Money Supply – October 2008

The final data for October 2008 indicates that the money supply has gone up by 8% as compared to October last year, to now almost $ 2 trillion.

It will be important to watch whether or not this trend hold up over the next 2 months. If it does, it is very likely that that the current asset market crash will bottom out in about 1 year from now.

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True Money Supply – September 09th 2008

As you can see above, the intermediary money supply data for September 08 indicates a further slowdown in true money supply growth. The effects of the bailouts of Fannie May, Freddie Mac, and AIG are not yet included in the data available, as this is from 09/08/2008.

It will most likely be available with the next set of data.

Over the past three months the impact of the slowdown of the true money supply has finally reached commodities and consumer prices, in addition to the already declining home and stock prices.

The overall outlook for the next months is a further lowering of stock, real estate, commodities, stock prices.

The US is facing a major credit crunch and an unprecedented economic correction. Rather than allowing the correction to occur freely, the government has embarked upon a path that it will not be able to back down from. One financial institution after another is being bailed out with public funds.

The Federal Reserve Bank has already filled up close to 50% of its balance sheet with bad debt. Policymakers have realized this and hence suggested setting up a completely separate entity to do just that: Buy bad debt from troubled banks, backed by taxpayer money.

I assume their reasoning is that they want to avoid turning the FED, it being the supposedly trustful lender of last resort, into a junk deposit which would sooner or later have to write down delinquent mortgage loans and factually declare bankruptcy. Instead they are trying to spread the garbage evenly across different institutions: Large banks (BofA with Countrywide, JP Morgan with Bear Stearns), the FDIC (Indymac), the Federal Reserve Bank (AIG and various bad debt instruments acquired against treasury bills in the term auction facility), and presumably the soon to be established Treasury sponsored entity.

Of course all these measures are bound to fail. With every intervention the final shakedown is merely being postponed and aggravated.

The main actors involved are clueless about the essence of the problems of credit expansion, the credit boom, and the credit crunch: The President has completely extricated himself from the process; Hank Paulson, the Treasury Secretary has fully endorsed a policy of interventionism as the panacea to the crisis; Congress leadership is hopelessly lost (as Senate majority leader Harry Reid said: “no one knows what to do”) and will most likely go along with anything that the President’s Working Group on Financial Markets will suggest, no matter how much it will cost the taxpayer. The SEC is about to announce another pseudo measure tomorrow: banning short sales on financial institutions. More prestigious businesses will be in line for bailouts shortly, in particular Citigroup, General Motors, Ford Motors, and General Electric are likely candidates.

What has been keeping the dollar strong recently is the fact that the federal reserve has not yet resorted to the ultimate weapon: hyperinflation. The money supply, as shown here has been slowing down. Most likely the Federal Reserve officials are not even aware of this because they are using wrong data to monitor the money supply. The question is if this trend will hold up with the interventionist path that the government continues to move forward with. We will keep monitoring the money supply closely.

Events indicate that we are approaching the collapse of the global financial system as we know it. As Libertarians and Austrian Economists have been warning again and again, and have been ridiculed for again and again: A fiat money paper currency system, facilitated by a central bank, will ultimately lead to the destruction of the paper currency and the collapse of the financial system.

One can only hope that once all this is over and decision makers will have to get together and frame a new financial system, maybe, just maybe people will at least sit down for a second and listen to the common sense solutions that we have been asking for over the years:

– Abolish the Federal Reserve Bank
– Allow for free market competition in the money market
– Let the market return to a gold standard
– Significantly downsize the federal government
– Abolish the federal income tax
– Abolish unconstitutional (and wasteful) federal institutions, in particular the IRS, the SEC, the Department of Homeland Security, the Department of Education
– Phase out the federal social security and medicare programs and let people manage their money themselves (one can only hope that at this point people realize what the government will do to your money)
– Reduce US troop presence around the globe, strengthen the defense of the homeland against foreign enemies (which is the first and foremost task of the federal government)
– and finally: legalize the US Constitution

It is disturbing that the crisis is giving me hope that people will listen. Common sense should lead people to these conclusions. Unfortunately common sense has not been very popular over the past decades.

(This article was first posted on 09/19/2008)

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Recessions and The True Money Supply

Our composition of the money supply, as I have outlined here, is the only logical and consistent measure for the true money supply in the United States.

Having figured out what is and what is not to be included, we can now have a look at how this measure actually helps us assess the true market situation at any given point in time and make predictions as to how markets are going to fare in the near and in the mid-term.

It is not a big surprise that our true money supply is the single best indicator for predicting booms and busts in the US economy.

Below please find the true money supply from 1959 until present:

As the money supply increases, booms are fueled via credit expansion. As outlined in that article, once the credit expansion is over, a credit crunch occurs, accompanied by an adjustment of asset and consumer prices. This correction is commonly referred to as a recession. It is accompanied or precipitated by a slowdown in the money supply growth or an outright drop in the money supply.

Below is a chart of the annual money supply growth from 1970 until now:

Click on image to enlarge.

As can be seen in this chart, drops below below 3% (circled in red) have either preceded or accompanied recessions (red lines on x-axis) in 5 out of 7 times. Drops below 0% have led to a recession in 3 out of 4 instances.

It should also be noted that periods of economic booms and increasing asset prices are preceded by a very high year on year growth of the money supply, such as the periods 1984-1987, 1992-1995, and 1996-2000.

The year-on-year growth of the true money supply will be monitored in this blog on a monthly basis.

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The Dispute About the True Money Supply

A lot has been written about the definition of the true money supply. The most advanced economists, the Austrian Economists, have long ago arrived at the correct definition of money: Money is a good that is broadly accepted as medium of exchange against all other goods.

So long as this definition is accepted, it is not hard to figure out what is to be included in and what is to be excluded from the true money supply.

Since I have already written about my definition of the true money supply, I want to use this post to reply to spurious arguments regarding what is to be included in the money supply.

1. Joseph T. Salerno writes:

“As the general medium of exchange, money is a good universally and routinely accepted in exchange by market participants.”

This is correct. We shall see if the rest of his writing is consistent with this statement.

He then goes on and writes:

“In the case of paper fiat money, such as the current U.S. Dollar, there is a second test that can be applied to determine whether a particular item should be counted in money supply statistics.”

However, he never clarifies what this second test is. Instead he goes on to explain the process of fiat money injection and how it is being used as the medium of exchange in the economy. Conceptually, he merely re-iterates what the function of money is and explains how fiat money in particular circulates in the economy.

“Demand deposits or checking account balances at commercial banks and other checkable deposits, such as NOW accounts held at S&Ls, are included in the TMS by virtue of the fact that they are claims to the standard money redeemable at par on demand by the depositor or by a third party designated by the depositor.” (TMS = True Money Supply)

This statement is substantially flawed. He said himself above that ‘money is a good universally and routinely accepted in exchange by market participants’. But suddenly he no longer applies this test. He now says that ‘claims to standard money redeemable at par on demand by the depositor or by a third party designated by the depositor’ are also to be defined as money. He fails to apply the very definition of money that he himself uttered above. If he wished to change the definition of what a money is, he should have done so before embarking upon the analysis of the different components of data provided.

But the definition of money, as uttered by the Austrian economists, is not arbitrary. It serves the purpose of understanding and analyzing human behavior in the marketplace. It is part of a broader framework which includes elements such as consumption goods, capital goods, credit transactions, etc. If we agree on what the definition of money is, then we need to apply this definition consistently. If we want to know the supply of money, of the medium commonly accepted as a means of payment in the economy we cannot include items that are not accepted as means of payment: NOW accounts, which are a part of individual savings deposits are NOT commonly accepted as means of payment. A buyer of an item cannot pay for it with a savings deposit. He cannot pay by transferring money from his savings account to the seller’s savings account. He cannot even do this with the checkable portion of his savings deposit. Only if this was the case could savings deposits be included in the money supply.

The savings deposit has to be turned into a demand deposit and then transferred to the seller’s demand deposit account or turned into cash.

To be very clear, I am not saying that this will never change. It is certainly conceivable, albeit unlikely, that some day savings deposits will be commonly used in payments. But in today’s world they are not. Hence they are not a part of the money supply.

Thus Salerno’s statement should be corrected as follows:

“Demand deposits or checking account balances at commercial banks are commonly accepted as payments in transactions. They are hence a part of the TMS. Other checkable deposits, such as NOW accounts held at S&Ls, are not included in the TMS by virtue of the fact that they are not commonly accepted as means of payment.”

He then says

“Savings deposits, whether at commercial banks or thrift institutions, are economically indistinguishable from demand deposits and are therefore included in the TMS. Both demand and savings deposits are federally insured under the same conditions and, consequently, both represent instantly cashable, par value claims to the general medium of exchange.”

Wrong: It is easy to distinguish savings deposits from demand deposits: They are not accepted as means of payment in transactions. Plain and simple. The fact that they are federally insured does not change this in the slightest.

“The objection that claims on dollars held in savings deposits typically do not circulate in exchange (although certified or cashier’s checks may be readily drawn against such deposits and are certainly generally acceptable in exchange), while not unimportant for some purposes of analysis, is here beside the point. The essential, economic point is that some or all of the dollars accumulated in, e.g., passbook savings accounts, are effectively withdrawable on demand by depositors in the form of spendable cash. In addition, savings deposits are at all times transferable, dollar for dollar, into “transactions” accounts such as demand deposits or NOW accounts.”

It is strange that Salerno says that applying precisely the definition of money that he himself uses at the beginning of the article is besides the point. Suddenly it is no longer relevant whether or not a thing is accepted as medium of exchange. Suddenly the criterion is ‘that some or all of the dollars accumulated in, e.g., passbook savings accounts, are effectively withdrawable on demand by depositors in the form of spendable cash’. He again evaded the use of the proper money definition. His remark regarding certified or cashier’s checks is of course spurious. It is true that checks can be drawn against savings deposits. But the buyer does not accept payment in savings deposit dollars. He only accepts payment in checking account dollars. Hence, the payer’s bank then has to turn the dollars in the savings deposit into demand deposit dollars and transfer them to the seller’s demand deposit account as such.

“In their own minds, money is what people consider as purchasing power, available at once or shortly. People’s “Liquidity” status and financial disposition are not affected by juristic subtleties and technicalities. One kind of deposit is as good as another, provided it is promptly redeemable into legal tender at virtual face value and is accepted in setting debts. The volume of total demand for goods and services is not affected by the distribution of purchasing power among the diverse reservoirs into which that purchasing power is placed. As long as free transferability obtains from one reservoir to the other, the deposit cannot differ in function or value …”

Now the money definition has changed again. Suddenly it is no longer the thing accepted as medium of exchange by everyone but what people consider as purchasing power in their own minds. He remains unclear as to what he means by “available shortly”. This completely changes the definition again. Money is NOT what someone considers his own purchasing power. Money is what one ACCEPTS as means of payment from someone else. One may believe that the value of his home grants him a certain level of purchasing power. He could sell his home and relatively ‘shortly’ have cash available for spending. But this doesn’t make his home a part of the money supply. The same applies to a different degree to savings deposits. True, the cash money would be available faster, but one still needs to turn his savings deposit into a demand deposit. Hardly anyone would accept payment in ‘savings dollars’, wired to his savings account, just as hardly anybody would accept a home in exchange for products and services.

We are trying to ascertain the true money supply for a reason. We want to explain the current and the future development of asset and consumption prices in the country, measured in dollars. The more money is available for spending the higher will the prices be. But prices emerge in exchange transactions where money is surrendered in exchange for goods and services. They change over time as a result of continuous ongoing exchange transactions. As a tendency, they change with every additional exchange transaction. The medium used in these transactions and thus affecting prices, and nothing but it, is what we need to measure. The mediums accepted and hence used in these transactions are cash and checking deposits, not savings deposits.

“Overnight repurchase agreements or “RPs” were devised in the mid-1970s as a means of evading the legal prohibition against the payment of interest on demand deposits. They are, in essence, interest bearing demand deposits held by business firms at commercial banks and therefore are included in the TMS.”

This is of course wrong. RPs are not in essence demand deposits. The essence of demand deposit money is that is that it is accepted as payment in transactions. In the case of an RP, the depositor surrenders demand deposit money in return for treasury bills and similar securities. He cannot use these securities in exchange. No one would accept securities in an RP account as medium of exchange. It is unclear as to why he even examines RPs under his analysis of M2. M2 does not contain repurchase agreements.

“Money market deposit accounts, as a hybrid of demand and savings deposits, are considered part of the TMS. MMDA’s are federally insured up to $100,000 per account, feature limited checking privileges, and offer par value cashability upon demand of the depositor.”

Again no word about the acceptability of the item in question in payments. No one accepts payments in money transferred into his market deposit account. MMDA’s are not part of the true money supply.

“U.S. Savings Bonds are instantly cashable at the U.S. Treasury (or at banks and thrifts acting on its behalf) at a fixed discount from their face value. As U.S. Treasury liabilities, moreover, their redeemability is “insured” by the full faith and credit of the federal government. U.S. Savings Bonds are therefore included in the TMS at their redemption value, because they represent secure and current claims against the Treasury for contractually fixed quantities of the general medium of exchange.”

But they are not accepted as a medium of payment in transactions which is the criterion for our money definition. U.S. Savings Bonds are clearly not part of the money supply.
2. Murray Rothbard writes:

“All economists, of course, include standard money in their concept of the money supply. The justification for including demand deposits, as we have seen, is that people believe that these deposits are redeemable in standard money on demand, and therefore treat them as equivalent, accepting the payment of demand deposits as a surrogate for the payment of cash. But if demand deposits are to be included in the money supply for this reason, then it follows that any other entities that follow the same rules must also be included in the supply of money.”

Here Rothbard errs. The justification for including demand deposits is not that people believe that they are redeemable in standard money on demand. The justification is that demand deposit money is broadly accepted as a medium of payment. This is our definition of money. Plain and simple.

“There are several common arguments for not including savings deposits in the money supply:(…)(2) they cannot be used directly for payment. Checks can be drawn on demand deposits, but savings deposits must first be redeemed in cash upon presentation of a passbook; (…) Objection (2) fails as well, when we consider that, even within the stock of standard money, some part of one’s cash will be traded more actively or directly than others.”

Here he sneaks in the word “directly”. It is true that pocket money is traded more actively than money stashed away. But both would be used directly as a means of payment at the moment of the transaction. No part of one’s money is traded more directly than others. All money is presented or transferred directly at the moment of payment.

“Thus, suppose someone holds part of his supply of cash in his wallet, and another part buried under the floorboards. The cash in the wallet will be exchanged and turned over rapidly; the floorboard money might not be used for decades. But surely no one would deny that the person’s floorboard hoard is just as much part of his money stock as the cash in his wallet. So that mere lack of activity of part of the money stock in no way negates its inclusion as part of his supply of money.”

This is true. But this comparison does not apply at all. Again, our argument has never been the lack of activity on the part of savings deposits in transactions. It is simply that they are not at all accepted as payments in transactions. Hardly anyone accepts a transfer into his savings deposit as a means of payment.

“Similarly, the fact that passbooks must be presented before a savings deposit can be used in exchange should not negate its inclusion in the money supply.”

The word “similarly” is misplaced. As I have explained above there is no similarity between the two examples. The floorboard money does not need to be presented and exchanged for something else before being used in a transaction. It can be used in transactions immediately and directly once taken out of its stash. The savings dollars do need to be exchanged for either cash or demand deposit money before being used in transactions.

“As I have written elsewhere, suppose that for some cultural quirk—say widespread revulsion against the number “5”—no seller will accept a five-dollar bill in exchange, but only ones or tens. In order to use five-dollar bills, then, their owner would first have to go to a bank to exchange them for ones or tens, and then use those ones or tens in exchange. But surely, such a necessity would not mean that someone’s stock of five-dollar bills was not part of Ills money supply.”

His scenario is of course spurious. If, in fact, suddenly no seller will accept a five-dollar bill in exchange it would cease its existence as money. It would no longer fit our definition of money. Plain and simple. The five dollar bills would also no longer be exchangeable for ones or tens. Since the only purpose of a note is its use as a medium of exchange, money, no one would accept it at par value. At best, it would trade at a significant discount against all other denominations. It would be utterly wrong to include it in the money supply. For as long as the 5 dollar bills are still in circulation they cannot exercise any upward pressure on prices. Even if there was a bank that would redeem it at par value (which is rather unlikely), the true money would only be circulating after the redemption and then have its effect on prices, which would duly be accounted for in our definition of the true money supply.

The significant difference with a savings deposit is that its primary purpose is not its use as a medium of exchange, but that of an interest bearing account. If this was not the case, people would not put their money into a savings account.


The inclusion by some economists of savings and similar components in the true money supply is the result of the failure to consistently apply the definition of money. All their arguments in favor of including these items, are crushed when one applies this simple test: Is the item in question broadly accepted as a means of payment in exchange for for products and services?

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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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