In their working paper Assessing UK money supply measures in the light of the credit crunch, Toby Baxendale and Anthony J. Evans provide a better measure of the money supply. In this article, Steven Baker explores the background to the paper and indicates some key findings.
This article was originally published in October 2009.
Many people know the Bank of England is creating new money through quantitative easing but if the quantity of money is being increased, how is that quantity being measured? What is counted as money?
As the Bank of England explains:
When the Bank is concerned about the risks of very low inflation, it cuts Bank Rate – that is, it reduces the price of central bank money. But interest rates cannot fall below zero.
So if they are almost at zero, and there is still a significant risk of very low inflation, the Bank can increase the quantity of money – in other words, inject money directly into the economy. That process is sometimes known as ‘quantitative easing’.
But when I consider quantitative easing, I am concerned with the following problems:
- It is not clear that the Bank of England has a useful definition of the money supply. The present measures do not correspond to economic activity — which is what the Bank is trying to increase with new money — and this crisis was famously not foreseen.
- As commentators have reported, “the Bank’s Governor, Mervyn King, seemed pretty confident that QE could work. But even he would admit he has no idea how long it will take – or how much money he will have to print to get there.” This uncertainty seems less than ideal given the risk of price inflation.
- As the end of the present round of QE approached, it appeared it was not working.
- According to Austrian-School economic scholars including Hayek and Huerta de Soto, injecting new money can create only a harmful illusion of prosperity1.
As my colleagues point out in their working paper, the fact that the monetary authorities have turned to increasing the quantity of money will focus attention on how that quantity is measured. This article provides some background information and indicates Baxendale and Evans’ key findings.
Conventional measures of the money supply
Today, the Bank of England publishes two measures of the money supply: “narrow money”, which is notes and coins (M0), and “broad money”, which is money in bank and building society accounts (M4).
Look a little further and you soon find that at least three different measures of the quantity of money are — or have been — used by various monetary authorities (M1, M2 and M3). Look back at the Bank of England in more detail and, confusingly, you find “M4”, “M4 excluding intermediate OFCs”, “M4Lx” and “M4Lx excluding intermediate OFCs”; these measures give quite different results, particularly during the recent crisis:
You might wonder if money can be counted at all or which measure is meaningful. You might wonder if the monetary authorities can effectively monitor the quantity of money in the economy as they add more.
Studying the history of the various conventional measures of the money supply is dispiriting. We find that the Federal Reserve abandoned M1 in 1987, M2 in 1992 and M3 in 2006. The Bank of England abandoned M0 in 2006. We have to ask not just whether those measures were useful, but whether they were the right measures at all.
So what is money?
A barter economy can only take society so far. A software engineer, marketing consultant or economist would have to look a long way indeed to find a cobbler who would swap a pair of shoes for their services.
In The Theory of Money and Credit, Mises writes:
Where the free2 exchange of goods and services is unknown, money is not wanted. In a state of society in which the division of labor was a purely domestic matter and production and consumption were consummated within the single household it would be just as useless as it would be for an isolated man. But even in an economic order based on division of labor, money would still be unnecessary if the means of production were socialized, the control of production and the distribution of the finished product were in the hands of a central body, and individuals were not allowed to exchange the consumption goods allotted to them for the consumption goods allotted to others.
That is, we find we have a choice between a tribal society, communism or a system based on money.
Money emerged to support a growing market economy, to enable individuals to cooperate to fulfill their wants. Rothbard defined money as follows:
Money is the general medium of exchange, the thing that all other goods and services are traded for, the final payment for such goods on the market.
But more specifically, these Northern Rock customers knew what they wanted; they wanted notes and coins:
However, most of the time, we buy goods and services using debit and credit cards or even cheques. As Mises writes:
When an indirect exchange is transacted with the aid of money, it is not necessary for the money to change hands physically; a perfectly secure claim to an equivalent sum, payable on demand, may be transferred instead of the actual coins. In this by itself there is nothing remarkable or peculiar to money. What is peculiar, and only to be explained by reference to the special characteristics of money; is the extraordinary frequency of this way of completing monetary transactions.
So, as members of the public, we can be quite clear: money is notes3 and coins, plus your bank balance, which you transfer in various ways.
The Bank of England’s definition of money
The Bank of England defines broad money — the measure which is more than just notes and coins — as follows:
The M4 private sector’s (i.e. the UK private sector other than monetary financial institutions (MFIs)) holdings of:
- sterling notes and coin;
- sterling deposits, including certificates of deposit;
- commercial paper, bonds, FRNs and other instruments of up to and including five years’ original maturity issued by UK MFIs;
- claims on UK MFIs arising from repos (from December 1995);
- estimated holdings of sterling bank bills;
from end-1986, 95% of the domestic sterling interbank (now inter-MFI) difference (allocated to wholesale deposits/other financial corporations, the remaining 5% being allocated to transits). This followed a review of its causes (see page 101 of the June 1992 Economic Trends).
Baxendale and Evans’ definition of money
With reference to the work of other Austrian-School economists, Baxendale and Evans consider an asset to be part of the money supply if:
- The asset is continuously owned by the depositor.
- The asset has a cash value which does not fluctuate.
- The asset is redeemable on demand.
- The asset is commonly agreed to be legal tender.
- The asset is a final means of payment.
Applying these theoretical criteria, the authors show that the money supply consists of:
- Demand deposits with commercial banks and thrift institutions.
- Government deposits with banks and the central bank.
- Savings deposits, which can only be spent via demand deposits.
- Money market mutual funds, retail market funds and other securities, which must be sold for money.
- Certificates of deposit, which have a notice period.
- Retail goods, which must be sold for money.
- Travelers’ cheques, which are a credit transaction.
The authors explain that the conventional measures of the money supply fail to correspond to economic activity not because the problem is intractable, but because the other measures lack a thorough theoretical basis for their composition.
Counting money by these criteria provides some important results.
By charting their actual measure of the UK money supply — MA — against the traditional measures, industrial production, GDP and retail sales, Baxendale and Evans show that MA differs by offering a close approximation to economic activity.
For example, consider this chart which plots, over the past ten years, the rate of change of retail sales and MA offset by 12 months:
We find that, unlike the measures published by the Bank of England, MA provides a useful indicator of economic activity.
It appears the Bank of England’s measure of money is less useful than a measure based on sound Austrian-School economic theory. Interestingly, for all the thousands of pages of theory written over many decades, the Austrian-School definition corresponds quite closely to the common-sense understanding of everyday people cooperating in the economy.
“Money is the general medium of exchange, the thing that all other goods and services are traded for, the final payment for such goods on the market.” This insight provides a better measure of the money supply.
In an era of quantitative easing, we should care how money is measured and, in the light of the usefulness of this Austrian measure of the money supply, we should pay more attention to another area of Austrian theory: the idea that the economic activity produced by new money lasts only as long as the supply of new money and that new money cannot be created forever.
- The Bank of England, Quantitative Easing Explained
- Toby Baxendale and Anthony J. Evans, Assessing UK money supply measures in the light of the credit crunch
- Mises, The Theory of Money and Credit
- Mises, The Austrian Theory of the Trade Cycle
- “The continuous injection of additional amounts of money at points of the economic system where it creates a temporary demand which must cease when the increase of the quantity of money stops or slows down, together with the expectation of a continuing rise of prices, draws labour and other resources into employments which can last only so long as the increase of the quantity of money continues at the same rate – or perhaps even only so long as it continues to accelerate at a given rate. What this policy has produced is not so much a level of employment that could not have been brought about in other ways, as a distribution of employment which cannot be indefinitely maintained and which after some time can be maintained only by a rate of inflation which would rapidly lead to a disorganisation of all economic activity.” Hayek, 1974 Nobel Prize Lecture [↩]
- “Free” as in “freedom”. [↩]
- Bank of England notes still have written on them “I promise to pay the bearer on demand the sum of ten pounds”. We might reasonably ask, “Ten pounds of what?” [↩]