Wednesday, June 2, 2010

The Shostak Inconsistencies

Frank Shostak is out with an article at that argues that money market funds should not be considered part of the money supply. I will argue that he is in error because his argument looks at the wrong part of the transaction. Indeed, I will argue that he implicitly looks at a similar transaction differently from the way he looks at money market funds. Thus, there is internal inconsistency within his article.

Here are the details.

Shostak is dismissing the concerns about the huge decline in M3, and while we focus on M2, when monitoring money supply (which is showing zero growth, rather than a decline) the general argument still holds.

Shostak writes, and this is where his confusion begins:

In order to account correctly for money, one must make a distinction between money that is deposited and money that is loaned out.
He continues:

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.

Here's where his confusion becomes obvious:

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.
Notice that Shostak doesn't mention demand deposit money that is loaned out. In such a case, the recipient of deposited demand deposit money and the original depositor of the demand deposit use their funds in the economy bidding for goods and services. Thus, the key IS NOT, as Shostak originally states, whether money is loaned out or deposited BUT which accounts are in fact actively used in the economy at any given time.

Since M3 includes money market funds and large time deposits, some of the supply (the money market factor) is indeed money, but not the large time deposits. Why so? Because money market money is out being used actively in the economy. Some people use money market funds  to pay their monthly bills, from rent to electric bills etc. Thus, it is actively being used. M2 incorporates this, but does not include the non-money large time deposits (No one uses a large time deposit to pay bills). This is why I use M2 instead of M3. However, Shostak dismisses M2, as well as M3, because of the inclusion of the money market funds measure.

Yet, it should be clear that if he identified how demand deposits are used in his money supply measure which he labels AMS, it would become clear that he is caught in an inconsistency by including demand deposits and not money market funds, since demand deposit money is loaned out bidding up goods as is the original depositor of the demand deposit funds. Further, it would reveal his confusion of his definition of money as being determined by "the distinction between money that is deposited and money that is loaned out."

From here, Shostak does reach the same conclusions that an Austrian monitoring M2 would that there is a slowdown in money printing that should result in a slowdown in the economy (a double dip) and a decline in the stock market, like the type we are currently witnessing.

However, AMS and M2 do not always move in tandem. For example, during a flight to safety, many may (as they did during the recent crisis) move funds from money markets to cash or demand deposits. This is a move within the forms of money and will give false signals to anyone watching AMS. AMS watchers will interpret this as a huge growth in money supply when it is a transfer between types of money.

Bottom line: Keep an eye on M2 to understand what is going on with the money supply not Shostak's AMS, which, btw, is based on Murray Rothbard's True Money Supply.


  1. I'm not an economist, but it would be interesting to hear Shostak comment on your comment. It seems to me that most economists didn't see the crisis coming, but the Austrians did (I know, I know..even a stopped clock is right twice a day). For economic prognostications, just who are we to believe?

    -Confused in Maryland

  2. So EPJ censors posts....interesting.

  3. Hopium,

    You have on at least two occasions, maybe others posted on subjects unrelated to the topic of the post. In one case you linked to a story about a hole in the ground. In the NY State Delays paying its bills post, you linked to an absurd article about Goldman Sachs selling BP stock before the Gulf of Mexico disaster, as if there was some kind of connection. Stay on topic and don't ever try to mislead about censorship again.

  4. RW, I'm not so sure about your thing about people selling off MMFs and moving into straight cash, causing an increase in the AMS.

    For sure, it would not cause an increase in M1.

    When someone "cashes out" his MMF shares what happens? Someone else in the economy transfers actual money (physical currency or checking account deposits) to the seller of the MMF holdings.

    In the same way, if I sold my baseball card collection in order to bolster my bank account, that wouldn't increase total checking account balances in the economy. It would just transfer the fixed amount of money from the person who is buying my baseball cards, into my bank account from theirs.

    I don't know exactly what Shostak puts into "AMS," so I could be wrong, but from the spirit of his article I think he would respond as I have done here.

  5. Also I'm going to challenge you on your claim that people pay bills with their MMFs. I'm not saying you're wrong, I just want to be perfectly clear on what happens.

    Let's say I owe $2,000 to my landlord for the rent. I can give him 20 Andrew Jacksons, or I can write him a personal check for $2,000 drawn on my account at HSBC. We all agree that the landlord will accept either of those, and so that's why physical currency and demand deposits at a reputable bank are both included in the term "money" (M1).

    OK now you're saying I can transfer some shares in a MMF directly to my landlord, and he will accept that instead? What's crucial here is that I'm NOT selling my shares for cash, and then paying him with the cash. You're saying I directly pay him not with dollars, but with shares of a MMF? How exactly does that work? Do I pay the landlord with a transfer order from my broker to his?

  6. Ha ha I am ripping my landlord off...I meant I can pay the landlord 20 Ben Franklins. I'm low class, I only deal with 100s at the casino...

  7. I also don't consider MMFs money for two basic reasons:

    1) An MMF is a credit instrument, essentially an investment, which in order to be spent must be liquidated first. Remember during the crisis, post-lehman, when there was a run on MMFs and the Reserve fund "broke the buck". Money should always trade at face; would a $10 bill ever trade at $9? Of course not. True, one could make the case that savings and demand deposits are investments too but they are still sparsely collateralized by reserves and would never trade under face unless they were over the FDIC limit and the bank went under.

    2)I've asked around and almost no one I know pays or even believes they can pay with MMFs. All the money that I keep in MMFs (as well as friends and family) is simply there as a means to park unused cash from an investment account; In fact I personally don't have the ability to use these funds to make purchases any more than the stocks or bonds I also hold in those accounts. I'm sure some people may use these funds to pay bills etc. but from my own anecdotal experience most people use demand and savings deposits for spending and treat MMFs as investments that are almost as safe and liquid as cash. Remember: when you put money into a MMF they exchange those funds for short-term liquid credit instruments like commercial paper. The actual money goes to the borrower while the fund receive an IOU. This is also the reason why REPOs shouldnt be considered money because even though you are making a short-term loan and the borrower is obliged to re-purchase the collateral there is no guarantee that he will. Short-term, liquid IOUs are still not money. That's why there is a haircut.

    Look at what happened during the crisis. Leading up to and during the beginning of the crisis retail and institutional MMFs rose significantly and we ended up with a period of price deflation. The CPI turned up around the time these aggregates rolled over(and continue dropping to this day). Small time deposits had a similar pattern while M1 and savings deposits continued to rise with the CPI. So people moved out of less liquid and riskier financial assets and into MMFs/time-deposits as a means to earn some kind of interest while essentially staying in cash equivalents but this was a deflationary sign. When people started moving out of MMFs/time deposits while M1+savings accounts continued to rise we saw a sustainable move up in CPI.