From NewsWars.com
According to popular thinking, the definition of money is flexible. Sometimes the money supply could be M1 (currency and demand deposits); at other times it could be M2 (all of M1, plus savings deposits, time deposits, and money market funds) or some other M. According to popular thinking, what determines whether M1, M2, or some other M is considered the money supply is whether it is well correlated 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, economists have suggested, is the financial deregulation that made the demand for money unstable. Consequently, the usefulness of money supply as a predictor of economic activity has significantly diminished. Some economists hold that the correlation between money supply and the GDP could be strengthened by assigning weightings to the different components of the money.
The Divisia monetary aggregates index, named after the French economist François Divisia, makes adjustments for differences in the degree to which various components of the monetary aggregate serve as money. These calculations, it is held, yield a more accurate picture of what is really happening to the money supply.
The primary Divisia monetary indicator for the United States is M3, which is a broad aggregate that includes negotiable money market securities, such as commercial paper, negotiable CDs, and treasury bills. It is held that by assigning suitable weights, estimated by quantitative methods, to the constituents of M4, one is likely to improve its correlation to various economic indicators. Consequently, one can consult this monetary measure to ascertain the future course of key economic indicators. However, does it all make sense?
Definition of Money
No definition of money can be established by means of a correlation. The purpose of a definition is to present the essence of its subject. To establish the definition of money, one must first ascertain 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 might have difficulties finding a fruit farmer who wanted his meat, while the fruit farmer who wanted to exchange his fruit for shoes might not be able to find a shoemaker who wanted his fruit.
The distinguishing characteristic of money is that it is the general medium of exchange. As Murray Rothbard wrote in What Has Government Done to Our Money?,
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.
In the world of money, the butcher could exchange his meat for money and then exchange that money for fruit. Likewise, the fruit farmer could exchange his fruit for money and then exchange that money for shoes. All these transactions become possible because money is the most marketable (i.e., the most accepted) commodity. Rothbard continues,
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 money is the thing that all other goods and services are traded for. This fundamental characteristic of money stands in contrast to the characteristics of other goods. For instance, food supplies necessary energy to human beings, and capital goods permit the expansion of infrastructure that in turn permits the production of a larger quantity of goods and services.
Contrary to mainstream thinking, then, the essence of money has nothing to do with financial deregulation, as the essence of money will remain intact in the most deregulated of markets. Money is the thing that all other goods and services are traded for.
Functions and Transaction Types of Money
Some commentators maintain that money’s main function is as a means of saving. Others argue that its main role is to provide a unit of account and to function as a store of value. While all these roles are important, they are not fundamental. The fundamental role of money is as a general medium of exchange. It is because of this function that money’s other functions—like the means of savings, the unit of account, and the store of value—emerge.
Through an ongoing selection process over thousands of years, individuals settled on gold as money. In today’s 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, which is employed in transactions. Goods and services are bought and sold for cash.
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 it; he has an absolute claim over it. No one else is expected to make use of his money, so the supply of money remains the same.
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 the lender to the borrower. Credit transactions do not alter the supply of money. If Bob lends $1,000 to Joe, the money is transferred from Bob’s demand deposit or wallet to Joe’s possession.
Why Various Popular Definitions and Counts of Money Supply Are Misleading
The definition of M2 includes money market securities, mutual funds, and other time deposits. However, an investment in a mutual fund is in fact an investment in various money market instruments. The quantity of money is not altered as a result of this investment; the ownership of money has only changed temporarily. Hence, including mutual funds as part of M2 results in the double counting of money.
The problem of double counting is also not resolved in the definition of money of zero maturity (MZM)—a relatively recent money supply measure. The essence of MZM is that it encompasses financial assets with zero maturity: assets included in MZM are redeemable at par on demand. MZM includes all types of financial instruments that can be easily converted into money without penalty or risk of capital loss. This definition excludes all securities, which are subject to risk of capital loss, and time deposits, which carry penalties for early withdrawal. Because MZM includes assets that can be easily converted into money in addition to money, this definition of money is flawed. It doesn’t tell us what money actually is, which is what a definition of money is supposed to do.
Observe that the Divisia index is not of much help either 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. In this sense the construction of the Divisia index is an exercise in curve fitting.
In addition, the Divisia of various Ms such as the Divisia M4 does not address the issue of the double counting of money. Remember that M4 is a broad aggregate that includes cash plus demand deposits plus negotiable money market securities, such as commercial paper, negotiable CDs, and T-bills. This is a mixture of claim and credit transactions (i.e., a double counting of money), which 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 erroneous components.
Furthermore, even if the components were valid, one does not improve the definition of money by assigning weights to components. The purpose of the definition is to establish what money is; this is not related to money’s correlation with GDP.
The introduction of electronic money has supposedly introduced another confusion regarding the definition of money. Some claim that electronic money is likely to make the current money (i.e., cash) redundant. On the contrary, electronic money is not new 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. Money is the thing that all other goods and services are traded for. Electronic money can function only as long as individuals know that they can convert it into fiat money (i.e., cash) on demand.
Conclusion
The essence of what money is cannot be established by means of a statistical correlation. It can only be established through understanding what money is all about. The attempt to strengthen the correlation between various monetary aggregates and economic activity by means of a variable weighting of the components of the money supply defeats the purpose of the definition of money.
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Source: News Wars Rephrased By: InfoArmed