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.
Thanks,
Jeff
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.
Using the delta of M3 – M2 as a measurement of how stretched is Federal Reserve’s balance sheet is a novel and interesting aspect to these numbers.
I revisited the definitions of M[0-3] and up to M2 it all measures cash in its various forms. M2 = cash + deposits + savings + money market. M3 = M2 + CDs + eurodollars + repurchase agreements.
Obviously repurchase agreements are evidence of expanding balance sheet but are they not masked by the amount in CDs and eurodollars? To me the delta of M3-M2 can’t clearly speak about Fed’s balance sheet.
I believe that on Fed’s web site you can find the amount of outstanding repurchase agreements, why would you need M3 to glean that? They must be less than $50bil and M3 is trillions. The size of the repurchase agreements is dwarfed by the other components of M3.
To me M3 demonstrates the amount of dollars that are abroad and less of an indicator of repurchase agreements.
The balance sheet of the banking system – credit or M. It doesn’t matter. Credit creates M at the macro level. The size of the balance sheet, both sides, is what’s key. As are capital ratios of course. Although ‘risk-adjusted capital’ ratios are now revealed to be as much of a sham as the risk managers’ math models.
Since the DIDMCA the money supply has become unknown & unknowable.
Even so, what went for M2 went for M3. And M2 erroneously includes MMFs in its definition. MMFs are the customer’s of the commercial banks. They are financial intermediaries.
Monetary savings are never transferred from the commercial banks to the intermediaries; rather are monetary savings always transferred through the intermediaries. Whether the public saves or dis-saves, chooses to hold their savings in the commercial banks or to transfer them to intermediary institutions will not, per se, alter the total assets or liabilities of the commercial banks; nor alter the forms of these assets or liabilities.
Financial intermediaries (MMFs) lend existing money which has been saved, and all of these savings originate outside the intermediaries. The utilization of loan-funds or activation of monetary savings by these financial intermediaries is captured thru the velocity of their deposits (bank debits/withdrawls), not thru the volume of their demand deposits.
I.e., from the standpoint of the economy, MMF deposits never leave the CB system. And the growth of the MMFs is prima facie evidence that existing funds/savings have already been spent/invested (transferred) by their owners/savers to borrowers. I.e., this represents a double counting.
Even now, M3 is meaningless.