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).

The Repo Crisis Tells Us the Assets Used as Collateral and the Borrowers’ Ability to Repay Are ALL Artificially Manipulated

The repo market is where borrowers seeking cash offer lenders collateral in the form of safe securities. Repo rates are the interest rate paid to borrow cash in exchange for Treasuries for 24 hours. . . .

When did hedge funds and other liquidity providers stop accepting Treasuries for short-term operations? It is easy money! You get a safe asset, provide cash to borrowers, and take a few points above and beyond the market rate. Easy money. Are we not living in a world of thirst for yield and massive liquidity willing to lend at almost any rate?

Well, it would be easy money . . .  Unless all the chain in the exchange process is manipulated and rates too low for those operators to accept even more risk.

In essence, what the repo issue is telling us is that the Fed cannot make magic. The central planners believed the Fed could create just the right inflation, manage the curve while remaining behind it, provide enough liquidity but not too much while nudging investors to longer-term securities. Basically, the repo crisis — because it is a crisis — is telling us that liquidity providers are aware that the price of money, the assets used as collateral and the borrowers’ ability to repay are all artificially manipulated. That the safe asset is not as safe into a recession or global slowdown, that the price of money set by the Fed is incoherent with the reality of the risk and inflation in the economy, and that the liquidity providers cannot accept any more expensive “safe” assets even at higher rates because the rates are not close to enough, the asset is not even close to being safe, and the debt and risk accumulated in other positions in their portfolio is too high and rising.

—Daniel Lacalle, “The Repo Crisis Shows the Damage Done by Central Bank Policies,” Mises Wire, entry posted October 11, 2019, https://mises.org/wire/repo-crisis-shows-damage-done-central-bank-policies (accessed March 30, 2020).