M-1, M-2, M-3,
MZM: What does it all mean? If the Federal Reserve System drops
M-3 after decades, what does that say for the other three?
Why did the
FED gather the statistics for M-3 in the first place? What was it
that the central planners of the monetary system thought they gained
from having reams of data defined as M-3? What theory did the central
planners have? How did they decide which data to monitor? How did
the statisticians decide which samples were the most reliable? Finally,
why did they give up on the entire project in 2006?
I am not actually interested enough in getting answers to these
questions as I am in judging the usefulness of the whole enterprise.
It was a waste of resources. The FED’s managers finally concluded
this in 2006.
In this report,
I will cover some of the basics of Federal Reserve reporting. I
will offer some guidelines on which monetary statistics are relevant
for forecasting, and which are not.
In doing this,
let me say from the outset that the world would be far better off
if the FED confined itself to gathering statistics and got out of
the money-management business.
In 1961, Murray
Rothbard wrote an essay for The Freeman, "Statistics:
Achilles’ Heel of Government." He argued that the State
needs to create the illusion of being able to plan an economy rationally.
To do this, it needs statistics. Without statistics, it would visibly
be flying blind. So, the State gathers statistics of all kinds.
planners believe that with statistics, they can make rational, effective,
beneficial decisions with other people’s money. Now, consider the
Federal Reserve System. It actually creates other people’s money.
It buys T-bills and other government debt certificates. It buys
them from a group of about 20 companies, who make money on every
transaction. The companies then send money to the U.S. Treasury.
The government then writes checks to pay for whatever the government
has decided to spend.
Mises, argued that statistics are records of the past. To make accurate
forecasts suitable for rational economic planning, the government’s
salaried specialists must be able to forecast the future in terms
of a specific theory of economic causation. Then they must select
the appropriate statistics that will provide insight regarding the
future. "If we do this, then that will be the result."
Why? "Because the immediate economic past was this." How
do you know? "Because we have these statistics." How do
you know they still apply. They’re old. "We can safely assume
it." How do you know that?
it is safer to assume it than to assume it’s wrong." Safer
for whom? "Us, dummy. That’s what we’re paid to do." They
are paid very, very well.
more than any other economic school of thought, have bet their careers
— and ours — on the assumption that monetary policy is the crucial
factor in preventing economic recessions. Keynesians bet their careers
— and ours — on the assumption that fiscal policy is more important
than monetary policy.
agree: the government must tax and spend to overcome recessions.
They disagree on the most effective way for government to get its
hands on the money to spend. It’s "tax, borrow, and print predictably"
vs. "tax, borrow, and print whatever taxing and borrowing doesn’t
are the supply-siders. Their position is "tax less in the higher
marginal income tax brackets, spend more, borrow more, and print
whatever is needed to keep interest rates low." A few of them
say they are gold standard people, but their gold standard is never
a gold coin standard with complete redeemability at a fixed price
at every bank. Their gold standard is some sort of mathematical
formula that only they understand. It’s not "Here’s my paper
money. Give me my gold coins."
disagree with all three schools. Their position is "Tax less
in all tax brackets, spend less, borrow nothing, print nothing.
If the budget goes into deficit, spend even less." Nobody in
government or academia listens.
of Central Banking
say that the most important justification for the Federal Reserve
System to control money is to keep monetary policy away from Congress.
They don’t trust democracy. Basically, this is the #1 justification
of central banking. It is maintained by all schools of economics
except the Austrians, who are ready to trust Congress and the commercial
banks before they trust central bankers. Given the Austrian’s low
opinion of the Federal government, this reveals a great deal about
their opinion of central banking.
don’t want to give discretion to the FED. They want the FED to increase
the money supply by [?]% per annum. No, they don’t agree on the
percentage. But this doesn’t really matter, because central bankers
never bind themselves to a fixed rule of anything other than the
usual rule of getting ahead at someone else’s expense.
So, the Keynesians
worry about interest rates, since that affects the government’s
ability to borrow, and the monetarists worry about prices, since
that affects the performance of the economy. The monetarists worry
about anything that slows down economic growth.
worry about the ability of the free market to survive in the face
of planning by Keynesians, monetarists, and supply-siders.
What we have
heard from Federal Reserve Board chairman since 1945 is that inflation
is the problem. Inflation remains a problem, year after year.
Reserve is in control of monetary policy. What does this tell us
about the cause of inflation? "Shhhh. Nobody is supposed to
ask that question."
For a Federal
Reserve official to say that inflation remains a problem is like
Willie Sutton warning us against the unacceptably high rate of bank
If you want
to understand the role of central banking, read all 800 pages of
Jess Huerta de Soto’s book, Money,
Bank Credit, and Economic Cycles (Mises Institute, 2006).
I have never read anything remotely as clear on banking theory and
policy. It is flawless, except for pages 200—260, which were
written for his academic peers, and who won’t read it anyway. You
can buy it for $45. It will cost you a great deal more than $45
in forfeited time. But if you want to understand what is wrong with
central banking — legally, economically, and morally — this is the
book to read, more than any book ever written.
who work for the Federal Reserve System have a theory of economic
causation that rests on this principle: "The free market cannot
supply an appropriate quantity of money. It cannot produce conditions
that are favorable to boom-free, bust-free economic growth. Only
a well-run central bank can do this." Everything else follows.
Retail prices? Wholesale prices? Discount prices? Going out of business
prices? Three a.m. infomercial prices? Used goods prices? Stolen
goods prices? Black market prices? Raw materials prices?
answer is a price index. But whose price index? According to what
theory of economic causation? Reported by whom? Reported to whom?
How recently? Under what degree of legal compulsion? Assessed by
which sampling technique? And, most important of all, weighed sectorally
for its economic relevance by what formula?
Only the most
sophisticated graduate student in statistics and economics can understand
these issues, let alone devise correct procedures that will actually
be followed. In short, the science of economic statistics functions
in much the same way that a priesthood functions. The statistician
is not the high priest, but he is surely the equivalent of a Levite.
He recites jargon that sounds suspiciously like prayers recited
in the outer court of the temple by the Levites just before the
high priest slips behind the veil of the holy of holies and stands
before the ark of the covenant.
The high priest
is the Chairman of the Board of Governors. He is less like a high
priest and more like the Wizard of Oz, surrounded by flashing lights
and smoke. Congress is like the scarecrow and the lion combined:
neither brains nor courage. (They all say they have a heart, so
I’ll leave out the tin man. But whenever they seek to prove their
heart-felt love, they invariably spend my money.)
became famous among other economists for insisting that the only
meaningful test of an economic theory is its ability to enable its
believers to make accurate predictions. He almost convinced me of
this in the 1970’s, because I remembered his prediction in the late
1960’s that gold’s price might fall if the government ever stopped
buying it for $35. I saw this as a good reason to dismiss monetarism
as an anti-gold, pro-inflation defense of fiat money. But I knew
that long before Nixon closed the gold window in 1971. I didn’t
need gold at $700 to prove to me that monetarism is statist to the
core. I understood this a priori!
when it comes to making predictions regarding future price indexes,
we can make valid assessments of the effectiveness of the various
M’s. It is not a question of which M provides a good forecasting
tool. It is a question of which one performs least poorly.
Note: I refer
to price indexes. As to how much good they are for predicting prices
that I will be facing — that will matter to me in my personal situation
— is a matter of considerable guesswork on my part. What about you?
How many prices are really significant for you? That depends on
your age, health, tastes, spouse’s tastes, and a lot of other factors
you don’t recall right now but will recall the next time some item
costs 30% more than today.
I use the median
CPI, published by the Cleveland Federal Reserve Bank. I like it
because I think its assumptions are more reasonable than the CPI’s
assumptions. It seems to fluctuate less. I can track it quarter
by quarter back to 1980. I can see its general direction.
But the CPI
gets more coverage. It’s not significantly different from the Median
CPI. Also, because the Federal Reserve Bank of St. Louis publishes
more statistics than the other regional FEDs, and because it makes
the CPI available, I will use it in this report.
for the CPI go back to 1913. There are real conceptual problems
with any price index this old. The enormous productivity of modern
capitalism has made obsolete just about everything that was counted
in the CPI in 1913, other than basic foodstuffs and the most basic
industrial commodities: steel, wood, paper, cement, glass. Is there
anything made in 1914 that you would want today instead of what
you’ve got? I would like a three-piece, custom-made wool suit. Make
that six. You probably wouldn’t. A one-story home near the library
at Berkeley, where you don’t need home air conditioning, which hadn’t
been invented yet. What about services? A haircut. A shoe shine.
A gourmet dinner in New Orleans, with a Dixieland band afterwards.
That’s about it.
So, I am interested
in the CPI since about 1965, when the Vietnam War started blowing
apart Federal budgets. I can remember 1965. We had color TV shows,
and better ones to watch. We had movie theaters with better films
to watch — and larger screens. We had books. We had air conditioning.
The main difference for me is word processing, and that has not
changed radically for me since 1981. The difference between 1980
and 1981 was gigantic . . . even life-changing. It hasn’t changed
at all since 1991 on the composing side, just the typesetting side.
It hasn’t changed at all since 1995.
a look at the CPI. This chart goes back to 1947, but not much changed
between 1947 and 1967. As you can see, the real change begins in
1971, when Nixon took the country off the Bretton Woods pseudo-gold
I got my first
full-time job one month after he did that. It’s odd. I can remember
the day he did it. My friend Bob Warford called. It was a Sunday.
He had just heard it. I was wrapping up my graduate school days
in California. A month later, I arrived in Irvington, New York,
to work for Leonard E. Read at the Foundation for Education. I had
come very close to working with the Nixon White House. My contact
there later went to jail. It was a good thing I got an offer from
I can recall
how upset Read was because of the price controls. He told our lunch
group that he had called some old buddy at the Chamber of Commerce
to vent his spleen. "But Leonard," the man had said, "the
Board just came out in favor of the controls." Read told that
story with a sense of incredulity. Were the leaders of American
business opinion this blind? They were indeed; the National Association
of Manufacturers had also publicly supported the controls. It was
as if Read had spent a quarter century shouting into the wind. But
I’m sure he was happy he had not accepted the job offer as head
of the International Chamber in 1946. He started FEE instead.
were followers of Mises, we all knew what was coming next. The controls
would cause shortages. They would distort production. They would
not hold down the consumer price index very much, but they would
surely hamper the flow of accurate information. They would distort
relative prices, which does the most harm to an economy. This is
exactly what happened over the next two years.
So, the most
that we can safely say about the following chart is that it displays
the effects of government when the President can call the Chairman
of the Federal Reserve Board and beg him to Do Something about recession.
Nixon had a bad one in 1971. The government ran back-to-back deficits
of $23 billion. Horrible! We get some sense of the world we have
lost when we recall that a $23 billion Federal deficit was considered
politically unacceptable in 1971.
the recession, Nixon wanted a growing economy. That meant lower
interest rates. He told Arthur Burns to provide them. Burns complied
by buying U.S. T-bills with newly created money. The result was
what we see below.
If we look
at 1971, it looks as though the upward sloping line is somewhere
around 40. If you look at it today, it’s around 200. If we divide
200 by 40, we get 5. Prices are five times higher. We can verify
this with the inflation
calculator. It is posted on the site of the Bureau of Labor Statistics.
Entering 1000 in the 1971 box, we get 5024 for 2007. This is close
to 5 to 1.
I propose is to take the standard money measures — M’s — to see
which one would have provided the best indicator of what happened,
1971 to 2007. Put another way, if you were to use one of them to
predict the general movement of prices, which one would you trust?
This is the
indicator I use most often. The reason for this is simple: it is
the one aggregate that the Federal Open Market Committee (FOMC)
can control directly. It records the FED’s holdings of assets that
serve as legal reserves for the money supply. The monetarists call
this high-powered money.
FOMC controls this aggregate, it provides the best indicator of
FOMC policy. We can see what the bureaucrats who make the decision
about the direction of consumer prices thought they had to do to
achieve this result.
The point is
this: we can compare FOMC policy with the statistical results in
the most commonly used and quoted price index. To the extent that
we are affected by the overall movement of prices, the adjusted
monetary base is what lets us assess the effectiveness of the FED
with respect to price inflation. That’s what FED Chairmen keep telling
us is most important. Let’s take them at their word.
has been collected only since 1984, so it doesn’t give me what I
really want. But I can still use this. With the index a little under
200 in 1984 and 845 today, we have a way to derive a figure to use.
Divide 845 by 190. We get 4.4.
Using the BLS
inflation calculator, I find that the CPI increased by 1.95.
So, the price
level increased by less than 2 times. The AMB overestimated price
increases by a factor of 2.2 (4.4 divided by 2). Prices increased
much less than this figure would have led us to believe.
This is the
good old boy of the monetary statistics. It is currency in circulation
plus checking accounts, meaning demand deposits. Currency is instant
money. A checking account is close to it.
If 1984 is
about 525, and 2007 is about 1390, the increase is 1390 divided
by 525, or 2.6. In other words, M-1 in 2007 is about 2.6 times larger
than in 1984. With the CPI increasing by just under 2, this indicator
is very close: 2.6 is only 30% above 2. (2.6 – 2.0 = .6 divided
by 2.0 = .3 = 30%).
The M-2 figure
used to be the preferred figure for the monetarists. I never understood
why. I always used M-1 because it is more liquid. M-2 is M-1 plus
time deposits, or savings accounts.
If 1984 is
about 2100, and 2007 is about 7200, then the increase is 3.4. This
compares with a 2-fold increase in the CPI. If we subtract 2 from
3.4, we get 1.4. Thus, the M-2 figure is 70% higher than the increase
in the CPI (3.4 – 2.0 = 1.4 divided by 2 = .7 = 70%).
M-3 is the
series that ended in 2006. The FED says it stopped collecting the
figures. Let’s see why.
If 1984 is
about 2,400, and 2006 was about 10,300, then the increase was 4.3.
We are told by site after site that M-3 is up by 10% since the figure
stopped being reported. So, add 10% to 10,300. That’s 11,330. So,
the increase is by a factor of 4.7 (470%). Yet the actual increase
in the price level was a little under 2. The overestimation of prices
was considerable. Prices increased by less than half of what M-3
would have led us to believe.
is not cited very often. It supposedly is highly liquid.
The 1985 reference
point looks to be about 1,500. Today, it’s at 7,400. The increased
by a factor of 4.9. This is by far the least accurate statistic.
It overestimates the rate of price inflation by almost two and a
It turns out
that the simplest definition of money, M-1, would have provided
the best indicator of price level increases of all the competing
definitions. M-1 is the closest definition of instant money that
the St. Louis FED publishes. This definition was the most effective
monetary forecasting tool available to the public.
What this tells
us is that the FED implemented its monetary policy by way of the
adjusted monetary base. Yet if we had used this indicator the whole
time, we would have significantly misforecasted the performance
of the consumer price index.
The CPI increased
from 1971 to 2007 by a factor of five. Using the four M’s — not
the adjusted monetary base — from 1971 to 2007, the figures are
M-1 = 5.75x
M-2 = 12x
M-3 = 17x
MZM = 15x
There is no
question which monetary aggregate would have supplied the most accurate
assessment: M-1. It was quite close. The others are so inaccurate
as to be useless. But beyond any doubt, M-3 is the least accurate.
It vastly overstated the rate of price inflation to be expected.
the FED discontinued publishing M-3, the hard-money e-letter world
has gone ballistic. It’s M-3 this and M-3 that. It’s as if the FED
had this secret tool for forecasting and is keeping it all to itself.
The FED is plotting mass price inflation. Gold will go to the moon!
Keep you eye on M-3. Of course, it’s gone. But there are ways of
tracking M-3. Nobody can say exactly how, but there are sites that
report M-3, and e-letter editors refer to them.
Yet M-3 was
hardly reported by anyone, including the FED, prior to 2006. It
reminds me of seller’s remorse. He finds this old hi-fi in his attic
that he has not turned on for 30 years. He sells it at a garage
sale for $10. Then someone tells him it has a gazorninplex dual
fazooler. The sound is just perfect. Why, it’s worth a fortune to
insiders who really know the world of classic stereo.
is depressed. He wants it back. He finds out that someone sells
a piece of software that converts an ordinary scratch-free CD-ROM
into a perfect imitation of a stereo system with a gazorninplex
The guy installs
it. He’s not sure if it really works as claimed. He thinks it might.
The only trouble is, the software reinserts the original clicks
and pops of his vinyl records.
let M-3 die the death of a crazy aunt who lived in the basement.
She meant well, but she was an embarrassment.
we look at M-1 from 2001 to the present, it reveals a flattening
since 2003. It has gone nowhere.
up about 15% since 2001. M-1 reveals an increase of 25% since 2001.
All of the other monetary aggregates reveal an increase of over
40% since 2001. But M-3 indicates an increase of 60% since 2001.
Again, M-3 was utterly useless. Of all the indicators, it deserved
most to be discarded.
All of the
monetary aggregates overshot the target, if the goal of a monetary
aggregate is to forecast the consumer price index. But M-1 has been
by far the most accurate from 1971 to the present.
If this is
correct, then what is M-1 telling us about the rate of price inflation?
It is not headed higher. Look at M-1 since the beginning of 2006.
It is falling.
the adjusted monetary base is up less than 2%. It is now running
closer than any other aggregate to the 3% per annum increase that
has been reported.
can I say other than this? The rate of price inflation is unlikely
to rise rapidly in the United States over the next three years.
The 10% figure that we keep hearing about regarding the "true"
increase of the "true" money — M-3 — should not be taken
seriously by anybody. The statistic was useless from day one as
a means of forecasting price inflation.