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A Truer Money Supply


Conventional aggregates no predictor of inflation.

TMS vs. M3 vs. M Prime

There's been an interesting discussion between Steve Saville and Paul van Eeden over the monetary aggregates M3 and TMS.

TMS stands for True Money Supply: It's a monetary measure based on Austrian economic principles. I'll come back to TMS in a moment; first, here are a couple discussion points from Steve Saville and Paul van Eeden.

From Steve Saville in TMS or M3?

A few weeks ago Paul van Eeden (PVE) posted an extremely bearish outlook on bonds that he justified, in large part, by the rapid expansion of M3 money supply. We responded that while we are long-term bearish on bonds (we expect bond yields to move much higher over the coming 5 years), we thought that PVE's premise was wrong. Our reasoning: M3 is a poor indicator of monetary inflation, whereas a vastly superior monetary aggregate, namely the TMS developed by Murray Rothbard and Joseph Salerno, reveals a relatively slow rate of monetary inflation.

Paul van Eeden responded with several charts illustrating M3 vs. TMS in relation to the Consumer Price Index (CPI):

Interestingly, the first chart would appear to show the superiority of TMS. By picking a different starting time period, M3 tracks the CPI better than TMS as the second chart indicates.

M3, TMS and the CPI 1959 to Present

M3, TMS and the CPI 1980 to Present

But I have to ask: Of what practical use is tracking an estimated M3 vs. a nonstandard definition of the CPI (one based on John Williams' measurements)?

I certainly see no reason to be shorting treasuries based on that premise, as the following chart suggests:

Click to enlarge

If M3 is such a good measure of inflation, why did 10-year treasury yields collapse - dropping from 15% to 4%? If, based on M3, you decided to short treasuries in size in August of 2007, you'd now be broke: Short term rates fell from 5.25% to 2%.

Assuming that M3 and the Williams CPI track -- which, to me, seems like a real leap of faith -- how do you take advantage of it? While M3 was sharply rising, gold was falling for decades, along with treasury yields.

I see absolutely nothing in those charts that makes M3 seem like any kind of economic indicator.

We're clearly in a recession. Treasury yields have plunged over the last year.

The M3 is soaring - which of those did it predict? M Prime dips below 2.5% or so are a strong signal of recession.

Why Is M3 Soaring?
The question that everyone's failing to ask is the most important one: Why is M3 through the roof?

The answer: Fearing that they may soon no longer be able to do so, businesses are tapping into credit lines. They're then parking that money in institutional money-market accounts; in response, M3 and MZM have been soaring.

These are certainly not inflationary conditions.

Indeed, bank credit is contracting.

Economist Paul Kasriel agrees, asking: If the Fed is so easy, why is the growth in money and credit aggregates so weak?

I am on record as stating that peak credit has arrived and deflationary hurricanes will hit the U.S. and U.K.

True Money Supply
Formulated by Murray Rothbard, the True Money Supply (TMS) represents the amount of money in the economy that is available for immediate use in exchange. It has been referred to as the Austrian Money Supply, the Rothbard Money Supply and the True Money Supply.

For a detailed description and explanation of the TMS aggregate, see Salerno, as well as Shostak's The Mystery Of The Money Supply Definition.

The TMS consists of the following: the currency component of M1, total checkable deposits, savings deposits, U.S. government demand deposits and note balances, demand deposits due to foreign commercial banks, and demand deposits due to foreign official institutions.

Click to enlarge

I have two problems with the above chart, both of them serious. The first is that the chart does not display TMS as Shostak defines it: "[The] money supply follows: Cash+demand deposits with commercial banks and thrift institutions+government deposits with banks and the central bank."

Shostak rightfully excluded savings deposits, because they're credit transactions (savings deposits are immediately lent out and aren't really available on demand). Sweeps are also missing from this understanding of TMS; inquiring minds will want to read Mystery of the Money Supply Definition for a complete discussion.

Secondly, I have a problem with the way the chart presents data: The best way to see what's happening is by looking at percentage change year-over-year - a perspective not offered by the Mises site.

M Prime
Using Shostak's definition and with much charting help from Bart of Now and Futures, I came up with M Prime - arguably what the TMS is supposed to be. For more details on the origins of M Prime, please see Money Supply and Recessions.

Should Mises incorporate Shostak's definition and offer percentage changes, there will be no further need to publish M Prime updates.

Click to enlarge

M Prime dips below 2.5% or so are a strong signal of recession.

Click to enlarge

M3 is essentially useless in predicting recessions - along with treasury rates, and the price of gold. In fact, I can't find a single practical use for it. That there should be such intense focus on so utterly irrelevant an indicator is staggering.

Click to enlarge

TMS did a better job predicting a few earlier recessions, but failed in 1995 (a non-recession year), 2001 and now. I am sticking with M Prime for theoretical reasons. Shostak is right on this one.


TMS and M Prime are clearly superior to M3 as indicators, by any practical measure that I can come up with.

As for measuring inflation or deflation, I don't think any of them will suffice - for the simple reason that credit marked to market is plunging. That's the way things need to be looked at.

Unfortunately, there's no accurate measure of the credit plunge because financial institutions are not marking credit to market. Instead, much credit is still in structured investment vehicles (SIVs) and/or hidden in Level 3 (marked-to-fantasy) assets.

We can say that bank credit is shrinking, but we also know that the numbers are distorted, due to SIVs gradual reappearance on bank balance sheets. That's on top of the distortion I mentioned earlier: Because credit lines are being tapped and parked in money market funds, M3 and MZM are expanding.

Judging from a collapsing real estate market, people simply walking away from their homes, increasing risk aversiveness, banks' unwillingness to lend -- along with the fact that credit which should be marked to market, isn't so marked -- I believe we're in deflation, right here and right now.

Those focused on M3, or energy, or food prices, are truly missing the boat. Trillions of dollars in housing wealth are being destroyed, and much more is coming. Add another trillion dollars in bank credit markdowns, on top of what we've already seen.

These are the numbers you should be watching to get a sense of the current state of affairs - not the M3, or any other monetary aggregate for that matter.
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