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The M3 money supply: much ado about nothing?

by Migeru Sat Oct 6th, 2007 at 06:29:49 PM EST

Nearly two years ago, the following obscure press release was put out by the US Federal Reserve:

Federal Reserve: Discontinuance of M3 (November 10, 2005)

On March 23, 2006, the Board of Governors of the Federal Reserve System will cease publication of the M3 monetary aggregate. The Board will also cease publishing the following components: large-denomination time deposits, repurchase agreements (RPs), and Eurodollars. The Board will continue to publish institutional money market mutual funds as a memorandum item in this release.

Measures of large-denomination time deposits will continue to be published by the Board in the Flow of Funds Accounts (Z.1 release) on a quarterly basis and in the H.8 release on a weekly basis (for commercial banks).

M3 does not appear to convey any additional information about economic activity that is not already embodied in M2 and has not played a role in the monetary policy process for many years. Consequently, the Board judged that the costs of collecting the underlying data and publishing M3 outweigh the benefits.

There was much gnashing of teeth by assorted conspiracy theorists, myself included, that the Fed was hiding away the canary in the gold mine of monetary policy.


The reason this matters is that the rate of growth of the money supply is (approximately) the sum of the rate of "real" GDP growth and the rate of inflation. So by ceasing to report on the growth of the M3 money supply, the conspiracy theory goes, the Fed is destroying the evidence of any tampering with the inflation statistics and of its own runaway monetary policy (where the money supply is believed to be growing at higher than 10% per year).

Now, a few days ago, for a discussion in an open thread, I pulled this chart from the Wikipedia article on the US money supply.

One feature of the graph caught my attention: that the share of "pure" M2 (savings, money-market accounts and "small" certificates of deposit) is more or less constant but that "pure" M3 ("exotic" money) is increasing its share as the share of M1 (cash or M0 plus "demand" deposits) decreases.

Somewhat perversely, I decided to take the underlying data for the wikipedia charts and rescale the axes. For the top chart I did a logarithmic scale, which shows rates of exponential growth as constant slopes, and for the bottom chart I did a "logit" or logistic transformation.

Apart from what appears to be the presidency of Bush the Father, the growth of the total money supply has been more or less at the same rate for the past 40+ years. If anything, it seems faster before 1988 than after 1992. So this is the first question: can one really see anything anomalous in these charts coreesponding to the dot-com bubble or the recent housing bubble? Can you point to where Greenspan's bubble begins?
Note, however, that the M1 money supply (cash and checking accounts) is the kind of money that "ordinary Americans" actually have, and that has hit an "undulating plateau" since Clinton came into office.
Now look at the shares of the different kinds of money over the past nearly 50 years, plotted on the logistic scale introduced to ET by Luis de Sousa in his Marchetti Curves diary...

Apart from an anomalous "bump" coinciding with the Clinton years, in which cash or M1 recovers "market" share at the expense of "exotic" or "pure M3" money, the last 50 years of US monetary history esentially see a constant share of "pure M2" (savings, money market accounts and CDs under $100K) and a transfer of market share from cash to exotic money, which on this scale actually looks faster in the 1960's than it does today. However, the flattening out of the M1 money supply since the early 1990's has a counterpart in a kink and subsequent significant growth in the share of "pure M3".

In the light of this chart, it seems the Fed is actually right when it claims

M3 does not appear to convey any additional information about economic activity that is not already embodied in M2 and has not played a role in the monetary policy process for many years.
The link between the money supply and inflation, which is behind most conspiratorial thoughht regarding the publication of the M3 figures, is the so-called "monetary exchange equation":

Since it appears that the M2 money supply is constant fraction of the M3 money supply over the past 50 years, it really doesn't matter which of the two is substituted into the monetary exchange equation. So, it doesn't seem to me that the Fed was actually hiding any sort of smoking gun when it decided to discontinue the publication of M3 figures.

Why assume ulterior motives when laziness suffices? Is all the M3 paranoia much ado about nothing?

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In the comments to Luis de Sousa's diary I proposed a modification of Marchetti's model and a way to estimate the "market share transfer" coefficients. It would be interesting to find out whether the M1 to M3 transfer coefficient has been more or less constant over the last 50 years.

We have met the enemy, and it is us — Pogo
by Migeru (migeru at eurotrib dot com) on Sat Oct 6th, 2007 at 06:34:58 PM EST
Yes, according to Gary North and Mish. I finally got around to reading these posts, and I think you might find them interesting. You all are about to converge at the same conclusion: the real action has been in M2 and FRB repos, the ultimate buy-back scheme. Basically, the discount window has been and will remain a cover for sucking money out of circulation; supply has been flat, after all. (Graphs of YoY data sets)

As for velocity, well, vortex is a good metaphor. I stand by my statements that US fiscal policy is geared to consolidate and add value to fiat in the top 1%. The domestic market will be squeezed of every penny earned. Psychology trumps data in predicting what makes the worm turn. Every time.

Diversity is the key to economic and political evolution.

by Cat on Sat Oct 6th, 2007 at 10:27:15 PM EST
I stand by my statements that US fiscal policy is geared to consolidate and add value to fiat in the top 1%. The domestic market will be squeezed of every penny earned.

Yes, very much so.

A political narrative is built into all the main structural economic indicators, and that makes them suspect as a measure of what's really happening in the real economy. (q.v. our discussions about unemployment.)

Using them as if they measure something that matters only propagates the narrative - it doesn't necessarily tell anyone anything useful about the real experience at street level.

by ThatBritGuy (thatbritguy (at) googlemail.com) on Sun Oct 7th, 2007 at 05:39:40 AM EST
[ Parent ]
Velocity and "GDP Deflator" are fudge factors: velocity is "that number which, multiplied into the chosen measure of money supply, equals the nominal GDP"; and the GDP deflator is "that number which, multiplied into the nominal GDP, gives the desired real GDP".

We have met the enemy, and it is us — Pogo
by Migeru (migeru at eurotrib dot com) on Sun Oct 7th, 2007 at 08:18:13 AM EST
[ Parent ]
Fudge factor, yes! I swear, anytime "multiplier" is dropped in conversation (much less "velocity" over the past 20 years), I first check my wallet then check my textbook definition.

Diversity is the key to economic and political evolution.
by Cat on Sun Oct 7th, 2007 at 10:33:14 AM EST
[ Parent ]
Well, actually velocity of money can be defined as the average number of time a unit of currency changes hand (by involving in a transaction) in a year. It could theoretically be measured if all transactions where centrally registered. In practice, accurate measurement is impossible, not just because of more or less shadow cash transactions, but also because the volume of data for registered transactions (cards, checks) is to large to centralize.

But this intuitive meaning helps you understand some extreme cases of the equation of money (like, in times of hyper inflation, cash burns your hands, you want to change it for material goods immediately, and the velocity of money increases greatly)

Pierre

by Pierre on Sun Oct 7th, 2007 at 04:03:11 PM EST
[ Parent ]
You're right, and I'm exaggerating.

We have met the enemy, and it is us — Pogo
by Migeru (migeru at eurotrib dot com) on Sun Oct 7th, 2007 at 04:18:58 PM EST
[ Parent ]
Changes in the money supply are notoriously difficult to connect to anything, which is why the Fed targets short-term interest rates as a policy instrument and not the money supply.

As the quantity theory indicates, the money supply will track changes in nominal GDP pretty closely: M = (1/v)*PQ. If you graphed nominal GDP you would probably mostly see the trend growth rate too, but that doesn't mean recessions don't happen (do a plot of the yearly growth rates of the series instead of the series itself).

As for the so-called "Greenspan bubble" I think it is mostly just a myth if you mean bubbles are caused by excessively low interest rates and too-rapid money creation. For example, US house prices started diverging from previous trends in 1995, at a time when Greenspan was actually raising interest rates. Greenspan can be blamed instead for trying to get a little more mileage out of a weak recovery by stupidly telling people to take out ARMs a couple of years ago.

The real culprits are IMHO financial deregulation and exploding income inequality, the combination of which channels ever more funds to increasingly exotic investments in search of higher returns. Real interest rates were on average lower before 1970 than they have been since, and we didn't have these kind of asset bubbles developing.

by TGeraghty on Sun Oct 7th, 2007 at 03:35:40 AM EST

The real culprits are IMHO financial deregulation and exploding income inequality, the combination of which channels ever more funds to increasingly exotic investments in search of higher returns. Real interest rates were on average lower before 1970 than they have been since, and we didn't have these kind of asset bubbles developing.

There has been a technological sea change, enabling much faster creation and trade of all sorts of financial instruments, and computer driven, arbitrage-seeking trading strategies driving massive volumes.

There has been an ideological sea change, making greed good, and defining monetary value as the main arbiter of value, leading to a focus on financial management as opposed to industrial or soci-economic strategies.

There have been massive global imbalances, requiring a lot more financial engineering to deal with.

In the long run, we're all dead. John Maynard Keynes

by Jerome a Paris (etg@eurotrib.com) on Sun Oct 7th, 2007 at 05:53:36 AM EST
[ Parent ]
There has also been an engineered political sea change which has eliminated the influence of labour from the political process.

And a useful redefinition and splitting of the working classes into pseudo-managerial and pseudo-entrepreunerial roles which give the illusion of participation while denying real power, while making unionisation very much more difficult.

by ThatBritGuy (thatbritguy (at) googlemail.com) on Sun Oct 7th, 2007 at 09:41:54 AM EST
[ Parent ]
If you go back pre-New Deal there were also periodic asset bubbles in the US from the War of 1812 through the early 1930s, often driven by global imbalances (e.g. the panics of 1837, 1857, and 1931-33) and enabled by changes in transport and communications technology (steamships, telegraph) that integrated global markets.

So asset bubbles and busts enabled by technological change and transmitted through international financial markets are nothing new in the long view, although they are new for us.

by TGeraghty on Sun Oct 7th, 2007 at 08:57:56 PM EST
[ Parent ]
... consequence of changes in economic activity, it is of course difficult to use changes in money supply to "explain" changes in economic activity.

M3 is most tightly connected with very large transactions, and therefore driven more by activity in capital markets than by changes in income flows.

A loss of correlation between changes in M3 and changes in GDP therefore seems to imply that there has been a loss of correlation between activity in capital markets and income transactions.


I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.

by BruceMcF (agila61 at netscape dot net) on Sun Oct 7th, 2007 at 10:40:22 AM EST
I think the danger lies in the way new types of "money" are being created outside the banking sector. The "complex" financial instruments are essentially was to create money through unregulated borrowing with infinitesimal margin requirements.

This leads to two problems. First, no one seems to know how much of this complex money exists and second, the Fed has no way to control it. Changing the reserve requirement for banks does nothing if the financing isn't going through banks.

In addition there is a bigger presence of foreign players in the US economy. We are now seeing the flip side of the days when Citibank could destabilize a South American country. Now China can do the same thing to the US.

The forgotten lesson from1929 is that highly leveraged deals always end badly.  

Policies not Politics
---- Daily Landscape

by rdf (robert.feinman@gmail.com) on Sun Oct 7th, 2007 at 11:22:23 AM EST
Lots of sensible comments here, time for me to drag this diary down the rabbit hole into Metatone's Paranoid World (TM).

What I see is that as a technical measure, M3, is as the Fed suggests, no more indicative than M2.

However, the changes in M3 indicate something and I think it was ChrisCook that drew my attention to it.

Money supply has been increased, but not so much through the old way, which was central bank action, rather by financial deregulation (as TGeraghty also notes.)

The key issue here is that if you sit down with:

a) M1 and M2
b) Interest rate decisions

you will happily conclude that inflation has been low because inflationary pressures are low. This allows you to ignore the "asset bubble." Incidentally, this kind of round robin of measurements probably plays into the "core inflation" debate too.

It's only when you look at M3 that you get an explanation for the "asset bubble."

Do I think the Fed did it on purpose?

No, I don't think that these figures are politically important enough to bother with in that way.

Do I think the result of de-emphasising the M3 number is to help people pretend to themselves and others that "there is no asset bubble and no inflationary consequences thereof."
Almost certainly...

by Metatone (metatone [a|t] gmail (dot) com) on Sun Oct 7th, 2007 at 11:22:49 AM EST
... at least not in a functional sense. Like any other type of liquidity, the ability to generate new purchasing power for large capital market transactions is permissive rather than being a driving force.

In terms of the driving forces, it is the asset bubble that explains the growth in M3 money.


I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.

by BruceMcF (agila61 at netscape dot net) on Sun Oct 7th, 2007 at 04:43:01 PM EST
[ Parent ]
Right, I meant "explains" in the sense that it proves (to some degree) that there is some kind bubble existing.

Might it be better phrased as M3 signifies that there is asset bubble, despite denials issued on the basis of M2?

by Metatone (metatone [a|t] gmail (dot) com) on Sun Oct 7th, 2007 at 05:02:06 PM EST
[ Parent ]
But M2 is growing at the same rate as M3. The important feature is that M1 is flat, and is a decreasing share of the money supply. Looking at what constitutes M2, other than savings accounts, only the relatively wealthy can afford to park their money in time deposits, let alone money-market accounts which have rather high minimum balances (in the tens of thousands of dollars). And in the US currently people are more likely to have a credit than a savings account. You have to have a lot of cash to have a sizeable balance on your savings account.

So the ratio of M3 (or M2) to M1 is a measure of wealth inequality, and that has been getting steadily worse since 1960's, except for the Johnson and Clinton Presidencies.

We have met the enemy, and it is us — Pogo

by Migeru (migeru at eurotrib dot com) on Sun Oct 7th, 2007 at 05:21:01 PM EST
[ Parent ]
In the sense that we're now dealing with two very different kinds of money circulating in different environments under different political and economic rules.
by ThatBritGuy (thatbritguy (at) googlemail.com) on Sun Oct 7th, 2007 at 05:37:25 PM EST
[ Parent ]
Just because M2 and M3 are growing at the same rate doesn't make them the same thing. What I'm suggesting is that the increase in absolute terms of M3 has a significance in understanding asset inflation.

Bruce McF suggests that M3 is the product of the asset bubble, which is fair enough. My point is that the value of taking M3 out of the public eye is that it removes this thing that is potentially an indicator of the asset bubble from the public vision.

M2 is also growing, but the mechanism for that is more easily explained in ways related to other fundamentals and as such doesn't act as a signifier of an asset bubble the way M3 might.

Maybe I'm not making any sense, I'm too tired to clarify this now, I'll try to remember tomorrow.

by Metatone (metatone [a|t] gmail (dot) com) on Sun Oct 7th, 2007 at 06:47:18 PM EST
[ Parent ]
... income loop:
Looking at what constitutes M2, other than savings accounts, only the relatively wealthy can afford to park their money in time deposits, let alone money-market accounts which have rather high minimum balances (in the tens of thousands of dollars).

An important part of the income loop is the provision of short term finance for operating capital ... sales of materials or stock on terms of 60 or 90 days net, the finance of the wage bill, etc.

The decline of the M1 component of M2 seems highly likely to be tied to the decline of cash and checks in total consumer purchases compared to credit and debit cards. The reduction of the average time that money is residing as cash between withdrawal and purchase, or in the checking account between writing the check and the check being covered, would seem to imply that  money in the income flow spends a larger share of its time in the firm sector, and that would imply an increase in the M2 ex M1 component relative to the M1 component.


I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.

by BruceMcF (agila61 at netscape dot net) on Sun Oct 7th, 2007 at 07:31:36 PM EST
[ Parent ]
Is M2 growing at the same rate as M3, or M2 ex M1 growing at the same rate as M3 ex M2?

If M3 ex M2 is growing faster than M2, then it is indeed at least compatible with growing financial wealth faster than incomes are growing ... and while there are various scenarios where that could happen, an asset bubble is one of the most straightforward.

M2 rather than M2 ex M1, since high income nations passed heavy reliance by retail and commercial enterprises on overdraft lines of credit decades ago ... M1 on its own doesn't directly indicate much about the total liquidity of the system.


I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.

by BruceMcF (agila61 at netscape dot net) on Sun Oct 7th, 2007 at 08:27:29 PM EST
[ Parent ]
It is M2 ex M1 growing at the same rate as M3, and M3 ex M2 growing faster than M2.

I have to admit this is beginning to make my head spin.

We have met the enemy, and it is us — Pogo

by Migeru (migeru at eurotrib dot com) on Mon Oct 8th, 2007 at 01:14:49 AM EST
[ Parent ]
Don't M2 ex M1 ... just M2.

M1 was certainly distinctly money before WWI, and at least in the US, even in the 50's many retail and commercial enterprises relied heavily on overdraft lines of credit, leaving a substantial distinction between cheques and saving accounts ... but today, whether the wage bill is coming out of retained earnings or is financed, it spends very little time in the cheque account of the employer, making the distinction between M1 and M2 mostly useful for tracing out things like how hard banks have to work to get deposits into CD's and other lower-reserve accounts in order to free up the reserves to issue loans.

So M2 as a percentage of M3, M3 ex M2 as a percentage of M3, and M1 as a percentage of M2 as a secondary indicator of what's going on.


I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.

by BruceMcF (agila61 at netscape dot net) on Mon Oct 8th, 2007 at 04:58:34 AM EST
[ Parent ]
Or in other words, M3 growth could be an indication of asset bubble.

How often the M3 statistics were published? Once per quarter? Wouldn't it be interesting to see the M3 numbers just before and after the August crisis? Do we have enough information to tell M3 dynamics after March 2006?

I see the ado not so great (no greater than cool down responses). It is still suspicious that routine information is not provided. Is it the "voodoo trick" of Bush administration to allow any crazy things happening as long as the M2/M3 aggregates grow "historically"?

As the financial market got decoupled from banking, it seems important to follow the money aggregates. As so much electronic money is generated by leverage loans and exotic finance, without any collaterization in GDP growth, why wouldn't it be informative how much money is chasing "limited" assets?

Won't we come across a phase change even with "normal" growths of M3? Can we get comparable statistics from the 1930's?

by das monde on Mon Oct 8th, 2007 at 12:41:10 AM EST
[ Parent ]
Unlike the Federal Reserve, the ECB still follows M3.

See The ECB's definition of euro area monetary aggregates

"Dieu se rit des hommes qui se plaignent des conséquences alors qu'ils en chérissent les causes" Jacques-Bénigne Bossuet

by Melanchthon on Mon Oct 8th, 2007 at 07:12:17 AM EST
And here is The latest data

See the increasing growth rate of M3 in the last years...

"Dieu se rit des hommes qui se plaignent des conséquences alors qu'ils en chérissent les causes" Jacques-Bénigne Bossuet

by Melanchthon on Mon Oct 8th, 2007 at 07:22:30 AM EST
[ Parent ]
This blog says that M3 has been increasing in the United States at a 14% rate, the fastest in 35 years.
by das monde on Tue Oct 9th, 2007 at 05:50:58 AM EST
[ Parent ]


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