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According to the British newspaper the
Telegraph from 26 of May US money supply M3 (the Fed doesn’t publish
this data any longer) displays a visible decline. The yearly rate of growth
of this measure of money stood in April at minus 5.3% against minus 4.3%
in March and plus 5.2% in April last year.
Economists that follow M3 are alarmed
with the sharp fall in this measure of money. They are of the view that this
large decline might be pointing to a nasty recession ahead. Most economists
that have expressed concern to the Telegraph about the large fall in M3
belong to the monetarist camp, which was formed by the late professor Milton
Friedman. Some of them hold that the plunge in M3 is on account of regulators
forcing the banks to raise capital asset ratios. It is held that this forces
banks to shrink their assets, which is blamed for the shaky economic
recovery.
Monetarists, or Friedmanites, are of the
view that the Fed is running the risk of repeating the errors that plunged
the US economy and the rest of the World into the Great Depression of
1930’s. According to monetarists the Fed then allowed the money supply
rate of growth to fall sharply. By July 1932 the yearly rate of growth of M3
stood at minus 14.7% (see chart). From this it follows that the Fed
should aim at reversing the current fall in M3 as soon as possible to prevent
an economic disaster.
It is quite possible that monetarists
are reaching valid conclusions with respect to the economy in the months
ahead. We are of the view however, that money M3 is not a valid measure of
money.
In order to account correctly for money,
one must make a distinction between money that is deposited and money that is
loaned out.
When an individual exchanges goods for
money he in fact increases his demand for money and when he lends his money
he is lowering his demand for money. Individuals can exercise their demand
for money in a variety of ways. For example, they can keep money in a jar, or
under the mattress, or in their wallets, or place the money in a bank
warehouse. From this it follows that the overall amount of money in
individual holdings should be the sum of money they hold in bank warehouses
also known as demand deposits plus the money they hold outside banks
warehouses.
This, in turn, means that the inclusion
of various term deposits such as large time deposits and money market mutual
funds deposits into the definition of money such as M3 produces an erroneous
account of the amount of money in the economy.
For instance, Tom places $1,000 into a
long-term saving account with Bank 1. The bank in turn lends this $1,000 to
Mike. This type of transaction temporarily transfers the ownership of the
$1,000 from Tom to Mike. Consequently, to add $1,000 in Tom’s long term
saving deposit into the definition of money will lead to double counting
since this money resides either in Mike’s pocket or in Mike’s
demand deposit.
Following this line of thinking, one
could easily note that, notwithstanding popular practice, money invested with
money market mutual funds (MMMFs), which is part of M3 definition must be
also excluded from the money supply definition. Investment in a money market
mutual fund is, in fact, an investment in various money-market instruments.
The quantity of money is not altered as a result of this investment; only the
ownership of money has temporarily changed. Including investments in MMMFs in
the money definition will only lead to a double counting again.
If one wants to use money supply as a
predictor of future economic events one must ascertain what money is all
about. This of course means that various credit transactions must be excluded
from the definition of money. Once one adjusts for credit transactions one
will get a clean monetary measure, which we have labeled AMS (the Austrian
School of Economics money supply).
Now contrary to M3 the growth momentum
of AMS currently shows a visible bounce. The yearly rate of growth stood at 4.7%
so far in May against 3.5% in April. We suggest that a major threat to
economic activity, or to be more precise to bubble activities, is the fall in
the yearly rate of growth of AMS from 32.9% in November 2008 to minus 10%
by November last year. Also note that the yearly rate of growth stood at negative
figure during October to December last year.
Contrary to monetarists more pumping by
the Fed can make things much worse. It will only weaken the process of real
wealth generation further and undermine the pool of real savings — the
key for economic growth. Also note that if the pool of real savings is in
trouble then banks are likely to encounter difficulties in finding good
quality borrowers i.e. wealth generators. In the framework of a declining
pool of real savings a lowering of banks capital asset ratios is not going to
make banks to expand their lending. Obviously one could try forcing banks to
expand lending. This type of lending, given that the pool of real savings is
in trouble, would amount to the creation of credit out of “thin
air”. So even if this type of credit were to revive the rate of growth
of money M3 it will not be able to revive the economy if the pool of real
savings is in trouble.
On the contrary such type of lending,
which is not backed up by real savings, will only further dilute the pool of
real savings. (Also this type of lending will erode further banks quality of
assets).
We suggest that it is on account of
previously loose monetary policies that the pool of real savings is currently
in trouble. It is the fall in the real savings that causes banks to shrink
their lending, which is mirrored by the fall in M3. This however,
doesn’t imply that the Fed should start pushing more money to reverse
the rate of growth of M3. Pushing more money will only make things much
worse.
Contrary to monetarists we suggest that
in order to lay the foundation for a meaningful economic recovery the Fed
should stop the money printing machinery as soon as possible. Printing more
money only weakens the pool of real savings and weakens prospects for
economic recovery.
Frank Shostak
Frank
Shostak is a former professor of economics and M. F. Global's chief economist.
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