True Money Supply

The money supply inside a country is the total nominal value of money units ready to be spent in its respective territory. Money is a medium of exchange. This is its ultimate purpose. All other so called money functions, like value storage medium, measure of utility, etc. are nothing but derivatives of this function. More precisely, money is that medium which is accepted by virtually everyone inside a certain territory as a medium of exchange for products and/or services rendered.

As explained in Credit Expansion Policy, the major business cycles, booms and recessions are caused by an increase and subsequent drop of the money supply, respectively.

If one carefully tracks the true stock of money and its growth or contraction over time, one can make fundamental assessments and predictions about the state of the economy and the outlook for asset and consumer prices in general.

The Federal Reserve Bank employs two measures for the money supply: M1 and M2. It also supplies other data, called ‘Other Memorandum Items’ which in its opinion is not part of the money supply.

We shall analyze each component of the data provided, and figure out whether or not it should be included in the money supply.

A lot has been written about the true money supply. There are completely different views on this matter. However, the solution to the question is pretty simple so long as one agrees that the definition of money is that it is the medium of exchange accepted by everyone within a certain territory.

Each component simply has to pass the following test: Is this item accepted by virtually everyone as a medium of exchange inside the USA?


M1: Currency + Traveler’s Checks + Demand Deposits + Other Checkable Deposits

Currency: This is cash money in the pockets, lockers, mattresses, or hands of individuals. Cash, when printed and used by the federal reserve to purchase assets and thus channeled into circulation increases the nominal amount of media of exchange available in society. Virtually everybody accepts cash as payment. It is without a doubt a component of the money supply.

Traveler’s Checks: Traveler’s checks are issued by American Express and other credit institutions. A traveler’s check has to be purchased in exchange for currency or checking deposits. Money is transferred from the purchaser’s account to the company issuing the traveler’s check. When used, money is transferred from the issuing company’s deposits to the person redeeming the check. Hence, traveler’s checks do not add to the overall availability of media of exchange, they are merely a means to facilitate the transfer of actualy money. Traveller’s checks are not commonly accepted as a means of payment inside the US. They are not to be included in the money supply.

Demand Deposits: Demand deposits are checking accounts. Additional checking account money can be created in different ways: When people deposit cash money in exchange for demand deposits, the overall money supply does not change. However, if we observe both figures, then all cash deposits will reduce the ‘Currency’ account, and increase the ‘Demand Deposit’ account. Another way of creating demand deposits is when the central bank issues new demand deposit money instead of printing new money, and purchases bank assets with it. In addition to that, banks may issue credit themselves by making out loans that are not fully backed by deposits. This money will appear on the loan recipient’s checking account. Checks can be written against them. Virtually everyone accepts payment in demand deposit money. Demand deposits are thus to be included in the money supply.

Other Checkable Deposits:These are savings deposits that can be drawn upon when demand deposits are overdrawn. But a savings deposit is not part of the money supply. A savings deposit does not function as a medium of exchange. When someone deposits money in a savings account the bank turns around and invests the money in credit instruments. It will then appear on the checking account of the seller of the credit instrument. This does not change when the savings deposit can be partially drawn upon. A buyer of a good cannot write a check against his savings deposits. At the best he writes a check against demand deposits that he is going to obtain after liquidating a fraction of his savings deposits. It would be rather impossible to try and use one’s savings deposits as a means of payment. No one would accept a payment ‘in savings deposits’. This even applies to that portion of it which can immediately be turned into checking account money. The recipient of a check written against the checkable portion of a savings deposit still demands checking account money as final means of payment. Thus the payer’s savings deposit dollars need to be converted into checking deposit dollars settling the transaction. (If this was NOT the case, savings deposits and other checkable deposits would indeed be a part of the money supply.) Other checkable deposits are hence not part of the money supply.


M2: M1 + Savings Deposits + Small-Denomination Time Deposits + Retail Money Funds

Savings Deposits: As explained above under ‘Other Checkable Deposits’, savings deposits don’t function as media of exchange. Nobody would accept a payment from someones savings deposit straight to his savings account. But our definition of money is that is is precisely that medium which is broadly accepted as payment. Savings deposits are hence not part of the true money supply.

Small-Denomination Time Deposits: These are deposits where the depositor contractually commits to not withdrawing the money for a fixed time frame. Time deposits cannot be used as media of exchange and are hence not part of the true money supply, even less so than savings deposits.

Retail money funds invest in short-term debt, such as US Treasury bill and commercial paper. They are not used or accepted as media of exchange, and are hence not part of the true money supply.


Other Memorandum Items: Demand Deposits at Banks Due To Foreign Commercial Banks and Foreign Official Institutions + Time and Savings Deposits Due To Foreign Commercial Banks and Foreign Official Institutions + U.S. Government Deposits + IRA and KEOGH Accounts

Demand Deposits at Banks Due To Foreign Commercial Banks and Foreign Official Institutions: These are checking account deposits held by foreign banks and institutions at American banks. Foreigners hold funds in checking accounts of other countries in order to cover expenditures in those same countries. These expenditures are covered using that country’s medium of exchange, money. They clearly are to be added to the true money supply.

Time and Savings Deposits Due To Foreign Commercial Banks and Foreign Official Institutions: As already explained above, time and savings deposits are not to be included in the true money supply.

U.S. Government Deposits: These are demand deposits held by institutions of the the U.S. Government at commercial and the Federal Reserve Bank. It is a curious fact that they have been excluded from the official money supply data. The money does not disappear from circulation. If A pays taxes to government entity B the funds are merely transferred from one account to another. The funds are used to cover expenses during day to day operations, pay employees, etc. and are hence a part of the true money supply.

IRA and KEOGH Accounts: These are, like savings and time deposits, merely investments in credit instruments and other investment vehicles and are not part of the true money supply.


Retail Sweeps

One more important item to be mentioned are so called bank ‘retail sweeps’. Retail sweeps were introduced in January of 1994 when the Federal Reserve Board allowed commercial banks to use a software that classifies certain portions of customers’ checking account deposits as money market deposits accounts (MMDAs). Researchers at the regional Federal Reserve Bank of St. Louis have summarized it as follows:

“At its start, deposit-sweeping software creates a “shadow” MMDA deposit for each customer account. These MMDAs are not visible to the customer, that is, the customer can make neither deposits to nor withdrawals from the MMDA. To depositors, it appears as if their transactionaccount deposits are unaltered; to the Federal Reserve, it appears as if the bank’s level of reservable transaction deposits has decreased sharply. Although computer software varies, the objective is the same: to minimize a bank’s level of reservable transaction deposits, subject to several constraints.”

This means that customers don’t notice the slightest change to their demand deposit account. In effect, their behavior doesn’t change at all, no matter whether or not their checking deposit has been reclassified. Retail sweeps are nothing but an accounting fiction that enable banks to lower their minimum reserves and lend out more money.

But this means that the statistics on demand deposit accounts have been inaccurate since 1994. That portion which has been reported as MMDA when it was actually demand deposit money to customers needs to be included in the money supply. The Federal Reserve Bank of St. Louis provides a monthly estimate on this number. Retail Sweeps are part of the true money supply.

Conclusion: Thus the true money supply ( we shall call it M(t) ) is defined as follows:

M(t) = Currency + Private Demand Deposits + Demand Deposits Due to Foreign Banks and Institutions + Government Demand Deposits + Government Federal Reserve Deposits + Retail Sweeps

Below is the development of the true money supply from 1959 through 2008:


Click image to enlarge.

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History of Money

The history of money doesn’t need to be confined to one specific country or time period. It is rather expedient to outline the role money has played and the changes it has gone through in virtually all countries over time. Some events might have occurred earlier or later in one nation or another. However, the general trend to date has been the same. Understanding this trend is of major importance when it comes to understanding money today. This article describes the imaginary story of a country that went from no money at all to a fiat money, paper money. It is conceptually applicable to any country on earth.

The demand for money arose with the appearance of division of labor, when individuals began producing for others rather than for themselves. This was of course a direct outcome of the law of comparative advantage and the corresponding specialization of labor. If individual A transforms land and produces a good that individual B demands, but B has nothing to offer that A demands for consumption, A might still consider receiving a product M in exchange that he can then give to individual C. C happens to demand B’s product for consumption AND offers something that A also demands for consumption. In this case, from A’s point of view M is a medium of exchange, a money.

With division of labor spreading, different goods would be used as money, such as tea, coffee, beans, salt, or cattle. There are numerous accounts of the usage of these goods as money in history. However, there are goods that are better and goods that are worse than others for usage as a medium of exchange. A medium of exchange needs to fulfill criteria such as durability, divisibility, homogeneity, measurability, sufficient but limited availability and broad acceptance. The metals gold and silver emerged as goods that best fulfilled these criteria when used on the market.

Consumers, entrepreneurs, capitalists, landowners, and workers dug up and/or used gold and silver as money in exchange and credit transactions on the market. Decentralized, competing gold mines would channel gold into the market, part of which was used as money. For a fee, some entrepreneurs began offering the service of depositing money in warehouses, also known as deposit banks, so the owners of the money wouldn’t have to carry it with them. They would issue receipts for the money deposited. Soon the receipts themselves, rather than the deposited gold, would be used as money, hence gaining value as media of exchange.

Some of the gold would not be redeemed but rather stay in the warehouses. Thus the entrepreneurs issuing the receipts started offering their own receipts in exchange and credit transactions which were not backed by their own gold. However, they had to be careful not to issue too many uncovered receipts. Because as the price of their additional receipts would drop, their customers would begin redeeming them in exchange for gold again. If there were too many uncovered receipts issued, the warehouse would ultimately lose all its deposits and hence go out of business.

Thus in the long run those deposit banks who managed their deposits most prudently would be the most successful and profitable ones.

But some of the depositors had loaned receipts to the government and hence accumulated public debt. When they faced the threat of going out of business, due to a massive drain upon their gold reserves they sought help with the government.

The government used its police force in order to prevent the deposit banks from having to redeem their customers’ receipts for gold. It declared the receipts of the banks a legal tender, which means that they became a fiat money, a money that people are forced to accept or face government force if they don’t. The operations of different banks were consolidated within one central bank and numerous fractional reserve banks with the exclusive authority to produce fiat money. In addition, the government forcefully confiscated private gold holdings and declared private ownership of gold illegal.

This central bank was no longer under the constraints that the deposit banks used to face. It didn’t depend upon gold deposits and it could inflate the money supply at will. Without voluntary competition within the country, the result was that the quality of the money produced was low. Inflation became a common phenomenon.

Just as seen in the example of the production of cars in the Soviet Union, the more monopolized and centralized the production of a good, the less competition exists, and the less the consumer is given a choice, the lower the quality of the good produced will be from the point of view of those consuming the good.

Roughly, this has been the History of Money and Banking in the United States and the course of events that led to the establishment of the Federal Reserve Bank.

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Inflation & Deflation

Inflation and deflation are market phenomena whose occurrence only becomes important under a fiat money system. Under a voluntary money system in which individuals are given the immediate choice to choose what they in fact prefer as the best money, goods that are limited in supply will naturally prevail and inflation will be modest and negligible. It is a historical fact that over time the precious metals gold and silver outstripped all other goods as media of exchange for their limited supply, durability, uniformity, divisibility, and aesthetic appeal. In the Untied States it was of course the compulsory intervention by a cash strapped government that outlawed the non-acceptance of the paper dollar, a fiat money, and on top of that outlawed any private ownership of gold.

Inflation

Inflation is defined as an increase in the money supply, the nominal amount of money units held by all individuals within a certain territory.

Inflation occurs in a fiat money system when the central bank or fractional reserve banks produce additional money to be used in a certain territory and use it to buy goods or to perform credit transactions with other individuals on the market.

Since the marginal value preference assigned by individuals to each additional unit of money will be lower the more money they hold, the price of goods expressed in terms of money will be more likely to rise over time, if the money growth exceeds the growth of other goods.

The fundamental issue with inflation is not that prices go up. If the newly created money was distributed evenly across society, all incomes would rise in lockstep with prices. The entire operation would be a zero sum game. The fundamental issue is that inflation in a fiat money system occurs through creation of new money that certain individuals receive earlier than others. Wealth is thus shifted from those who receive the money later (after prices have already gone up) to those who receive it earlier (before prices have gone up). Typically this means a shift of wealth from workers to the government and to owners of fractional reserve banks and the central bank. It lowers the general standard of living insofar as it becomes less desirable to perform work that fulfills voluntary value preferences and more desirable to perform work based on bureaucratic government decisions that involve theft and compulsory action.

Deflation

Deflation is defined as a drop in the money supply. It occurs when the central bank or fractional reserve banks reduce the money supply by reversing their inflation by selling goods other than money, thus withdrawing money out of circulation, or when individuals make more re-payments as part of credit transactions (which they entered into with the central banks or fractional reserve bank) than additional money is produced.

As the money supply declines, the price of other goods in terms of money is more likely to drop over time.

Deflation is in essence a correction of the previous misallocations created by inflation.

Addendum: What I was referring to above is monetary inflation. Please see more details in Inflation & Deflation Revisited.

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Credit Expansion Policy

Objectives of Credit Expansion

Credit expansion is the policy where the central bank produces additional money in order to purchase debt from the government or from entrepreneurs, such as banks. In a system where gold is used as money there exist strict limits for money producers when it comes to credit expansion, due to the natural scarcity of the precious metal. In a fiat money system there are no natural limits on the amount of additional money produced. As a result, the interest rate for additional credit transactions drops.

The policy of credit expansion is broadly accepted as a measure to make people prosperous.

It is its declared objective to make credit abundant. New credit is said to spur business activity, capital becomes inexpensive, entrepreneurs can borrow more money for investments, commerce flourishes and soon all of society is permeated by the magical boon that the credit boom bestows upon it. Everyone is supposed to enjoy all the consumer goods they have been longing for under the stingy policy of tight credit.

This idea is based on the substantially flawed assumption that capital can be created out of nothing. Capital can only exist when factors of production are produced. Every investment necessitates the use of factors of production that turn out more or higher valued goods after a roundabout process rather than consuming fewer or less valuable goods immediately. Factors of production can only exist if people have generated savings. Savings are generated if one forgoes immediate consumption for the prospect of future consumption. Foregoing present consumption can only be feasible if one considers the future remuneration he gets in return more valuable than the immediate consumption he forgoes. This is what is called time preference. Time preference is expressed on the market in the form of interest rates.

This causality ensures that market interest rates always provide an indication of the time preferences of the individuals in that market, and hence the willingness to forgo present consumption of consumer goods for future consumption of goods created by new factors of production. While prices give entrepreneurs an indication as to which consumption goods are desired more and which less at a specific moment in time, interest rates provide a measure as to when they are desired or needed in the future. It creates an environment where entrepreneurs have an incentive to fulfill demands based on value preferences and time preferences at any given point in time.

The Effects of Credit Expansion

It is now necessary to examine what the process of credit expansion entails. The central bank that creates money does not own any capital, it does not create factors of production. The only thing it channels into the market is fiat money.

Before examining the purchase of credit instruments it makes sense to take an intermediary step and look at the simple purchase of consumption goods. For example, if it were to purchase houses with the newly printed money, its governing board could decide to supply the homes to all its officials. They will be able to enjoy the houses before their prices rises and hence they will not be available to other would-be buyers who would have purchased them at a lower price that would have represented their value preferences. The entrepreneurs selling the homes, too, benefit because they are the first ones to receive the new fiat money and get to spend it before other prices go up and before others get to spend it. Those who receive the new money later will suffer from the prices that have already gone up. While on the market, people can only buy goods when producing demanded goods in return, and while all transactions are based on voluntary exchange and value preference, the central bank does not act under these constraints. Its fiat money can be produced cheaply and the government enforces its acceptance and outlaws competition. Goods are hence violently withdrawn from those who actually produced demanded goods in exchange and end up in the hands of those who didn’t. Now, entrepreneurs will begin producing more homes, while withdrawing factors of production from other, more urgent, uses. If this plan were to be carried out to completion, at one point the majority of entrepreneurs would employ workers and resources in the production of houses for those who printed and enforced the money while a shortage of other demanded goods for all other individuals would ensue.

The equivalent, however, occurs in the sphere of time preference if the central bank purchases debt on the market. People who demand credit on the market issue credit instruments such as merchant bills, governments issue government bonds and bills. The credit instruments purchased by the central bank will go up in price after each additional purchase, interest rates drop as a tendency. Other providers of credit on the market whose time preferences were matched by the credit instruments offered will abstain from entering into the corresponding credit transaction. Now the central bank has withdrawn future money from the market that would have gone to those who were outbid by it in the process of purchasing the debt. They were not able to enter into a transaction that would have represented their time preferences.

On top of that, the interest rates for the loan contracts purchased drop below the market rate that represents actual time preferences of those operating in the market on a voluntary basis. This has the effect that the entrepreneurs’ assessment of time preferences is skewed. They think that present goods against future goods are valued less than actual voluntary time preferences warrant. Those roundabout projects, that were not being embarked upon, because interest rates indicated time preferences in favor of less roundabout projects (whose goods would be consumable earlier) now appear to be feasible. Entrepreneurs begin embarking upon more roundabout projects that yield an output in the farther future. At the same time they set aside those less roundabout projects which the market interest rates would have induced them to begin, had the credit expansion not taken place. The result is now precisely that consumers are again not supplied with products as desired as per their time preference.

The Credit Boom

Since no additional capital has been created via real savings, prices for factors of production used for the longer term will rise. The stock market, it being the main market for factors of production, will see a price increase, primarily in those stocks for businesses whose projects yield a later output. In particular, a lot of businesses incorporate, that are currently not producing anything, nor plan to produce immediately, but are rather aiming to turn out goods a few years down the road, after spending time on roundabout research and production processes. As a tendency, the labor force of society becomes employed in roundabout, long-term projects.

The same holds true if the credit instruments that are purchased are largely used to finance a specific consumption good, such as owning a home. By purchasing home credit instruments, the central bank will create an environment where many individuals who have not produced enough to exchange against a home will nonetheless obtain a home. Prices of homes will rise since the credit expansion has not at all expanded the amount of homes produced on the market. It is only after this initial expansion that more and more entrepreneurs will begin employing more and more workers in the home construction business.

The Credit Crunch

The labor force, however, at the same time represents the bulk of the consumers whom those products are intended to be produced for. But their time preferences have not changed in reality. While being employed in very roundabout projects and processes, they still desire present goods over future goods more strongly than the entrepreneurs expected based on the lowered interest rates. After the credit expansion is completed, consumer spending and saving habits will not be in line with those expectations. They demand more present products than are available and hence bid up their prices. Due to their shortage, an overall tendency towards rising prices for present consumption goods, such as food and gasoline, ensues. People will need most of their money to buy these consumption goods and hence cut back on spending it elsewhere or making it available in credit transactions. Market interest rates will now readjust in accordance with real time preferences again, based on real savings. They will move up to the market level again. Incorporation of companies with overly roundabout projects will decline. Some entrepreneurs, who are in the middle of overly roundabout projects will not immediately realize this. They will keep employing factors of production in these projects.

However, when they announce their new earnings expectations they will have to take into consideration the fact that most consumers will not have enough money left to purchase their products. They will have to let the capitalists know that their capital will not yield the return expected. This will cause a downward pressure on the prices of those factors of production used for overly roundabout processes. Correspondingly the prices for shares in such companies decline. They will be sold at prices that reflect true time preferences again. However, the time that resources have been employed in overly roundabout projects has been wasted. The true yield of their output did not match the capitalists’ expectations. The capitalists have suffered a loss.

Some of the factors of production and workers will have to be released from their current employment and need to be employed in new lines of production where they contribute towards the production of more urgently demanded consumer goods. Flexible resources will be aligned accordingly and the supply of those goods will increase again and hence their prices will drop back to market levels. Other resources however, which are fixed and specific to one particular project and are merely half finished may be forever lost, in particular this will be the case for huge construction or manufacturing projects that involve the erection of factories, machinery, etc. which have turned out to be useless. A credit contraction will occur and the money supply will be reduced to lower levels in a healthy deflationary process which induces people to save and spend as time and value preferences mandate. The market, once again, returns from an inflationary, regressive resource misallocation to progress and a move toward market equilibrium.

Depending on the amount of excess credit channeled into the market and depending on the duration of the credit expansion, the repercussions can be anything between mild and disastrous.

It is a fact that the correction of the allocation of labor and other factors of production is highly unpopular with the populace. As a rule, individuals, in particular entrepreneurs from businesses employed in unprofitable lines of production, will be in favor of continuing the credit expansion. The positive term “correction” will be replaced by the unpopular word “recession”. A prudent government should not fall for this fallacy. If the process of readjustment is not hampered with, the problems caused by the credit expansion will be within limits. The market will quickly recover, albeit, at a level that is less desirable than where it could have been at without credit expansion. If, however, the government doesn’t allow for the correction to occur, the misallocation of factors of production will be kept up and aggravated until it all culminates in a devastating collapse.

Conclusion

The objective of credit expansion, namely to ensure that more capital is generated in order for the market to provide more of what consumers demand, fails. In fact, it has the opposite effect. It skews the entrepreneurs’ judgment and makes them align resources to produce products that consumers are not demanding and makes them use factors of production for processes that turn out products later than consumers are demanding them while withdrawing them form those production processes that would have been in compliance with consumers’ time preferences.

Historical Relevance

The policy of credit expansion has been pursued by governments time and time again. It has become prevalent in the United States under President Woodrow Wilson after the establishment of the Federal Reserve Bank under the Federal Reserve Act during the Christmas Holiday of December 1913. Since then, it has caused major credit booms and crunches in the form of asset booms and subsequent crashes and economic booms and subsequent recessions. In particular this has been the case in the years of 1929, 1987, and 2001, and will be visible in 2008 and the following years. It has always precipitated precisely the effects outlined above. Its workings and effects have been fully explained by this theory of the business cycles. No one has ever refuted the correctness of this theory.

Yet, to date economists and politicians appear completely riddled as to what causes booms and crashes. It is claimed to still be a matter of discussion amongst experts. It has been attempted to impute it upon humans’ greedy nature and natural exuberance. Whenever a crisis emerges the pundits, experts, central banks and politicians will try and regulate the market to stave off the impending crunch. They forget or don’t have the intellectual capacity to understand that it has been their own policy that has caused the crisis in the first place.

As long as the central banks keep pursuing this policy, there is no need to be surprised when the next credit crunch occurs. Neither is there any need to be surprised about the fact that all countermeasures taken by the government will turn out to be utter failures that will accomplish nothing but aggravate the crisis. For if the cause of the problem has been too much government intervention, then more government intervention will only add to it.

Update: I refined the process and added much more detail in the post The Business Cycle.

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