Bye-Bye M3?

November 23, 2005 - M. Roberts

The fortunes of empires tend to be predicated by the fortunes of their currencies.

- A. E. Fekete

   The Federal Reserve announced on November 10, 2005 that it intends to stop publishing the M3 monetary aggregate after March 2006. Most people would probably respond to such an announcement with a puzzled "huh?", then turn the page of their Newsweek and not give it another thought. I too was clueless until just a few days ago. Since then, I have discovered that the M3 is the broadest measure of America's money supply, which in recent years has been increasing at a furious rate. The consequences of this increase affect every American's paycheck and life savings and it concerns me that the government would see fit to stop publishing such an important economic vital sign. Why would they do that? Are times not as good as they say? Does our government not want us to know some vital truths about the health of the American economy?  

 Figure 1. Historical growth in the money supply. Money creation in America has accelerated significantly over the last few years. Source: St. Louis Federal Reserve

   Figure 1 shows the M3 over the last 45 years of our history. Notice that the money supply has doubled from around $5 trillion just a decade ago to nearly $10 trillion now. This is a huge increase in the money supply, especially since it happened only within the last 10 years. Now why would it be a bad thing to have more money in the economy?  After all, more money in circulation means that there is more to go around, right? Sure, but more money in circulation results in a devaluation of all money in circulation. In other words, every dollar added to circulation results in a devaluation of every other dollar in circulation. When the dollar is devalued it is called inflation, and the result is that it takes more dollars than before to buy things such as a gallon of gas or a carton of milk. Inflation is defined as follows: 

A persistent increase in the level of consumer prices or a persistent decline in the purchasing power of money, caused by an increase in available currency and credit beyond the proportion of available goods and services. 1

In other words, when money is created at a rate that outpaces growth in goods and services inflation results. More dollars are chasing around fewer goods and services, so every dollar in circulation is worth less and the prices of goods and services increase. Figure 1 shows that the increase in the money supply over the last ten years is nearing 100%, astronomically higher than the growth in the GDP, which has averaged around 5% for the same period of time. Clearly, the growth in the money supply has greatly exceeded the growth in the economy.

   Now why exactly would the Federal Reserve want to add to the money supply? It does this because the money added is in the form of credit that can be used to finance economic expansion. If credit is abundant, businesses can borrow to expand their operations. If businesses are expanding, more people are employed and accumulating wealth and more people are consuming and starting up new businesses. The theory is that as long as the Federal Reserve provides abundant credit, the economy will expand. How does it do this? Where does the money come from?  It comes from the printing press (or the computer). The Federal Reserve simply creates the money needed to meet the demand for credit out of thin air.

   It used to be back in the old days that market forces would regulate the cost of credit, which is reflected in interest rates. If the amount of credit available for new loans becomes more limited, the cost of credit climbs. It is a simple law of economics: limited supply results in higher prices. If outstanding loans are repaid quickly, more credit becomes available and the cost of credit drops. Well, the Federal Reserve was created in 1913 to do away with the problem of a finite amount of credit in America. You see, some people noticed that limited credit usually translated into slower economic growth. If somebody could come up with a way to provide limitless credit to the economy, businesses would always have the money needed to expand and the economy would always grow. So, the Federal Reserve was created to provide limitless credit. 2 Now it's one thing to provide credit, but another thing to get people to borrow it. Instead of allowing market forces to dictate the cost of the credit, the Federal Reserve intervened by regulating interest rates itself. If the Fed lowered rates, credit would cost less and consumers would borrow more. If it raised rates, credit would cost more and consumers would borrow less.

   Most Americans have heard about the Fed adjusting interest rates, but few probably know what really is happening. The rate the Fed adjusts is the federal funds rate, which is the interest rate charged by the Federal Reserve for the use of its funds. When the Fed cuts rates, the intent is to inject more credit, or liquidity, into the economy to fuel economic expansion. Because the federal funds rate is lower, it is less expensive for banks to borrow money from the Federal Reserve to make new loans. The banks pass the lower costs on to the consumer by charging lower interest rates on loans. Because the cost of credit in the economy is cheaper, demand for credit increases, and to meet the increased demand, the Federal Reserve simply fires up the printing presses. New dollars are created out of thin air to meet the increased demand for cheap credit, resulting in an increase in the money supply and a devaluing of all dollars in circulation due to inflation. 

   The danger of limitless, cheap credit is that it can result in speculative booms that can send inflation through the roof. If a borrowing frenzy ensues, such as in the white-hot real estate market of the past few years, the Federal Reserve finds itself in the position of having to create astronomical amounts of money to meet the demand for credit. It cannot simply shut down the printing presses because that would cause credit to dry up very quickly, resulting in a shock to the economy. The Fed has to ease demand by gradually raising interest rates. The danger here is that if it raises rates too quickly, economic expansion could halt and a recession could result. If it raises rates too slowly, inflation could increase. The challenge is for the Fed to strike a balance between economic expansion and inflation, achieving the maximum expansion for the minimum inflation. History demonstrates that it has not always been successful at finding that balance. 

   High inflation is a danger to the stability of our economy. It results in the devaluation of the dollar, making goods and services cost more. It undermines the confidence in our economic system that is absolutely essential to the continued financing of America's huge deficits. It is politically damaging to the ruling class because Americans have demonstrated that they vote with their wallets. But increasing inflation also would be a sign that the health of the economy is deteriorating. Because of an astronomical debt burden, increasing, out-of-control inflation could be a sign that the American economy is headed for very turbulent waters. This American is cynical about the intentions of the Fed with regard to the M3. Many have already made a strong case that the government is understating inflation. The decision to stop reporting the M3 seems to be another way to mask the true picture of inflation.