The Mystery of the Money Supply
At his Humphrey-Hawkins testimony, chairman of the Federal Reserve Alan Greenspan was asked whether the Fed attaches any significance to the money supply data. The Fed chairman replied that he regards money as an important variable but admitted that he has difficulty in establishing what part of liquidity constitutes "money." In short, Greenspan was suggesting that US central bank policy makers are in the dark regarding the correct definition of money.
But, knowing the definition of money is imperative in tracking the effect of the central bank's monetary policies on the prices of goods and services and boom-bust cycles. Furthermore, if the mandate of the Fed is to manage the money supply, how on earth can it do so if the policy makers do not even know what money is?
According to mainstream economics the correct definition of money is decided pragmatically. Whether M1, M2 or some other M will be called money depends on the strength of its correlation with national income. Most economists argue that financial deregulations of the early 1980s changed the nature of financial markets and consequently past definitions of money no longer hold.
This implies that the Fed’s policy makers cannot employ a given money supply data series to assess the impact of monetary policy and the direction of economic activity because various conventional definitions of money no longer have a sufficiently high correlation with gross domestic product.
This entire approach, however, is defective. No definition can be established by means of a correlation. The purpose of a definition is to tell us the fundamental characteristics, or essence, of a particular entity. Whatever the merit of statistical correlations, they could never tell us this.
To establish the definition of money, we have to comprehend how a money-using economy came about. Money emerged because without a general medium of exchange trading and specialization were limited. To enjoy the benefits of more exchange and an extension of the division of labor, some traders transcended the barter market by using a medium of exchange. Money, the general medium of exchange, developed into the most marketeable commodity. As Mises wrote, "There would be an inevitable tendency for the less marketable of the series of goods used as media of exchange to be one by one rejected until at last only a single commodity remained, which was universally employed as a medium of exchange; in a word, money."
Similarly Rothbard wrote that,
- Just as in nature there is a great variety of skills and resources, so there is a variety in the marketability of goods. Some goods are more widely demanded than others, some are more divisible into smaller units without loss of value, some more durable over long periods of time, some more transportable over large distances. All of these advantages make for greater marketability. It is clear that in every society, the most marketable goods will be gradually selected as the media for exchange. As they are more and more selected as media, the demand for them increases because of this use, and so they become even more marketable. The result is a reinforcing spiral: more marketability causes wider use as a medium which causes more marketability, etc. Eventually, one or two commodities are used as general media-in almost all exchanges-and these are called money."
In short, money is item that trades against and for all other goods and services. General salability is the distinquishing fundamental characteristic of money in contrast with other goods. For instance food supplies the necessary energy to human beings. Capital goods permit the expansion of the infrastructure that in turn will permit the production of a larger quantity of goods and services. Contrary to mainstream thinking, the essence of money has nothing to do with financial deregulation, as it will remain intact in the most deregulated of markets.
Some commentators maintain that money’s main function is to fulfill the role of a means of savings. Others argue that its main role is to provide services of a unit of account and to function as a store of value. While all these roles are important they are not primary. The fundamental role, the essence of money, is that of a general medium of exchange. All other functions of money emerge because money is the general medium of exchange.
Through the ongoing selection process, over thousands of years people settled on gold as money. In today’s statist monetary system, however, the core of the money supply is no longer gold, but coins and notes issued by the government and the central bank. Thus, the state's coins and notes constitute the standard money also known as cash that is employed in transactions.
Apart from cash however, people also employ demand deposits since checks written against demand deposits are accepted in payment. The reason for this acceptance is that demand deposits confer an immediate claim on the money deposited on demand at par value. Similarly saving deposits, which, effectively can be withdrawn on demand, must be also included in the definition of money.
It is important to contrast money claims that are exchangeable on demand for standard money at par with various credit transactions that are not part of the money stock. For instance fixed term deposits like CD’s are credit transactions. In a credit transaction an individual lends present money to somebody else in exchange for a claim on future money. The CD cannot be considered money since its holder reliquishes his claim to present money. He can only acquire present money again by liquidating, i.e., selling, the CD for money at a discount.
Clearly, the current practice of including various assets into the definition of money because of their liquidity is flawed. There is no gray area between money claims and credit claims where highly liquid assests reside that can be considered as part of the money stock. Liquid assets like stocks and bonds, as with other goods and services, are bought with and sold for money and cannot be used to buy and sell goods. Moreover, inventories of retail goods might be as liquid as stocks or bonds. But, no one would consider these inventories as part of the money supply. In fact they are just other goods that are bought with and sold for money in the market.
Following the distinction between a credit and a claim transaction, money invested with money market mutual funds must be excluded from the money supply definition. Investment in a money market mutual fund (MMMF) is an credit transaction into various money market instruments. The quantity of money is not altered as a result of this investment, only the ownership of money has temporarily changed. Including MMMF funds into the money definition is double counting.
Although travellers checks are regarded as an integral part of the narrowly defined money M1 they should not be. Travellers checks are receipts for investments in companies that issue these checks. In short travellers checks are the result of a credit transaction and therefore are not part of the money supply. Cashing a traveller check means that AMEX or Visa must transfer money from their deposits to the holder of the check. The amount of money in the economy is not affected by this transaction.
Government demand deposits, however, should be included in the money stock since they are spendable funds in the same manner as private demand deposits. Following Mises and Rothbard, the money supply should be defined as: Cash+demand deposits with commercial banks and thrift institutions+saving deposits+government deposits with banks and the central bank.
This definition shows clearly that any expansion in the money supply takes place solely as a result of central bank injections of cash and commercial banks practice of fractional reserve banking.
On the following chart the Austrian school of economics money supply (AMS) is presented (see chart). Year-on-year the rate of growth of the AMS fell to 5.1% in early February from 6% in January and 9.4% in January last year.
You may also read an interview with Shostak in the Austrian Economics Newsletter.
See also the Austrian Study Guide.