Why Do I Follow M3?

I like the no-nonsense attitudes of some bloggers. Dr. Jeff would be one of them. In response to my piece Looking Beyond the Three Percent Horizon he posed the following question:

David –
I understand that the Fed discontinued M3 and that you have a good proxy. My question is, “Why?”

In my research on money supply measures, I have been asking economists what they are trying to measure and why. So far, none has had any reason to track M3. I’ll get around to my reasons for this in a future post, but before doing so, I am curious about why you think this is important. The same question might be asked of MZM.



I do have a reason to track M3, so maybe this will help Dr. Jeff.  At RealMoney, as M3 was eliminated, I made the following post:

David Merkel
Taking a Substitute for Vitamin M3
3/14/2006 3:26 PM EST

If you’re not into monetary policy, you can skip this. Within the month, the Federal Reserve will stop publishing M3. Now, I think M3 is quite useful as a gauge of how much banks are levering themselves up in terms of credit creation, versus the Fed expanding its monetary base. I have good news for those anticipating withdrawal symptoms when M3 goes away: The Federal Reserve’s H.8 report contains a series (line 16 on page 2 – NSA) for total assets of all of the banks in the US. The correlation between that and M3 is higher than 95%, and the relative percentage moves are very similar. And, from a theoretical standpoint, it measures the same thing, except that it is an asset measure, and that M3 incorporated repos and eurodollars, which I think are off the balance sheet for accounting purposes, but should be considered for economic purposes.

But it’s a good substitute… unless Rep. Ron Paul’s bill to require the calculation of M3 passes, this series will do.

Position: none

My reason for wanting an M3 measure is that the process of intermediated credit creation is important.  As we go down the monetary aggregates, from cash, to the monetary base,  to M1, M2, and MZM, we get further away from cash, and closer to credit.  At one point in time, the Fed had a measure called L for total liquidity, which was broader than M3.  In a credit-driven economy like ours, measuring the differences between various types of credit creation can give signals as to how the banks are faring, and how well aggregate demand will do in the intermediate term.  That’s why I look at M3; it helps me to see how much the banks are stretching their balance sheets compared to how much the Fed is stretching its balance sheet.  There are limits to how much independent stretching the banks can do, in the absence of aid from the Fed.

Perhaps I’m just a wonk here, but the willingness of banks to extend credit in our economy is important, and M3 was better correlated with that than most other monetary measures.  That’s why I went in search of an M3 proxy.