Reply to Selgin on the Velocity of Money

George Selgin commented on my post, "Krugman and Macroeconomics," expressing reservations about my statement that his and Steve Horwitz's version of Austrian business cycle theory incorporates significant Keynesian elements. My belated reply, which follows, is long enough to warrant a separate post:

George, thanks so much for your comment, with which I mostly agree. I admit that many pre-Keynesian economists, Hayek, and some Monetarists all saw negative velocity shocks as one important source of depressions or recessions. But I still think it is fair to describe that view as Keynesian. After all, a Keynesian attack of "animal spirits" is nothing more nor less than a velocity shock. Indeed, I would identify this as the central proposition of Keynesian business cycle theory, although the Keynesian insistence upon referring to changes in velocity (i.e., money demand) as changes in "autonomous spending," or even worse, as a divergence between "planned saving and planned investment," often obscured this simple fact.

Three distinct positions on velocity seem to have dominated the debate after Keynes: (1) the traditional Keynesian view that autonomous falls in velocity were the only source of economic downturns because the money stock, for the most part, did not matter; (2) the orthodox Monetarist position, as exemplified by Milton Friedman, that the cyclical behavior of velocity was mainly a function of what was happening to the money stock, and that therefore, while in theory velocity shocks could cause economic fluctuations, in practice fluctuations are almost always driven by the money stock;  therefore velocity is unimportant as an independent causal factor; and (3) the view of many (but not all) Austrian economists that velocity shocks, to the extent that they arose from changes in people's preferences, could not cause business cycles, even in theory.

The third position, that velocity doesn't matter, is certainly the view of Rothbard, and I take it to have been the view of Mises as well, although it has been a long time since I read Mises closely, so correct me if I am mistaken. And Roger Garrison's version of Austrian business cycle theory, in contrast to your and Steve's version, assigns little role to velocity, apparently because he holds the orthodox Monetarist view. In his chapter included in Brian Snowden and Howard R. Vane's Modern Macroeconomics: Its Origins, Development and Current State (p. 491), Roger writes: "An exogenous change in money demand is rarely if ever the source of macroeconomic disruption. (Here the Austrians fall in with the monetarists.)" Ironically, a pure version of New Classical real business cycle theory also seems to agree with Rothbard that velocity doesn't matter. New Keynesian economists, on the other hand, have adopted significant Monetarist elements by giving monetary shocks equal billing with velocity shocks, which is one of several reasons why Greg Mankiw admits New Keynesians could just as accurately be labeled New Monetarists.

This raises one question that I may have asked you in the past, but if so, I've forgotten your answer. Given your position that negative velocity shocks can cause a recession or depression, doesn't that require that you also conclude that a positive velocity shock can cause a boom with its associated malinvestment? Yet every time I've suggested that possibility among Austrian economists, dating back to the summer of 1977, I have encountered vociferous objections.

Let me conclude by stating that I agree with you that if monetary shocks can cause business cycles, then it logically follows that velocity shocks can do so also. Because whether we call a shock one or the other depends on the slippery question of how we define the money stock. The banking panics of 1930-33, which made the Great Depression so severe, were a negative monetary shock if we are looking at M1 or M2 but a negative velocity shock if we use the base as the definition of money. However, I am not shy about conceding that this conclusion involves a significant Keynesian element.