Clarifying the M3 Contraction

Many have been writing asking how the chart and commentary in M3 Contraction - The Future Is Now can possibly be correct. Here is the chart and a snip of text once again for convenience. The key sentence below is in bold.

The Telegraph is reporting Sharp US money supply contraction points to Wall Street crunch ahead.

The US money supply has experienced the sharpest contraction in modern history, heightening the risk of a Wall Street crunch and a severe economic slowdown in coming months.

Data compiled by Lombard Street Research shows that the M3 ''broad money" aggregates fell by almost $50bn (£26.8bn) in July, the biggest one-month fall since modern records began in 1959. "Monthly data for July show that the broad money growth has almost collapsed," said Gabriel Stein, the group's leading monetary economist.

On a three-month basis, the M3 growth rate has fallen from almost 19pc earlier this year to just 2.1pc (annualised) for the period from May to July.

This is below the rate of inflation, implying a shrinkage in real terms. .....

Questions about that chart have been in comparison to charts of M3 on Now and Futures and ShadowStats.

Before we look at some charts, let's address the alleged "contraction". I would not have used the word on my own accord but I can explain where it comes from. Read the last sentence in the excerpt above for an explanation. The contraction is in "real terms". "Real"  means inflation adjusted, and "inflation adjusted" means via the CPI or PCE deflator.

Sheeesh. Had enough? I hope so. So let's look at some charts.

M3 - Now And Futures

(Click on charts to enlarge.) The above chart courtesy of Now And Futures.

M3 - Shadowstats

The above chart courtesy of  ShadowStats.

So which chart is correct?

The correct answer, most likely, is all three. Now and Futures and ShadowStats are looking at year over year comparisons, while the first chart is presumably a comparison of three month annualized vs. the prior three months annualized. There is merit to both methods.

As for the difference between the second and third charts, Now and Futures offers this explanation:

John Williams' monthly reconstruction of M3 is here. Ours tends to be more volatile and averages slightly higher than his, partly because it's weekly and partly because of our minor differences in calculating the Eurodollar component of M3 and repos.

What's Going On With M1?

As long as we are discussing charts, inquiring minds may notice that M1 is rising in the ShadowStats chart. M Prime (M') and TMS are doing the same. (See TMS: A Truer Money Supply? for a discussion of the superiority of M' and TMS vs. M3 for economic purposes)

With M1 as with M3 it is important to understand why something is happening or very wrong conclusions will be drawn. One explanation is that consumers are moving money from savings accounts, T-Bills, CDs, and even brokerage accounts to checking accounts. A second explanation is consumers are saving, rather than spending their stimulus checks. A third explanation is that base money supply is rising. Why M1 is rising is likely a combination of all of those. If so, at least a part of M1's rise is a last ditch effort by consumers to maintain liquidity by draining other accounts and saving the stimulus.

The biggest reason M3 was soaring is corporations were tapping credit lines at a rapid pace and parking the money in institutional money market accounts before those lines of credit were shut down. Now and Futures explained this way back on 11/30/2007 as follows. "Much of the large growth in M3 lately has been in flows into CDs and Money Market Funds, a normal occurrence during financial turmoil."

Ironically, what was described by many as evidence of hyperinflation was actually a flight to cash while cash was still available!

The recent plunge in M3 makes it likely that credit lines have been fully tapped and/or banks have simply turned off the spigot. Liquidity shrinks by the day. Banks Scrambling To Refinance Long-Term Debt are going to have a very tough go of it. Weekly unemployment claims are soaring. Consumers out of a job are going to have a tough time paying bills. Those looking for a bottom in these conditions are simply barking up the wrong tree.

Comments

[neeb??:]

It might be all of the above. The bit about hyperinflation was overblown but could be interpreted as such simply by ignoring the rush to savings etc. All it would take is for a general freeze up in the credit market to completely collapse any economic growth.

2008 Aug 22 09:11 AM

[flow5:]

M3 has not contracted in absolute terms, rather it's rate-of-change or growth rate has contracted/slowed. And M3 is mudpie anyway. M3 is not representative of the "broad" measure of the domestic money stock. And no money supply figure standing alone is adequate as a "guide post" to monetary policy.

The money supply is unknown & unknowable, as any monetarist can ascertain.

First, there is no ambiguity in forecasts. In contradistinction to Bernanke (and using his terminology), forecasts are mathematically "precise” (1) nominal GDP is measured by monetary flows (MVt); (2) Income velocity is a contrived figure (fabricated); it’s the transactions velocity (bank debits, demand deposit turnover) that matters; (3) “money” is the measure of liquidity; & (4) the rates-of-change (roc’s) used by the Fed are specious (always at an annualized rate; which never coincides with an economic lag). The Fed’s technical staff, et al., has learned their catechisms;

Friedman became famous using only half the equation (the means-of-payment money supply), leaving his believers with the labor of Sisyphus.

The lags for monetary flows (MVt), i.e. proxies for real GDP and the deflator are exact, unvarying, respectively. Roc’s in (MVt) are always measured with the same length of time as the economic lag (as its influence approaches its maximum impact; as demonstrated by a scatter plot diagram).

Not surprisingly, adjusted member commercial bank "free/gratis" legal reserves (their roc’s) corroborate/mirror both lags for monetary flows (MVt) –-- their lengths are identical.

The lags for both monetary flows (MVt) & "free/gratis" legal reserves are indistinguishable. Consequently it has been mathematically impossible to miss an economic forecast. There are no inaccuracies, just some non-conforming & unavailable data This is the “Holy Grail” & it is inviolate & sacrosanct.

The BEA uses quarterly accounting periods for real GDP and deflator. The accounting periods for GDP should correspond to the economic lag, not quarterly.

Monetary policy objectives should not be in terms of any particular rate or range of growth of any monetary aggregate. Rather, policy should be formulated in terms of desired roc’s in monetary flows (MVt) relative to roc’s in real GDP. Note: roc’s in nominal GDP can serve as a proxy figure for roc’s in all transactions. Roc’s in real GDP have to be used, of course, as a policy standard.

Because of monopoly elements and other structural defects which raise costs and prices unnecessarily and inhibit downward price flexibility in our markets, it is probably advisable to follow a monetary policy which will permit the roc in monetary flows to exceed the roc in real GDP by c. 2 percentage points. In other words, some inflation is inevitable given our present market structure and the commitment of the federal government to hold unemployment rates at tolerable levels.

Some people prefer the devil theory of inflation: “It’s all Peak Oil's fault.” This approach ignores the fact that the evidence of inflation is represented by "actual" prices in the marketplace. The "administered" prices of the world's oil producing countries would not be the "asked" prices were they not “validated” by (MVt), i.e., validated by the world's Central Banks.

2008 Aug 22 11:40 AM

[flow5:]

To the Keynesian economists on the FEDs research staff, transactions velocity is a statistical "stepchild", it is income velocity that matters (see Milton Friedman WSJ Sept 1 1983), see also (www.nowandfutures.com/...) Income velocity is calculated by dividing nominal GDP for a given period by the average volume of the means-of-payment money in vogue, for the same period. A decline in the income velocity of money is supposed to suggest that the FED initiate an expansive or less contractive monetary policy. This signal could be right - by sheer accident.

Nominal GDP is determined by the volume of goods and serveices coming on the market relative to the actual (transactions ) flow of money. Rates of change in money flows for all transactions can serve as a reasonably good proxy for the rates of change of those money flows which finance real GDP.

Any increase in transactions velocity, since it will tend to cause nominal GDP to rise, will give the income velocity economists false signals. This is true even though both the volume of money and transactions velocity tend to move in the same direction. The effect on money flows and nominal GDP of an increase in both money and transactions velocity is obviously greater than an increase in either money or transactions velocity. Consequently income velocity declines. Given these circumstances it is a tighter money policy that is probably needed, not the easier policy the income velocity economists would probably recommend.

The exercise in futility derives from the Keynesian emphasis on the importance of GDP and the accompanying national income accounts. Obvioulsy income velocity will falll if, ceteris paribus, (1) nominal and/or real GDP increase, (2) the volume of money decreases, and (3) the GDP deflator rises.

This tells us nothing about the dynamics of money flows because it measures neither the volume or rate of change of actual money flows - it is real means-of-payment money actually changin hands that affect price levels, price trends, interest rates, employment, production, etc.

2008 Aug 22 11:44 AM

[flow5:]

A chronic increase in prices "across-the-board" (i.e. inflation/housing bubble) cannot occur unless fueled by a chronic increase in the volume and/or velocity of money. A chronic increase in means-of-payment money cannot occur unless the FED, through excessive open market operations of the buying type, supplies the commercial banks with an excessive volume of legal reserves. Excessive, of course, in terms of rates-of-change in real output, and changes in the velocity of money.

Why has the FED so grossly mismanaged our money??? There are three principal reasons:

(1) the FED has never used the transactions velocity concept in the formulation of monetary policy. The Open Market Committee defines goals in terms of the quantity of money, not in terms of the volume of monetary flows (MVt) through the economy.

It is obvious that money has no significant impact on prices unless it is actually being EXCHANGED.

(2) Beginning in the sixties and continuing until the present the FEDs technical staff in charge of open market operations assumed that the proper volume of money could be achieved through the manipulation of the federal funds rate.

(3) Political pressures have almost invariably been toward an excessively easy money policy.

2008 Aug 22 11:47 AM

[Jason Rines...:]

Wow, the article was great as always Mish. But the comments of Flow5 have got to be some of the best I have ever seen on Seeking Alpha! Thank you for posting it and please do run for office some day in Washington and advise the Administration. Back in March, I sent a less technical outline to the President which said to listen to Paul Volker and invest heavily into the energy infrastructure. In June of 2007, I calculated a -20% GDP by 2011 a deflation of 25 years of a recently proven failed economic policy from Friedman. Gentlemen, we have to square this away with Washington as part and parcel of a restoration of this nation. Take care and thank you all for such excellent and factual education and tireless care for the American citizen. I sleep better at night knowing there are others whom give a damn and are taking definative action to correct our country. True American Patriots...

2008 Aug 22 06:28 PM