Do Some Money Measurements Double Count?

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Can Correlations Help Define Money?

According to popular thinking, the government’s definition of money is of a flexible nature. Sometimes it could be M1, and at other times it could be M2 or some other M money supply. M1 includes currency and demand deposits. M2 includes all of M1, plus savings deposits, time deposits, and money market funds. By popular thinking what determines whether M1, M2, or some other M is considered money is whether it has high correlation with key economic data such as the gross domestic product (GDP).

However, since the early 1980s, correlations between various definitions of money and the GDP have broken down. The reason for this breakdown, many economists believe, is that financial deregulation has made the demand for money unstable. Consequently, the usefulness of money as a predictor of economic activity has significantly diminished.

Some economists believe that the relationship between money supply and the GDP could be strengthened by assigning weights to money supply components. The Divisia indicator, named after the French economist François Divisia, adjusts for differences in the degree to which various components of the monetary aggregate serve as money. This, in turn, supposedly offers a more accurate picture of what is happening to money supply.

The primary Divisia monetary indicator for the US is M4. It is a broad aggregate that includes negotiable money market securities, such as commercial paper, negotiable CDs, and T-bills. By assigning suitable weights, which are estimated by means of quantitative methods, it is held that one is likely to improve the correlation between the weighted monetary gauge and economic indicators.

Consequently, one could employ this monetary measure to ascertain the future course of key economic indicators. However, does it make sense?

Defining Money

No definition of money can be established by means of a correlation. A definition is supposed to present the essence of the subject being identified.

To establish the definition of money, we must determine how a money-using economy came about. Money emerged because barter could not support the market economy. A butcher who wanted to exchange his meat for fruit would have difficulty finding a fruit farmer who wanted his meat, while the fruit farmer who wanted to exchange his fruit for shoes might not have been able to find a shoemaker who wanted his fruit.

The distinguishing characteristic of money is that it is the general medium of exchange. It has evolved from the most marketable commodity. According to Murray Rothbard:

Just as in nature there is a great variety of skills and resources, so there is a variety in the marketability of goods. Some goods are more widely demanded than others, some are more divisible into smaller units without loss of value, some more durable over long periods of time, some more transportable over large distances. All of these advantages make for greater marketability. Eventually, one or two commodities are used as general media—in almost all exchanges—and these are called money.

With money, the butcher can exchange his meat for money and then exchange money for fruits. Likewise, the fruit farmer could exchange his fruit for money. With the obtained money, the fruit farmer can now exchange it for shoes. The reason why all these transactions become possible is because money is the most marketable commodity (i.e., the most accepted commodity).

According to Rothbard:

Money is not an abstract unit of account, divorceable from a concrete good; it is not a useless token only good for exchanging; it is not a “claim on society”; it is not a guarantee of a fixed price level. It is simply a commodity.

It follows then that all other goods and services are traded for money. This fundamental characteristic of money is contrasted with other goods. For instance, food supplies the necessary energy to human beings. Capital goods permit the expansion of the infrastructure that, in turn, permits the production of a larger quantity of goods and services. Contrary to the mainstream thinking, the essence of money has nothing to do with financial deregulation as this essence will remain intact in the most deregulated of markets.

Some commentators maintain that money’s main function is to fulfill the role of a means of savings. Others argue that its main role is to be a unit of account and a store of value. While all these roles are important, they are not fundamental. The basic role of money is to be a medium of exchange, with other functions such as unit of account, a store of value, and a means of savings arising from that role.

Through an ongoing selection process over thousands of years, individuals have settled on gold as money. In today’s monetary system, the money supply is no longer gold, but metal coins and paper notes issued by the government and the central bank. Consequently, coins and notes constitute money, known as cash, that is employed in transactions.

Distinction between Claim and Credit Transactions

At any point in time, an individual can keep money in a wallet or somewhere at home or deposit the money with a bank. In depositing money, an individual never relinquishes ownership over the money having an absolute claim over it.

This contrasts with a credit transaction, in which the lender of money relinquishes a claim over one’s money for the duration of the loan. As a result, in a credit transaction, money is transferred from a lender to a borrower. Credit transactions do not alter the amount of money. If Bob lends $1,000 to Joe, the money is transferred from Bob’s demand deposit or from Bob’s wallet to Joe’s possession.

Why Are Various Popular Definitions of Money Misleading?

Consider the money M2 definition, which includes money market securities, mutual funds, and other time deposits. However, investing in a mutual fund is, in fact, an investment in various money market instruments. The quantity of money is not altered because of this investment; only the ownership of money has temporarily changed. Hence, including mutual funds as part of money results in double counting.

The Divisia monetary gauge is of little help in establishing what money is. Because this indicator was designed to strengthen the correlation between monetary aggregates such as M4 and other Ms with an economic activity indicator, the Divisia gauge can better be seen as an exercise in curve fitting.

The Divisia of various Ms, such as the Divisia M4, does not address the double counting of money. The M4 is a broad aggregate and includes a mixture of claim and credit transactions (i.e., a double counting of money). This generates a misleading picture of what money is.

Applying various weights to the components of money cannot make the definition of money valid if it is created from erroneous components. Furthermore, even if the components were valid, one does not improve the money definition by assigning weights to components.

The introduction of electronic money has supposedly introduced another confusion regarding the definition of money. It is believed that electronic money is likely to make the cash redundant. We hold that electronic money is not new money, but rather a new way of employing existing monetary transactions. Regardless of these new ways of employing money, definitions and the role of money do not change.

Conclusion

The attempt to strengthen the correlation between various monetary aggregates and economic activity by using variable weighting of money supply components defeats the definition of money. The essence of money cannot be established by means of a statistical correlation, but rather by understanding what money is about.

About the Author

Frank Shostak is an Associated Scholar of the Mises Institute. His consulting firm, Applied Austrian School Economics, provides in-depth assessments and reports of financial markets and global economies. He received his bachelor’s degree from Hebrew University, his master’s degree from Witwatersrand University, and his PhD from Rands Afrikaanse University.  

Understanding Money as the Lubricant for Wealth

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Why Does Money Exist?

Imagine a world without money. With no way to buy stuff, you might need to produce everything you wear, eat or use unless you could figure out how to swap some of the things you made for other items.

Just making a chicken sandwich would require spending months raising hens and growing your own lettuce and tomatoes. You’d need to collect your own seawater to make salt.

You wouldn’t just have to bake the bread for your sandwich. You’d need to grow the wheat, mill it into flour and figure out how to make the dough rise without store-bought yeast or baking powder.

And you might have to build your own oven, perhaps fueled by wood you chopped yourself after felling some trees. If that oven broke, you’d probably need to fix it or build another one yourself.

Even if you share the burden of getting all this done with members of your family, it would be impossible for a single family to internally produce all the goods and provide all the services everyone is used to enjoying.

To maintain anything like today’s standard of living, your family would need to include a farmer, a doctor and a teacher. And that’s just a start.

This article was republished  with permission from The Conversation, a news site dedicated to sharing ideas from academic experts. It represents the research-based findings and thoughts of M. Saif Mehkari, Associate Professor of Economics, University of Richmond.

Specializing and Bartering

Economists like me believe that using money makes it a lot easier for everyone to specialize, focusing their work on a specific activity.

A farmer is better at farming than you are, and a baker is probably better at baking. When they earn money, they can pay others for the things they don’t produce or do.

As economists have known since David Ricardo’s work in the 19th century, there are gains for everyone from exchanging goods and services – even when you end up paying someone who is less skilled than you. By making these exchanges easy to do, money makes it possible to consume more.

People have traded goods and services with one kind of money or another, whether it was trinkets, shells, coins and paper cash, for tens of thousands of years.

People have always obtained things without money too, usually through barter. It involves swapping something, such as a cookie or a massage, for something else – like a pencil or a haircut.

Bartering sounds convenient. It can be fun if you enjoy haggling. But it’s hard to pull off.

Let’s say you’re a carpenter who makes chairs and you want an apple. You would probably find it impossible to buy one because a chair would be so much more valuable than that single piece of fruit. And just imagine what a hassle it would be to haul several of the chairs you’ve made to the shopping mall in the hopes of cutting great deals through barter with the vendors you’d find there.

Paper money is far easier to carry. You might be able sell a chair for, say, $50. You could take that $50 bill to a supermarket, buy two pounds of apples for $5 and keep the $45 in change to spend on other stuff later. Another advantage money has over bartering is that you can use it more easily to store your wealth and spend it later. Stashing six $50 bills takes up less room than storing six unsold chairs.

Nowadays, of course, many people pay for things without cash or coins. Instead, they use credit cards or make online purchases. Others simply wave a smartwatch at a designated device. Others use bitcoins and other cryptocurrencies. But all of these are just different forms of money that don’t require paper.

No matter what form it takes, money ultimately helps make the trading of goods and services go more smoothly for everyone involved.

Money Moving Out of Foreign Investments is Supporting U.S. Markets

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Why So Much Money from Overseas is Flowing to Soft U.S. Markets

In 2016, Mohamed El-Erian, chief economic advisor at Allianz, and President of Queens’ College, Cambridge published a book called The Only Game in Town. It was written during a period approximately halfway between the last big stock market sell-off and the 2022 bear market. In it he suggests the only reason investment dollars from overseas are flocking to U.S. markets is because we are “the cleanest dirty shirt.” In other words,  the U.S. economy and financial system may not be great, but it is far more appealing than the alternatives.  

Labor Day 2022 is now behind us, the S&P 500 is down 16% YTD, the economy receded during the first half of the year and its growth is probably still stunted. The U.S. Treasury index indicates that bonds are down 11% YTD, so why are international money flows moving to U.S. markets? Do investors from overseas think this is a buying opportunity, are we the “cleanest dirty shirt,” or is there something else?

There are probably a number of correct answers, which, when taken together, provides the reason. Investors need to be aware of the dynamics as flows into and out of the U.S. impact all of the country’s markets, including real estate and currency.

“The U.S. looks the least challenged in a very challenging world,” Christopher Smart, chief global strategist at Barings and head of the Barings Investment Institute told the Wall Street Journal. “Everybody is slowing down, but the U.S., because of the continuing strength of the jobs market, still seems to be slowing more slowly,” he added.

And the data shows just how much money is reaching our markets. Assets have been withdrawn from international stock funds for 20 consecutive weeks, according to Refinitiv Lipper data. Money flows have been in to U.S. equity-focused stock and mutual funds for four of the past six weeks.

The U.S., relative to large economies outside of the states is better; employment is strong, there are expectations that a long protracted recession isn’t likely, and consumer spending hasn’t faded, while price increases (inflation) have been tapered. 

Recent performance of U.S. markets has been impressive. Since the low point of the year (June 14), the small-cap Russell 2000 index is up 7.2%, the S&P 500 is up 6.5% and even U.S. Treasuries are positive despite the Fed’s stated intention of higher rates.

The S&P 500 has outpaced major stock indexes in Europe and Asia since hitting its low for the year in mid-June, meanwhile the pan-continental Stoxx Europe 600 has added only 2.9%, Japan’s Nikkei 225 has advanced 4.5%. Germany’s DAX and the Shanghai Composite have slid 1.3% over the same period.

Source: Koyfin

And there is one other self-fulfilling incentive for U.S. dollar-denominated assets; the dollar has surged to a 20-year high relative to a standard basket of global currencies. To date it is 25.2% stronger than the yen, it increased 12.2% higher versus the euro, and gained 15% above the British pound. Even with the U.S. major indices down, investor conversion back to non-U.S. native currency is a big win compared to what they would have lost. And for U.S. investors that were in international markets, they are better off having repatriated their dollars, even if they are down on the year.

The longer the dollar’s strength continues, the more the strength will feed on itself.

What investors should pay particular attention to now is anything that may trigger a turnaround, and money going back into international markets. This does not seem imminent, but it helps to know what is making “other shirts dirtier.”

Among Europe’s challenges are war-related supply shortages which have led to skyrocketing gas and electricity prices. Recently added to the list, Russia’s Gazprom PJSC said Friday (Sept. 2), that it would suspend the Nord Stream natural-gas pipeline to Germany. Winter is coming and the continent is on the path to a worsening energy problem, one that would add to upward inflation pressures for them.

China the world’s second-largest economy, has been severely weakened by the impact of its response to Covid-19. Other factors weighing on its economy are a real-estate downturn, heightened regulation of technology companies, and unusually bad weather. Weakness in China creates problems for economies around the globe since much of the world’s commodities and manufacturing come from the country.

A turnaround in these factors, such as a friendly resolution to the war, increased productivity from China, or lower inflation across Europe and the tide may turn causing more investment to gravitate away from the U.S., creating less demand for assets here. To date, there is no sign that any of these possibilities are imminent, and the longer the U.S. is the only game in town, the more money will be kept in U.S. dollar assets and the more upward pressure there will be on these assets.

Paul Hoffman

Managing Editor, Channelchek

Sources

https://www.amazon.com/The-Only-Game-in-Town-audiobook/

https://www.refinitiv.com/en/financial-data/fund-data

https://en.wikipedia.org/wiki/Mohamed_A._El-Erian

https://www.wsj.com/articles/u-s-dollar-strength-lifts-americans-relative-spending-power-11662304836?mod=Searchresults_pos4&page=1

https://www.wsj.com/articles/investors-are-pouring-into-u-s-stocks-to-avoid-greater-turbulence-overseas-11662421967?mod=Searchresults_pos1&page=1