Wednesday, September 26, 2007

The Money Supply Definition Issue Revisited

I recently explained why Frank Shostak's narrow definition of money is false and why his arguments for it are of really poor quality. I won't repeat this now so in case you forgotten about it or didn't read it, follow the link.

Two famous Austrian-leaning economists who have fallen for Shostak's nonsense are Mike Shedlock and Gary North. Mike Shedlock basically repeated Shostak's false claim that some forms of money should be viewed as credit transactions rather tha money plus arguing that it better predicted recessions. In the linked post, I explained why that argument was false too.

Gary North today on LRC linked to a paper written by himself where he argued M1 -the official money supply measure most similar to Shostak's- is better than broader measures like M2,MZM and M3.

His argument is actually worse than Shostak's. He rejects on account of being the money supply measure increasing in the long run most similar to the CPI. This is so unbelievably nonsensical. Even setting aside the usual Austrian objections to this Friedmanite approach, there is no reason theoretically to expect the money supply to follow the CPI even in the long run and even assuming the CPI correctly measure true consumer price inflation. This is first of all because shifts in asset values relative to GDP can mean that money supply can increase faster or slower than the value of production. And secondly and even more importantly, money prices of goods and services do not just -I can't believe I have to explain this to someone considering himself an economist- depend on the money supply but also the supply of goods and services. If the supply of goods and services increase, then the CPI will of course even in the long run increase a lot slower than the money supply.

The most relevant number to compare the money supply would actually be nominal GDP. And the money supply measure most closely tracking that would be M2 or M3. Nominal GDP between 1985 and 2005 -fourth quarters for GDP, December for money supply, the reason why 2005 is the last year is because that was the last year M3 was published- increased by a factor of 2.95, whereas M2 increased by a factor of 2.7 and M3 by a factor of 3.15. M1 strongly undershot it by increasing by a factor of just 2.2. MZM on the other hand strongly overshot it by increasing a full 4.1.

However, to the extent we should expect some under- or overshooting of nominal GDP, that would be overshooting it. The reason is that asset values have increased far faster than nominal GDP, with both stock- and house markets being far, far higher valued relative to GDP in 2005 than 1985. This means that either M3 or MZM should be considered the money supply measure most closely tracking economic activity. And since M3 has been "discontinued" by the Fed, this means MZM in practice for us.M2 is less useful, while M1 -as well as Shostak's closely related measure- should be considered completely useless.

9 Comments:

Anonymous Justin Rietz said...

I have to disagree with you re: Money Market Mutual Funds and the money supply.

MMMFs are neutral. No money is created when a person deposits money in a MMMA. The deposit is made and money is lent out. The depositor is not spending the money, but the ultimate borrower is spending it. Hence, the amount of money active in the economy is unchanged.

Now if the depositor writes a check against his MMMA, assets are sold (which are ultimately loans to borrowers) by the MMMF. The amount of money held by the "borrower" is reduced, but the amount of money to whomever the check was written increases by this same amount. Net neutral.

Also, my reading of Shostak is that changes in money supply are true inflation, and that CPI is a somewhat useless mix of inflation plus price changes due to supply and demand.

8:20 PM  
Blogger stefankarlsson said...

Justin, first of all, you're relating to a discussion in the previous post on the money supply, not one dealt with in this post.

Secondly, yes money is created when you deposit money in MMMFs. That is because the depositor gives the receiver cash which is certainly money for the receiver, while still having that value as money because he or she has the potential ability to use the deposited value as a means of payment. It is the potential ability which is the key here. Before the transaction only the holder of the cash had the potential ability to use it as a means of payment. After the transaction however, both the new holder of the cash and the holder of a MMMF value is potentially able to use it as money.

And yes, you're right that Shostak considers money supply changes to be true inflation and that the money price of goods and services depends upon both the money supply and the supply of goods and services. The discussion here was not with Shostak himself, but with one of the people following his money supply definition, Gary North, who tried to justify Shostak's definition by comparing it with changes in the CPI.

10:25 PM  
Anonymous Justin Rietz said...

I apologize - I meant to comment on the early post.

I am not sure how "potential" is relevant, though I admittedly might be missing something Let me illustrate:

1. Joe deposits $100 in an MMMA, thus taking $100 out of circulation.

2. MMMF buys $100 of assets, resulting in $100 being put back into circulation.

3. Joe writes a check for $50 against his MMMA, putting $50 into circulation.

4. MMMF clears the check, it selling $50 of its assets, thus pulling $50 out of circulation.

Outside of the fact that the check clearing process takes some amount of time, the net is a $0 change in the amount of money in circulation.

Unlike fractional reserve banking in which two people can literally spend the same $100, in the scenario above it is only possible to hold $100 of goods at any one time ($100 being the deposited amount).

4:17 AM  
Blogger stefankarlsson said...

Justin-I don't see how you can claim the money is taken out of circulation when you deposit it at a MMMA since you can still use the value you hold there directly as a means of payment. It is no different from the case of a demand deposit. The reason why your demand deposit holdings should be considered money is that you can still use it directly as a means of payment. The same thing goes for a MMMA, which is why it should in fact be considered a form of fractional reserve banking, just like demand deposits-and saving deposits.

By contrast, you cannot use say your holdings of stocks as a means of payment. That wealth is unavailable as a means of payment until after you sell the stocks. But with demand deposits, savings deposits and MMMAs, the wealth can be used directly as a means of payment before the bank has sold off any of the underlying assets.

5:09 AM  
Anonymous Justin Rietz said...

I think I understand where we differ.

When I take my money out of my demand deposit account, say writing a check against a checking account, the bank doesn't sell assets to get money in order to clear my check. In other words, they haven't given my money to someone else and then have to get it back (from that person or someone else) in order to meet my demand for money. This is not the case for an MMMF.

I think, however, we should refocus on the double counting. Whomever sells the asset to the MMMF receives the money and must do something with it - say they put it in a checking account. When we then calculate the money supply, if we included all MMMAs and checking accounts, we would count the original deposit twice: once as a deposit in the MMMF, and once as a deposit in a checking account. This would be incorrect, because the money can't be spent twice.

Another way to look at it: let's assume we have three parties: Joe, the MMMF, and the rest of the world ("RoW" to keep things simple). Joe deposits $100 with the MMMF. The MMMF buys $100 worth of assets from RoW. RoW puts this money in a checking account. Now can both Joe and RoW spend this money? No - if Joe spends it, the MMMF has to sell $100 assets to RoW, thereby taking $100 from RoW (MMMFs are not fractional reserve institutions). Hence, the $100 can't be spent twice.

8:33 AM  
Blogger stefankarlsson said...

"When I take my money out of my demand deposit account, say writing a check against a checking account, the bank doesn't sell assets to get money in order to clear my check. In other words, they haven't given my money to someone else and then have to get it back (from that person or someone else) in order to meet my demand for money."

No. This is only true to the extent that they have saved it as bank reserves. However, in a fractional reserve banking system most of it is lended out. And if enough people started to reclaim their money the reserves would be depleted and the bank would in order to avoid collapse be forced to sell their assets, which is to say their loans. Of course, in practice they would more likely be bailed out by loans from the central bank, but that does not change the principal nature of how banks in order to stay solvent beasically would have to sell assets.

So far from being an argument against MMMA being a form of fractional reserve banking, this in fact illustrates that it is a purer form of fractional reserve banking, since they usually have lower level of reserves.

"Whomever sells the asset to the MMMF receives the money and must do something with it - say they put it in a checking account. When we then calculate the money supply, if we included all MMMAs and checking accounts, we would count the original deposit twice: once as a deposit in the MMMF, and once as a deposit in a checking account"

Ultimately all transactions usually means that the money again ends up in another bank account, but that doesn't mean its double counting. Someone who borrows money from a bank (i.e. sells the asset of a loan to the bank) that the bank got from a demand deposit will spend it somehow -say, on buying a house or whatever-, and the person who sells that house to the person who borrows from the bank will probably put it in a bank account. That is not double counting except in the sense that fractional reserve banking is always double counting and to no lesser extent that the example you used is double counting.

"Another way to look at it: let's assume we have three parties: Joe, the MMMF, and the rest of the world ("RoW" to keep things simple). Joe deposits $100 with the MMMF. The MMMF buys $100 worth of assets from RoW. RoW puts this money in a checking account. Now can both Joe and RoW spend this money? No - if Joe spends it, the MMMF has to sell $100 assets to RoW, thereby taking $100 from RoW (MMMFs are not fractional reserve institutions). Hence, the $100 can't be spent twice."

You're missing the point here. You're again like Shostak pointing out the obvious fact that if the money is in effect withdrawn by being used in a purchase, the supply of money is being reduced. That is because before the transaction both Joe and RoW had the right to spend the money at a time of their choosing, meaning in effect that both parties had the money. But after the transaction Joe will lose the right to use it -since he has spent the money- while the RoW will keep the right (although there will be a redistribution within that group).

This is really no different from how if the level of demand deposits are reduced, then banks will ultimately have to reduce their lending (in effect sell assets) unless they're willing to have lower reserve levels.

12:45 PM  
Blogger Mark said...

Thanks for taking the time to post this. I don't think it's an issue of single vs. double counting as the other comment suggested, but one of single vs. zero counting.

An individual or institution can hold it's savings in many kinds of debt instruments: treasuries, commercial paper, other govt. debt., etc. If it does so, these savings don't show up in MZM. However, if those same debt instruments are managed by a money fund on behalf of that same individual or institution it's counted as MZM money. At least this is the way I understand it.

I do have to wonder what the usefulness is of all or nothing counting of liquidity. Holding short term debt instruments is almost as liquid as funds deposited in a MMMF, so long as the market for those securities is liquid. Presumably when MZM is shooting up 20%/yr, outstanding short term debt instruments are not increasing at that rate, but only the amount of those instruments under MMMF management is. Just because debt held outside MMMFs is outside some clearing mechanisms (like ACH) does not suggest to me that it is 100% less money-like than MZM money, because it's readily salable for MZM money at any moment. I don't understand how calling debt based assets in one form 'money' and in another not sheds any light when discussing inflation.

4:24 AM  
Blogger Flirtilizer said...

Stefan.... Doesn't any cash deposit create money? Banks in the US are required to have reserves that are far below the actual deposits they have on hand. For every dollar they have, they can load out 3 or 5 or 8 depending on what the Fed Reserve Bank regulations are at a time.

11:24 AM  
Blogger Nima Mahdjour said...

Flirtilizer:

No additional money is created at the time when cash is deposited.

The money disappears from the cash in circulation and instead appears as a demand deposit (checking deposit).

Now, after that the bank does have more reserves available in order to loan out money. In the US a bank has to keep 10% and can loan out the remaining 90%. It is at the moment when the bank makes an additional loan that the money supply grows.

Best,
Nima

http://nimamahdjour.blogspot.com/2008/03/money-supply-watch.html

6:59 PM  

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