 1930s. As money in circulation dries up, the amount of goods you can get for an increasingly scare dollar goes up - that is, prices go down. Like rental prices in Dublin in the last 2 years. As prices go down, employers try to push wages down (or go out of business). But although prices for new goods goes down, the numerical figure for existing debts stays the same. So in practice as the value of money goes up, so the weight of existing debts on debtors gets heavier.

So there’s a strong push to reduce spending and increase saving on those that can. Also if you now that what you can buy for two dollars to day, likely you can get for 1 dollar tomorrow, you have an additional incentive not to buy today what you can put off until tomorrow. And that reduction in spending and increase in saving, is of course, more slowing down of money. The result is mass unemployment, no interest in borrowing money to start up new businesses for lack of potential customers, a vicious downward spiral.

This, before the 1930s was claimed to be impossible by all the then mainstream economists, because they all believed in Say’s Law - that is demand will automatically match supply, eventually. Nowadays sometimes expressed in the rather obscure ritual formula that “markets will clear in the long run”. This prompted Keynes’ famous sarcastic comment that in the long run, we’re all dead. By which he meant, in the depths of the depression (which actually started in the 1920s in Britain) that if we wait for the magic of the market to sort things out we could be waiting a very long time. Keynes it should be said, took a keen interest in these ideas of supply and demand, particularly demand. But also about the conventional ideas around money. Unfortunately most of the people called Keynesians today, like Paul Krugman, Brad deLong etc in the US, haven’t carried on the monetary aspect of this criticism, more or less accepting the quantity theory of money. Only a relatively obscure group called the Post-Keynesians, have carried on Keynes’ rejection of the conventional Legoland idea of money.

The monetarist like Milton Friedman, and his student, Ben Bernanke, accept that something got messed up in the Great Depression. Basically they say that the Fed acted in wrong way by further restricting the money supply, when it was already falling. But they believe that the money multiplier means that the state can increase the money supply at any time, just by pulling a lever. So a modern day Great Depression should be easily avoided. Their classic argument is that to avoid a debt-deflation scenario you could print up a load of money and just drop it out of helicopters. Ben Bernanke (the current US Secretary of the Treasury) is actually nicknamed “Helicopter Ben” for this reason.

Let’s return to banking again. I appreciate we’re jumping back and forth between stories, but hopefully this is not as confusing as a film like Pulp Fiction or Memento or something. But anyway.

We’ve already seen how the difference between the rate and frequency of deposits and withdrawals naturally means that banks can accelerate money to serve the normal in and out flows of money and leave a substantial residual reserve of unused money. So they do the natural thing with the slow or static reserve of untouched cash and lend it out to the modern day descendants of Sir Roger the penniless knight. And as they lend it out and it goes back into circulation (i.e. speeds up) more money is created. Especially when, that money ends back up in another account and then becomes part of the reserves that they can lend out again. You get a positive feedback loop.

Now anybody who’s ever got an electric guitar too close to the amp its plugged into knows that undamped positive feedback creates a runaway reaction that fairly quickly leads to something going bang. And this happened repeatedly with banks really since their inception, but particularly from the 18th and 19th century onwards when more and more people became dependant on the money economy for their subsistence.

Banks went bang with alarming regularity in the 19th century. On average there was a major banking crisis every 7 - 10 years. And the eventual result was that the state brought in regulation to try and damp down that positive feedback cycle by requiring a percentage level of reserves that have to be held back by every bank against every loan - often 10%. This fractional-reserve banking system is what we have now.

If you do the maths of the maximum amount of money the fractional reserve process can create it works out as the multiplier equation which is basically 1 divided by the reserve expressed as a fraction. So 20% would be a rate of one fifth and one divided by one fifth is 5, similarly if it was 10% that’s a tenth, so the multiplier is one over one tenth, i.e. ten. Now there’s two things to say about this creation of money by fractional reserve banking and the role of the multiplier.

The first is that a number of people find the whole concept very disturbing. Many people object that the banks are creating money “out of thin air”. The “out of thin air” phrase is a key meme here, repeated all over the place. For sure if we were creating Lego or bicycles “out of thin air”, then we would rightly suspect that something illegitimate or fraudulent was going on. But the point of this talk, and I’m sure you’re getting sick of hearing me repeat it, is that money isn’t like Lego or bicycles, for the reasons already discussed.

The second (thing to say about fractional reserve banking etc) is to do with the role of the multiplier and whether “Helicopter” Ben is right that the Treasury has to power to boost money supply by pulling a lever and pushing out base money which the so-called “money multiplier” will automatically expand up to ten times the original size.

Or, instead, to use the term Keynes used, is the effectiveness of such actions akin to pushing on a string. Just because a string is effective in allowing you to pull in one direction, doesn’t mean you can use it just as well to push things the other way. Since the onset of the crisis Bernanke has, through this thing called Quantitative Easing (QE) pushed out a lot of Fed money to the banks. In fact I’ve seen a figure that the actual mass of US base money has actually trebled in this time.

But if the banks decide that none of their US customers are enough of a safe bet to be lending money to and decide to buy low-earning US treasuries instead (or take a punt on sexy but risky high-earning PIGS bonds) or invest the money in Brasil, India or China, then Bernanke really has been pushing on a string. The difference here is whether credit is created by the pull action of consumers and businesses demanding loans, or by the push of the Treasury printing money. This is sometimes called the difference between endogenous and exogenous theories of money. [...explain words...]

All of this may sound like I’m defending the banks or the current financial system, including central banking, fractional reserve banking and so on. In fact I’m not. What I think is important is to have a radical critique - i.e. one that goes to the roots of the problem (which is where the word radical comes from) - rather than a superficial misunderstanding that mistakes effects for causes. And to do that we need to understand the real logics and dynamics of the current system, so that we can know what we really need to change to end its problems.

So now, I’m going to finish very briefly, with a consideration of what it means that all our money is effectively credit money and how that actually relates to our lived experience of economic slavery, of wage slavery.

What is the meaning of credit? Well that’s a big topic, but I want to finish by focusing on just one aspect of it. That is that credit is money for what James Connolly called “the people of no property”. Which is all of us here (unless there’s some secret millionaires present?) and the vast majority of people in this society and most of the rest of the world. That is, if we focus too much on money and the credit system in isolation, we forget that the reason we are all in debt, is that because we begin the game with nothing. And in order to fix that, we need to do more than address the problems with money, we need to fix the problem of the private property system that means we do not have the freedom to use our labour to create the world we want to build. In other words, anybody who thinks that we can cure wage slavery by getting rid of fractional reserve banking or credit money, has missed the main problem.

But, as I say, that’s another debate. Today I wanted to talk to you about the speed of money and I hope that you got something useful out of what I’ve been wittering on about, but it’s time to let other people speak. Thanks for listening.

[Imbalances vs Contradictions] 

[errata: the first copy of this had F = 1/2 mv^2 rather than K - thanks to GM-G for spotting that!]



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