Monday, November 28, 2005

A Quickie on “Money”

A Quickie on “Money” by Doug Noland

“Money” connotes quite different things to different people. Some would argue that gold – a store of value over the ages that is nobody’s liability – is money in its purest form. Others have a more traditional (narrow) focus on currency and banking system reserves (“money stock”), and would generally analyze “money” primarily in terms of its role in consummating transactions. Many still view the money supply as something under the Federal Reserve’s control, holding “Fed pumping” responsible when the monetary aggregates expand rapidly. It is common for pundits to focus on what they believe “money” should be rather than the distinguishing characteristics of the creation, intermediation, risk profile, function and various effects of today’s extraordinary inflation of myriad financial claims.

And while most will view it as unconventional, I believe my “money” analytical framework is consistent with the thinking of some of the leading monetary economists of the past. Consistent with Ludwig von Mises’ “fiduciary media” approach, monetary analysis must be quite broad in scope and focused on the “economic functionality” of new financial claims. Allyn Abbott Young was keen to appreciate the “preciousness” attribute of money throughout history. It is the perceived preciousness (“moneyness”) of specific types of contemporary financial claims that leave them highly susceptible to over-issuance. Traditionally, when it came to financial claims expansion it was government issued currency and central bank created reserves that generally enjoyed the type of persistent (“store of value”) demand conducive to protracted Credit inflations. These days, the defining feature of contemporary Wall Street finance is the amalgamation of financial sector intermediation, the proliferation of credit insurance, financial guarantees, derivatives, implied and explicit GSE and government guarantees, and myriad sophisticated risk-sharing structures that have created to this point unlimited capacity to issue perceived “precious” financial claims. It is the Inherent and Dubious Nature of The Moneyness of Credit that Supply Creates its Own Demand.

I will loosely define contemporary “money” as financial claims perceived to be a highly safe and liquid store of nominal value. Simple enough, one would think, although it is a definition quite problematic for most. The catch is “perceived.” You can’t model perceptions, so my definition would be unacceptable to most academics, econometricians and trained economists (including Fed economists that measure and monitor money growth). Nonetheless, it is my view that the type of financial claims that demonstrates the “economic functionality” of “money” can vary greatly depending on evolving marketplace perceptions with respect to safety, liquidity, and the capacity to maintain nominal value.

And, importantly, I strongly argue that over the life of an inflationary boom the marketplace will come to perceive characteristics of “moneyness” in an expanding array of financial claims, and that this expanding universe of readily accepted instruments plays a defining role in perpetuating the boom. This is particularly the case when it comes to asset Bubbles and the underlying claims backed by inflated collateral values (i.e. after a protracted real estate boom, ABS and MBS today enjoy perceived moneyness qualities). Almost by definition, the final precarious boom-time speculative blow-off is financed through the frenetic expansion of dubious, yet momentarily treasured, financial claims.

With the above as background, I will attempt to clarify my view that we are at no analytical loss with the upcoming relegation of M3 to the government data scrapheap. First of all, M3 is today definitely not reflective of marketplace perceptions with respect to “moneyness.” With each boom year, the spectrum of perceived safe and liquid instruments expands. This year will see record ABS and commercial paper issuance, with the combined growth of these two categories of financial claims likely in the range of total M3 growth. M3 captures little of this imposing monetary expansion.

The monetary aggregates (“M’s”) were constructed for a bygone monetary era largely dictated by banking sector liabilities, intermediation and payment clearing. The expansion of deposits and other bank liabilities (“repos,” euro deposits, etc.) would sufficiently capture total system Credit growth, with the M’s generally correlating well with nominal economic output and indicative of general financial conditions. However, several fundamental developments have profoundly altered the monetary landscape and the capacity for the M’s to reflect relevant economic and market developments. The rise to prominence of non-bank lending mechanisms has profoundly changed the nature of financial sector liability creation and intermediation.

Market-based securities issuance is now a major aspect of monetary expansion, and the M’s are undoubtedly ill-equipped for such an environment. The unprecedented expansion of GSE obligations (debt and MBS) created several Trillion dollars of perceived safe financial sector liabilities. The enormous growth of Wall Street intermediation has spurred both a boom in securities issuance and incredible growth in (individual and institutional) account balances held throughout the (international) broker/dealer community. Technological advancement has also played a key role in expanding “moneyness.” For example, the Internet now allows households and institutions to directly purchase Treasury bills and myriad securities online, when much of these funds would have in the past been held in bank or money fund deposits (and included in the M’s). I also believe our massive Current Account Deficits and the corresponding ballooning of foreign central bank dollar holdings have impacted the relevancy of the M’s. Every day now, a couple billion dollars of Credit growth immediately flows to overseas institutions, where much of it is recycled back to financial claims (Treasuries, agencies, MBS, and ABS) not included in the monetary aggregates. If these funds were instead held domestically as savings, it is quite likely that a large percentage would be held in instruments included in the M’s.

It is also worth noting that the M’s can at times prove especially flawed indicators of Credit expansion. In periods marked by a significant augmentation of Marketplace Risk Embracement, disintermediation out of low-yielding bank and money fund deposits into riskier instruments may meaningfully distort the M’s (recall 2003’s 4th quarter). Not only would stagnant monetary aggregate growth fail to reflect system Credit expansion, it would give decidedly erroneous signals with respect to system liquidity. And I know this is unconventional thinking, but I have come to completely disassociate the M’s from system liquidity. I would argue that system liquidity is today determined by the capacity of the broader financial system (including Wall Street, hedge funds, the “repo market”, foreign bank and global central bank dollar holdings) to expand, almost irrespective of the M’s.

In summary, the M’s no longer reflect either system Credit growth or system liquidity, and are prone to give erroneous signals at critical junctures (when Marketplace Risk Embracement is modulating). I have watched repeatedly over the past few years as analysts have pounced on any slowdown in the M’s as an indicator of waning Credit growth and liquidity. This year, it was the stagnation of MZM that captured analysts’ attention, notwithstanding that this development was largely related to continued disintermediation from the money fund complex and the shift to higher-yielding term deposits; Credit growth remained on record pace, and the Bubble economy carried on. Moreover, M3 is clearly not capturing the historic expansion in the securities-financing repurchase agreement (“repo”) marketplace. While primary dealer “repo” positions have expanded $975 billion over the past two years, the M3 component bank net “repo” liability position has increased $27 billion. And while some “repo” positions are being captured in Money Funds holdings, there are enormous perceived “money” assets held in the ballooning securities financing arena outside the purview of the M’s.

If the Fed endeavored to shroud the extent of current monetary inflation, I suggest they stick with publishing M3. And it is inconceivable at this point to expect the Fed – or the economic community – to embrace a broad-based measure of monetary instruments that would include Wall Street marketable securities and “repos.” Anyway, contemporary “money” is a moving target that changes at the whim of marketplace perceptions. And while I question the premise that the Fed has much to gain by eliminating M3, this nonetheless misses the much more salient point: The Fed has lost control of our nation’s “money” and Credit creation processes. The Greenspan/Bernanke Fed can now only administer feeble attempts to remove accommodation, hoping that over time baby-steps makes some headway but without ever attempting to impede, interrupt or discipline Wall Street Monetary Processes.

The market today believes that a slowing real estate market is in the process of restraining system Credit growth. I am skeptical. It is my view that after the past year’s boom in energy and commodities prices, along with booming exports and a strong inflationary bias throughout much of the economy, it will now take considerably more restraint in mortgage Credit to meaningfully moderate total system Credit growth. And the greater U.S. and global stocks and bonds rally, the more likely the Credit Bubble refuses to miss a beat.

The late 1920s saw the Benjamin Strong Fed acquiesce to the demands of the broker call market after it had evolved into a commanding source of monetary inflation and system liquidity. Today’s securities finance Bubble – certainly including the massive “repo” market – is at a scope unlike any in history. And once a substantial component of a nation’s (world’s) “money” supply is wrapped up in financing market Bubbles – well, you have one hell of a predicament. On the one hand, such powerful Bubbles are (as we have witnessed) strongly self-sustaining. On the other, the consequences of popping the Bubble ensure policymaker timidity and ongoing accommodation. Dr. Bernanke certainly has no intention of administering any meaningful restraint. Yet, inevitably, financial Bubbles do burst and the downside of boom-time Perceived Moneyness and Marketplace Risk Embracement manifest in financial dislocation and a crisis of confidence.

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