Thursday, May 27, 2010

Will the Fed Bring Back M3?

Is the M3 money supply making a comeback? It seems to be gaining attention as Bloomberg, the FT Alphaville, and now Ambrose Evans-Pritchard are discussing the deflationary implications of the dramatic slide in the M3 money supply over the past year. I am not as concerned about deflation as they are, but am sympathetic to their view that M3 is currently a better measure of the U.S. money supply than M1 or M2.* I believe this argument was first made by Gary Gorton in his research on the financial crisis. He makes the case for M3 by noting that an accurate measure of the money supply today should include repurchase agreements (which are not in M1 and M2) because (1) they too are bank liabilities used as money and (2) they have grown increasingly important:
[T]he bank liabilities that we will focus on are actually very old, but have not been quantitatively important historically. The liabilities of interest are sale and repurchase agreements, called the “repo” market. Before the crisis trillions of dollars were traded in the repo market. The market was a very liquid market like another very liquid market, the one where goods are exchanged for checks (demand deposits). Repo and checks are both forms of money...


Repo is money. It was counted in M3 by the Federal Reserve System, until M3 was discontinued in 2006. But, like other privately‐created bank money, it is vulnerable to a shock, which may cause depositors to rationally withdraw en masse, an event which the banking system – in this case the shadow banking system—cannot withstand alone...
This reasoning makes sense to me. The big problem, however, with M3 is that it is no longer published by the Fed. Thus, there are only private sector estimates of M3 and no one knows how accurate they are. I wonder if the Fed is reconsidering its decision to abandon M3. Surely they are aware of Gorton's research and its implications for the conduct of U.S. monetary policy. And surely they can no longer stand by their original cost-concern justification for ceasing the publication of M3:
M3 does not appear to convey any additional information about economic activity that is not already embodied in M2 and has not played a role in the monetary policy process for many years. Consequently, the Board judged that the costs of collecting the underlying data and publishing M3 outweigh the benefits.
To be clear, though, I am not advocating a monetarist position here. I still think monetary policy should aim to stabilize aggregate demand (i.e. implement some kind of a nominal income target) and could do so effectively if it (1) had the will and (2) had a nominal GDP futures market to help guide its decisions.

HT to Josh Hendrickson

*An even better measure of the money supply would be a M3 monetary divisia measure.

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