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How Confusion About the Money Supply is Damaging the US Economy

At last the National Review Online has published an article attacking the dangerous idea that "the Federal Reserve should set the fed funds rate" (Stop Targeting the Fed Funds Rate). Paul Hoffmeister, chief economist at Bretton Woods Research, argues that price pressures ought to force supply-siders to reconsider their belief that the Fed needs to lift short term rates to halt the rise in the price of gold. It's his opinion that current trends in the US economy suggest that targeting the funds rate "has wholly failed in effectively restraining money-supply growth in relation to money demand".

In Hoffmeister's view the Fed should use open market operations to hall back the price of gold to "$400 an ounce". In other words, the Fed should deflate. He observes that though the funds rate rose from 1 per cent in June to 5.25 per cent today the monetary base appears unaffected. This is where it gets interesting. As I never tire of pointing out the real problem is not the monetary base (cash) but credit expansion.

He draws attention to the fact that since June 2004 the Fed's balance sheet reveals "reserve bank credit" has been growing at a rate of 4 to 7 per cent. (Readers may recall that I have previously stressed the Reserve Bank of Australia's monthly assets and liabilities as an indicator of monetary growth). Hoffmeister further observes that currently "loans and investments by commercial banks, is currently growing at a 9.5 percent year-over-year rate, an increase from 6.2 percent during June 2004".

Although his conclusion that the growth in credit demonstrates that the Fed has not been draining funds from the banking system is correct we are still left with the problem of defining the money supply. It logically follows that this cannot be successfully done without first properly defining money itself. Fortunately this was done more than 200 years ago by Walter Boyd. In his Letter to Pitt the Younger (1801) he made clear with admirable clarity the distinction between "ready money" and so-called money substitutes:

By the words 'Means of Circulation, '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. The latter is the Circulator; the former are merely objects of circulation.

Unfortunately Boyd's monetary insight has been all but lost, which helps account for the current confusion between 'money' and 'money substitutes'. This brings me back to Hoffmeister. His observation about the amount of "loans and investments" by commercial banks is only suggestive with respect to monetary growth.

Accepting Boyd's sensible definition of money leads to the conclusion that credit instruments like certificates of deposits, travellers' cheques and other credit transactions are not part of the money supply -- being "merely objects of circulation". 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. (In this respect the banking school was right and the currency school egregiously wrong).

The question of money and credit instruments is a vital point at which the great majority of economists, including Hoffmeister, seriously err. He, like most economists, calls MZM (money of zero maturity) "the most liquid form of money". Let's take a closer look at MZM. An MZM asset is one that can be immediately redeemed without suffering a penalty or a capital loss.

It is this 'liquidity' that is supposed to make MZM part of the money supply. But it ought to be self-evident that in order to obtain money we must first offer something for it. This is why MZM, irrespective of the prevailing monetary view, cannot be part of the money supply. Anything that has to be exchanged for money cannot be money. Something that Walter Boyd made exceptionally clear.

Hoffmeister compounded this error with the another one. According to the prevailing view, which he shares, a "slower economy requires less money". It follows that a growing economy requires more money. Therefore monetary policy should reflect changes in GDP. This is a very dangerous fallacy and one the classical economists thought they had permanently put to rest. They understood that increasing the quantity of money did nothing to raise living standards. This could be done only by accumulating more capital. Moreover, the idea that the money supply should be expanded in line with economic growth smacks of the buy-back-the-product fallacy.

He finished by "calling for the Fed to directly target a $400 gold price by selling bonds to immediately drain the excess liquidity flooding the economy". This, as I already said, is a deflationary policy and would probably cause a deep recession. It also misses the vital point that there is no purpose in the Fed targeting a gold price. If you want to link gold to monetary policy then go the whole hog and recommend a gold standard.

The gold price argument reveals the inconsistency of Hoffmeister's argument. Any policy that recommends monetary expansion in line with GDP, which is what the great majority of economists mean by economic growth, must eventually cause the price of gold to rise relative to the dollar. (This situation reminds me of the highly instructive gold bullion controversy that started in 1801).

Despite his opening round it is clear that Hoffmeister does not understand, any more than most other economists do, that the problem is a four-fold one of (a) failure to properly define money, (b) failure to grasp the fact that credit expansion is the root cause of the boom bust cycle, (c) failure to understand the nature of capital and (d) failure to comprehend the fact that money is not neutral.

Until mainstream economists adopt Walter Boyd's definition of money and the reality that money is not neutral the US economy will continue to be plagued with recurring recessions.


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