Monetarism Is the Dog Feverishly Chasing Its Own Tail

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Back in November 2005, the Federal Reserve quietly announced that it would discontinue collecting data and publishing the M3 monetary aggregate series. It set off a bit of backlash in quarters where monetary aggregates have heavy meaning, largely because the M3 series was the broadest measure of the 'money' supply for the US dollar. Contained in that series was the opaque world of large time deposits, institutional money market funds, repurchase agreements, and eurodollars.

The first two of that M3 list are still collected and published today - large time deposits are part of the Flow of Funds report released quarterly, while institutional money market fund balances are included as a memo with M2. However, the latter two in the list account for the bulk of what is now known as the multi-national shadow banking system.

The discontinuation of M3 was met with conspiracy theory, that the Federal Reserve was engaged in a cover-up over the ballooning housing bubble, actively trying to suppress its own fingerprints in the over-financialization of the global economy. Since M3 tracked so much of the edges of the known financial world, there should have been a more determined effort to quantify and understand financial innovation of that period. The lack of such effort was taken as an implicit acceptance of bubblenomics.

I tend to believe, as the old cliché goes, never attribute to malice that which is adequately explained by ignorance or stupidity.

The official reason given to discontinue the M3 aggregate was as follows:

"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."

Essentially, from the Fed's perspective, it was all cost with no benefit. For a monetarist regime in place at that time, just as Greenspan was exiting for Bernanke, that statement rings especially true. The traditional, mainstream economists at the Fed placed no value in understanding (even today) finance. Money was money; money is money, so there is no use in a broad definition.

But the second part of that official justification should have been something of a warning about all things in the monetary realm. The "costs of collecting" excuse was greeted by Fed critics with more than a hint of derision since it smacked of too much disingenuousness. It seemed like a lame attempt to hide banking gone into overdrive.

The Fed, however, was actually honest here, and that should have been, and should be still, meaningful in the context of monetary engineering and the economy's paradigm shift in 2008/09. Those two elements of M3, repos and eurodollars, were the epicenter of crisis. The fact that it would have cost the Fed too much to attempt to measure these "money" aggregates shows just how far the banking system strayed from the light of the regulated regime. Yet, as the Fed demonstrated in the first sentence of its official rationale, our central bank had little interest in that monetary/banking arena.

We know that the Fed was on to something about the difficulty in quantifying repos and eurodollars because we still have no idea today how much "money" appears out of nowhere due to repos and eurodollars. The Bank for International Settlements (BIS) essentially corroborated that in one of its attempts at analyzing the 2008 crash in an October 2009 Working Paper, The US Dollar Shortage in Global Banking and the International Policy Response. Independently, the BIS was interested in figuring out how many eurodollars there were at the time to gauge what was essentially the "crowded trade" of the century (to date, anyway) - the shortage of US dollars in the eurodollar market created largely by European banks engaged in multi-national shadow banking.

The BIS could not come up with an answer; not for lack of trying. After careful study, the authors concluded:

"The end result is a dataset with the consolidated balance sheet positions for 19 banking systems for the Q2 1999-Q1 2009 period at a quarterly frequency. It is important to note that the constructed positions are estimates based on imperfect underlying data, and in places require assumptions to address known data limitations."

These data limitations are the exact costs that the Federal Reserve used to justify ditching the M3 series. The BIS, in its best efforts, came up a bit short in quantifications. They did note that, in so many words, the Federal Reserve, indeed the entire global economy, would have been better off had the Fed pushed beyond its ideologically locked operating theory and just endured the cost of understanding and quantifying M3:

"The origins of the US dollar shortage during the crisis are linked to the expansion since 2000 in banks' international balance sheets. The outstanding stock of banks' foreign claims grew from $10 trillion at the beginning of 2000 to $34 trillion by end-2007, a significant expansion even when scaled by global economic activity (Figure 1, left panel). The year-on-year growth in foreign claims approached 30% by mid-2007, up from around 10% in 2001. This acceleration took place during a period of financial innovation, which included the emergence of structured finance, the spread of "universal banking", which combines commercial and investment banking and proprietary trading activities, and significant growth in the hedge fund industry to which banks offer prime brokerage and other services."

In coming to that conclusion, however, the BIS authors had to pull apart, as noted above, various banking system and individual bank level data. It was not only cumbersome, but it was a tangled web of "money" trails that does not fit any traditional notion of what money is or is supposed to be.

For example:

"If we assume that banks' on balance sheet open currency positions are small, these cross-currency net positions are a measure of banks' reliance on FX swaps. Many banking systems maintain long positions in foreign currencies, where "long" ("short") denotes a positive (negative) net position. These long foreign currency positions are mirrored in net borrowing in domestic currency from home country residents. UK banks, for example, borrowed (net) in sterling (some $550 billion in mid-2007, both cross-border and from UK residents) in order to finance their corresponding long positions in US dollars, euros and other foreign currencies. By mid-2007, their long US dollar positions stood at $200 billion, on an estimated $2 trillion in gross US dollar claims."

Does a currency swap count in the US money supply figures? Or just the netted amounts?

Pushing on past these esoteric complications, the BIS finally concluded that they don't really know:

"By this measure, the major European banks' US dollar funding gap had reached $1.0-1.2 trillion by mid-2007. Until the onset of the crisis, European banks had met this need by tapping the interbank market ($432 billion) and by borrowing from central banks ($386 billion), and used FX swaps ($315 billion) to convert (primarily) domestic currency funding into dollars. If we assume that these banks' liabilities to money market funds (roughly $1 trillion, Baba et al (2009)) are also short-term liabilities, then the estimate of their US dollar funding gap in mid-2007 would be $2.0-2.2 trillion. Were all liabilities to non-banks treated as short-term funding, the upper-bound estimate would be $6.5 trillion."

What, in all that snarled banking mess, constitutes the relevant US dollar money supply? They do implicate central banks here, at least to the tune of $386 billion. So there really should not be much room for anyone at the Federal Reserve to plead ignorance, but this modern banking system seems to be beyond the grasp of traditional economists.

Unlike the decision to shut down M3, this was not a trivial matter. As I have noted previously, the FOMC in September 2007 was caught off guard as to the extent of the European dollar problem. Bill Dudley, then Manager of the FOMC's Open Market desk, admitted, "I think we have all been a bit surprised by the size of some of the conduits that some European banks were sponsoring relative to their capital." At the intersection of crisis and counter-response, the policymaking body for the entire Federal Reserve System pointedly admitted that they had no idea about the quantity of US dollars available to the shadow system, and thus the real economy.

In light of the November 2005 decision to shut down M3, the lack of intellectual depth was not really a surprise. What is illuminating about the September 2007 FOMC admission is that they finally realized that it mattered; they were shaken, only briefly, from their traditional monetary slumber and dreams of a simple monetary relationship with the real economy. Yet, in the end, they were eminently confident of their own ability to mitigate the growing crisis through a simple half-point decrease in the Federal funds target rate. Traditional economics dies hard.

In the context of QE 3 & 4, this matters even more since the publicly stated goal of the Federal Reserve is to tie directly the "money" supply to the level of unemployment in the real economy.

In the old days when "money" colloquially meant physical currency, the relationship between its supply and the real economy was far less ephemeral - it was never straightforward but we are talking in relative terms here. Dictating and achieving goals in the real economy through the money supply under these simple constructions was far more realistic (and yet still littered with economic carnage). It hardly seems to square with the financial realities of today, the misunderstood progress of a massive, yet largely hidden, banking evolution and revolution.

We have little idea of what the money supply is at regular intervals, let alone in anything approaching real time. The BIS estimations of the dollar shortage were taken largely from public and regulatory filings of the individual banks themselves. Anyone who has at least casually followed bank filings knows that these are simply window-dressed numbers. What banks do in the interim between filings is not ever known individually, certainly never in the aggregate. At best there are third hand glimpses (repo fails or term currency swap rates) into what is really taking place behind the scenes.

The fundamental problem with this element of the "money" supply is that repos, eurodollars and even derivative arrangements are largely done OTC or bespoke. There is no central record of all these massive funding arrangements, tangled together in a web of agreements netted against counter-agreements netted against still more counterparties and their funding agreements.

The BIS estimates that at the end of H1 2012 there were $68.6 trillion in gross notional forex derivatives. Not all of these are funded US dollar positions, they only use the US dollar figure as a standard of measure across all currencies - ironic, given the context here, that the reserve currency would fill this monetary role (standard of measure) in such an abstruse fashion of derivations. Of that $68.6 trillion, $24 trillion consists of currency swaps.

We have massive and unseen markets of trillions of "dollars" of ledger accounting adjustments that simply transfer digits from one perception (in a computer system) to another, and still policymakers deign to be able to control it all enough to make sure this supply of "dollars" makes an immediate, direct, and positive impact in the domestic economy. Are we supposed to believe that a multi-billion "dollar" cross currency basis swap between Unicredit and Citigroup, for example, funded by the Fed's attention to the "money" supply, is going to put someone other than a trader to work? In that cross currency basis swap an exchange of "currency" (nothing more than ledger money moving between computerized accounting software) links the arrangement to both individual liquidity perceptions and general banking conditions (for both liquidity and creditworthiness). The Fed has no more control over where "money" ends up as it does over directing the economy as a full-blown central planner. It tries to play the role of central planner but has no actual authority or ability to direct channels of monetary flow; in the end it ends up as a confused mess.

These kinds of monetary arrangements are far more important than most economists realize, entangling beyond just individual banks or even individual bank systems. For example, in that BIS paper the authors cited the special case of Japanese banks that netted approximately $600 billion (in 2007) in claims on non-banks in the US - primarily the US government. Funding those claims were deposit and security liabilities of Japanese residents. So, in short, Japanese depositors were/are boosting the "money" supply available to the US in the purchase of US government debt; made possible solely through the "money" supply of bank "dollars" in derivatives markets. Again, what constitutes the US dollar money supply?

This is truly relevant now that more and more economists, rationally unsatisfied with the lack of success in the Fed's ability to direct real economic parameters to date, begin to openly court NGDP targeting. It never seems to occur to these economists exactly how a "dollar" gets from the Fed's open market desk to your car loan or credit card limit. There are an infinite number of pathways (and even pathologies) and channels that the potential Fed "dollar" can take as it winds its way through primary dealers and into the ocean of modern finance. Just as the contraction of "money" supply in 2007 confounded these economists' traditional notions of banking, why would we expect anything different in an expanding phase?

In fact, we have already experienced such a program during the last decade. As noted above, the banking system busily expanded the hidden supply of "money" at exactly the same time the regulatory authority charged with ensuring such a disposition was not to become harmful publicly announced its determined disinterest. And still the shadow system was funded, as the BIS noted, by central bank billions. The Fed was not really too concerned with all that newfangled money sloshing around in the shadow system; after all even the flawed and incomplete M3 conveyed no meaningful information around FOMC headquarters.

John Tamny ably and aptly dismissed the idea of NGDP targeting over at Forbes just a few days ago. All I would add to his appropriate criticisms is that for NGDP targeting to work requires at least some understanding of how a dollar leaves the Federal Reserve and arrives in the real economy. I believe it is abundantly clear that the economists and policymakers that would be in charge of such a regime had and continue to have absolutely no idea of what even constitutes the supply of US dollars. In point of fact, nobody does. It should be a precondition for further monetary policies that someone at the central bank actually admit it.

The modern banking system can swallow an entire QE whole (where did QE 2 go again?) and the real economy would barely feel the smallest ripple. And that would send the monetarists back to the euphemistic printing press again and again, creating new ones and zeroes of ledger "dollars" as fast as cross currency basis swaps could collateralize them. It's not malice.

Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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