Readers have been emailing me about the state of the US economy. The main bone of contention has been the monetary slowdown in the face of a roaring economy. Sure, they ask, any monetary tightening is bound to affect manufacturing and incomes after an interval of some 6-9 months?

Lags between changes in the money supply and it affects on other economic factors are subject to considerable change. The old rule of thumb view, which was always qualified, basically assumes that other factors more or less do not change.

The Austrian approach stresses that money is not neutral and there is no proportionality in monetary induced price changes. What this means is changes in the money supply not only influence prices in general but also prices in particular. In other words, inflating the money supply by forcing down the rate of interest distorts the pattern of production by inducing businesses to invest in projects that would not otherwise be economically viable. When the rates of interest eventually rises again many of these projects have to be abandoned.

(When a situation likes occurs some economists argue that it is one of investment outpacing savings when in fact it is a case of inflation pure and simple. These economists have managed to overlook the fact that the excess investment' is driven by credit expansion. This is something the classical economists understood. However, it has led some modern economists to argue that real investment can lead savings).

What we can comfortably predict is that monetary expansions always come to grief. I have been saying for sometime that the Fed has once laid down the foundations of another recession. I said the same thing about the Clinton boom and the same applies to the Bush boom. What I did in the '90s was not to predict the timing of a recession but to draw attention to what Hayek called "pattern predictions".

This means that instead of actual 'predictions' we are really dealing with a prognosis. Although doctors can identify a terminal disease they cannot give the time and date of death. All they can do in a case like this use their experience and training to give a rough estimate of when the end will arrive. Even then the patient can go into remission. A close friend of mines was diagnosed as having cancer and was told how much time he had. He outlived the doctors' prediction by several years.

One of the patterns I predicted was that when the boom comes close to its final stage aggregate employment would continue to rise even as employment and out put fell in manufacturing. This is exactly what happened. So we can comfortably predict that if inflated credit is largely directed to the higher stages of production, these stages will become over-extended and eventually begin to contract even though the nation's economic aggregates are looking rosy. (US unemployment and the tyranny of aggregates).

There is also the question of how to define money. There is some dissension even among the Austrians regarding the nature of money. I personally stick to the simple definition of money as being a medium of exchange. If something is not performing this function then it is not money. More than 200 years ago Walter Boyd cleared away the confusion about what really constitutes money. In his Letter to Pitt the Younger (1801) he made clear admirable clarity the distinction between "ready money" and so-called money substitutes:

By the words 'Medium of Exchange', 'Circulating Medium', and 'Currency', which are used almost as synonymous terms in this letter, I understand always ready money, whether consisting of Bank Notes or specie, in contradistinction to Bills of Exhange, Navy Bills, Exchequer Bills, or any other negotiable paper, which form no part of the circulating medium, as I have always understood that term.

What Boyd did was to draw a clear line between "ready money" as the final payment and financial intermediaries, a distinction that is lost on most modern economists. Boyd's sensible definition of money means that credit instruments like certificates of deposits, travellers' cheques and other credit transactions are not part of the money supply. On the other hand, demand deposits with commercial banks and thrift institutions plus saving deposits plus government deposits with banks and the central bank are money.

Unfortunately Boyd's work was largely forgotten and it never gained the intellectual recognition it deserves with the result that the vast majority of economists lost sight of the nature of money and its power.

Returning to the current money supply there does appear to be some oddities, at least to monetarists. From January 2003 to January 2004 M1 rose by 6.5 per cent. For 2004 to 2005 it rose by 4.7 per cent and only 1.2 per cent the following year. January to April this years saw it rise by a 0.6 per cent. This would be about 2 per cent annually. Using Boyd's definition of money these figures need to be reduced because M1 includes travellers cheques which are not money but credit instruments.

On the basis of the M1 figures alone some have therefore concluded that the economy should be sliding into recession instead of booming. Taking a closer look at M1 we find that bank and thrift deposits for the same period as above were 8%, 4%, -2% per cent and virtually zero. Moreover, the trend for currency was 5.4%, 5%, 4.5% and 1.4% which is about 4.5 per cent annually. (These figures suggest to me that the current account deficit might begin to fall).

Clearly there has been some monetary tightening. The first thing to note is that to Austrians even what some call a low rate of monetary expansion is still dangerous. An annual expansion of 4% means that over a 5-year period money supply will have risen by more than 20 per cent. The second factor has been President Bush's 2003 tax cuts. Back in 2000 when the results of the election still appeared to be in doubt I wrote that

It ought to be obvious that when a country goes into recession that is the time to lighten the tax burden, not increase it. You don't make a feeble man strong by simply piling more weights on his shoulders until he collapses. You take them off. (When recession strikes Bush tax cuts will be just the tonic, The New Australian, 24 November 2000).

I also warned that

The missing link in the administration's very limited tax package is capital gains. This is of crucial importance because capital gains are economic profits, not accounting profits, which when invested fuel economic growth and hence living standards. (Capital gains: the missing link in Bush's tax cuts, The New Australian 9 June 2001).

I had made the mistake of assuming that the administration would quickly move to cut capital gains taxes. I was obviously wrong. Nevertheless, when these cuts came the response of the economy struck many as remarkable. And this, I believe, is the key to the monetarist riddle. By cutting capital gains -- which are really profits -- Bush lifted a huge burden off production by generating additional savings. It is my opinion that these tax cuts that are spurring the economy.

Austrianism has never denied the possibility that an impending recession can by put off if a change in time preference is large enough to provide sufficient savings to fund all the investments that are taking place. Now I do not know if such a situation has ever occurred. I do know that it isn't happening in the US. Although the tax cuts are beneficial I still believe there are insufficient savings, including foreign savings, to fund all of the undertaken investments.

If aggregate business spending, including spending on intermediate goods, begins to fall expect dark clouds to form over the economy as another recession begins to unfold.