Distributed Economics

When debugging complex systems, it can be useful to ask, “What’s missing?”. Especially when looking at  the available monitoring information, which tells you not only what the designers of the system thought it was important to know, but also by omission, what wasn’t. Critical realtime systems, we’re talking Nuclear Power plants and their ilk, are monitored fairly closely, but if the right information isn’t provided to the operator, then that won’t necessarily help all that much.

In this sense, it’s quite interesting that  Economics doesn’t seem to have  a definition of what money is, in any satisfactory, scientific sense. Rather it seems to have various descriptions of what money does. The “Money is a matter of functions four, a medium, a measure, a standard, a store.” dogeral that is found in some textbooks and on Wikipedia is the perfect illustration of this. This is not a definition of what money is, it’s simply a list of the things money is used for. This confusion can also be found in the various measures used to quantify the total amount of money in the Economy, which are variously M0, M1, M2, and depending on which country you’re in M3 or M4.

Interestingly, and perhaps damningly in the context of the current credit crisis, no single, monitored central bank measure appears to completely capture the information that is of most interest today – which is what is the total quantity of money that commercial banks and reserve based savings institutions are allowed to create loans against.

M0/Monetary Base

This is the “narrowest” definition of the money supply. The British, who technically invented the entire system, used to use M0, but since 2006 it’s the “Notes and coins and reserve balances” figure (YWMB43D), whilst the Federal Reserve simply refers to this as the Monetary Base, and reports it in the H3 Aggregate Series.  It is defined as the reserves from the Banks held on deposit by the Central Bank, and the total amount of physical currency. This measure probably made more sense under the Gold Standard than it does now, when a significant number of bank deposits don’t in fact carry a reserve requirement, and physical currency is simply printed to meet day to day demand.

Reserves held at the central bank used to be a very fixed, and important part of the system’s regulation, since this directly controlled lending. In that implementation of the system, the Commercial Banks had to deposit the reserve on deposits they were required to hold behind for each loan (i.e. the 10% fractional reserve requirement), at the central bank. For two simple reasons. It kept them honest, and it gave the Central Bank complete control, and indeed visibility, on the monetary expansion that was occurring. Assuming for example, that the Banks were correctly depositing their reserve on deposits at the central bank, then if that amount started growing, the central bank immediately knew that the loan supply was increasing and vice versa.

Only net transaction accounts in the US Banking system carry a reserve requirement currently, so that part no longer works very well. Even so – when the Federal Reserve saw the non-borrowed reserves drop by 25% in December 2007, and indeed go negative the following month, it was a clear warning sign of major systemic issues. The Bear Stearns collapse into bankruptcy would occur 3 months later in March 2008. How significant it is that there is also a fall in the British reserve measure, beginning in July 2006 and reaching its nadir in September 2007 before an abrupt recovery, is hard to say.

M1

M1 is technically physical currency and checkable deposits. Quite what it will be when it is no longer possible, as it will be and to a large extent already is in Europe, to write a cheque on a bank account, is an interesting question. It’s reported by the Federal Reserve as part of the H.6 dataset, along with its cohort M2, and they also helpfully break out the different components of M1 if you scroll down a little.

Broadly then, it’s physical currency and demand, or instant access checkable deposit accounts, which appear to be the Net Transaction Accounts for which there is still a reserve requirement. I have an HSBC internet savings account, it has no cheque book, pays a (very) small interest rate, and which i can transfer to and from using the Internet at will. Is it classified under M1 or M2? Does it have a reserve requirement? Does that even matter?

The last question is perhaps the most interesting. The answer appears to be both yes and no as it happens. Since reserve requirements are no longer used to directly regulate loan expansion – equity capital does that – then it doesn’t strictly matter if an account has a reserve requirement or not. Except of course, that the Banks can at the moment get quite a nice interest rate from the Federal Reserve on their reserves, which is why reserves so dramatically increased a year ago. Now there’s no correspondingly dramatic shift in the components of M1, so it looks like the Banks just dumped all their spare money onto the federal reserve – which lends some credence to the claim that this has inhibited lending. Except of course, that they’re still as busy as ever creating and  selling Asset Backed Securities.

M2

Strictly, M2 is all of M1 plus Bank savings accounts and Retail Money Funds. The Federal Reserve helpfully breaks out the non-M1 components of M2 as part of its H6 dataset, which makes life a little easier.

Now this is where it gets quite interesting. Retail Money Funds, which were a non-existent category at the beginning of 1959, and peaked in October 2008  at slightly over $1 trillion are around 15% of the total quantity of M2. Retail money funds are funds that generally provide an extremely safe return, that is expected to track the safest form of investment (government securities), and never not return their capital investment. They’re also expected to be very liquid, i.e. you can get your money back more or less on demand. This essentially means that they invest in short term debt securities, although only ones of very high quality. Like triple A rated, insured, top of the tranche Mortgage Backed Securities for example?

Leaving aside the interesting co-incidence that the growth of retail money funds begins in the same period as MBS were introduced (late 1973, sales don’t really kick off until the S&L crisis in the early eighties); just the total quantity of retail money funds indicates that some of them must be in MBS securities. There simply aren’t enough other suitably ’safe’ instruments paying a suitable rate of return otherwise. Which means that some proportion of the M2 money supply measure, is actually debt.

This helps to explain the divergence in the growth between M1 and M2, in the USA and other countries, since thanks to the Asset Backed Security loophole, debt is currently growing faster than money within the banking system. It also i think, provides a measure of proof, that the Central Banks really don’t understand what’s going on in the system these days. Because if they did, they would not publish statistics that obviously confuse money with debt, especially in a system where money is regulating the total quantity of debt, and vice versa. Of course, if they did understand that, then Banks wouldn’t be allowed to hold debt instruments in their equity capital holdings either.

M3

And then there’s M3. Which was somewhat notoriously, and to the great delight of the FRLF, discontinued by the Federal Reserve in 2006. If you want proof that many of the critics of the current banking system also have no idea how it actually works, threads on the Federal Reserves  discontinuance of M3 can be quite enlightening, if for no other reason than their blind assurance that it was a valid measure of the money supply.

But no, if you look at the largest, and towards its end, most rapidly growing components of M3, it’s Institutional Money Funds, followed by something called “RPS”. Institutional money funds are retail money funds writ large, and stuffed with those wonderful top tranche Asset Backed Securities. RPS are,  i believe i’m correct in saying, Repurchase agreements owned by the banks. Repo’s as they’re otherwise called are one of those interesting pieces of financial alchemy, whereby you sell a financial instrument to somebody, for cash, along with a guarantee that you will buy it back at a specified amount sometime in the future. It’s essentially a loan in return for an agreement to buy a loan.

Quite how you can get away with calling that part of any money supply measure, I have no idea.

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cc Credit Crises, Empirical Analysis, Fractional Reserve System