What is the Money Supply?

In the EPJ Daily Alert, I have been reporting that money supply growth has been crashing. Near the start of the year, three month annualized money growth was around 11.2%. It is now at 2.2%.

I use the Fed's money supply measure M2 (non-seasonally adjusted) to calculate the growth.  If the slowdown in growth continues, it suggests that the Fed manipulated economy will slow once again and that the stock market is likely to once again crash.

But is M2 the correct measure of money supply? Often, I get questions like this from EPJ Daily Alert subscribers:

Fellow Austrian (Ed Buges) says money growth is actually much higher than your M-2. He removes MMF and Time Deposits which he says are double counted? Question: Do we have higher (2 X) money growth than your calculation?

Before I go into a discussion of whether money market funds and time deposits should be included as part of the money supply, it should be noted that it is not as easy as one might think to define exactly what the money supply actually is.

Here is Nobel Prize winning economist Friedrich Hayek, in a critique of Milton Friedman, making just this point about defining money:

The idea that money market funds should not be considered part of the money supply came about because of a measure of money supply developed by Murray Rothbard, now called the True Money Supply.

In his book, The Mystery of Banking, Rothbard wrote with regard to money market funds:

For money market funds rest on short-term credit instruments and they are not legally redeemable at par, much like savings deposits. The difference seems to be that the public holds the savings deposit to be legally redeemable at par, whereas it realizes that there are inevitable risks attached to the money market fund. Hence, the weight of the argument is against including these goods in the money supply.

But it is curious that in his book, America's Great Depression, Rothbard included the surrender value of life insurance policies as part of the money supply (my bold):

Life insurance surrender liabilities are our most controversial suggestion. It cannot be doubted, however, that they can supposedly be redeemed at par on demand, and must therefore, according to our principles, be included in the  total money supply. The chief differences, for our purposes, between these liabilities and others listed above are that the policyholder is discouraged by all manner of propaganda from cashing in claims, and that the life insurance company keeps almost none of its assets in cash---roughly between one and two percent.

It is difficult for me to see how Rothbard could include the cash value of insurance policies as part of the money supply and not the new development, since he wrote AGD, of money market funds. I would venture to guess that most of the public that holds money market funds sees them as immediately redeemable with no risk, which would meet Rothbard's criteria for money.

Indeed, after excluding money market funds from the money supply, Rothbard writes in The Mystery of Banking:

The point, however, is that there are good arguments either way on the money market fund, which highlights the grave problem the Fed and the Friedmanites have in zeroing in on one money supply figure for total control.

In other words, he wasn't as hard core against including money market funds as part of the money supply as some would believe.

But a very signifiacnt reason as to whether something should be considered part of the money supply is How  important an impact does the factor have on such things as the capital structure and price fluctuations? Joseph Salerno, who sides with Rothbard in arguing that money market funds should not be counted as part of the money supply, nonetheless, I believe, provides the best argument as to why money market funds should be considered as part of the money supply. He writes in Money, Sound and Unsound:

The existence of MMMFs does have an effect on overall prices in the economy[..]

He adds that this does not mean it is part of the money supply but:

Rather, the liquidity and checkability features of  these assets permit their holders to reduce the amount of money they need to keep on hand to meet anticipated payments and to insure future contingencies. 

I would argue that it is simply a case of money being held as money market funds, instead of, say, as demand deposit money, since they pretty much accomplish  the same thing. But, further, if one of our goals in watching money supply is to get a sense for what type of price inflation we might expect, and money markets have an impact on prices, then we sure ought to watch what is happening to the size of money market funds, when we are considering money supply.

(Note: Salerno likens money market funds to credit cards, which he says can also impact prices--true to a degree, but I would argue that credit cards are a different animal then money market funds, since a liability is taken on when a credit card is used.)

As for Buges not including small denomination time deposits (CDs), my views are in line with those of Salerno:

As time deposits, CDs nominally are not cashable on demand, but are payable in dollars only after a contractually fixed period of time ranging from thirty days to a number of years. However, the fact that the issuing institutions stand ready to redeem these liabilities in current dollars at any time  prior to maturity does constitute a theoretical argument for their inclusion in TMS [The True Money Supply] at their current redemption value.

Bottom line: It is best to look at the factors that do have a very close impact on prices (either consumer or capital goods prices), and include them as part of the money supply. Money market funds and small-denomination time deposits (CDs) fit this criteria.