One of the great annoyances of the day is the inability of many to understand the differences between legitimate debates and weird debates were one side obviously knows more than the other. In the olden days of political economy there was the traditional divide between the two mainstream schools of thought on money and inflation, the Monetarist and the Keynesians. However Recent political shifts have led to the heterodox Austrian school of economics replacing the Monetarist school  view, at least in popular and political thought. Were as the old debate used to focus on somewhat different interpretations of certain facts, the modern debate usually focuses on the Austrian schools bizarre tendency to insist they are right even in the midst of being horribly, horribly, wrong.

In part 1 of this series we will be discussing different measures of the money supply. When many think of money supply they think of things like dollar bills, coins, or cowry shells. But money also includes electronic and conceptual forms, such as the money in your bank account. Both the mainstream schools and the Austrian school agree that the money supply influences the price level to some degree or another.

There are several different measures of the Money supply, which include different things as being money, the two most popular with mainstream schools of thought are called M1 and M2. The Austrian school has partially rejected M1 and M2 and instead created their own version which they quite humbly named the TRUE Money Supply, we will be calling it the more accurate name the Austrian Money Supply (AMS). According to Joseph T. Salerno one of the creators of the AMS:

Measures of the US money stock in current use in current use in economic and business forecasting and applied economical ans historical research are flawed precisely because they are not based on an explicit and coherent theoretical conception of the essential nature of money. Given the all-pervasive role of money in the modern market economy, existing money-supply measures therefore tend to impede, rather than to facilitate, a clear understanding of the past or future development of actual economic events. (Salerno 1987)

Further as stated both the mainstream and Austrian view is that the main use of measuring money supply is to predict changes to the price level. As Ludwig von Mise, the grandfather of Austrian economics states:

[A]n increase in the quantity of money (in the broader sense of the term, so as to include fiduciary media as well), that is not offset by a corresponding increase in the need for money (again in the broader sense of the term), so that a fall in the objective exchange value of money must occur Again, deflation (or restriction, or contraction) signifies a diminution of the quantity of money (in the broader sense) which is not offset by a corresponding diminution of the demand for money (in the broader sense), so that an increase in the objective exchange value of money must occur If we so define these concepts, it follows that either inflation or deflation is constantly going on, for a situation in which the objective exchange value of money did not alter could hardly ever exist for very long. (Mise 1953)

So I have a simple test to see if the AMS truly does what it says i.e predicts increases in the price level. We will take a measure of the Price level in this case the Personal Consumption Expenditures index (PCE) and test the different measures of money supply against it. If the AMS correlates best to the PCE, then the AMS really could be said to facilitate a better understanding of economic events as Salerno claims. On the other hand if in performs poorly then it will have failed to demonstrate its usefulness in the primary use of a measure of money supply.

Note: Since both the measures of money supply and the price index increase exponentially, I’ve converted the statistics to their natural logs, which allows us to better calculate the correlation across time periods.

Because we are dealing with statistics that all increase over time the correlations will all appear quite high, because they are all moving in the same direction. But just because two measures increases over time does not mean there is a connection between the two. In order to successfully tell whether the correlation is sufficient to be useful we will need to calculate a minimum correlation. In this case we will use the correlation between the price index and its own trend line. The trend line is simply the line depicting what the estimated index would be if it just increased at its average rate every year. It is one of the most basic and simple models there is and something has a lower correlation to the PCE Index worse than the trend line, then it doesn’t have much of a connection to the PCE. As we can see below the AMS has a lower correlation than  basic trend line and M1 and M2 clearly have a much higher correlation.

Why does the AMS perform poorly as compared to the trend line? It’s useful to take a look at the rates of change. As you can see below the annual rate of change for the Austrian school has a strong negative correlation to the PCE, this means that the higher the AMS growth rate the slower the price level growth rate and vice versa, exactly the opposite of what you would expect from Austrian monetary theory which claims that the AMS directly correlates to price level growth . Given that Austrians like to use the “long-run” as an excuse for why their predictions fail, it’s rather funny that the only time the AMS has a higher correlation than M1 and M2 measures is in the short run (1-year growth rates), unfortunately for the Austrians that correlation is going in the exact opposite direction then they would predict.

Some Austrians might say I am being unfair and that the AMS is correct in the long run stating, “Of course one should not expect that changes in money supply have an immediate effect on inflation. Taking into account adjustment processes, it takes some time for the change in money supply to make itself felt in the economy.” (Polleit 2005) This is why if you look above I’ve included the 5 and ten-year rates of change in the chart above. As you can see the the very long twerm 10-year rate correlations are still negative but less strong. So in the long run the Austrians are less wrong but they are still really wrong.

One argument an Austrian might use to defend the AMS is that “no definition can be established by means of a correlation. The purpose of a definition is to present the essence, the distinguishing characteristic of the subject we are trying to identify. … But no definition can be established by means of a correlation. The purpose of a definition is to present the essence, the distinguishing characteristic of the subject we are trying to identify.” (Shostak 2010) They might argue that the Austrian definition is the accurate definition based on their concept of money regardless of whether or not it meets any statistical tests I have for it. If fact a huge and rather annoying tendency of Austrians is to define something and then state that its true because they defined it that way.

The above criticism may be rebutted by another one of the key claims of the Austrians, Ludwig von Mise says, “If there is no increase in the quantity of money and if there is no credit expansion, the average height of prices and wages will by and large remain unchanged. But if the quantity of money and credit is increased, prices and wages must rise, whatever the government may decree.” (Mise 1980)   If what von Mise says is true then there will always be a direct positive correlation between price level and money supply. This is the case with both M1 and M2 but it is not the case with the AMS.

This means that either the Austrian claim that money supply is the major driving force in the increase in the price level is false or there is some major flaw in the AMS as compared to M1 and M2. In either case a major component of Austrian Monetary Theory is false. Going forward in part 2 we will ignore the AMS and concentrate on the Austrian view that an increase in money causes an increase in prices. This is more useful because AMS is such a failure that if we used it the discussion would end here. Further by continuing the discussion using M2 in Austrian models we will be able to compare different models of price level changes more accurately.

In Part two we will compare the rather simple Austrian Model of Money and Inflation to a simplified Keynesian model.

Sources:

FRED Economic Data, St. Louis Federal Reserve, accessed July 8, 2010, http://research.stlouisfed.org/fred2/graph/?g=8Er. (all statistical data)

“True Money Supply,” Ludwig Von Mise Institute, accessed July 8, 2010, http://mises.org/content/nofed/chart.aspx. (For a list of components of the Austrian Money Supply)

Joseph T. Salerno, “The ‘True’ Money Supply: A Measure of the Supply of the Medium of Exchange in the Economy,” Austrian Economics Newsletter, Spring 1987, accessed July 9, 2010, http://mises.org/journals/aen/aen6_4_1.pdf.

Ludwig von Mises, “The Theory of Money and Credit,”, 1953, accessed July 9, 2010, http://mises.org/books/Theory_Money_Credit/Part2_Ch13.aspx.

Thorsten Polleit, “Why Money Supply Matters,” Mises Daily, November 08, 2005, accessed July 10, 2010, http://mises.org/daily/1956.

Frank Shostak, “THE MYSTERY OF THE MONEY SUPPLY DEFINITION,” THE QUARTERLY JOURNAL OF AUSTRIAN ECONOMICS, Spring 2000, accessed July 8, 2010, http://mises.org/journals/qjae/pdf/qjae3_4_3.pdf .

Ludwig von Mises, “Economic Freedom and Interventionism,” 1980, accessed February 8, 2010, http://mises.org/efandi/ch20.asp.