Galtland Index

Monetary Aggregates and Credit Expansion

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Monetary Aggregates and Credit Expansion

The theoretical target

Mises defines inflation as the quantity of money in the broader sense outrunning the demand for money in the broader sense (see The Theory of Money and Credit Excursus to Ch. VII §7). The supply side of that test — “broader-sense quantity of money” — is what an empirical aggregate must capture. Per Mises’s typology (see Cash Holding and the Demand for Money):

  • Money proper (commodity / fiat / credit money)
  • Money-certificates (100%-covered substitutes; warehouse receipts)
  • Fiduciary media (uncovered substitutes — the inflation-relevant subtype)

A correct Austrian aggregate counts money proper outside bank reserves plus money-substitutes held by the public, with cover not double-counted (the specie sitting behind money-certificates is already inside the money-proper figure — see the accounting rule in Cash Holding and the Demand for Money). The fight in monetary statistics is about where to draw the line on what counts as a money-substitute.

M2 — the standard aggregate, theoretically muddled

M2 (per the Fed’s H.6 statistical release) is M1 plus small-denomination time deposits and retail money-market funds. M1 itself is currency in circulation plus demand deposits plus other liquid deposits (other checkable deposits + savings deposits at depository institutions). M2 is widely available, official, and standardized.

The problem for Austrian use is that M2 lumps two categorically different things:

  • Fiduciary media (demand deposits, other checkable deposits) — uncovered bank-issued claims, exactly what Austrian Business Cycle Theory targets.
  • Commodity-credit instruments (small-denomination time deposits / small CDs, retail MMMFs) — these represent savings transferred to a borrower via the bank or fund, which by Mises’s Credit and Deferred Payment distinction is not inflationary in the same sense. The saver gives up present-good claims; the lender does not create money out of nothing.

Households moving cash from currency holdings into small CDs re-shuffles M2’s composition (currency falls, small time deposits rise, M2 level roughly flat) without any fiduciary-media expansion. Conversely, banks issuing new demand deposits expands the fiduciary-media subset of M2 and lifts the level — but the M2 number alone can’t tell the operator which is happening, because small-time-deposit and retail-MMMF flows contaminate the signal. M2 is usable as a coarse trend indicator, theoretically noisy as a level reading of cycle pressure.

Rothbard’s True Money Supply — the cleaner Austrian aggregate

Rothbard argued in America’s Great Depression Ch. 4 “The Inflationary Factors” that the test is whether an instrument is treated as convertible into cash on demand, whatever its formal label. By that test he included not just demand deposits but also time deposits, savings-and-loan shares, credit-union shares, and cash surrender values of life insurance — because in practice all are redeemable on demand even where notice is formally required.

But if we concede the inclusion of time deposits in the money supply, even broader vistas are opened to view. For then all claims convertible into cash on demand constitute a part of the money supply, and swell the money supply whenever cash reserves are less than 100 percent.

— Rothbard, America’s Great Depression, Ch. 4

Joseph T. Salerno later refined this in his 1987 paper “The ‘True’ Money Supply: A Measure of the Supply of the Medium of Exchange in the U.S. Economy” as the True Money Supply (TMS). Per Salerno’s own component-by-component specification, TMS comprises:

  • Currency in the hands of the nonbank public, excluding Treasury, Fed, and commercial-bank vault holdings
  • Demand deposits + other checkable deposits (NOW accounts)
  • Money market deposit accounts (MMDAs) at commercial banks and thrifts
  • Savings deposits at commercial banks and thrifts
  • Overnight repurchase agreements (RPs) and overnight Eurodollars
  • U.S. Savings Bonds at their current redemption value
  • (Memorandum items) U.S. government demand deposits at the Fed and at commercial banks; foreign official and foreign commercial-bank demand deposits held in the U.S.

Salerno excludes money market mutual funds (MMMFs), term RPs, small-denomination time deposits and CDs (treated as loans to banks rather than money-substitutes), large CDs, and short-term Treasury securities. This is a deliberate narrowing of Rothbard’s AGD-era criterion, which had included time deposits on the de-facto-redeemable argument; Salerno’s 1987 paper distinguishes overnight commitments (genuinely money-substitute) from term commitments (genuinely loans).

TMS captures the total medium of exchange — money proper plus money-substitutes held by the public — rather than the fiduciary-media subset specifically. The use case for which Austrian economists deploy TMS is the cycle-theory diagnostic, where fiduciary-media expansion is what matters; TMS is preferred over M2 there because it excludes the small-time-deposit, money-fund, and term-repo components that contaminate M2 with commodity-credit savings. The Mises Institute publishes a TMS series; the Federal Reserve does not. The popular book-length treatment of the underlying money-supply criterion appears in The Mystery of Banking.

Why central-bank policy rates are an input, not a measure

The Fed funds target rate, ECB deposit rate, BOJ short rate, BoE bank rate — these are the central bank’s signal to commercial banks about the price of marginal liquidity. They are an input: low policy rates lower banks’ cost of issuing fiduciary media, which increases their incentive to do so, which is what the cycle theory wants to measure. So policy rates predict expansion but do not quantify it. A 50bp cut does not specify by how much fiduciary media will subsequently grow; the answer depends on banks’ and borrowers’ response.

Worse, the natural rate of interest is unobservable. So the theoretical test “is the gross market rate suppressed below the natural rate” cannot be verified directly — it has to be inferred from outcomes (booms in interest-rate-sensitive sectors, capital-structure lengthening, eventual bust). Rates give intent; outcomes give evidence.

The sectoral diagnostic

Rothbard on Fed-Induced Booms supplies the structural test that doesn’t depend on aggregate measurement at all: are interest-rate-sensitive sectors expanding disproportionately? Construction, heavy machinery, raw-materials extraction, R&D, long-duration capital projects — these respond first and largest to suppressed rates. Consumer goods (lower-order) draw down relatively. When the sectoral skew widens, the production structure is lengthening, regardless of what the headline aggregate says. This is the Rothbardian diagnostic from his 1921-1929 analysis in America’s Great Depression.

Practical triangulation

No single number captures Austrian credit expansion. A working triangulation:

  1. TMS (or M1 if TMS unavailable) — the stock proxy for broader-sense money. M2 is acceptable as a trend indicator with the noise caveat above.
  2. Policy rate vs long-term real yield — a rough heuristic for the natural-rate gap, not a direct natural-rate proxy (the natural rate is unobservable; long-term real yields are themselves shaped by policy and term premia). Persistent suppression is the predictor.
  3. Sectoral asymmetry — the structural signature. Capital-goods vs consumer-goods activity ratios, construction and heavy-machinery sector employment vs services, yield-curve shape signalling where the lengthened production structure is concentrated.

When all three signal expansion together — TMS growth, policy rate below long real yields, sectoral skew toward higher-order goods — the cycle theory’s preconditions are present. When one signals and the others don’t, you have ambiguous data, not a confirmed cycle.

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