RateWatch #306 - Money Supply
June 1, 2002
By Dick Lepre

What's Happening

A key thing to watch for mortgage rates is the yield on the 10-year Treasuries. What we are hoping for is for this to drop below 5%, which would likely trigger a buying wave and send mortgage rates to their low for the year. We were within 0.02% of that but some healthy economic data on Friday provided reason to buy equities and sell Treasuries.

We still feel that we will get below 5.00% on the 10-year and have a rally. This may take a week or two.

The Money Supply

We assume that the government should have as its primary economic policies: low unemployment, low inflation and a modest expansion of GDP. The classic economic problem is trying to avoid the annoying trade off of high inflation followed by high unemployment. These were what Keynes called business cycles.

Keynesian policy indicates that the government should aggressively regulate the money supply. The concept is that having too much money around causes inflation and having too little money around causes recessions. The concept is intuitive enough. If I have a lot of extra cash in my
pocket I am more inclined to buy things. If enough people have extra money demand may exceed supply and prices will rise. Conversely, if no one has any extra money the prices of things will fall.

The government should then be able to prevent unwanted inflation and recession cycles by turning up the money supply when a recession is about to hit and turning it down just in time to avoid unacceptably high inflation. For decades it was believed that regulating the money supply would smooth out the bumps in the business cycles.

The person who first started tearing down this concept was Milton Friedman. Friedman is what would be described at a late 20th century conservative economist. "Conservative" is the sense that he wanted the government to butt out of money policy. Friedman contended that the government
moves too slowly to make these policies work. It takes some time to recognize the problem, additional time to implement a solution and then a perhaps very long time for the now-in-place solution to have any effect. The proposition that Friedman made was that the problem would have fixed itself without intervention and, worse yet, the policy would set the inflation-recession cycle
into motion in the other direction. Imbued in this is a notion common to conservative values: government is a self-perpetuating thing - it tends to create problems that it then has to fix.

Friedman is a clever dude. To better sell this notion he sold a redefined concept of money. (Let's face it - that is a major accomplishment.)

What is Money?

In times gone by money was something that you could exchange for gold. Gold was equal to wealth. Nations fought wars for the opportunity to plunder the gold of the vanquished. Spaniards came to Mexico to "relocate" gold to Spain. These "problems" could be attributed to a very narrow definition of wealth and an unsophisticated concept of money. These folks simply lacked:

1)international telephony and the Internet
2)Fed-Ex & DHL and
3)the Fed funds system to instantly wire transfer gigantic sums of money over long distances. A world in which the IMF can arrange for wire transfers of $500 million to an economically distressed nation is a lot different world than one in which the economically-distressed nation may have seen its only recourse as declaring war on a wealthy neighbor.

The "money" that we currently have is the U.S. is not backed by precious metals and it thus described by the term "fiat money". Fiat money is money because the government says so. To be a bit more practical: it is money because the government says so and can convince people that it is so. The power that was once help by Emperors and armies is now held by the Federal Reserve.

Ultimately, money is simply something that we get for our present goods and services so that we may exchange them for future goods and services. Money has value in as much as it can be relied upon to buy stuff in the future. Inflation erodes the reliance that money will buy an adequate amount of stuff at some later date. Inflation is the enemy of money. Our musings in describing inflation as "The I-Monster" are justified.

Perhaps then, the principal charges of the Federal Reserve are: don't screw up the economy and don't screw up the perceived value of money.

But it is not all that simple. Let's get back to the "money supply" thing. If we are going to regulate
the supply of "money", what precisely should be counted as money?

Let's go to the Federal Reserve for the answer. These folks say that there are several different
"supplies" of money. (Digress for a moment and personalize this. You may regard your "money supply" as:
1) the cash you have on you (a mugger would)
2) the cash you have on you plus your checking account - a mugger whose buddy was a forger would or
3) your cash plus your checking account plus your savings account (a divorce attorney would.)

Every Thursday the Federal Reserve releases a report on the money supply. There are 3 money supplies: M1, M2, and M3. M1 consists of currency outside the U.S. Treasury, Federal Reserve Banks, and the vaults of depository institutions; travelers checks of non-bank issuers; and checking accounts. M1 is money ready to be spent. It buys groceries and gas for the car and pays the rent or mortgage.

M2 is M1 plus savings deposits (including money market deposit accounts), small-denomination time deposits and balances in retail money market mutual funds. M2 buys groceries and gas for the car and pays the rent or mortgage plus it buys the car and makes a down-payment for the house. It also is a source of capital investment.

M3 consists of M2 plus large-denomination time deposits (in amounts of $100,000 or more), including institutional money funds.

The most commonly watched money supply is M2.

Friedman convinced people that the government should expand M2 at approximately the same rate as GDP expansion - about 4% per year. This policy is called monetarism. This policy was, largely, followed until the stock market crash of 1987 when Greenspan and the other members of the Federal Reserve allowed funds to expand and dropped rates. Some inflation resulted but the economy recovered nicely and saw a decade of expansion.

Greenspan has achieved success either by an extraordinary amount of luck or by being pragmatic: not following any dogma but applying a small dose of the right medicine at just the right time. The medicine had been small changes in the Fed Funds rate.  He even showed that he was not
"dialed in" to that and dramatically slashed rates in 2001.

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