By Dr Frank Shostak
According to popular thinking, the 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. 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 the money supply definition is whether M1, M2 or some other M has a high correlation with key economic data such as the gross domestic product (GDP). On this way of thinking the high correlation between the money supply and various economic indicators makes the money supply data useful in ascertaining the future course of economic activity.
It is however held that since the early 1980s, correlations between various definitions of money and the GDP have broken down. The reason for this breakdown, it is held, is financial deregulation that made the demand for money unstable. Consequently, the usefulness of money as a predictor of economic activity has significantly diminished. Indeed, since the early 1980’s economists have been paying very little attention to the money supply data.
Some economists are of the view that the correlation between money supply and the GDP could be strengthened by assigning weighting to the money supply components. For instance, the Divisia indicator, named after the French economist, Francois Divisia, makes the adjustments for differences in the degree to which various components of the monetary aggregate serve as money. This is believed to offer a more accurate picture of the state of the money supply.
The primary Divisia monetary indicator for the US is money M4. It is a broad aggregate, which 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 various economic indicators.
Consequently, one could employ this monetary measure to ascertain the future course of key economic indicators. However, does it all make sense?
Defining what money is
We hold that no definition can be established by means of correlation. The purpose of a definition is to present the essence of the subject we are trying to identify.
To establish the definition of money we have to ascertain how a money-using economy came about. Money emerged as a result of the fact that barter could not support the market economy. A butcher who wanted to exchange his meat for fruit might have difficulties to find a fruit farmer who wanted his meat, while the fruit farmer who wanted to exchange his fruit for shoes might not 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. On this Mises wrote,
There would be an inevitable tendency for the less marketable of the series of goods used as media of exchange to be one by one rejected until at last only a single commodity remained, which was universally employed as a medium of exchange; in a word, money.
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.
In the world of money, the butcher can now 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.
It follows then that money is the thing that all other goods and services are traded for. This fundamental characteristic of money must be 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 is going to permit the production of a larger quantity of goods and services.
We suggest that regardless of financial deregulations, the definition of money is not going to change i.e. it is going to be the thing that all other goods and services are traded for. Through an ongoing selection process over the thousands of years, individuals have settled on gold as money.
In the present monetary system, the money supply is no longer gold but coins and notes issued by the government and the central bank. Consequently, coins and notes constitute money, known as cash that is employed in transactions. Goods and services are bought and sold for cash.
Distinction between claim and credit transactions
At any point in time, an individual can keep his money in his wallet or somewhere at home or deposit the money with a bank. In depositing his money, an individual never relinquishes his ownership over the money; he has an absolute claim over it. No one else is expected to make use of it.
This should be contrasted with a credit transaction, in which the lender of money relinquishes his claim over the 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 the Joe’s possession.
Why various popular definitions of money are questionable?
Consider the money M2 definition. This definition includes money market securities, mutual funds and other time deposits. However, investing in a mutual fund is an investment in various money market instruments. The quantity of money is not altered as a result of this investment; only the ownership of money has temporarily changed. Hence, including mutual funds as part of money results in the double counting of money.
Observe that the Divisia monetary gauge is also not of much help either in establishing what money is. Please note again that this indicator was designed to strengthen the correlation between monetary aggregates such as M4 and other M’s with an economic indicator. In this sense the construction of the Divisia gauge is an exercise in curve fitting.
The Divisia of various M’s such as the Divisia M4 does not however, address the double counting of money. Note again that the M4 is a broader aggregate, which includes cash plus negotiable money-market securities, such as commercial paper, negotiable CDs, and T-bills.
What we have here is 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 the definition comprises of erroneous components. Furthermore, even if the components were valid one does not improve the money definition by assigning weights to components. The purpose of the definition is to establish what money is. This however, is not related to the money’s correlation with GDP.
The problem of double counting is not resolved by the relatively new definition of money such as the money of zero maturity (MZM). The MZM encompasses financial assets with zero maturity. Assets included in the MZM are redeemable at par on demand. This definition excludes all securities, which are subject to the risk of capital loss, and time deposits, which carry penalties for early withdrawal. The MZM includes all types of financial instruments that can be easily converted into money without penalty or risk of capital loss.
Observe that the MZM includes assets that can be easily converted into money. This is precisely what is wrong with this definition, since it doesn’t identify money but rather various assets that can be easily converted into money. It doesn’t tell us what money is.
The introduction of electronic money has introduced another level of confusion regarding the definition of what money is. It is held that the electronic money is likely to make the current money i.e. cash redundant. We hold that the electronic money is not money, but rather a new way of employing existing money i.e. cash in transactions. Regardless of these new ways of employing money, the definition of money does not change. It is that for which goods and services are exchanged for.
Conclusion
The essence of what money is cannot be established by means of statistical correlation but rather by means of understanding what money is all about. We suggest that the attempt to strengthen the correlation between various monetary aggregates and economic activity by means of a variable weighting of the money supply components defeats the purpose of establishing the definition of money.
