11 July 2010

Austrian Economics: True Money Supply, Deflation and Inflation

Here is the Austrian theory of money supply and its measures in a nutshell.

"The True Money Supply (TMS) was formulated by Murray Rothbard and represents the amount of money in the economy that is available for immediate use in exchange. It has been referred to in the past as the Austrian Money Supply, the Rothbard Money Supply and the True Money Supply.

The benefits of TMS over conventional measures calculated by the Federal Reserve are that it counts only immediately available money for exchange and does not double count. MMMF shares are excluded from TMS precisely because they represent equity shares in a portfolio of highly liquid, short-term investments which must be sold in exchange for money before such shares can be redeemed.

For a detailed description and explanation of the TMS aggregate, see Salerno (1987) and Shostak (2000).

The TMS consists of the following: Currency Component of M1, Total Checkable Deposits, Savings Deposits, U.S. Government Demand Deposits and Note Balances, Demand Deposits Due to Foreign Commercial Banks, and Demand Deposits Due to Foreign Official Institutions."

True Money Supply, Ludwig Von Mises Institute

Here is some additional reading on the subject. The Austrian Theory of Money by M. Murray Rothbard

The weakness in TMS is the same as in all of the narrower money supply aggregate measures, in that it is very volatile in the short term because of seasonal demand. Ideally one would perform long term trending to get a better idea of the expansion or contraction of the money supply.

As one can see, the trend in money supply growth has been quite strong, almost parabolic.

Why do I present this? Because I thought it would be a good idea for those who aspire to be Austrian economists to know what the Austrian School thinks about money supply and how to measure it.

So when some point to M3, for example, and see an argument for deflation rampant, they should at least understand that they are not being 'true to their school.'

I should disclose here that although I have sympathy for many of the things that the 'Austrian School' says, I am not an 'Austrian' or a member of any economic school of thought for that matter. I think the Austrian school has been influenced to the point of being hijacked by the neo-liberal economists, due in large part to its marginalization in the study of economics and its lack of vigor.

Returning to what the Austrians think, a fairly recent discussion of this deflation issue was penned by Richard M. Ebeling in The Hubris of Central Bankers and the Ghosts of Deflation Past.
"One fact should be pointed out in terms of the current economic crisis. There has been no monetary deflation -- that is, an absolute decrease in the quantity of money and credit in the economy. Just the opposite. Since 2008, the Federal Reserve has increased the total amount of reserves in the banking system by around $1.5 trillion, mostly by buying up many of those "toxic" mortgages that were guaranteed by Fannie Mae and Freddie Mac.

This huge expansion in the potential quantity of money and credit that could flood through the financial markets and generate significant price inflation has been held off the market due to the fact that the Federal Reserve has been paying banks interest to hold those sums as unlent reserves. With key market interest rates being kept artificially low at near zero or one percent through activist Fed policy, banks have found it more profitable earn that positive rate of interest at the Federal Reserve.

But unless the Fed finds some way to drain those "excess reserves" out of the banking system, significant inflationary -- not deflationary -- forces may be at work looking to the next few years ahead."

This could help some people understand why the expected effects of monetary deflation have not been appearing as they planned.

There is certainly an undeniable slump in aggregate demand that it putting pressure on prices, and some sectors, like housing, are experiencing the collapse of asset bubble.

Some point to credit contraction as deflation, but as the Austrian school would point out, credit is not money, only a means of money creation. The Fed owns a printing press, and as most recently seen, can expand its Balance Sheet and True Money Supply almost at will.

Some things I have seen recently from 'Austrians' leads me to think that a portion of that camp has been hijacked by the neo-liberal economists. That would indeed be a shame if it is true, and ti becomes a trend. Stranger things have happened. But I see it clearly in the calls for austerity, and liquidationism, and 'free markets' from some who wear those school colors.

Markets are always and everywhere never naturally free. They require diligent effort and serious work to be maintained free of fraud, corruption, and inefficiencies. But some find it easy to believe in or at least promulgate economic theories based on the natural goodness of man, and assorted fairly tales and urban myths, if it suits their ideology or duplicitous agenda. One can usually spot them by the quantity of invective and rhetoric against the quality and detail of their thought.

As for Ben's printing press, baby, you ain't seen nothing yet.