Monetary Statistics

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Recently, I
was asked a question about money statistics. The person asked if
I thought a particular unofficial index is better than the official
indexes: M1,
M2, M3, MZM.

The article
by "Mish" discusses a recent article by Frank Shostak.
I am familiar with the work of both men. They are thoughtful, well-informed
analysts of economic trends. Shostak does this for a living. He
actually invests money for clients. Mish is an advocate of Elliott
wave theory forecasting. I am not. Shostak is an Austrian School
economist, a view I share. But I don’t always follow his logic.
This may be my fault.

Mish’s article
makes several important observations about the relationship between
the most prominent monetary aggregates and the economy. He finds
that M1 is far better than the other three in forecasting recessions.

In a detailed
report to my Remnant Review subscribers in April, 2007, I
compared the four major monetary aggregates as predictors of price
inflation. Only M1 was remotely accurate over the last four decades.

Mish has come
up with a new aggregate, which he calls M-prime. He symbolizes it
as M’. Using Shostak’s article as a guide, he argues that M’ is
superior theoretically because it does not include any credit transactions,
i.e., "sell this asset and get money." I agree with his

Then he presents
some charts on the success in predicting recessions by using M’.
He says that 6 of the last 6 recessions were called accurately,
with two as false signals: 1985 and 1995. This, if true, makes M’
the best indicator of the five monetary aggregates.

Here is his
claim: whenever the increase dipped below 5% per annum, a recession
followed in 6 out of 8 times. He provides a
detailed chart

Click through.
Print it out. I’ll wait.

All right,
let’s look at the chart.

From 1968 until
1984, the M’ figure for money in circulation moved up slowly and
steadily. Yet this was a time of very high price inflation. It was
also a time in which there were three major recessions: 1970, 1975,
and 1981 (some would separate 1981 and 1982). Looking at the chart,
I would have missed all three, as well as gold’s boom after 1967.

Mish says that
we should focus on the rate of change. This is provided by the yellow
line. This does seem to be an accurate forecasting tool.

Notice what
has happened since 2002. The rate of increase peaked in early 2004:
10% per annum. It fell to 5% in late 2005. In January, it was slightly
above 0%. The last time it was this low was in 2001, just as the
recession began. It was slightly below 0%, but only briefly.

When coupled
with the inversion of the yield curve earlier this year, and the
present inverted condition of the 90-day/10-year rates, with the
90-day/30-year rates flat, I regard the M’ indicator as pointing
to a recession.

The problem
with M’ is that it is an unofficial statistic. If someone published
it on a week-to-week or even month-to-month basis, I would use it
as a supplement. But as far as I know, Mish’s articles are the only
public references to it.

The article
was published in January. Mish did a follow-up on May 9: "Money
Supply Is Soaring — Right?

It takes to
task the use of M-3. I agree wholeheartedly. In my report to Remnant
Review subscribers in April, I showed that no monetary aggregate
has a worse track record for predicting price increases. M-3 vastly
overstates the rate of monetary inflation and therefore price inflation.
The Federal Reserve System finally ceased reporting M-3 a year ago.
It took them two decades to come to the realization that the statistic
has always been useless. Bureaucrats learn slowly.

Mish reported
that M’ was slightly below 0%. This has not happened since just
before the 2000 recession.

He drew some
conclusions from this information. He asked: What does it mean?
His answers:

  • Credit is
    expanding rapidly but with fractional reserve lending via sweeps
    and other mechanisms such as GSE debt creation and various carry
    trades, actual money itself is now contracting.
  • This is
    further proof that the Fed has now totally lost control. What
    else can it mean when credit is soaring in the face of what otherwise
    appears to be rather tight monetary policy?
  • The distinction
    between money and credit is significant. A huge expansion in money
    supply leads to hyperinflation like the Weimar Republic or Zimbabwe.
  • A huge expansion
    in credit eventually leads to things like the tulip mania implosion,
    the railroad bust, and the great depression.
  • The Fed
    will fight this tooth and nail but right now their hands are tied.
    When the Fed starts lowering rates to combat this malaise, look
    for gold to soar.
  • Long term,
    there is no way out. The policies of Greenspan and Bernanke will
    be repudiated.

The FED is
now walking a tightrope. It doesn’t want to push the economy into
a recession. It also wants to avoid mass inflation, what Ludwig
von Mises called the crack-up boom.

So far, Bernanke’s
FED has successfully walked the tightrope. Consumer price increases
are slowing. The housing bubble has ended, but it has not popped
nationally. The Dow Jones Industrial Average rose to 14,000 on July
19 before turning downward. The fact that it was still down from
its 2000 high by about 30% as measured in euros did not get any
attention by the media. The public is not worried about the economy.

I see the FED
as capable of monetizing everything listed on any exchange, and
then some. I see no limit on fractional reserve banking’s ability
to destroy the purchasing power of a nation’s currency. I believe
that the crack-up boom is ahead of us, not behind us.

This is why
I rely most heavily on the statistic published by the Federal Reserve
Bank of St. Louis: the adjusted monetary base. This statistic reveals
what the FED is doing to inflate, stabilize (ha!), or decrease the
money supply. It reports on the FED’s holding of monetary reserves
for the American banking system. You
can access it here.

In periods
of transition to lower price inflation, the FED reduces the rate
of monetary inflation. We have been in such a transition period
ever since Bernanke took over as FED Chairman in February, 2006.
The FED has been remarkably tight: around 2% per annum.

If we look
at the effects on M’, the reduction of monetary growth has been
remarkable. It had been declining ever since 2004. The rate has
now gone negative.

I applaud the
FED for its action. I hope this continues from now until doomsday.
But if it does, there will be an intermediate doomsday in the financial
markets and the housing markets. This doomsday is what Congress
will tell Bernanke to avoid. The FED will reverse its policy again.
It will respond to political pressure. But I think it will take
a much lower stock market and a much higher unemployment rate for
this pressure to be applied by a unified Congress.


I think M-prime
is a better measure than the other M’s. If I could get access to
it every month on Mish’s site, I would consult it.

I think we
should use whatever data are available to us, but always within
a framework of the Austrian theory of the business cycle. I
have written about this here.

weekly update of the adjusted monetary base is useful in assessing
the recent direction of FED policy. The yield
is also important to see how investors regard the threat
of a fall in the short-term interest rate. If they think short rates
will fall rapidly due to recessionary conditions, they will buy
long-term bonds. This forces down the long-term bond rate.

8, 2007

North [send him mail]
is the author of Mises
on Money
. Visit
He is also the author of a free 19-volume series, An
Economic Commentary on the Bible

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