Are We Targeting the Wrong Monetary Aggregates?

From 2003 through summer of 2007, a significant portion of the credit boom was funded through what Nouriel Roubini has described as the Shadow Banking System. By Prof. Roubini’s definition, the Shadow Banking System comprised approximately $10.5 Trillion in 2007, including $2.2 Trillion of commercial paper conduits, $2.5 Trillion in the repo/reverse repo market, $4 Trillion of brokerage assets and $1.8 Trillion in hedge funds. 

For analytical purposes I believe it makes sense to define Shadow Credit more broadly to include various other financial institutions, conduits and debt markets not regulated as banks. These sources of credit include private equity groups (PEGs), mortgage backed securities (MBS), structured investment vehicles (SIVs) , collateralized loan obligations (CLOs), collateralized debt obligations (CDOs), Fannie Mae, Freddie Mac, etc., etc.  Many of these vehicles have been supported by credit default swaps (CDS), further leveraging their impact on the monetary system.  

The growth of these alternative credit and liquidity sources during the current decade has been so significant that they can no longer be ignored in formulating monetary policy. At a minimum, using Prof. Roubini’s definition, Shadow Banking is 40% larger than M2 and more broadly defined Shadow Credit may be as much as three times M2 (i.e. well in excess of $20 Trillion). To date there is no recognized monetary aggregate that adequately measures the impact of this Shadow Credit on the Effective Money Supply and as a result policymakers have utilized the traditional tools at hand such as M2. In retrospect this may have contributed significantly to the recent credit collapse.

Using its traditional tools the Fed allowed moderate growth in M2 from late August 2007 until late August 2008 at an annual rate of approximately 5.4%.  

Given the inflationary pressures at the time, this appeared to be a logical response, neither too accommodative, nor too restrictive. However, from late March until early September 2008, the Fed conducted a more restrictive monetary policy with essentially no monetary growth, presumably in an attempt to soak up perceived excess liquidity created around the time of the Bear Stearns collapse.

Taking this same data and applying a new lens, we see a far different picture. Assume for the moment that M2 reflects only a small portion of the total credit and liquidity available to the economy, perhaps as little as 25%. Assume further that, by applying an appropriate multiplier not yet empirically defined to the non-regulated credit and liquidity that makes up the Shadow Credit System, one could determine a measure of Effective Money (i.e. the total credit availability that drives activity in the real economy). In that case a divergence between the growth rate of traditional money and that of Effective Money could cause significant distortions in the real economy. 

I believe that such a divergence occurred between August 2007 and September 2008, resulting in a slowing of the Effective Monetary Growth Rate sufficient to have had a seriously negative impact on the real economy.   After August 2007, with the collapse of the syndicated credit market, the creation of new Shadow Credit effectively ground to a halt. Since that time there has likely been a meaningful decline in aggregate credit available in the Shadow Credit System. The collapse of the SIVs alone took $400 Billion of credit out of the system worldwide, forcing much of it onto the balance sheets of already strapped banks. 

For purpose of example, if we assume M2 of $7.5 Trillion and Shadow Credit of $22.5 Trillion and apply a multiplier of as little as 33% for measuring the impact of Shadow Credit on the Effective Money Supply, the net impact of changes in Shadow Credit could easily be as great as that of changes in M2. Since there’s not yet an agreed yardstick for measuring Shadow Credit and no empirical data as to the appropriate multiplier, the actual impact could be lower or higher, but it is inconceivable that the growth and decline of Shadow Credit has not had a significant impact on Effective Money.

In the above example, a decline in Shadow Credit of a little more than 5% from August 2007 to August 2008 would have been enough to fully offset the growth of M2 during the period. Bringing the analysis to the present crisis, the accelerating decline of Shadow Credit during the period following the Bear Stearns collapse, combined with the stagnation of traditional monetary aggregates, would indicate that Effective Money may actually have shrunken significantly from spring 2008 until the onset of the financial collapse in September 2008. Such an effective tightening of the money supply when the system was already quite shaky, could easily have played a significant role in catalyzing the current crisis. 

Going forward let’s hope that the monetary authorities and the academic community can get their arms around the impact of this non-traditional money on the Effective Money Supply and develop tools to bring the Shadow Credit System under sufficient control to prevent similar impacts in the future.

Comments

[flow5:]

Your impediments to achieving the monetarist goal, involve acquiring a technical staff for Congress and the FED which:

(1) does not confuse the supply of money with the supply of loan-funds;

(2) can make the proper distinctions between means-of-payment money and liquid assets;

(3) knows the difference between money creating institutions and financial intermediaries;

(4) recognizes aggregate monetary demand is measured by the flow of monmey not nominal GDP;

(5) recognizes that interest rates are the price of loan-funds, not the price of money;

(6) loan-funds are equal to the volume of money in only one incremental sense - when commercial banks make loans to or acquire securites from the non-bank public.

(7) recognizes that the price of money is represented by the price level (price indices); &

(8) realizes that inflation is the most important factor determining interest rates, operating as it does through both the demand for and the supply of loan-funds;

(9) and above all else, recognize that even a temporary pegging of a series of federal funds rates over time, forces the FED to abdicate its power to regulate properly the money supply.

2008 Oct 16 11:45 AM

[John Ryskamp:]

What is more, the failure to take cognizance of these 9 things, makes for greater opportunity in the shadow banking system, and greater problems when credit is withdrawn which had been created because these 9 things were not present.

Conclusion? Shadow credit was approximate 12 times, not 3, as much as M2, and as we uncover more of the facts, that number 12 is climbing. It is climbing daily.

Mr. Slater is not imaginative enough to encompass all the corruption involved in Shadow Credit, or the scope of it.

2008 Oct 16 02:55 PM