Paul van Eeden

The Actual Money Supply
July 4, 2008

There is a lot of debate going on about the inflation rate. Are we in an inflationary or deflationary environment? What can we expect going forward? There are no obvious answers, partly because the debaters don’t really know what money is, how to measure the money supply or how to calculate the inflation rate. Even Alan Greenspan could not define money (link).

For something we use every day and that is an integral part of our lives, it is remarkable how little we know about money.

When the money supply increases (inflation) money loses value (prices rise). Because the money supply is almost always increasing (inflation), and therefore decreasing the value of money, it means that our standard of living is eroded over time if our income is fixed, or not rising as fast as the inflation rate (the rate of increase in the money supply). Yet there is no credible measure of the inflation rate. I have been searching for an answer to the actual inflation rate for more than a decade and there was none that I felt was accurate enough, so I had to turn to first principles. Let’s start with how money is created, and then define how much money exists. From that, finally, we’ll know the actual inflation rate.

All currencies today are fiat currencies. “Fiat” means a decree, or an arbitrary order, so fiat money is money created by decree. It has no value in and of itself and exists only because of legislation. Without legislation, such as a law that requires taxes to be paid with a particular fiat money, or that forces the acceptance of fiat money for the settlement of debt, such money would probably not be accepted out of free will. Since fiat money can be created merely by decree, inflation (the rate of increase in the money supply) is therefore constrained only by the discipline of politicians and the central bankers who create the money.

The banking system is called a fractional banking system because banks don’t actually have the money to back the deposits their clients have made into their accounts. Instead, the banks are required only to keep a small fraction of such deposits on hand. When something with inherent value, such as gold, is used for money banks often go bankrupt under a fractional banking system since they do not have sufficient reserves to repay their depositors’ money. However, in a fractional banking system based on fiat money banks need never go bankrupt, since the central bank can create an unlimited amount of new money to repay any demands from depositors. The limiting factor is only the public’s acceptance of fiat money.

In the absence of a fractional banking system all the money in the system is physical money, such as notes and coins. We would know at all times exactly what the money supply is: it is the total of all the notes and coins. We would also know exactly what the inflation rate is: it is the rate at which the total amount of notes and coins increases. In such a system inflation can only occur by the creation of more physical notes and coins, whether it is fiat money or hard money, such as gold.

However, in a fractional banking system defining what constitutes the money supply is not so simple, which is why it is such an enigma and why the real inflation rate is so obscure.

While central banks can influence the money supply directly, most of the money that is created is actually created by commercial banks when they make loans to borrowers.

If I went to my bank and arranged a car loan, no money would have been created when the loan was created, but when I bought the car and the car dealer deposited my check into his bank account an amount of money equal to that payment would have been created in his account. My bank doesn’t actually have the money I borrowed but when the car dealer deposited my check into his bank account, his bank balance increased. The system balances because the increase in his checking account is the same as the increase in my debt (car loan) to my bank. But, remember, my bank account balance did not decline by the amount of my purchase, my debt increased instead.

Not all liabilities create money. When a corporation issues a bond to the public no new money is created – the money merely moves from the public’s accounts to the corporation’s account. But when the same corporation borrows money from a bank, money is created and the money supply increases. Only money borrowed from a bank increases the money supply since the banks create the money they lend out of thin air. The only restrictions to the creation of money are rules that determine how much capital and reserves banks should have in proportion to their assets and liabilities, and the willingness of borrowers to assume more debt.

Now let’s look at some accounting. My car loan is debt I have to pay to my bank and it is therefore an asset of my bank. The car dealer’s checking account is money his bank owes him and is therefore a liability of his bank. From a bank’s perspective, all of its clients’ deposits (checking, savings and term accounts) are liabilities while clients’ loans, such as mortgages and car loans, are assets.

Notice that the extension of credit by a bank does not in itself constitute an increase in the money supply until the moment when that credit is used to pay for a purchase. The money supply then increases by an amount equal to the purchase price. The credit limit on a credit card is not money but every time you use that credit card to make a purchase the money supply increases by the purchase amount.

Conversely, when bank loans are repaid the money supply decreases. History shows that bank loans (in the US at least) have been growing, meaning that new debts are created faster than old debts are paid off and that, in short, is the inflation we all know exists but were not able to quantify.

Since all our money exists either as currency (notes and coins) or in bank deposit accounts we can measure the money supply merely by adding the currency in circulation to all bank deposit accounts. I call this method of measuring the money supply the Actual Money Supply (AMS).

Here is a comparison of the components of AMS and other monetary aggregates that were created to define money supply in
the past.

Below is a chart comparing M1, M2, M3 and AMS up to and including May 2008. M3 data since February 2006, when the Federal Reserve stopped publishing it, were obtained from John Williams (link).


You can see that AMS:

  • is substantially greater than M1 because M1 excludes too many deposit accounts that should be counted in the money supply,
  • is approximately the same as, but not identical to M2 since M2 includes retail money market mutual funds that are not money, but financial assets, and excludes large time deposits which are money,
  • is less than M3 because M3 includes both institutional and retail money market mutual funds, repurchase agreements and Eurodollars that should not be included in the money supply.

Money market mutual funds are not money; they are securities (investments) like short-term bonds. Repurchase agreements are not money either; they are contractual obligations to swap assets. While Eurodollars are money, they reside in a separate banking system and do not affect the US money supply.

M1 is a woefully inadequate measure of the money supply since it excludes too many deposit accounts that should be counted in the money supply. M2 both excludes large time deposits that should be included in the money supply and includes retail money market mutual funds that should not be included. It is therefore an incorrectly constructed measure of the money supply and therefore inaccurate. M3 includes data that is not money at all and grossly overstates both the money supply and the inflation rate. It is now possible to see why the Federal Reserve abandoned its monetary aggregates as tools for monetary policy. As Greenspan said, they didn’t work. As an example, the flow of money in or out of money market mutual funds reflects market conditions and sentiment, and is not an actual increase or decrease in the money supply yet such flows would affect both M2 and, especially, M3. AMS measures the actual money supply and therefore allows us to now calculate the Actual Inflation Rate (AIR) of the US dollar.

Below is a chart showing the Actual (annual) Inflation Rate (AIR) from 1901 to 2007 as well as the interest rate on 3-month US Treasury Bills for comparison.

In this chart we can clearly see the inflation of the Roaring Twenties after the Federal Reserve Bank was created, two periods of dramatic deflation caused by bank failures when the US was still on a gold standard, the inflation during the Second World War, the broad based inflation during the 60s and 70s, the decline in the inflation rates during the 80s and the steady increase in the inflation rate since 1991.

The inflation rate during the 60s and 70s appears less dramatic than the inflation during the Second World War, but that is misleading. The total inflation from 1939 to 1945 was 151% while the total inflation from 1960 to 1981 was 396%. There may not have been a spike during the 60s and 70s as spectacular as the 31% inflation rate of 1943, but a broad based, persistent inflation is much more devastating over the long run. It is precisely such broad based and persistent inflation that we have seen lately, and why I believe we are starting to see such erratic and wild price swings in hard assets and commodities. The average annual inflation rate from 1960 to 1980 was 7.84% and the average annual inflation rate from 2000 to 2007 was 8.20%. The average inflation rate for the first five months of this year is 8.51%, so we are clearly in an inflationary environment as bad, or worse, than the 1970s.

Inflation devalues the currency and leads to speculation because people realize that their money is losing value, so they try anything they can think of to maintain their purchasing power. Since 1991 we have seen 182% inflation – that is already significantly more inflation than during the Second World War!

It is of paramount importance to realize that inflation is an increase in the money supply that will cause prices to rise. Inflation is not an increase in prices itself. Prices can rise due to changes in demand or disruptions in supply and can decrease as a result of technological advancements that lead to increased productivity. But regardless of what else may influence prices, prices will always rise in excess of where they would otherwise have been as a result of inflation -- which is an increase in the money supply. This is why knowing the actual money supply and being able to calculate the actual inflation rate is so important, and now we can do it. The average annual inflation rate for the eight years from 2000 to 2007 is 8.20% and the inflation rate for 2007 is 7.92%. The average year-over-year inflation rate for the first five months of 2008 is 8.51%. The year-over-year inflation rate for May 2008 is 8.10%. So, as you can see, the money supply is still increasing.

My prior reliance on M3 to gauge changes in the money supply caused me to over-estimate inflation. The Actual Money Supply (AMS) and Actual Inflation Rate (AIR) will give us much better insight into what is happening in the economy and will also help us make better decisions about the future.

Paul van Eeden

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