Money Supply Metrics, the Austrian Take

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All economists,
whether they are of an Austrian, a Keynesian or a Monetarist bent,
as well as nearly every investor, would agree that money plays a
vitally important role in the economy. And a correct measure of
its supply is an indispensable input into every economic and financial
forecast. How could it not, for money is one half of every economic
transaction.

Yet, despite
its importance, the money supply metrics used by the majority of
today’s economists and investors are seriously flawed, for
they are founded on a faulty definition of money.

I ask you,
are you using the wrong money supply metrics as input into your
economic and financial forecasts? If so, I submit to you, that is
a serious error. And if you are an investor it’s an error that
could cost you serious money.

So then, what
is money? And how does one properly measure its supply? Keynesian
and Monetarist formulations of the money supply, based as they are
on empirical correlations and inductive statistical techniques,
are not the way to go. A correct formulation of the money supply
must be based on a deductively derived, theoretically sound definition
of money.

Well it just
so happens that the Austrians have the inside track here, a track
that I invite you now to get on.

Defining
the Money Supply

Let’s
start with this simple definition of money. To quote Austrian economist
Murray Rothbard, from his essay Austrian
Definitions of the Supply of Money
:

…money
is the general medium of exchange, the thing that all other goods
and services are traded for, the final payment for such goods
and services on the market.

Pretty straightforward,
a definition I think we can all agree.

Of primary
import, a point that can not be overemphasized is the requirement
that for a thing to be money it MUST serve as the FINAL means of
payment in all transactions. In other words, it must be the thing
which FULLY extinguishes the debt incurred in a transaction.

To bring this
point home, take the case of credit cards which facilitate the purchase
of countless goods and services but in no way should be classified
as money. Austrian economist Joseph Salerno, in his essay The
True Money Supply: A Measure of the Supply of the Medium of Exchange
in the U.S. Economy
, explains why:

…credit
cards [should] not [be] counted as part of the [money supply]
because use of a credit card in the purchase of a good does not
fully discharge the debt created in the transaction. Instead,
it gives rise to a second credit transaction that involves present
and future monetary payments. Thus the issuer of the credit card
or lender is now bound to pay the seller of the good immediately
with money on behalf of the card-holder or borrower. The latter,
in turn, is obliged to make a monetary repayment of the loan to
the issuer at the end of the month or at a later date, at which
time the transaction is finally completed.

Even more to
the point and on similar grounds, consider the widely held view
that travelers’ checks, a component of the Federal Reserve’s
M1 money supply measure, are money. Again, to quote Salerno:

What a travelers’
check represents… is a credit claim on the investment portfolio
of the issuing company. The purchase of travelers’ checks
from American Express involves, in effect, a “call”
loan by the purchaser to American Express, which the latter pledges
to repay to the purchaser or to a designated third party at an
unspecified date in the future. In the meantime, most of the proceeds
of such loans are invested by American Express on its own account
in interest-bearing assets, while a fraction is held in the form
of demand deposits to meet anticipated payments of its travelers’
check liabilities as they “mature.” In exchange for
the foregone interest (and a small fee) the purchaser receives
access to an alternative payments system which avoids the risk
of loss associated with carrying cash payments and the potential
delay or non-acceptance involved with payment by personal check
drawn on a distant bank. But the travelers’ checks themselves
are not the final means of payment in a transaction: the sellers
who receive travelers’ checks in exchange quickly and routinely
present them for final payment at a bank and obtain either cash
or a credit to their demand deposit accounts, with the sums paid
out ultimately being debited to the demand deposit account of
American Express.

With these
concepts in mind, it’s easy to see why economists, of all schools,
would include currency – in the U.S. being Federal Reserve
notes and Treasury token coins – as part of the money supply.
What could be more basic, for what discharges a debt more fully
then the exchange of a good or service for currency.

But what about
demand deposits and other checkable accounts at banks? What about
savings accounts that permit the instantaneous transfer of your
money to a checking account. Or what about money market mutual fund
share accounts that feature checking privileges? Are these things
not money, things that all other goods and services are traded for,
the final payment for such goods and services on the market?

Indeed, the
Keynesian and Monetarist inspired mainstream measures of the money
stock as reported by the Federal Reserve Board – M1 and M2
and until discontinued in February of 2006, M3, diligently followed
by millions of economists and investors the world over, include
all these things (and more) in the money supply. And there are quite
a few things to say the least:

M1 Components

  • Currency
  • Nonbank
    Traveler’s Checks
  • Demand Deposits
  • Other Checkable
    Deposits (OCD) at Commercial Banks
  • Other Checkable
    Deposits (OCD) at Thrifts

Non-M1 M2
Components

  • Savings
    Deposits at Commercial Banks, including MMDAs
  • Savings
    Deposits at Thrifts, including MMDAs
  • Small Time
    Deposits at Commercial Banks
  • Small Time
    Deposits at Thrifts
  • Retail Money
    Funds

Non-M2 M3
Components

  • Large Time
    Deposits at Banks
  • Large Time
    Deposits at Thrifts
  • RPS
  • Euro Dollars
  • Institutional
    Money Funds

So then, how
do we make sense out of all this in light of our definition of money?
Are all these things money?

The dean of
the Austrian School of Economics Ludwig von Mises in his classic
Theory
of Money and Credit
laid out the framework:

Money supply
= standard money + money substitutes

In today’s
fiat money system, standard money is easy to define. It’s simply
Federal Reserve notes plus Treasury token coins, the combined total
popularly termed currency.

Money substitutes,
that’s the challenge.

To paraphrase
the Austrian masters, money substitutes are perfectly secure
and IMMEDIATELY convertible, PAR VALUE claims to standard money
which, by virtue of this immediate convertibility substitute FULLY
for standard money in individual’s cash balances, and as such,
are used by individuals as a surrogate for cash – namely, a
thing that all other goods and services are traded for, the final
payment for such goods and services on the market. On this basis,
not only are all the Federal Reserve’s M1, M2 and M3 components
not money, but some are not even money substitutes.

In a format
similar to Salerno’s essay on this subject, and with these
definitions firmly in mind, let’s build the correct formulation
of the money supply by “testing” each of the Federal Reserve’s
M1, M2 and M3 components against these definitions.

Currency

As we saw above,
in today’s fiat money system, currency is simply Federal Reserve
notes plus Treasury token coins. In Mises terminology, standard
money. It goes without saying that both meet our money test and
should be included in the money supply.

Demand Deposits
and Other Checkable Deposits at Banks

Demand and
other checkable deposits at commercial banks and thrifts are the
embodiment of money substitutes. Without question they pass the
money test and should be included in the money supply.

Rothbard makes
the case for demand deposits, at the same time explaining the essence
of a money substitute:

…demand
deposits [are] not other goods and services, other assets exchangeable
for cash; they [are], instead, redeemable for cash at par on demand.
Since they [are] so redeemable, they [function], not as a good
or service exchanging for cash, but rather as a warehouse receipt
for cash, redeemable on demand… Demand deposits [are] therefore
“money-substitutes” and [function] as equivalent to
money in the market. Instead of exchanging cash for a good, the
owner of a demand deposit and the seller of the good would both
treat the deposit as if it were cash, a surrogate for money. Hence,
receipt of the demand deposit [is] accepted by the seller as final
payment for his product.

Rothbard goes
on to highlight a key Austrian insight, that being the fact that
it is the subjective deliberations of market participants which
give a good or service value in the market. And nowhere is this
subjectivity more important than in the case of money substitutes:

It is important
to recognize that demand deposits are not automatically part of
the money supply by virtue of their very existence; they continue
as equivalent to money only so long as the subjective estimates
of the sellers of goods on the market think that they are
so equivalent and accept them as such in exchange.

Now, with FDIC
insurance behind every demand deposit, and Treasury guarantees behind
the FDIC, all supported by the Federal Reserve’s ability to
print Federal Reserve notes at a moments notice, to make good on
any shortfall that might exist in the FDIC or Treasury coffers,
is there any doubt that demand and other checkable deposits are
deemed by individuals everywhere as perfectly secure, and immediately
convertible par value claims to standard money which substitute
fully for standard money in individual’s cash balances,
and as such, perform all the functions that one expects of standard
money? The answer of course is no. And it’s why demand deposits
must be included in the money supply.

Nonbank
Traveler’s Checks

As we saw above,
travelers’ checks at first glance look like money substitutes,
but they are neither perfectly secure immediately convertible, par
value claims to standard money or a final means of payment. As such
they must be excluded from any money supply measure.

Small Time
Deposits at Banks

Small-denomination
time deposits are federally insured certificates of deposit (CDs)
at commercial banks and thrifts, with maturities ranging from a
few months to several years. In economic terms, they are credit
transactions, specifically loans made by the bank’s depositors,
where the depositor foregoes the use of his money for the length
of the loan in return for interest plus the return of his deposit
at maturity. So, while perfectly secure, CDs are not immediately
convertible claims to standard money and as such fail our money
test. On those grounds, they should be excluded from any money supply
metric.

The failure
of a time deposit to meet our money test speaks to the essence of
what is meant by immediate convertibility, that being the difference
between what Austrians call a claim transaction or warehouse receipt,
best represented by a demand deposit, and a credit transaction,
like a time deposit. Have a read of Austrian economist Frank Shostak’s
explanation of the difference between a claim transaction, in this
case a demand deposit and a credit transaction from his essay The
Mystery of the Money Supply Definition
:

Once an individual
places his money in a bank’s warehouse he is in fact engaging
in a claim transaction. In depositing his money, he never relinquishes
his ownership. No one else is expected to make use of it. When
Joe stores his money with a bank, he continues to have an unlimited
claim against it and is entitled to take charge of it at any time.
Consequently, these deposits, labeled demand deposits, are part
of money…

This must
be contrasted with a credit transaction, in which the lender of
money relinquishes his claim over the money for the duration of
the loan. Credit always involves a creditor’s purchase of
a future good in exchange for a present good. As a result, in
a credit transaction, money is transferred from a lender to a
borrower.

The distinction
between a credit and a claim transaction serves as an important
means of identifying the amount of money in an economy…

Here’s
Rothbard, with the application of this concept to time deposits:

a genuine
time deposit – a bank deposit that would indeed only be redeemable
at a certain point of time in the future, would merit very different
treatment [from a demand deposit]. Such a time deposit, not being
redeemable on demand, would instead be a credit instrument rather
than a form of warehouse receipt. It would be the result of a
credit transaction rather than a warehouse claim on cash; it would
therefore not function in the market as a surrogate for cash.

You say, wait
a minute. Isn’t it true that banks stand ready to redeem these
small-denomination time deposit CDs at any time prior to their maturity?
In that case, couldn’t one make the case that these CDs, at
least on paper, are not credit transactions but instead money substitutes?
In theory, yes at current redemption value. But, given the fact
that banks typically charge depositors heavy redemption penalties
in addition to forfeiture of accrued interest in the event of early
withdrawal, depositors typically treat these CDs as true credit
transactions. And because CDs are insured by the government and
therefore backed by the Federal Reserve’s printing press, the
likelihood of early withdrawal owing to depositor concerns about
bank solvency is practically non-existent. In fact, during the depths
of 2008–09 financial crisis, small-denomination CDs actually
attracted depositor money likely because of this insurance.

In summary,
and a position universally shared in the Austrian camp, the weight
of the argument suggests that small-denomination time deposits should
be excluded from any measure of the money supply.

Retail Money
Funds

Because of
their check-writing privileges, money market mutual fund share accounts
(MMMF) look like demand and other checkable deposit accounts to
the naked eye and therefore appear to be money substitutes. But
because they are neither immediately convertible, par value claims
to standard money, nor a final means of payment, MMMFs fail our
money test and as such should not be included in any money supply
measure. Salerno lays out the case:

Each MMMF
share represents a claim to a pro rata share of a managed investment
portfolio containing short-term financial assets, such as high-grade
commercial paper, certificates of deposit, and U.S. Treasury notes.
Although the value of a share is nominally fixed, usually, at
one dollar, the total number of shares owned by an investor (abstracting
from reinvested dividends) fluctuates according to market conditions
affecting the overall value of the fund’s portfolio. Under
extreme circumstances, such as a stratospheric rise in short-term
interest rates or the bankruptcy of a corporation whose paper
the fund has heavily invested in, the fund’s investors may
well suffer a capital loss in the form of an actual reduction
of the number of fixed-value shares they own. Unlike a check drawn
on a demand deposit or MMDA, therefore, an MMMF draft does not
simply represent a direct transfer of current claims to currency,
but a dual order to the fund’s manager to sell a specified
portion of the shareowner’s asset holdings and then to transfer
the monetary proceeds to a third party named on the check. Note
that the payment process is not finally completed until the payee
receives money, typically in the form of a credit to his demand
deposit.

Savings
Deposits at Banks, including Money Market Deposit Accounts (MMDAs)

This is the
tough one, a debate even among the Austrians. Are savings accounts
(and their cousins MMDAs) at commercial banks and thrifts money
substitutes, like demand deposits, or are they credit instruments,
like time deposits? Let’s have a look at both sides of this
debate as represented by their most distinguished proponents and
see if we can come to a conclusion – in or out.

According to
both Rothbard and Salerno, savings accounts are money substitutes,
economically indistinguishable from demand deposits and should therefore
be included in the money supply. To quote Salerno:

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. The objection that claims
on dollars held in savings deposits typically do not circulate
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.

Salerno penned
these thoughts in 1987. In 2010, the transferability he speaks to
is near instantaneous, nothing more than a few taps on your BlackBerry
or iPod keypad.

Salerno goes
on to support his case for savings accounts with this quote by German
banker and economist Melchoir Palvi, a quote which speaks to the
importance of individual subjective valuations as cited by Rothbard:

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 settling 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 deposits cannot differ in
function or value…

Now, moving
to the other side of the debate, according to Shostak, savings accounts
fail the money test and should be excluded from the money supply.
In the final analysis, Shostak seems rests his case solely on the
premise that when one deposits his or her money in a savings account
he or she relinquishes “ownership” over that money. Shostak
writes:

The crux
in identifying what must be included in the money supply definition
is to adhere to the distinction between a claim transaction and
a credit transaction. Following this principle, it is questionable
whether savings deposits should be part of the money supply. According
to popular thinking, the inclusion of savings deposits into the
money supply definition is justified on the grounds that money
deposited in saving accounts can always be withdrawn on demand.
But the same logic should also be applied to money placed with
an MMMF. The nub, however, is that savings deposits do not confer
an unlimited claim. The bank could always insist on a waiting
period of thirty days during which the deposited money could not
be withdrawn. Savings deposits should therefore be considered
credit transactions with depositors relinquishing ownership for
at least thirty days. This fact is not altered just because the
depositor could withdraw his money on demand. When the bank accommodates
this demand, it sells other assets for cash. Buyers of assets
part with their cash, which in turn is transferred to the holder
of the savings deposit. The same logic is applicable to fixed-term
deposits like CDs, which are credit transactions.

Shostak’s
points are well taken, but in this authors opinion not enough to
warrant the exclusion of savings accounts from the money supply.

To see why,
let’s examine each of Shostak’s points.

His first point
– that savings accounts are not legally redeemable on demand,
the bank permitted by law to force the depositor to wait up to 30
days for his or her money – is certainly true. If enforced
it would indeed make such deposits more like credit transactions
and not money substitutes; in other words, it would mean the depositor
had relinquished ownership over his money. The argument though is
tenuous at best. As Rothbard asserts, it focuses on legalities rather
than economic realities:

…the
objection fails to focus on the subjective estimates of the situation
on the part of the depositors. In reality, the power to enforce
a thirty-day notice on savings depositors is never enforced; hence,
the depositor invariably thinks of his savings account as redeemable
in cash on demand. Indeed, when, in the1929 depression, banks
tried to enforce this forgotten provision in their savings deposits,
bank runs promptly ensued.

Never of course
is a strong word. Having said that, one could easily argue that
because savings accounts are insured by the government and therefore
backed by the Federal Reserve’s ability to print at will, clearly
not the situation in 1929, the reason for a bank ever having to
enforce its notice period is, for all intents and purposes, non-existent.
In fact, in this author’s opinion, the potential for such an
invocation would likely arise ONLY in the event of a system-wide
bank run, in which case the government would almost assuredly take
control over the entire banking system and ration the withdrawal
of depositor money across ALL deposit classes, making savings deposits
no different than demand deposits.

Shostak’s
second point – that even if no notice period existed, savings
accounts are still credit transactions because the bank can accommodate
a depositor redemption by selling other assets for cash, at which
time buyers of assets part with their cash, which in turn is
transferred to the holder of the savings deposit – is a
huge leap. Agreed, once the bank loans money entrusted to it by
a depositor it is no longer in the bank’s coffers, but instead
in the hands of the borrowers and/or the borrowers’ vendors.
But unless the notice period is enforced, contrary to Shostak’s
assertion, no ownership of money has passed from the depositor to
the borrower in this exchange. In the eyes of the depositor, that
money is still part of his or her cash balance, immediately convertible
at par to standard money whenever he or she so desires. In point
of fact, no money was ever transferred from the hands of the depositor
to the hands of the borrower in the first instance so no money needs
to be transferred back in the second instance. The result of this
entire transaction is this: if our depositor entrusted $10,000 to
the bank, and the bank loaned out the full amount, we have increased
the aggregate amount of money in individual’s cash balances;
namely, the money supply, by $10,000.

It is certainly
true, that in our fractional reserve banking system, banks can and
do make loans by creating demand deposits out of thin air at a multiple
of their cash reserves, while they can only loan out the money deposited
in savings accounts on a one-to-one basis. This does not mean, as
many in the Shostak camp seem to argue, that money deposited in
a savings account and then loaned out by a bank is any less of a
money substitute in individuals’ cash balances than if that
money had been deposited in a demand deposit or other checking account.
As Rothbard explains:

…this
distinguishes the sources or volatility of different forms of
money, but should not exclude savings deposits from the supply
of money… while each of these forms of money is generated
quite differently, so long as they exist each forms part of the
total supply of money…

Palvi, as Salerno
suggests, does an admirable job of explaining these issues in commonsense
terms when he writes:

A source
of confusion is the identification of savings deposits with savings.
The former are no more and no less u2018saved’ than are the funds
put on a checking account or the currency held in stockings. In
all three cases, someone is refraining from consumption (for the
time being); in all three, the funds constitute actual purchasing
power. And it makes no difference in this context how the purchasing
power is generated originally: dug out of a gold mine, ‘printed’
by a government agency, or ‘created’ by a bank loan.
As a matter of fact, savings banks and associations do exactly
what commercial banks do: they build a credit structure on fractional
reserves.

In the opinion
of this author, once it is agreed that savings deposits are immediately
convertible claims, at par to standard money, they are by definition
money substitutes and should be included in the money supply.

Non-M2 M3
Components

In February
2006, many Fed watchers were aghast when the Federal Reserve Board
discontinued publishing M3, claiming that the costs of collecting
the underlying components and publishing the series outweighed the
benefits. Well, if the purpose of M3 in the eyes of these Fed watchers
was to track the ebb and flow of the money supply, than this is
one time this author must agree with the logic of the Federal Reserve.
M3 is dominated by accounts that fall under the category of credit
transactions and by and large should not be included in the money
supply.

The Federal
Reserve’s Other Memorandum Items

The Federal
Reserve publishes several data series under what it calls “Other
Memorandum Items,” none of which it feels worthy of the status
of money. Oddly enough, several of these items are in fact money
substitutes and should be included in the money supply. These are
demand deposits at banks due foreign commercial banks and official
institutions and U.S. government demand deposits and note balances
held at commercial banks and at the Federal Reserve. As Salerno
writes:

The somewhat
mysterious exclusion of these items from money supply measures
is typically justified by one recent writer who claims that the
deposits of these institutions “…serve an entirely different
purpose than the holdings of the general public” or are “…viewed
as being held for ‘peculiar’ reason.” This overemphasis
on the particular “motives” for holding money, as opposed
to the importance of the quantity of money itself, is one of the
modern legacies of the Keynesian revolution.

The case for
inclusion of U.S. government demand and note balances is of particular
import today because of the growing size and volatility of these
accounts. As such, it’s worthy of some discussion.

Let’s
start with the theoretical case for the inclusion of U.S. government
deposits in the money supply. Salerno, quoting economist Harold
Barger:

The Treasury’s
deposits are not part of its reserve against money that it has
issued, but are rather part of the general fund of the Treasury
available for meeting general expenditures. Output is purchased
and taxes are collected with the help of these deposits, and they
would seem to be as much a part of the money stock with which
the economy operates as are the deposits of state and local governments,
which are included in adjusted demand deposits. Much the same
may be said of Treasury deposits at Federal Reserve Banks.

Treasury deposits,
whether held at commercial banks or at the Federal Reserve (the
latter known as the “General Account”), are simply demand
deposits owned by the U.S. government. They are clearly money substitutes
and should therefore be included in the money supply.

In September
of 2008, well after Barger and Salerno penned these thoughts, the
Treasury at the request of the Federal Reserve established a new
account at the Federal Reserve – the Treasury’s Supplementary
Financing Account (SFP).

In contrast
to traditional Treasury deposit accounts which were created for
the purpose of collecting the government’s taxes and paying
the government’s bills, the SFP was created as a special case,
“temporary” account under the control of the Federal Reserve
for the purpose of managing down the explosion in excess reserves
owing to the Federal Reserve’s en masse purchase of toxic securities
and special loan programs. The Federal Reserve Board describes the
SFP and the reasons for its creation as follows:

With the
dramatic expansion of the Federal Reserve’s liquidity facilities,
the Treasury agreed to establish the Supplementary Financing Program
(SFP) in order to assist the Federal Reserve in its implementation
of monetary policy. Under the SFP, the Treasury issues short-term
debt and places the proceeds in the Supplementary Financing Account
at the Federal Reserve. When the Treasury increases the balance
it holds in this account, the effect is to drain deposits from
accounts of depository institutions at the Federal Reserve. In
the event, the implementation of the SFP thus helped offset, somewhat,
the rapid rise in balances that resulted from the creation and
expansion of Federal Reserve liquidity facilities.

The SFP then
is really a reserve management tool, in fact, accounted for as such
on the books of the Federal Reserve; namely, as reduction in depositories
“Reserves Balances at Federal Reserve Banks.” Consequently,
the SFP is nothing like traditional Treasury deposits and in this
context should not be included in the money supply.

It should be
noted that the author is aware of differing opinions among practicing
Austrians with regard to the “moneyness” of the SFP. For
example, Shostak includes the SFP account in his measure of the
money supply while Sean Corrigan over at Diapason Commodities does
not. Indeed, as Salerno suggests, the emphasis by this author on
the particular motives of the Treasury and the Federal Reserve as
justification for the exclusion of the SFP from the money supply
is a slippery slope. Who’s to say that the SFP will be temporary
or will be used only by the Federal Reserve to manage down the excess
reserves amassed as a result of the financial crisis? The answer
is, no one knows. But as long as the SFP remains under the direct
control of the Federal Reserve for the specific purpose of managing
reserves, the author is inclined to believe that the SFP is not
a thing that all other goods and services are traded for, the
final payment for such goods and services on the market and
therefore should not be included in any money supply measure.

Austrian
Money Supply Metrics for the Economist and Investor

I happen to
believe that Austrian economics, properly applied, can give any
economist, financial forecaster or investor a competitive edge in
his or her deliberations. And if Austrian economics has taught me
anything, it’s the importance of the money supply’s ebb
and flow in the economy and financial markets. That’s why the
correct measurement of the money supply is so vital, for using a
flawed money supply measure is an accident waiting to happen.

So then, to
repeat my opening salvo, are you using the wrong money supply metrics,
as input into your economic and financial forecasts, or worse, your
investment decisions? If so, I’m here to help.

On THE CONTRARIAN
TAKE
, I offer up the following Austrian Money Supply metrics,
three series updated each month:

TMS1.
A narrow definition of the money supply based largely on Shostak’s
AMS formulation of money – excluding savings deposits but adding
back bank deposit sweep programs (those monies banks “sweep”
out of demand deposit accounts and into savings and MMDAs to lower
effective reserve requirements).1,2

TMS2.
A broad definition of the money supply based on Rothbard-Salerno’s
TMS formulation of money, brought current in accordance with the
conclusions presented in this essay, and the most complete and most
correct measure of the money supply.

M2.
Federal Reserve Board’s broad money supply measure.

The composition
of each series is presented below:

Given the
conclusions presented in this essay – that TMS2 is the most
complete and most correct measure of the money supply – you
might ask, why track TMS1? Two reasons:

1. in recognition
of the fact that there exists a tenuous, legal right of a bank to
deny immediate convertibility for money deposited in a savings account
for up to 30 days, and

2. as Salerno
wrote, and to me the more important reason, that claims on dollars
held in savings deposits typically do not “circulate”
in exchange, making a TMS1 measure important for certain analysis.

Similarly,
why track M2? That’s easier to answer – as a means to
track the reality that is TMS against the perception of reality
that is M2. As Kevin Duffy, a co-manager of Bearing Asset Management
once said:

Investment
management is simply capturing the arbitrage available between
perception and reality. It is paramount to know both.

You will find
my Austrian Money Supply metrics here.

THE
CONTRARIAN TAKE
tracks several other economic data series,
tables and charts with an Austrian slant, all of which can be found
here.

Notes

  1. To quote
    Shostak, “Since January 1994, banks and other depository
    financial institutions have initiated sweep programs to lower
    statutory reserve requirements on demand deposits. In a sweep
    program, banks “sweep” funds from demand deposits into
    money market deposit accounts (MMDA), personal savings deposits
    under the Federal Reserve’s Regulation D, that have a zero
    statutory reserve requirement ratio. By means of a sweep, banks
    reduce the required reserves they hold against demand deposits.
    As a result of the sweep program one could argue that the money
    definition outlined above will not cover the total money supply.
    This criticism, however, is misplaced, for it has nothing to do
    with the definition as such, but with the difficulties of measuring
    money, which was transferred out of demand deposits by banks without
    the depositors’ consent.”
  2. To clarify
    any confusion for those readers familiar with Frank Shostak’s
    AMS metric, note that (a) as is the case with AMS, TMS1 excludes
    savings deposits but adds back bank deposit sweep programs, and
    (b) in contrast to AMS, TMS1 does not include the SFP account.

References

This originally
appeared on True/Slant.

April
23, 2010

Michael
Pollaro [send him mail]
is a retired Investment Banking professional, most recently Chief
Operating Officer for the Bank’s Cash Equity Trading Division. He
is a passionate free market economist in the Austrian School tradition,
a great admirer of the US founding fathers Thomas Jefferson and
James Madison and a private investor. He is a columnist for True/Slant
magazine.

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