Saturday, March 12, 2011


The concept of the money supply is central to understanding events and prospects in modern, mixed economies. What the money supply is doing, and what the manipulators of the money supply are doing, are key indicators of immediate and intermediate economic events. In my blog, I refer to the money supply often. Analysts and writers who are influenced by the Austrian school of economics, and here, as always, I am referring to von Mises and his predecessors, will refer to the money supply in understanding business cycles in modern, mixed economies. So, how do we know what is happening with the money supply?

From the U.S. government we have several measurements of the money supply, called M1, M2, and M3 (no longer published). There is also MZM, my preference generally. There are also indicators such as the balance of payments, for indications of the outflow of money. Another important tool to keep in mind is the changing level of bank loans. The past two asset price inflation events have both been created by bank loans. Finally, there are some private measurements available at various websites.

As with any measurement, it is absolutely necessary to clearly understand what is being measured, how, and how those measured elements relate to your conceptual framework. You must also know how the measurement in question performed in the past, i.e., what the results meant and how the economy performed.

All too often, what I see when reading other authors is that they have chosen tools that reinforce their own expectations. They ignore other tools that currently are pointing in other directions. That is especially true of the people who are expecting hyperinflation in today’s world. I certainly sympathize with the hyperinflationists. There is reason to be concerned, from what I can see. But I do not accept their knee jerk approach.

My approach is to look at all of the indicators that I have identified and try to make sense of them and what is happening in the economy.

One indicator can also be the interest rate set by the Federal Reserve Board. One influential online group recently used the argument that since the Fed had set the Reserve rate at zero, there had been billions of dollars created. In other words, it was automatic. If the interest rate is set well below a market rate, then money will be created. This same reasoning occurs when the Fed creates reserves. For example, in 2008, the Fed created nearly $1T in member bank reserves. People immediately said that the Fed had created billions of dollars in the economy. But, there is a difference here. Lowering the interest rate and creating reserves are not the same as actually printing money. Printing money and shoving it into people’s hands through government handouts or expenditures or payrolls put money into circulation immediately. That money is in play.

But the actions of the Fed are different. The Fed can create reserves and lower interest rates, but the Fed depends upon the banks and businesses to actually put the money into play. If the banks do not lend (which requires a borrower) then nothing happens. That is what we have seen over the last two years. The Fed has tried to put more money into play, but the banks have not cooperated. The Fed’s influence is not automatic. The claim that low interest rates have created massive amounts of money is not substantiated by the level of bank loans and other indicators, e.g., MZM. It is important to objectively understand how this stuff works.

I saw an argument that claimed that it is wrong to argue if the money supply has expanded or not. According to this person, looking at the facts was not thinking in principles. Instead, he said that we should state that the Fed is, “The reality is that money has been created out of nothing and it therefore will alter behavior (otherwise why do it?). … that this money has created price increases in several sectors, commodities and oil among them, despite the ‘we haven't really increased the money supply’ theory.” Somehow, for this person, thinking in principles does not include relating one’s ideas to the real world nor having a sound, fact based argument for our position. We merely sate that the government has made money that raised prices without being able to even demonstrate it, not to mention, prove it. It does not include looking at the present, specific situation and making sense of it or presenting your position in the context of the crisis we actually face. I do not know how this person thinks that we can be convincing or persuasive.

Some will then point out that the Fed has recently been buying Treasuries from the Government directly, thus putting newly made money directly into the economy. That is true. That step leads directly to expanding the money supply and to affects in the economy, generally, to increases in consumer prices. However, given the size of the economy vs. the amount of purchases the Fed has made, the effect is not particularly significant. We would have to see closer to $1T of Fed direct purchases from the Treasury for the Fed to trigger consumer price rises.

Potentially more significant would be the return of sizable amounts of the dollars held overseas via Treasury Bond purchases. With a $1.7T deficit, if $1T was financed from overseas, we would see a mammoth flooding of dollars flooding our markets. This returning money, often as much as $500B in the past few years, has been a source of some of our price inflation. Higher amounts would put more pressure on prices.

Yet another recent argument that I have seen implies that in today’s world, real market forces (as opposed to governmental influences) have no impact on prices. The field of play, this person held, is controlled completely by governments. Again, there was no attempt to demonstrate how this is so. The position was presented as necessarily following from the fact that governments act and have bad influences, there were bad events happening (the raising of oil prices), therefore, it was completely because of government intervention. No facts about the current situation were necessary.

Thus, it is important to look at the various moving parts of the make up of the money supply and their impact. Then, it is imperative that your understanding relates these different measuring tools to the real world in an objective manner. For example, look at M2 , the simple view would be that inflation is rampant and that prices should be going through the roof. But have they? I just saw an observer on PJTV who kept track of his expenditures of a few items over the last year. His personal stats did show across the board significant price increases. What is your experience? Mine has been that there has been little change for some time, with some bigger increases just recently. Even if prices are going up, does that mean that the hyperinflationists are correct in saying that general, average price increases of 20% or more (hyperinflation) are beginning soon? That is a big jump.

Some argue that because certain prices went up, there is inflation. Most recently, these are the prices of gold, oil, and food commodities. But prices go up and down for various reasons. That is especially true in a “mixed economy”, where government actions have hidden, unforeseen, and often weird, effects. You have to be careful when attributing reasons for price movements, which means actually finding a cause and effect. For example, the decades old efforts by governments around the world to control oil discovery and production in many different ways means that there are restrictions on production and supply. The result is an artificial shortage of oil. Supply shortages would mean higher prices, given level demand. In our situation today, and for the last several years, demand is actually growing. So you have three different factors pushing the price of oil upward, including whatever inflationary pressure there might be. But the price would be going up anyway. When discussing the price of oil, you cannot objectively leave out the supply restrictions and all of the reasons for increases in demand.

Turning back to the analysis of the money supply, my overall point is that many things are happening within an economy that will affect whatever actions governments take to manipulate the money supply. How it plays out and what the ultimate effect will be depends upon those factors. To accurately explain events, you need to have identified the actual causal connections and explained other details that may seem to be contrary to your conclusion. A site or writer who ignores those contrary elements only means that they are pushing their pet theory without actually relating it fully to reality. Economics is a difficult science, but it is a science. Economics is about the real world, and one’s standard of truth must be consistency with reality.


  1. But what exactly *do* the M1 and M2 reports measure? It *looks* as though both indicate a general expansion of the U.S. money supply up to the present day.

    I've been reading a lot from the NIA (and watching a lot of their videos). It predicts that the U.S. will enter a hyperinflationary depression this decade, likely by 2015. By its nature it is a frightening prospect; it would be worse than a second great depression brought about by the Federal government defaulting on some or all of its debts. Law and order would break down. People who had not prepared by stocking up on precious metals and other commodities would have to become violent criminals or starve to death--and the crime rate would skyrocket beyond anything most Americans can imagine. I would *like* to think that we shouldn't be as certain of that outcome as the NIA claims, but their articles and videos seem reasonable. It makes a *huge* practical difference. For example, the question of whether to move to another country (such as Australia) depends on how certain I should be of that outcome.

  2. Also, judging by Yaron Brook's apearances on PJTV's _Front Page_, he seems concerned about "stagflation" and a second depression (presumably brought about by Federal debt default), but not very concerned about hytperinflation. He has a PhD in economics (or something related). I wonder if his reasoning about this is similar to yours.

  3. I also read NIA, but their claims are generally based upon what supports their claim: that the U.S will experience hyperinflation. They tend to ignore what doesn't support their position. They tend to grab on to anything that supports their claim, even if it is really trivial. They have explicitly stated that claims of drought, which would imply lower crop yields, is merely a cover-up by the media so that you won't realize the level on inflation. You have to look at their stuff very critically, ask how important the facts they bring forward are, and know enough economics and the news of the day to make good judgments about their specific claims. If you look back at some of my posts on inflation and on the debt you will see that I have talked implicitly about their posts several times.

    As I have said before, their single-minded focus on inflation means that they ignore other problems. If people get tired of waiting for the hyperinflation, they may miss the destructive power of Obama's continuing deficits and debt.

    In my opinion, M1 & M2 measure small portions of the money supply. Few people actually use currency. Further, it is estimated even by the government that two thirds of our currency is outside the country. I prefer MZM because it measures a wider set of deposits and assets that people and businesses use for transactions. But you then also need to also look at bank loans, because that is the source for asset inflation, e.g., securities and real estate. Finally, the balance of payments, which has been in deficit for at least two decades, tells you how dollars are building up overseas. Some of these dollars are coming back in loans to the Federal Government and become a means of direct insertion of made-up money into the economy.

    One problem with people looking directly at M1 or M2 is that, while they seem to going up rapidly, we have not seen a similar (high) steady rate of increase in consumer prices. Something is happening there that inflationists like NIA cannot explain, or at least do not explain. To anticipate the threats and what to do about them, things like M1 vs. consumer prices have to be explained.

    Thanks for the questions.

  4. Is the second entry the same anonymous?

    Yaron Brook has a degree in finance. I have been surprised and pleased to find something he says on PJTV to be consistent with something I have written. Sometimes, something he says spurs me to write, which is the case, in part, with the potentially of a depression . And, I find that my thinking is consistent with the reasons he gives. As I said in my post from Thursday, I agree with his estimation of the threat of the debt.

  5. You posit that debt is the largest of the many deleterious policies affected upon us by our congress and downplay the effects of the governmental increase in money supply. The fact that at this time and over the past ten years the US is and has been exporting inflation to foreign countries is irrelevant according to your thesis, since US prices are not on the rise - yet that is.

    I look to economics to determine a course of action for spectulation and investment purposes.

    The fact that bank reserves haven't entered circulation -yet- nor the because foreign countries are still importing our monetary inflation is a non event for US prices. The problem is that the tide has gone out way too far and that by the time the wave hits the beach it will probably be too high to make any last minute preparations. According to your arguments, the hyper infationists and inflationists are speaking in hyperbole.

    Debt default and hyper inflation are two sides of the same coin. If I was to wait to see how high the wave that is coming at us is going to be, I would be washed away as most Americans will be.

    As you state Macro Economics is a complex science, but how many factors need to add up before you say that the current US policy of dollar debasement via monetary inflation are a threat and that the way the US Fed/Treasury is going to deal with the debt level is through inflation.

    I would not recommend waiting and acting until after prices have gone throug the roof to prove an academic point.

    PS. Yes, I do believe that the US debt level is absurd. However, given the history of the US, Congress, the treasury and the Fed- how is the US going to pay for our current debt level?-none other than by inflation. And if the US was to default, what then would the dollar be worth?

    and which are not letting their currencies fallImplying that becasue

  6. CW, you say "Some will then point out that the Fed has recently been buying Treasuries from the Government directly, thus putting newly made money directly into the economy. That is true."

    How exactly does the Fed print money when it buys treasuries under QE2? The Fed simply buys treasuries from the dealers in exchange of reserves. As you correctly say earlier, for the money supply to increase, these banks need to lend (create deposits). Clearly, the Fed does print money in its open market operations, but not through QE2.

  7. Anonymous (of March 24, Sorry for the delay, I had other things going on.), allow me a small clarification, I don’t think that the hyperinflationists are engaging in hyperbole. I think that they are not making real connections, i.e., real science. Their approach is not consistent or rigorous.

    There is a potential for consumer prices to begin rising at a much higher rate in the future. But it is a potential, not guaranteed, as the hyperinflationists would have us believe. We must continue watching and working to figure things out.

    On the other hand, the debt is there now and rapidly growing. The debt is more than a potentiality. The effects of Obama’s budget, this year’s and the continuing shortfalls in Medicare and Social Security, and the staggering growth in those programs in the coming years are all actualities, unless an amazing change in attitude occurs. My point is that when the your ship is heading for the rocks, you don’t worry more about some other potential problem. You are certainly right, the government might choose to inflate its way out of the debt, but it is the debt that will send us into an economic depression, it just isn’t clear what the exact path will be. Take care of the debt and we have a fighting chance with the other problems. Before Obama, the Medicare and Social Security mess was still coming, but still a few years away and we could worry more about the inflation potential. The ObamaDeficit and the resulting debt levels have made the other issues secondary. Either way, higher rates of consumer price rises are potentials. The debt mess is a certainty.

    I have argued for the last two years that the U.S. is exporting inflation (and has been for a couple decades). It still is. The amount being exported is not growing particularly, so the marginal impact around is maybe less, certainly not more. The real potential harm to us, a rapid return of those dollars to our markets, doesn’t seem to be imminent. I don’t see anyone precipitating a rapid sell off of dollars. It wouldn’t be good for anyone. There is a problem and it will need to be fixed, but doing it quickly would be dumb. Further, I don’t think many people on the international level realize there is a problem, for whatever reason. China, for example, is causing its own problems. It would have price inflation and the consequences of its pegged currency without the U.S. inflation. Its own policies are as bad as the ones the U.S. is following.

    I expect to see a rise in the interest rates before a large dose of price inflation. It will be interesting to see what the Fed does (as well as the Treasury and other countries) when interest rates begin to rise. That will tell us more about what path we will take.

  8. Anonymous of March 30, when the Fed buys from the Government directly, it writes a check of newly made-up money and places it into the Treasury’s account at the Fed. The Treasury can write checks on that account directly and that “money” immediately goes into circulation. When the Fed buys normally, it buys the bonds from the banks and puts the made-up money payments into the member bank’s Fed deposit account, which, under the current setup, the bank can either take out and expand its lending or leave in place and earn a little (very little) interest. So there is a significant, direct difference in the effect of how the Fed does business. (For a more through discussion of the Fed’s capabilities, see my blog posts on the Fed and the money supply.)

    I am not sure that I understand your distinction between open market operations and QE2. Nor do I see a necessary connection between QE2 and purchases directly from the Treasury. Either way, it doesn’t matter. What matters is where the “money” goes, i.e., which account.

  9. This comment has been removed by the author.

  10. It is so weird to look and see that it says that a post was removed by me. I accidentally posted the same material twice, so I deleted the redundant copy. No big deal. Sorry.

  11. CW, the Fed does not buy government bonds directly from the Treasury, it buys them through its designated dealers. In fact, if you look at the latest Fed balance sheet, the Fed still owes the Treasury about $125 billion that it borrowed in late 2008 in the SFA account.

  12. Okay, Anonymous, okay. I was being too simple in my presentation. So let’s look closer. It is necessary to look at how the money moves to tell what the Fed is doing. The Fed takes very precise, different steps in different transactions which have very different effects. That is the problem with your comment about a “loan” from the Treasury. The Fed classifies that transaction in a particular way and follows set procedures as to how it can handle that money. How it treats that “loan” is vastly different from how it can treat other transactions. As I understand your brief comments, Anonymous, there is no way for the Fed to get money directly to the Treasury and those people who are complaining that the Fed is “monetizing the debt” are completely confused. The question is, “Is the Fed directly funding the Treasury in some fashion?”

    In the normal Open Market transactions, the Fed buys and sells treasuries held by the banks (not actually an “open market”). That is because its purpose is to manipulate the reserves of the banks. When the Fed buys from some other source than the banks, the bank has to worry about putting money in or taking money out of the account of the third party. When the Fed buys from or sells to the bank, it is the bank alone that is affected. The bank has either more or less reserves than it had before and adjusts its lending.

    When one of the select bond dealers buys bonds at the Treasury auction, it gives a check to the Treasury which the Treasury deposits in its account at the Fed. The Fed then deducts the money from the dealer’s bank’s Fed reserve account. Then the bank deducts the funds from the dealer’s checking account. The bank has the choice of keeping the money at the bank or moving it to its Fed reserve account to keep its reserves at the previous level. If the bank keeps the money, in most circumstances, the bank actually reduces the level of lending that it can maintain. So the tendency is to replace their reserves. I say “most circumstances” because the level of reserves for major banks since September, 2008 has been close to ten times previous levels. The bottom line is that when the dealer buys in normal circumstance, there is no increase in the money supply. The Fed has not created money.

    On the other hand, when the Fed buys recently auctioned Treasury Bonds from the dealer, the Fed puts the purchase money into the bank’s reserves, replacing the amount that the Fed had previously taken when the dealer bought the Bonds, and the bank puts the money back into the dealer’s account that it took out. The dealer and the bank see their accounts even out. There is no change in their situation at the end of this two-step transaction. However, there is new money in the Treasury’s Fed account and the money supply has been expanded. No, the Fed did not buy directly from the Treasury, but the consequences, when all of the moving about has finished, are the same.