The Actual Money Supply

On February 17, 2000, then Federal Reserve Board Chairman, Alan Greenspan, was answering a question from Congressman Ron Paul during a House of Representatives Committee on Financial Services hearing, when the following exchange took place.

Mr. Greenspan: “Let me suggest to you that the monetary aggregates as we measure them are getting increasingly complex and difficult to integrate into a set of forecasts.

“The problem we have is not that money is unimportant, but how we define it. By definition, all prices are indeed the ratio of exchange of a good for money. And what we seek is what that is. Our problem is, we used M1 at one point as the proxy for money, and it turned out to be very difficult as an indicator of any financial state. We then went to M2 and had a similar problem. We have never done it with M3 per se, because it largely reflects the extent of the expansion of the banking industry, and when, in effect, banks expand, in and of itself it doesn’t tell you terribly much about what the real money is.

“So our problem is not that we do not believe in sound money; we do. We very much believe that if you have a debased currency that you will have a debased economy. The difficulty is in defining what part of our liquidity structure is truly money. We have had trouble ferreting out proxies for that for a number of years. And the standard we employ is whether it gives us a good forward indicator of the direction of finance and the economy. Regrettably none of those that we have been able to develop, including MZM, have done that. That does not mean that we think that money is irrelevant; it means that we think that our measures of money have been inadequate and as a consequence of that we, as I have mentioned previously, have downgraded the use of the monetary aggregates for monetary policy purposes until we are able to find a more stable proxy for what we believe is the underlying money in the economy.”

Dr. Paul: “So it is hard to manage something you can’t define.”

Mr. Greenspan: “It is not possible to manage something you cannot define.”

Here we have possibly the most influential and powerful banker in the world, who is in charge of managing the most widely used money in the world – the U.S. dollar – telling us not only that he doesn’t know what money is, or how to measure how much of it there is, but admitting that it’s impossible to manage the money supply precisely because they have not yet figured out what it is or how to measure how much of it there is.

For something we use every day and that is an integral part of our lives, it is remarkable how little we know about money.

When the money supply increases (inflation) money loses value (prices rise). Because the money supply is almost always increasing (inflation), and therefore decreasing the value of money, it means that our standard of living is eroded over time if our income is fixed, or not rising as fast as the inflation rate (the rate of increase in the money supply). Yet there is no credible measure of the inflation rate. I have been searching for an answer to the actual inflation rate for more than a decade and there was none that I felt was accurate enough, so I had to design my own.

Actual Money Supply (AMS) is a tool that I created to measure the money supply in the United States and therefore the actual monetary inflation rate. The chart below is always the most recent one I have and is updated as data becomes available.


Because the monthly, year-over-year data depicted in the chart is so volatile I added a rolling 12-month average of the Actual Inflation Rate to the chart. The rolling 12-month average inflation rate is itself still quite volatile, but much less so than the actual monthly data.

It is interesting to note that the average rolling 12-month inflation rate averages 8.25% for the past 15 months. To put that in context, the average inflation rate from 1970 to 1979 was 8.32%. We are, absolutely, in a highly inflationary environment. Deflation is not only unlikely given the structure of the US banking system, but nowhere to be seen in the data either.

Demand destruction has had a severe impact on the prices of many goods and services, but that should not be confused with deflation. Inflation and deflation are monetary phenomena and the recent decline in prices has only lead to confusion and further obfuscation of what is really going on.

Monetary inflation is currently mitigating the price declines we are witnessing, meaning those prices that are declining would have declined much more were it not for the inflation, and will eventually cause prices to start rising again. Our greatest concern should not be with the current falling prices of goods and services, but with the rate at which they will rise in the future vis-à-vis our capital and income. I suspect there are very few people out there whose income and investments are keeping up with the inflation rate, which means their wealth is eroding in real terms.

I have also been aggregating and calculating similar money supply and inflation data for Canada and found that the Canadian dollar’s inflation rates for 2007 and 2008 were much higher than the inflation rates of US dollar. However, the average inflation rates for 2009 thus far are exactly the opposite. Canada’s inflation rate is falling while that of the US is remaining steady above 8%.

2007 7.93% 9.55%
2008 8.31% 10.23%
2009 8.48% 6.89%

For those interested in gold, my fair value of gold for 2008 was $763 an ounce. Using the average of 2008 and 2009’s inflation rates for the U.S. dollar, and gold’s inflation rate for 2008, I come up with an approximate average value for gold of $815 for 2009. Please note that this is an estimate of the average value for the year, and not a year-end estimate.

Clearly the gold price is well above $815 an ounce, and has been so for quite some time. The macro economic environment has probably never been so obviously in favor of gold and it is my belief that the market has already priced much of this into the gold price. While I fully recognize gold’s lure at these times, and the probability that the gold price could still increase quite substantially, I remain cautious about gold. Recall that investors who bought gold when it was grossly over-priced during 1979 and 1980 and then forgot to sell, suffered severe losses.

I would personally prefer gold to sell down to around $800 an ounce, where I know it represents good value, than buy gold at over-valued prices and hope that it keeps going up.


Paul van Eeden
for The Daily Reckoning