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A reply to Steve Saville - TMS or M3?

By Paul van Eeden      Printer Friendly Version
Jun 2 2008 10:30AM

This week’s commentary is more technical than my usual letters but it is one I had to write -- sorry.

One of the advantages of writing about ideas is that they sometimes elicit a response that helps further our understanding. This was the case when Steve Saville suggested that I was making a mistake using M3 in my calculations, because M3 incorporates components of the banking system that are strictly speaking “not money”. Steve suggested that a monetary aggregate created by Murray Rothbard, called TMS (True Money Supply), would be more appropriate. Furthermore, Steve pointed out that TMS is currently declining (suggesting deflation) while M3 is rising (suggesting inflation) and that I may be making an error expecting an inflationary environment going forward.

I was blissfully unaware of the existence of TMS and so I am very grateful to Steve for bringing it to my attention. As you can see in the chart below, when we plot M3 and TMS on the same chart together with John Williams’ Consumer Price Index* (labeled “CPI”) all indexed to 1959, it appears as if M3 is grossly overstating inflation while TMS and the CPI correspond very well to each other. To a casual observer this may suffice as conclusive evidence that M3 is not a very good measure of monetary inflation and that TMS is, in fact, a better gauge of monetary inflation because of its close correlation to the CPI.

Chart 1

Fundamentally there is justification for this proposition: TMS was constructed with the intention of defining a true monetary aggregate that could tell us something about the true nature and extent of America’s money supply. M3, on the other hand, includes components of the banking system, such as money market mutual funds, that are clearly not money and which make M3, strictly speaking, not a true “monetary” aggregate. Alan Greenspan perhaps better defined M3 when he remarked that M3 told us more about the expansion of the banking system itself than about money per se.

As I wrote in last week’s letter, actually defining what money is nowadays is a very difficult task. During a hearing before the House of Representatives Committee on Financial Services Alan Greenspan conceded that neither he, nor the Federal Reserve Bank, could define what constitutes money. Yet any increase in the supply of money will cause the value of each unit of it to decrease, leading to higher prices of goods and services. We are used to measuring our savings in dollars, so the increase in the supply of dollars with its concomitant debasement of these same dollars is important.

Therefore, which of TMS or M3 gives us a better idea of the increase in monetary inflation is actually not just of academic interest -- it affects how we plan for retirement and which investments we make. So let’s dig a bit deeper.

M3 increased more than twice as much as TMS since 1959 (see Chart 1 above), but M3 and TMS both increased at approximately the same rate since 1980.

Chart 2

That means the divergence between M3 and TMS occurred sometime during the 1960s and 70s. The chart below shows this divergence graphically.

Chart 3

You will notice that while M3 increased marginally faster than TMS during the 60s it increased considerably faster than TMS during the 70s. We already know that both TMS and M3 increased virtually at the same pace since 1980 and therefore the key to which is a better proxy for monetary inflation will hopefully be found in an analysis and comparison of the data from the 60s and 70s.

The 1970s were an inflationary period in the US, and I am sure there are very few people who would argue otherwise. Let’s keep that in mind as we review the following data, which shows the average annual compound increase in M3, TMS and the CPI, as well as the average prevailing one-year Treasury interest rates during selected periods.

Compound annual increase in TMS, M3 and CPI, and average one-year Treasury rate





Interest Rates

1959 – 1970





1970 - 1980





1980 - 2007





1959 - 1980





1959 - 2007





Keeping in mind that the 1970s was characterized as one of the most inflationary periods in US history, I find it odd that the annual compound increase in TMS was substantially higher between 1980 and 2007 than during the 1970s. Judging by the annual compound increase in TMS since the 80s one would conclude that the 1970s was a period of much milder inflation than the period from 1980 until now, which is not in line with reality. Nor does TMS fit with the compound annual increase in the CPI, which shows the 1970s as having the highest inflation rate of all periods since 1959. M3, on the other hand, conforms to expectations, with the highest compound annual increase occurring during the 1970s.

It is not possible that the monetary growth that lead to price increases during the 70s occurred mostly during the 60s, since TMS growth during the 60s was noticeably lower than during the 70s. From all the data it appears as if the bulk of the monetary expansion occurred during the 70s yet TMS clearly suggests that that was a period of lower inflation than the period from 1980 until now.

It is also not possible that the increase in the rate of TMS growth from the 1960s to the 1970s was sufficient to explain the inflation of the 70s, because it contradicts our experience in the 1980s. The compound annual increase in TMS was 21.5% higher during the 70s than during the 60s, but 25.5% higher since 1980 than during the 1970s, which would suggest substantially more inflation occurred since the 1980 than during the 70s, which does not correspond well with common experience, the CPI or interest rates.

Let’s look at interest rates: Interest rates during the 1970s were clearly higher than during any other period since 1959. The average one-year interest rate for the entire period from 1959 until now is 6.06%. During the 70s the average interest rate was 23% higher at 7.46% yet the growth of TMS during the 70s was below its average from 1959 to 2007. M3, on the other hand, conforms to expectations as its highest rate of increase corresponds to the period with the highest interest rates. Also, the rate of expansion of M3, of 11.53%, far better explains peak interest rates of over 15% than the meager increase of TMS during the 1970s.

Now let’s consider something else. You’ll notice that the compound annual increase in TMS since 1959 is 6.22% while the compound annual increase in the CPI is 6.27%. This is over a span of 48 years so one would expect short-term effects to have cancelled out. On the face of it, such a similar rate of increase might suggest that TMS as a measure of monetary inflation is corroborated by the CPI; however, I don’t think that is correct.

Over a long period, such as the one we are now considering, we actually expect prices to rise more slowly than the increase in the money supply. That’s because price increases due to inflation would be offset by real price declines due to increases in productivity. The fact that the rate of increase in TMS is virtually identical to the rate of increase in the CPI suggests that there has not been any increase in productivity in the US economy since 1959 -- a proposition that I find hard to accept.

On the other hand, the compound annual increase in M3 since 1959 is 8.03%. Compared with the compound annual increase in the CPI it suggests that, on average, there has been an average 1.76% increase in productivity per year in the US economy since 1959. This sounds far more reasonable but actually over-states productivity gains. As the population grows the demand for money will grow correspondingly and the economy will expand, which means we have to adjust the money supply increase for population growth (ignoring changes in demographics for the time being). The average compound increase in the US population since 1959 is approximately 1%. Therefore, we have to deduct 1% from the difference in the annual percentage growth rate of the money supply and the CPI to arrive at a better estimate of the actual increase in productivity. Using M3 and the CPI, and adjusting for the population growth, suggests that the average annual increase in productivity was only about 0.76% per year. When we use TMS (adjusted for population growth) it would suggest an average annual compound decline in productivity in the US since 1959 of approximately 1%, which is even less believable than no productivity growth.

Now let’s see if we can address the divergence between TMS and M3 that we noticed right at the beginning.

From 1980 to 2007 TMS, M3 and the CPI all increased at a similar rate: 7.09%, 7.08% and 7.21% respectively. For all practical purposes these are identical. If we now adjust for population growth we see that both TMS and M3 suggest that the US economy had negative productivity growth of approximately 1% per year since 1980.

While I am certain that every government economist and, perhaps, most main stream economists will vehemently argue that the negative 1% productivity growth in the US since 1980 is impossible, I would suggest that it might just be correct. The United States has been losing manufacturing jobs to developing countries since 1980 and has become entirely dependent on foreign borrowing to sustain internal consumption. I don’t think it’s far-fetched at all that productivity growth in the US since 1980 has been non-existent, or negative.

But TMS and the CPI growth rates between 1959 and 1980 were also essentially identical which means that TMS suggests the American economy also had negative productivity growth of approximately 1% per year during America’s boom years. That is hard to believe. M3, on the other hand, suggests the increase in annual productivity was 3.2% from 1959 to 1980. That seems like an awfully high increase in annual productivity, until you consider that the period we are talking about was the Golden Age of the United States. There is some lag between monetary inflation and an increase in prices and the high rate of monetary inflation during the 1970s may mean that implied productivity growth for the period is over-stated. But let’s accept the data as it is and then consider that during the Second World War both Europe and Japan’s manufacturing complexes were destroyed and the United States was the only major economic power that was not bombarded. After the war the United States became the major producer of just about everything. Labor was abundant, capital creation occurred at a dizzying pace and real economic growth was perhaps the highest in the history of the United States. Could it be that the economy was enjoying 3.2% average annual productivity growth? It seems far more plausible than to suggest the productivity growth during America’s best years was a negative 1% per annum, which is what TMS would suggest.

We could write books about all that’s been said above, but the bottom line is that an analysis of TMS, M3, the CPI and interest rates leads me to believe that while TMS may be a better monetary aggregate than M1 or M2, it is by no means able to explain observed economic trends since 1959.

When Alan Greenspan conceded that he did not know how to define or measure the money supply of the United States, he also commented that any standard used to gauge the expansion of the money supply should be judged by whether “it gives us a good forward indicator of the direction of finance and the economy”. I would add that one could also use the same test to see if it can explain the past. It seems that TMS fails the test while M3 appears to pass.

Greenspan also made another interesting comment: he said that while the Fed had used M1 and M2 for monetary policy decisions and finally discarded both, it never used M3. I found that very interesting -- I am sure that if they went to all the trouble of conceiving and producing M3 for 47 years they must have tried it once or twice.

What Greenspan did say, was that M3 “largely reflects the extent of the expansion of the banking industry”. And, as I noted last week, the true nature and quantity of money may be impossible to define, or measure, because we are dealing with a fractional banking system based on a fiat currency. Perhaps that is precisely why M3 is a better gauge of monetary inflation: it is a measure of the expansion of the banking system and not a direct attempt to quantify money**.

In closing, I do want to thank Steve Saville once again for bringing TMS to my attention but with respect to his conclusion that relying on M3 is a mistake, I would suggest the following:

Look at the chart of TMS and M3 since 1980 again, and notice that while the average annual compound increase in TMS and M3 were essentially identical, TMS is a lot more volatile than M3.

Chart 2

Relying on TMS as an indicator of monetary inflation between 1980 and 1983, 1987 and 1991, 1994 and 1996, during 2000, or since 2005, would have led to the conclusion that monetary inflation was non-existent while in reality the average annual growth of inflation was over 7%. In other words, during all those periods TMS would have given incorrect readings as to the continued inflation of the money supply and if one had invested on the expectation of deflation it could have had dire consequences. Could the volatile nature of TMS be giving us yet another such “false” signal that inflation is non-existent? There is only one such period of low inflation visible on the M3 chart, from 1989 to 1993, and that was a period during which it appears from other data sources, such as M2 and the gold price, that the inflation rate was most likely very benign.

A further problem with TMS is that it reports a 47.3% increase from August 1982 to May 1983. A 47.3% increase in the money supply in just nine months is worrisome. I checked both M1 and M2, and there was no such corresponding increase in either aggregate. During that time M1 increased by 9.8% and M2 increased by 10%. So, not only is TMS very volatile and therefore not very useful when considered over relatively short periods of time, such as a few years, but there could also be problems with the data integrity published by the Ludwig von Mises Institute. I would be very curious to know the cause and origin of the 47.3% increase in TMS as described above.

For the time being, I think I’ll stick to M3 and anticipate continued inflation rather than deflation, as suggested by TMS.

Incidentally, the reason why prices are so stable during a gold standard is that the rate of increase in the gold supply corresponds very closely to the increase in population. Since 1800 the annual compound increase in the gold supply has been around 1.5% while the population growth has been approximately 1% per year. If we allow 0.5% per year for productivity increases we see that prices should be very stable indeed under a gold standard, over the long term. Historical data corroborates this proposition.

Paul van Eeden

* For the Consumer Price Index (CPI) I used the official data up until 1980 and John Williams’ data (link) since 1980. John Williams’ CPI data is calculated in the same manner as the official CPI prior to 1980, which means it is devoid of owner’s equivalent rent, geometric and hedonic adjustments.

** I have given the nature of M3 a lot of thought since I started working on this article and Greenspan’s comment that it tells us more about the banking system than money struck a cord. I checked the increase in commercial bank assets since 1973 and the compound annual rate of increase is 8.17% compared with the compound annual increase in the rate of M3 since 1959, which is 8.03%. So it seems Mr. Greenspan was correct about M3, it does tell us more about the banking system than about money. But we don’t know what constitutes money any more, and so perhaps it would make more sense to view the expansion of the banking system as equivalent to the expansion of money, since, after all, almost all the money in the system is ultimately held by commercial banks. I intend to do more work along these lines and am optimistic that it will lead to an even better gold price model. I will, of course, keep you informed of my progress.



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