Money Supply: Questions about Credit

I have received several questions recently about my statement "The problem with using M2 or M3 as a measure of money is that both include credit transactions." (See Is the Fed Deflating? for the source of the question)

From HBR:

Why do you say there are credit components in M2? It looks to me like it is only physical currency, bank accounts, money markets, and CD's. None of those are credit.

This is from Wikipedia:

M2: M1 + most savings accounts, money market accounts, and small denomination time deposits (certificates of deposit of under $100,000).

From C:

The government website says this about M2:
"M2 consists of M1 plus (1) savings deposits (including money market deposit accounts); (2) small-denomination time deposits (time deposits in amounts of less than $100,000), less individual retirement account [IRA] and Keogh balances at depository institutions; and (3) balances in retail money market mutual funds, less IRA and Keogh balances at money market mutual funds. Seasonally adjusted M2 is constructed by summing savings deposits, small-denomination time deposits, and retail money funds, each seasonally adjusted separately, and adding this result to seasonally adjusted M1."

Can you please explain what you mean by M2 containing credit transactions?
Thanks!

Mish:

Believe it or not savings accounts are not aptly named.

Saving accounts would be better described as lending accounts. By that I mean, savings accounts consist of deposits that by agreement, are make available for loans. In other words, banks take those deposits and lend them out. In return, depositors get interest. This arrangement is known by the depositor of that money. After all, how else could the bank pay interest on the money if the bank did not loan it out at a higher rate?

The reality then is that money in savings accounts is not really there (nor is it expected to be there). The money was lent out (spent or invested) with a promise by the borrower to pay the money back in the future. In the banking industry such accounts are called TDA accounts (Time Deposit Accounts).

Because the money was willingly lent out it's a credit transaction. There is no money in saving accounts. All that is there is a promise by someone to pay back what was lent out.

Checking accounts, however, are known in the industry as DDA accounts (Demand Deposit Accounts). Money deposited to a DDA (checking) account is by definition available on demand. At least its supposed to be. In actual practice, given that Greenspan authorized sweeps from DDA accounts, money that is supposed to be readily available on demand isn't really there in practice.

Sweeps are transactions that move (sweep) money from one account (in this case a DDA account) into another account (say a savings account) where the money can be lent out. This happens nightly and is done without the checking account depositor having any say in the matter. To repeat: Money that is supposed to be there, really isn't there. It's all a mirage. If you think money is sitting there in your checking account to the amount shown on your statement, you are mistaken. It was lent out.

The system would literally freeze up if all depositors wanted their money in cash tomorrow. Heck, there would be massive convulsions if even 10% of the people wanted their money in cash tomorrow. Far more money has been lent out than really exists.

Since the allowance of checking account sweeps, M1 has been under counted. That is why I add sweeps back into the monetary aggregate I call M Prime (M'). Please see Money Supply and Recessions for a complete description of M'.

A short version of the writeup is that M' is for all practical purposes what M1 was before Greenspan allowed sweeps. There are subtle differences between M' and what M1 used to be, travelers checks for example, but the amounts those are so small they can be ignored.

The problem with travelers checks is they are double counted. You buy travelers checks and the money sitting in your wallet as travelers checks is added to M1. But the Money you spent to buy the checks is sitting a bank somewhere as collateral. The net effect is that travelers checks are double counted. Travelers checks are not included in M'. As a practical matter however, the total amount of travelers checks in circulation is so small it can be ignored.

Comments

[greeytop:]

an excellent and lucid explanation of lesser known aspects of the bankin g and money system.

2007 Oct 22 08:39 PM