The True Money Supply

This interview was originally published in the March 2018 issue of the Lara-Murphy Report.

Lara-Murphy Report: We ultimately want to ask you about the latest readings on the “true money supply” calculation, but before we do that, can you first explain to our readers why there are different concepts about “the money supply” in the first place? We don’t even mean what the Austrians say. Right now, can you just explain why there are different measures, such as M1, M2, etc., and why there is even a debate as to what counts as “money”?

Joseph Salerno: The Fed calculates several monetary aggregates. M1 includes currency held by the (nonbank) public and checkable deposits, both standard checking accounts and “other checkable deposits” such as NOW accounts, which are checking deposits that pay interest. M1 is an attempt to quantify the total number of dollars that people hold for the purpose of making transactions. M2 includes M1 plus “non-transaction accounts,” which people hold mainly as liquid savings and which include: small time deposits, which are certificates of deposit (CDs) of $100,000 or less that cannot be withdrawn without penalty before their maturity date; savings deposits including money market deposit accounts that offer limited checking privileges; and money market mutual fund shares (MMMFs) issued by nonbank financial institutions and offering check writing privileges. M2 is the preferred aggregate of policymakers and mainstream economists because it has the most stable relationship with interest rates and total spending in the economy. The Fed also calculates MZM, for “money of zero maturity,” which is a relatively new aggregate and is an attempt to capture the supply of dollars that are immediately accessible at par value (that is, without penalty). It is basically equal to M2 minus small time deposits plus wholesale MMMFs available only to large institutions. In terms of its purpose and its components, MZM is much closer to the aggregate that Rothbard believed and some contemporary Austrians like me believe is most useful for applied work.

LMR: Now that you’ve given the readers a crash course in monetary aggregates, can you explain the development of the so-called Austrian true money supply (TMS)? You developed it with Rothbard, right?

JS: In his book, America’s Great Depression published in 1963, Rothbard developed a U.S. monetary aggregate based on the theoretical definition of money as the general medium of exchange. Rothbard elaborated on this definition in an article published in 1978 and in his book, Mystery of Banking, published in 1983. In creating this new monetary aggregate, Rothbard aimed at capturing the supply of dollars instantly accessible for spending by the public. Thus he included all currency outside bank vaults plus deposits at commercial banks and thrift institutions (savings banks, saving and loan associations, and credit unions) that could be withdrawn on demand at par value. These deposits naturally included all checkable deposits but also all savings deposits. Rothbard also added U.S. and foreign government deposits at banks and the Federal Reserve, which had been routinely included in the money supply by most economists before World War 2. More controversially, Rothbard included the cash surrender values of life insurance policies, that is, the savings component of life insurance policies that could be withdrawn on demand.

In 1987, I published an article in the Austrian Economics Newsletter entitled “The ‘True’ Money Supply: A Measure of the Supply of the Medium of Exchange in the U.S. Economy.” My article was an attempt to elaborate and defend Rothbard’s definition of the money supply, especially with respect to the items he chose to include or exclude from the money supply. I called Rothbard’s monetary aggregate the “‘true’ money supply” or TMS, with the word “true” in scare quotes to emphasize the fact that the proposed monetary aggregate was true in the limited sense of approximating the theoretical definition of money as the general medium of exchange. Thus for an asset to be included as a component of TMS, I argued that it must be either generally and routinely accepted in exchange as a final means of payment for goods and services, like dollar bills issued by the Federal Reserve or immediately redeemable for dollar bills at par on demand by the depositor. All of the items in TMS meet this criterion. Or, if we wish to put it in these terms, all components of TMS are “money of zero maturity,” dollars that are instantly accessible by their owners at par value.

Sometime after I published my article, Rothbard and I agreed that we should delete the savings component of life insurance policies, mainly for practical reasons. Besides being controversial, it was difficult to acquire the data on this series necessary to calculate TMS in a timely manner. Also, Professor Timberlake, a prominent monetarist, had claimed that by including this item in the money supply Rothbard had deliberately overstated the inflationary nature of the 1920s. However, in defending Rothbard, I recalculated the TMS series for the 1920s without the life insurance component and found that it made very little difference to the growth rate of the money supply. I also found that several authors of mainstream money and banking textbooks in the 1960s and 1970s routinely included this item in their broader definitions of the money supply or as near-moneys. Nonetheless, TMS no longer includes the net cash values of life insurance.

Here, I will digress a bit to distinguish between TMS and the Fed’s MZM aggregate. About a year after my article was published, Brian Motley, a senior economist at the San Francisco Fed, argued based on empirical factors that M2 should be redefined based on “the single distinction between deposits that have a specified term to maturity (term accounts) and those that have no fixed term and are, for practical purposes, withdrawable on demand (nonterm accounts).” He proposed a new monetary aggregate, which he called “nonterm M3”and which included all the components in TMS, except government deposits. However, he also included MMMFs, which are excluded from TMS. In 1991, William Poole, later president of the St. Louis Fed, referred to the importance of the aggregate in testimony before Congress and labeled it MZM. Shortly thereafter the Fed began to calculate MZM and added it to its menu of official aggregates. So Rothbard had anticipated the Fed by nearly 30 years in developing a monetary aggregate that emphasized instant redemption as the key criterion for determining which dollar deposits should be included in the statistical definition of the money supply.

In contrast to MZM, however, TMS excludes MMMFs. Despite the fact that they offer checking privileges, MMMFs are not instantly redeemable claims to a fixed quantity of dollars. Rather they are equity shares in a portfolio of short-term assets, like high grade commercial paper and treasury bills, whose value fluctuates proportionally to the gains and losses to the value of the underlying assets. Although the value of a share is fixed at $1.00, in the case of extreme losses on the fund’s portfolio, such as occurred during the financial crisis, the shares may “break the buck” and fall below the value of $1.00. As with a decline in the value of any investment, the shareholder would bear the burden of the capital loss. Furthermore, when a buyer writes a check on an MMMF to make a payment, say $10,000, the shares themselves are not actually transferred from the buyer to the seller. The check is actually drawn on a bank associated with the MMMF and $10,000 is transferred from the MMMF’s bank deposit to that of the payee named on the check. The bank then informs the MMMF of the transaction, which in turn liquidates $10,000 of assets, replenishes its checkable deposit at the bank, and debits that amount to the share account of the person who drew the check. MMMFs therefore do not meet the criteria to be included in TMS: they are not redeemable at par under all circumstances nor are they a final means of payment. In short, MMMFs are not fixed claims to immediately spendable dollars, but are shares of ownership in a portfolio of assets that must first be sold for dollars before spending can take place.

LMR: Now we are in a position to ask: What’s been happening lately with this particular measure, i.e. what’s happening with “the true money supply”?

JS: During the past year the growth rate of TMS has fallen sharply from over 10% per year to 4% per year. This parallels the behavior of TMS growth during 2005, the year leading up to the end of the housing bubble, when the growth rate declined precipitously from 9% to 2%. After a further decline of TMS growth rate to 1% and a leveling off of housing prices in 2006, the subprime and financial crises and the Great Recession struck in 2007-2008. In fact if we go back to 1978, we observe similar sharp falls in the growth rate of TMS preceding the recessions of 1980-82, 1990-91, and 2001. (See the TMS graphs constructed by Jeff Peshut.)

LMR: Of course Austrian economists know that we can’t predict the future. Even so, can you give our readers a sense of what you think is in store? Many financial pundits are becoming very alarmed about asset markets, now that the Fed is hiking rates. What do you think?

JS: We should be clear that the Fed does not directly control interest rates. When we say that the Fed is “raising or lowering rates,” what we really mean is that it is changing the quantity of money in the economy. For what the Fed controls directly and completely is the monetary base, which it creates out of thin air and which consists of currency (dollar bills) held by the public and bank reserves. By increasing the bank reserves component, the Fed increases the funds that banks have on hand to lend. The “reserves” are actually just digital entries in the banks’ reserve deposits in the Fed’s computer, which can be turned into currency on demand. In order to induce businesses and households to borrow these newly created funds, the banks reduce the interest rate and create new checking deposits for the borrowers, up to $10 for every dollar of reserves. If this is a one-shot deal and the Fed were then to stop creating reserves in exchange for government securities purchased from the banks via “open market operations,” then the interest rate would return to roughly its former level despite the increased supply of money in existence. In order to suppress the interest rate permanently below its market or “natural” level the Fed must continually inject new reserves into the banking system thus constantly expanding the money supply. And this was exactly what it did from the end of 2008 to the end of 2015 when it maintained the fed funds rate—the basic interest rate that banks charge each other on overnight loans—at roughly 0 percent. The Fed actually created more bank reserves than necessary to hold interest rates at zero under its policy of quantitative easing (QE). Since 2015 it has permitted the interest rate to rise very slowly to 1.5 percent. As a consequence of these monetary policies and its attempt to manage a super-slow unwinding of its zero interest rate policy (ZIRP) in the past two years, the Fed expanded the money supply (MZM) by 66% or $6 trillion, from $9.275 trillion at the end of 2008 to $15.365 trillion in March 2018.

The Fed’s “unconventional” monetary policies thus brought us a gigantic monetary expansion that fueled bubbles in the housing market, the student loan market, and equities markets. After reaching all time highs early this year, The Dow Jones Industrial Average lost about 8.5% of its value and the NASDAQ lost 7.8%. The Wilshire 5000, which approximates the total capitalization of the stocks issued by U.S.-based firms, shed 7.7% or over $2 trillion dollars of value. But there is still a long way down, because these indexes currently stand well above the highs reached immediately prior to the financial crisis of 2007-2008. In addition, the housing bubble continues to expand despite the uptick in mortgage rates as housing prices continue to accelerate well beyond their previous all-time high of early 2007. As a result the qulity of mortgage loans continues to deteriorate. For example, roughly 20% of the conventional mortgages that were approved last quarter went to borrowers who are spending 45% or more of their pretax monthly incomes on mortgage payments and other debts. This is the largest percentage of mortgage borrowers spending such a high proportion of their monthly income on debt service since the percentage spiked to 35% shortly before the subprime mortgage crisis.

Given these conditions, if the Fed adheres to its recently stated commitment to raise interest rates two more times and shrink its balance sheet by nearly one-half trillion dollars in 2018, it will further throttle back the growth rate of TMS, possibly turning it negative. This portends a spike in market interest rates, a collapse of the housing bubble, and a deep dive in equity prices. The ensuing financial crisis and recession will be made worse by the fact that large financial institutions and are still in a weakened state. While these events cannot be precisely timed and quantified, Austrian business cycle theory teaches us that they are the inevitable outcome of the Fed’s 10-year manipulation of money and interest rates.

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