Friedman and Schwartz’s Case That the Demand for Money (the Inverse of Velocity) Is Constant Is Statistical Legerdemain (a Sleight of Hand)

For many years I [Joseph T. Salerno]—and other Austrians—have had to endure charges by monetarists that Murray Rothbard fudged the data to increase monetary growth rates during the 1920s in order to portray it as an inflationary decade. As I argued in an exchange with eminent monetary historian Richard Timberlake these allegations are baseless. So, now it is with delicious irony that I draw your attention to an explosive article by three econometricians thoroughly debunking the empirical claim made by Milton Friedman and Anna Schwartz that the velocity of money in the U.S. has exhibited long-run stability for more than a century leading up to 1975. 

Neil Ericsson, David Hendry, and Stedman Hood argue that dubious “data adjustment” in Friedman and Schwartz’s empirical models “dramatically reduced apparent movement of the velocity of circulation of money and . . . adversely affected the constancy and fit of his estimated money demand models.” In other words, Friedman and Schwartz’s empirical case that the demand for money (the inverse of velocity) is constant, which Friedman and Schwartz painstakingly elaborated in three statistical tomes published from 1963 to 1982 and which is the linchpin of monetarism, has been exposed as statistical legerdemain. 

Friedman and Schwartz adjusted the raw data to account for: 1. the sudden onset of rapid developments of financial instruments and institutions in the U.S. economy compared to the U.K. economy; and 2. short-run fluctuations in velocity associated with business cycles. In adjusting for “changing financial sophistication,” Ericsson et al. point out, Friedman and Schwartz added a linear trend of 2.5% on money supply observations prior to 1903, but made no trend adjustment at all to the data after that year. In the process, they “adjusted” the money stock for 1867 from its raw or unadjusted value of $1.28 billion to $3.15 billion. This is a phantom increase of 246% on the observed money stock! The result of this trend adjustment was to substantially suppress the effect of the precipitous decline in observed velocity of more than 50% from the early 1870s to 1903 on its variability over the entire period studied (1867-1975). Thus although the adjustment applies to only 30% of the period studied, it accounts for almost 75% of the total variance of velocity.

—Joseph T. Salerno, “Milton Friedman Debunked—by Econometricians,” Mises Wire, entry posted May 12, 2017, https://mises.org/wire/milton-friedman-debunked-econometricians (accessed April 16, 2021).