The dispute about the true money supply

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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 thing that is broadly accepted as medium of exchange against products and services traded.

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.

Conclusion

The inclusion by some economists of savings and similar deposits in the true money supply is the result of a failure to consistently apply the definition of money. All their argumets 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?