Saturday, November 29, 2008

Is M3 Important?

There is interesting discussion on Paul Krugman’s NYT blog today regarding monetary expansion and the Great Depression. For the current crisis, I think you need to look at the divergence of M2 and M3. As institutional money market investors fund commercial paper that funds asset sales by originators, M2 is converted to M3. The money multiplier becomes unlimited as the original reserves used to fund loans are returned in full to the banking system with no new net increase in deposit liabilities. What’s happening right now is the reverse – M3 is liquidating and the monetary base is expanding to, in part, accommodate the conversion. If you look at Institutional Money Market Funds on Z.1 you will see the reductions in this (and, I believe other) components of M3 relating to credit expansion in the modern financial system. I have been waiting for the next Z.1 to confirm these movements.

I believe M3 is important, notwithstanding the Fed’s decision to stop publishing it. I have not concluded that the M3 expansion is the cause of the bubble, but it certainly shows how monetary expansion and, in particular credit expansion, contributed. I plan to post more on this after the holiday weekend.

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Anonymous said...

I just read about the latest stunt to jump start the mortgage market. Paulson wants to reduce mortgage rates to 4.5%. The idea is that lower rates will stimulate mortgage demand and move the economy forward.

There are some inherent flaws in this logic though. The government can try to solve the supply side all they want, but I still don't know anyone who wants to buy a house right now. On Long Island, prices have not moved much in the neighborhoods I'd want to live in.


1) Mortgage rates have risen because of a dysfunctional mortgage market. But a piece of that is because there is real risk of someone not repaying their loan. Why is the gov't trying to artificially control supply and demand? Won't this price floor spring back hard when the gov't exits?

2) If credit is cheap again (4.5%) doesn't this create the same situation that fed the first housing bubble earlier in the decade??? 1% interest rates - check. Just coming out of a bubble - check.

3) Even at 4.5%, an average home on Long Island still requires about 100K down payment. Even a 0% mortgage isn't going to help me with that nut.

dd said...

Palermo - for the record, it wasn't me who left the previous comment but I couldn't agree with it more ;). Unless I left it subconsciously and don't remember.

Palermo's Blog said...

I think you have very legitimate concerns. This is obviously an attempt to prevent deflation which could lead to depression-like conditions, but the risk is clearly inflation on a large scale. Easy money is what to do to avoid declining prices. Many people will refinance, saving money on monthly payments and freeing up income for consumption rather than debt burden. Add that to a huge government stimulus plan and the fall back in oil prices and you could at least soften the crash landing. Doing nothing in the face of the current economic data would be asking for even worse trouble, I think. The job numbers are looking very grim. Not sure I have a better plan. In the long run, however, I think the Fed needs to re-evaluate what it monitors and how it implements monetary policy.