MONEY SUPPLY MUSINGS
by Rob Kirby
KirbyAnalytics.com
July 24, 2007

In recent years, the relevance of different measures of Money Supply have been debated, scrutinized and in the case of the Federal Reserve – diminished and discarded:

So why did they do it? Hard money writers have offered a variety of possible reasons, but I think it all comes down to one thing: M3 have during the last few years increased more than M2. Just like the Fed and pro-administration pundits makes sure to focus on whatever consumer price measure increases the least (currently the "core" PCE deflator), the Fed wants people to focus on a money supply measure which increases less.

The quote above references the Federal Reserve’s decision to quit publishing M3 money supply aggregate data as of March 26, 2006. 

So, is it really as simple as the ‘old’ M3 was growing faster than M2?

I suspect NOT. Instead, I now believe the Fed was trying to get-out-in-front-of demands to EXPAND the definition of the broadest measure of money - M3. Let me explain:

Institutional [derivatives] leverage ratios according to noted financial reporter Bill Fleckenstein:

(Editors note: Leverage, sometimes known as the leverage ratio, divides assets by total equity in a company and gives a sense of its ability to withstand shocks. Fannie has a leverage ratio of 63.1. Freddies is 38.0. The leverage ratio of the banks in the Standard & Poors Banking index is 11.3.)

Now, let’s stop to consider what Investopedia has to say about Leverage:

1.       The use of various financial instruments or borrowed capital, such as margin, to increase the potential return of an investment. 

2.       The amount of debt used to finance a firm's assets. A firm with significantly more debt than equity is considered to be highly leveraged.

Leverage helps both the investor and the firm to invest or operate. However, it comes with greater risk. If an investor uses leverage to make an investment and the investment moves against the investor, his or her loss is much greater than it would've been if the investment had not been leveraged - leverage magnifies both gains and losses. In the business world, a company can use leverage to try to generate shareholder wealth, but if it fails to do so, the interest expense and credit risk of default destroys shareholder value. 

So now, let’s stop and consider how Investopedia defines Money Supply:

            The entire quantity of bills, coins, loans, credit and other liquid instruments in a country's economy.

Money supply is divided into multiple categories - M0, M1, M2 and M3 - according to the type and size of account in which the instrument is kept. The money supply is important to economists trying to understand how policies will affect interest rates and growth.

Instead of “dropping” M3 – perhaps a new category, DERIVATIVES, should have made up a new category – M4. After all, it is through the use of derivatives that the Plunge Protection Team [PPT] increasingly manages a host of strategic financial and commodity markets on an almost daily basis.

But then again, admission of these realities wouldn’t have done much for international confidence in the dollar, ehh?

Classical money supply aggregates [M1, M2, and M3] were all “coined” [pun] or defined – largely – by old-school economists in a pre-derivates world. With the cancerous growth of derivatives [now totaling – conservatively - 400 TRILLION in NOTIONAL globally] in recent years – an academic argument was inevitable [probably imminent] – suggesting these items be included in some manner as a legitimate constituent in an ACCURATE ACCOUNTING of monetary aggregates.

The reason: These items are born of leverage [debt/credit] and as proxies for their ‘underlying’ - they are created out of ‘thin air’ just like fiat and ‘spend’ like cash. They also impact bank’s balance sheets and therefore, ultimately, their ability to create new loans. If you don’t believe this – just ask the folks over at the Bank of Montreal. 

So how can this activity possibly be excluded from the broadest working definition of the supply of money?

The Federal Reserve acted preemptively to GET-OUT-IN-FRONT-OF what surely and inevitably would have been demands for the definition of money supply to be EXPANDED.

This becomes clear when one stops and really analyzes the words of Dallas Fed’s Richard Fisher,

"The Federal Reserve will do what it takes to maintain its credibility, which is central to preserving the
integrity of the US dollar," Dallas Federal Reserve Bank President Richard Fisher said on Tuesday.

This report, from Reuters, continues: "We seek to get it right. And the answer to your
question is we will do what gets it right," said Fisher.
 
Answering audience questions after a speech to the Dallas Friday Group, Fisher said the US dollar is a
"faith-based currency" dependent on the credibility of a central bank.
 
"In addition to a faith-based currency, we are the currency of the world and we must maintain its
integrity..."

The reality folks, the Federal Reserve is – and has been – growing the money supply at larcenous double-digit++ growth rates, and has been doing so for some time.

By eliminating M3 they’ve ‘turned the tables’ and made the debate one of: Is M2 or M3 the best measure? - instead of – Does M3 adequately capture what constitutes money and should there really be an M4?

These masters of misdirection could make an illusionist blush.

It’s a great show to behold until you know how the magic is really done.

© 2007 Rob Kirby
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Rob Kirby
Kirby Analytics
Toronto, Ontario, Canada
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The opinions of FSU contributors do not necessarily reflect those of Financial Sense.