===== PAGE 1 ===== ~Austrian Economics Newsletter Spring 1987 ® The Ludwig von Mises Institute The “True’’ Money Supply: A Measure of the Supply of the Medium of Exchange in the U.S. Economy by Joseph T. Salerno Lubin Graduate School of Business Pace University | The “Tue Mogg Supply (IM3), developed by Pro-. “| fessor Murray Rothbard and myself,’ is an admittedly im- perfect attempt to provide a statistical measure of money that is consistent with the theoretical definition of money as the general medium of exchange in society.’ Measures of the U.S. money stock in current use in economic and business forecasting and in applied econom- ics and historical research are flawed precisely because they are not based on an explicit and coherent theoretical con- #7 ception of the essential nature of money. Given the all- pervasive role of money in the modern market economy, existing money-supply measures therefore tend to impede, rather than to facilitate, a clear understanding of the past or future development of ‘actual economic events. Each one of the familiar set of M's calculated by the Federal Reserve System, for example, both excludes some items "Dr. Joseph T. Salerno that are identifiable as money by our definition and in- cludes other items that lack the essential properties of a In the case of a paper fiat money, such as the current general medium of exchange. U.S. dollar, there is a second test that can be applied to As the general medium of exchange, money is a good determine whether a particular item should be counted in —universally-and-routinely-accep ele money supply statistics. Unlike any good produced in the the participants; or, put another way, it is the 0 one goad that i is “market, including a commodity money, whose quantities traded for all other goods on the market. One important are ultimately determined by the interaction of supply and implication of this fact—and an important empirical test demand,! the quantity of government fiat money (but not of whether or not a thing can be counted as money —is that its purchasing power) at any point in time is determined money serves as the final means of payment in all transactions. solely by decisions of suppliers of the good, i.e. government For instance, credit cards are not counted as part of the central banks, without respect to the desires and actions of TMS, because use of a credit card in the purchase of a good the demanders. The fact that money is routinely accepted does not finally discharge the debt created in the current transaction. Instead, it gives rise to a second credit transac- tion that involves present and future monetary payments. INSIDE Thus the issuer of the card or lender is now bound to pay phe seller of the good immediately with money on behalf James M. Buchanan: Nobel Prize Winner ...... 7 of the card-holder or borrower. The latter, in turn, is Early Italian ECONOMISES .ccoevvecsorseeccscsescecesseesd 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 Southern Economics Association ..c..ceeeeesecesss 10 time the transaction is finally completed.’ ===== PAGE 2 ===== as the final means of payment by all participants in the every depositor at a given bank or thrift against loss, but market means that fiat money can be literally lent and which, in practice, has almost always guaranteed the full spent into existence regardless of the public's existing de- worth of all deposits, usually by subsidizing the merger of mand for it. For example, if an additional quantity of Fed an ailing institution with a healthy one.® Second and mor notes is printed up and spent by government on various importantly, there is the Fed itself, which, in its much * goods and services, an excess supply of money will tempo- publicized function as the “lender of last resort,” always rarily be created in the economy. The initial recipients of stands ready to head off a banking panic by simply printing the new money will quickly get rid of the excess cash up and lending the needed quantities of Fed notes to banks simply by increasing their own spending on. goods; those or thrifts unable to meet their demand liabilities.” For these who eagerly receive the new money as payments in the reasons, checkable deposits held at federally-insured banks second or later rounds of spending will do likewise, in the and thrifts are readily acceptable in exchange as perfect process bidding up the prices of goods, reducing the pur- substitutes, dollar for dollar, for Federal Reserve notes. chasing power of the dollar, and, consequently, increasing the quantities of dollars that each individual desires to In contrast, travelers’ checks issued by nonbank financial keep on hand to meet expected future payments or for institutions, such as American Express, are excluded from other purposes. In summary, any excess supply of fiat the TMS because they neither are riskfree claims to imme- money does not go out of existence, but is spent and diate cash nor serve as final means of payment in transac- respent and continually passed on like a “hot potato” ~~ tions. What atraveters-ctheck represents franrzmreconontic-- throughout the economy until the surplus money is finally point of view is a credit claim on the investment portfolio and fully absorbed by the resulting increase in general of the issuing company. The purchase of travelers’ checks prices and in desired dollar holdings.’ It is this criterion from American Express involves, in effect, a “call” loan by which is applied below in resolving the apparent inconsis- the purchaser to American Express, which the latter tency of including demand deposits and money market pledges to repay to the purchaser or to a designated third deposit accounts (MMDASs) in the TMS, while excluding party at an unspecified date in the future. In the meantime, checkable money market mutual fund (MMMF) equity most of the proceeds of such loans are invested by Ameri- shares. can Express on its own account in interest bearing assets, In what follows, I explain briefly why various items have been included in or excluded from the TMS. To simplify the exposition, I organize my explanation around the sev- eral Fed definitions of the money supply and of total liquid assets. while a fraction is held in the form of demand deposits t meet anticipated payments of its travelers’ check iabilici A) as they “mature.” In exchange for the foregone interest (and a small fee) the purchaser receives access to an alterna- tive payments system which avoids the risk of loss associ- ated with carrying cash payments and the potential delay Components of M1 or nonacceptance 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 transac- tion;’ 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 nerally accept edium f exchange in in the U.S. econ-ca genera ly accep! ed medium o he deposit ACTouts, with the sums paid But out ultimately Ty being omy. Federal Reserve notes of various dollar denomina- debited to the demand deposit account of American Ex- tions (as well as token coins and paper notes issued by the : hv unlikel hat fi 1 U.S. Treasury) are the “standard money” or ultimate press. Moreover, in the highly unlikely event that financia “cash” of the U.S. monetary system. havine replaced wold reverses force the issuing company into institutional liqui- be yy ise 8 dation, the holders of its outstanding stock of travelers’ i is function, at least for American citizens, in 1933. ) in this function, © f | checks would be, economically and legally, in the same Currency in the hands of the nonbank public, i.e., ex- cluding currency held by the U.S. Treasury, the Fed, and in the vaults of commercial banks, is counted in the TMS, precisely because it is the physical embodiment of the Demand deposits or checking account balances at com- boat as debtholders of any insolvent business firm, having mercial banks and other checkable deposits, such as NOW no political guarantee of a dollar-for-dollar payoff of their accounts held at S&Ls, are included in the TMS by virtue debt claims, such as that provided by federal deposit insur- of the fact that they are claims to the standard money ance and privileged access to the lender of last resort. redeemable at par on demand by the depositor or by a third party designated by the depositor. Despite the fact Components of M2 Not Included in M1 that these deposits are only fractionally backed by cash or Savings deposits, whether at commercial banks or thrif; immediately cashable reserve deposits at the Fed, their institutions, are economically indistinguishable from dy instantaneous redemption at par value is effectively guar- mand deposits and, are therefore included in the TMS. anteed by two factors. First there is federal deposit insur- Both demand and savings deposits are federally insured ance, which legally insures up to $100,000 of each and under the same conditions and, consequently, both repre- ===== PAGE 3 ===== sent instantly cashable, par value claims to the general repay the loan plus interest. When the purchase or loan medium of exchange. The objection that claims on dollars initially made, the bank debits the firm’s demand depc held in savings deposits typically do not circulate in ex- balance and credits its RP account by the amount of t © change” (although certified or cashier’s checks may be loan. On the following day, the bank repays the loan wi readily drawn against such deposits and are certainly gener- interest by reversing the process and crediting the firr ally acceptable in exchange), while not unimportant for demand deposit with a sum that exceeds the previous da some purposes of analysis, is here beside the point. The debit by the amount of the interest payment. Since t essential, economic point is that some or all of the dollars loans are maturing daily, the firm has virtually inst: accumulated in, e.g., passbook savings accounts are effec- access to the full amount of its dollars on deposit with t tively withdrawable on demand by depositors in the form bank." of spendable cash." In addition, savings deposits are at all times transferrable,” dollar for dollar, into “transactions” accounts such as demand deposits or NOW accounts.” Overnight Eurodollars are counted in the TMS for t same reason as overnight RPs: they are basically an : counting fiction that permit U.S. banks to pay interest The common-sense case for the inclusion of savings de- their business demand deposits and are therefore virtua posits in the stock of general media of exchange was co- redeemable on demand. In the case of overnight Eurod gently presented by the eminent German banker and econ- lars, deposits are made by U.S. firms in interest beari omist, Melchior Palyi: accounts at the Caribbean bank of a U.S. bank, where U + in their own minds, money is what people consider -asz~Jil interest-rate regulations have no legal force. The doll purchasing power, available at once or shortly. People’s thus deposited plus interest earned are credited daily to t “Liquidity” status and financial disposition are not firms’ demand deposit accounts held at the parent banl affected by juristic subtleties and technicalities. One Money market deposit accounts, as a hybrid of dema . . . 3 » * ’ kind of deposit is as good as another, provided it is and savings deposits, are considered part of the TM promptly redeemable into legal tender at virtual face MMDAEs are federally insured up to $100,000 per accou value and is accepted in settling debts. The volume of feature limited checking privileges, and offer par va total demand for goods and services is not affected by cashability upon demand of the depositor. the distribution of purchasing power among the di- = verse reservoirs into which that purchasing power is Although MMMF share accounts at first glance lc ! _ placed. As long as free transferability obtains from like MMDAs, they are clearly excludable from the » one reservoir to the other, the deposits cannot differ because they are neither instantly redeemable, par va in function or value... . claims to cash, nor final means of payment in exchan This requires a brief explanation of the nature A source of confusion is the identification of savings MMMFs." deposits with savings. The former are no more and no less saved’ 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 Each MMMF share represents a claim to a pro rata sh: of a managed investment portfolio containing short-te; financial assets, such as high-grade commercial paper, c ) : tificates of deposit, and U.S. Treasury notes. Although t the time being); in all three, the funds constitute ac- POs! ) y ; : value of a share is nominally fixed, usually, at one doll tual purchasing power. And it makes no difference in re ban al ER pr the total number of shares owned by an investor (abstra 4 this contexr*how the purchasing power is generatedw==jill=~::— ng Cy , ing from reinvested dividends) fluctuates according originally: dug out of a gold mine, 'printed’ by a gov- , ) market conditions affecting the overall value of the fun ernment agency, or ‘created’ by a bank loan. As a . portfolio.’ Under extreme circumstances, such as a stra matter of fact, savings banks and associations do ex- spheric rise in short-term interest rates or the bankrupt actly what commercial banks do: they build a credit p : DAnKTHP ) y of a corporation whose paper the fund has heavily invest structure on fractional reserves. in, the fund’s investors may well suffer a capital loss in t Overnight repurchase agreements or “RPs” were devised form of an actual reduction of the number of fixed-val in the mid-1970s as a means of evading the legal prohi- shares they own. Unlike a check drawn on a demand bition against the payment of interest on demand deposits. posit or MMDA, therefore, an MMMF draft does r They are, in essence, interest bearing demand deposits held simply represent a direct transfer of current claims to ci by business firms at commercial banks and therefore are rency, but a dual order to the fund’s manager to sel included in the TMS. In a repurchase agreement, a firm, in specified portion of the shareowner’s asset holdings a fect, makes a loan to a bank which is collateralized by then to transfer the monetary proceeds to a third pa N— government securities. The bank “sells” government se- named on the check.” Note that the payment process is r curities to the firm with an agreement to “repurchase” finally completed until the payee receives money, typica them the following day at a slightly higher price, i.e., to in the form of a credit to his demand deposit.? ===== PAGE 4 ===== Another feature that distinguishes checkable MMMF cally assess heavy penalties—varying from forfeiture of shares from demand deposits and MMDAEs is the fact that accrued interest to loss of part of the original principal —in the former cannot be permanently expanded beyond the the event of premature redemption. The ultimate decision limit set by the public's willingness to hold such assets. If an to exclude this item was also heavily influenced by the excess supply of fund shares happens to emerge, the conse- practical problem of obtaining the data necessary to permit ~" quence would not be the general rise in prices occasioned a reasonable estimate of its value in current dollars, i.e., net by people’s attempts to rid themselves of surplus dollars of penalty assessments. through increased spending. Unwanted MMMF shares , Components of M3 Not Included in M2 simply go out of existence, as fund investors directly re- deem them for money or use MMMF drafts to purchase Large-denomination time deposits, such as CDs issued alternative investment assets or consumers’ goods. In the in denominations of at least $100,000, are bona fide time extreme case, if the public suddenly preferred to invest liabilities, because they are not payable by the issuing insti- directly in the short-term credit market, without the inter- tution before maturity.” Since they are not par value mediation of managed mutual funds, checkable MMMF claims to immediately available dollars, they are excluded shares would simply disappear from existence. from the TMS. The same reasoning applies to the exclu- sion of term RPs and term Eurodollars from the TMS. The It is important to realize that the existence of MMMFs shares of “institution-only” MMMFs are excluded from does have an effect on overall prices in the economy, but the TMS for the same reasons asthe shares-of the “general — not because checkable fund shares constitute an addition purpose & broker/dealer” MMMFs included in M2. to the money supply. Rather, the liquidity and . checkability features of these assets permit their holders to Components of L Not Included in M3 reduce the amount of money they need to keep on hand to U.S. Savings Bonds are instantly cashable at the U.S. meet anticipated payments and to insure against future Treasury (or at banks and thrifts acting in its behalf) at a contingencies. This is also true, as we saw, of credit cards, fixed discount from their face value.* As U.S. Treasury which similarly provide their holders with access to an liabilities, moreover, their redeemability is “insured” by alternative payments system that economizes on money. By the full faith and credit of the Federal government. U.S. thus reducing the overall demand for money, MMMFs Savings Bonds are therefore included in the TMS at their and credit cards encourage a higher rate of aggregate redemption value, because they represent secure and cur” spending in the economy that results in a general rise in rent claims against the Treasury for contractually fixed prices. However, the price increase associated with a given quantities of the general medium of exchange.” In fact, expansion of MMMFs is a “one-shot” phenomenon, whose U.S. Savings Bonds may usefully be treated as specific magnitude is strictly governed by the corresponding reduc- claims against “Treasury Cash,” since this provides a ratio- tion in the aggregate desired money balances of market nale for the conventional omission of the latter item from participants. This sharply contrasts with inflation, which money-supply statistics.” typically refers to a money-supply phenomenon involving a persistent decline in the purchasing power of the mone- , persis P ng p - ties are not payable before maturity and are therefore tary unit that results from the creation of additional quan- Ca hn excluded from the TMS, tities of government fiat money, which, in theory, is lim- ited only by the onset of a hyperinflationary currency © mee" Memorandum Items breakdown. In contrast to savings bonds, short-term Treasury securi- Three items which are not included in any Fed measure Small-denomination time deposits refer mainly to feder- of the money supply (M1, M2, M3) or even of overall ally-insured certificates of deposit (CDs) in denominations liquidity” (L) find a place in the TMS. These are the demand and other deposits held by the U.S. government, of less than $100,000 and are excluded from the TMS : Cre : . foreign official institutions, and foreign commercial banks because they involve loans by the public to banks and at U.S. commercial and Fed banks. thrifts.” As time deposits, CDs nominally are not cashable on demand, but are payable in dollars only after a contrac- The somewhat mysterious exclusion of these items from tually fixed period of time ranging from thirty days to a money-supply measures is typically justified by one recent number of years. However, the fact that issuing institutions writer who claims that the deposits of these institutions stand ready to redeem these liabilities in current dollars at “...serve an entirely different purpose than the holdings any time prior to maturity does constitute a theoretical of the general public” or are “... viewed as being held for argument for their inclusion in the TMS at their current ‘peculiar’ reasons.”” This overemphasis on the particular] redemption value. On the other hand, depositors do have “motives” for holding money, as opposed to the impor- - a strong incentive to abstain from cashing small CDs be- tance of the quantity of money itself, is one of the modern | fore their maturity dates, because issuing institutions typi- legacies of the Keynesian revolution.” ===== PAGE 5 ===== Moreover, there is nothing at all “peculiar” about the ‘As a former FDIC Chairman has recently written: “The pendulun reasons for which such deposits are held. As one modern has swung once again toward 100 percent protection of depositors anc advocate of their inclusion in monev-supply statistics creditors. Despite the fact that Congress made it clear in the 1950 Ac . y-SuUpPPl that FDIC was not created to insure all deposits in all banks, in the year points out: since Congress has gradually increased the insured amount to $100,00( 1 The Treasury’s deposits are not part of its reserve In addition, the regulators have devised solutions that protect even th against money that it has issued, but are rather part of uninsured in the preponderance of cases.” (Irvine H. Sprague, Bailow the general fund of the Treasury available for meeting An Insider's Account of Bank Failures and Rescues {New York: Basi Books, 1986}, p. 32.) Moreover, the uninsured depositors who incurre« losses in a handful of recent bank failures were mainly holders o deposits in the category of “large time deposits,” which, for the reason 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 stated below, are not included in the TMS definition of the mone with which the economy operates as are the deposits supply. The FDIC's recent attempt to enforce market discipline on th of state and local governments, which are included in banking industry by leaving the uninsured holders of large time deposit adjusted demand deposits. Much the same may be in small (but not large) banks unprotected appears to have had littl . : substantive effect. On this, see R. Alton Gilbert, “Recent Changes ii said of Treasury deposits at Federal Reserve Banks. Handling Bank Failures and Their Effects on the Banking Industry, Also foreign-owned deposits at commercial banks are The Federal Reserve Bank of St. Louis Review 67 (June/July 1985): 21 included, so why not foreign-owned deposits at the 28. 72 . . . . Federal Reserve! In his refusal to include “transactions balances,” including deman Finally, pre-Keynesian monetary theorists routinely and deposits, in his statistical definition of the U.S. mpney supply, becaus properly counted “U.S. Government Deposits” in the they allegedly all cannot be spent simultaneously in any conceivabl “Total Deposits” component of the money supply.® This pattern of payments, Osborne ignores these institutional considerations . , . . . ’ . . . t Us interchanging into one another unit per unit without altering the S, oR © J a assets © N 0 non ie Public, ine uding U.S. total supply of money. (Lin Lin, “Are Time Deposits Money?” AVIS SONS anc tne net cash vatues of re msurance, which come American Economic Review 27 {March 1937}: 85.) very close to the TMS. There are no significant omissions, and the onl” TE clearly objectionable item is short-term government securities. See Al- For one of the earliest hints of recognition of the monetary function of bert G. Hart and Peter B. Kenen, Money, Debt and Economic Activity, 3rd time deposits, see Frank A. Fetter, Economics, vol. 2: Modern Economic ed. (Englewood Cliffs, NJ: Prentice-Hall), pp. 3-6. Problems, 2nd ed. (New York: The Century Co., 1923), pp. 102-103. ¥Actually, “Treasury cash” refers to the small amount of Treasury- “Melchior Palyi. An Inflation Primer (Chicago: Henry Regnery, 1961), held gold which has not been monetized by the issue of gold certificates pp. 137-38. to the Fed in exchange for Treasury deposits. Nonetheless, since this For a discussion of overnight RPs, see Meyer, Monetary Economics, p. “nonmonetized” gold stock may be converted into a stock of dollars at 28, any time, via the issue of gold certificates to the Fed, it may be consid- ered a monetary reserve for the redemption of savings bonds. On Trea- On overnight Eurodollars, see ibid, pp. 28-29. sury cash, see John G. Ranlett, Money and Banking: An Introduction to "The next three paragraphs, with some alterations, are drawn from Analysis and Policy, 3rd ed (New York: John Wiley, 1977), pp. 6067. Joseph T. Salerno, “What Investors and Depositors Should Know about "Meyer, Monetary Economics, pp.26-27. B Banks and the Financial Services Revolution,” Jerome Smith’s Investment Perspectives 2 (June 1984): 3-4. A more detailed analysis of the nature of MMMFs and of their relationship to the supply of and demand for money under the gold standard may be found in Joseph T. Salerno, ®[n analyzing the Keynesian motives for holding money, Hart and Kenen cogently argue that “We cannot divide the cash balance of a given holder into definite parts representing each of these motives. . . . “Gold Standards: True and False,” The Cato Journal 3 (Spring 1983): If, for example, he also has accumulated cash for speculative purposes, 255.58. he also has a margin of safety, so that his needs under the {precaution- ary} motive are swallowed up in those under the {speculative motive]. “For a similar characterization of MMMFs, see Meyer, Monetary Eco- Besides, the different motives shade into one another. In analyzing nomics, p. 29; and White, “Definition and Identification of Money,” p. them, it is less important to keep them distinct than to keep track of the 310. common element that binds them all together —the adaptation of business dealings to uncertainty.” (Hart and Kenen, Money, Debt and Economic “Typically, the funds establish a central clearing account at a bank. Activity, pp. 223-34.) When checks, really drafts, written by individuals are presented to the bank, it notifies the mutual fund of the number of fund shares that PBarger, Money, Banking and Public Policy, p. 53. must be liquidated to cover the check.” (Monica Langley, “Holds on © } ] ] Checks Annoy Investors in Money Funds,” The Wall Street Journal See, for example: Edwin Walter Kemmerer, High Prices and Deflaciondfl (Princeton, NJ: Princeton University Press, 1920), p. 27; Benjamin M. 2) (November 11, 1986), p. 39. Anderson, Economics and the Public Welfare: A Financial and Economic As White points out, “... the item that the check-writing MMMF History of the United States, 1914-1946, 2nd ed. (Indianapolis: Liberty customer relinquishes (ownership of shares in a portfolio of assets) is not Press, 1979), pp. 98, 183, 265; and Palyi, The Twilight of Gold, p. 36.