Money Remains a Medium of Exchange and Is Not a Series of Data Points

According to much mainstream economic 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. According to such 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). The high correlation between the money supply and various economic indicators allegedly makes the money supply data useful in ascertaining the future course of economic activity.

However, it is also held that, since the early 1980s, correlations between various definitions of money and the GDP have broken down. The supposed reason for this breakdown 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 1980s, economists have been paying very little attention to the money supply data.

Some economists believe 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 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 of the economy. However, does it all make sense?

What Money Is

No definition can be established through 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 originated. Money emerged from barter exchanges, leading eventually to a suitable medium of exchange. 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. 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 market commodity).

Regardless of financial deregulations, the definition of money should not change. 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 physical paper, coins, and digital notes issued by the government and the central bank. Consequently, these things constitute money and goods and services are sold for money (unless traded against other goods).

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. No one else is expected to make use of it. This should be contrasted with a credit transaction, in which the lender of money temporarily 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 Joe’s possession.

Popular, but Questionable, Definitions

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. 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.

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 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. 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. Therefore, it doesn’t tell us what money is.

The introduction of electronic money has introduced another level of confusion regarding the definition of money. It is held that electronic money is likely to make physical cash and coins nearly redundant. Regardless of these new ways of employing money, the definition of money does not change.

Conclusion

The essence of money cannot be established by means of statistical correlation but rather by means of clarity concerning its function. The attempt to strengthen the correlation between various monetary aggregates and economic activity by means of variable weighting of the money supply components defeats the purpose of establishing the definition of money.