Our monthly Monetary Watch, an Austrian take on where we are on the monetary inflation front examining the money creation activities of the Federal Reserve and private banks…

True “Austrian” Money Supply TMS

The U.S. money supply aggregates based on the Austrian definition of the money supply, what Austrians call the True Money Supply or TMS, saw robust growth in April, with narrow TMS1 posting an annualized rate of increase of 10.7% and broad TMS2 showing an annualized rate of increases of 16.5%. That brought the annualized three-month rate of growth on TMS1 and TMS2 to 8.0% and 13.7% respectively, up 270 and 390 basis points from the growth rates seen in March.

Turning to our longer-term twelve-month rate of growth metrics – more indicative of the underlying trends – and focusing on our preferred TMS2 measure, we find that TMS2 continues to march higher, in April growing at an annualized rate of 11.0%. That’s up 40 basis point from March and 120 basis points from the recent low of 9.8% seen back in November 2010. That’s also the 28th time in the last 29 months that TMS2 posted a twelve-month rate of growth in the double digits, equating to a cumulative increase of some 35% over those 29 months. As readers of the Monetary Watch are aware, the run-up to the now infamous housing bubble turn credit implosion turn Great Recession saw a string of 36 months of double digit growth for a cumulative increase of 48%. So, on the heels of two massive asset monetization programs – namely QE I and QE II – the Federal Reserve has been behind a monetary largesse that, in terms of time and size, is now fully 81% and 73%, respectively of that which brought on the Great Recession. Supported by a QE II asset purchase program likely to extend through the end of June, this means that this, our current monetary inflation cycle, is on track to produce a cumulative monetary infusion of near 40% by the time America is celebrating the 4th of July. Yes, not as large as the last inflation cycle, but one we think has the makings of still more to come.

To that question we now turn. To lay the groundwork, first, as we do each month, a look at TMS2 internals…

A Look at TMS2 Internals

As we have often discussed in our Monetary Watch series, we put a lot of effort into analyzing the drivers behind the growth in the money supply, a component view we call TMS2 by Economic Category and Source. And for the third month running, this month’s component analysis reveals just how important the Federal Reserve’s QE II asset purchase program has been to the continued double digit growth in the money supply.

For first time readers of our Monetary Watch, our component view zeroes in on the who and the how behind the ebb and flow of the money supply, reducing monetary inflation to two basic institutions and three primary venues:

• Federal Reserve, via the issuance of what Austrians call covered money substitutes: the simultaneous issuance of on-demand bank deposit liabilities and bank reserves, created by the Federal Reserve through its purchase of assets, by writing checks on itself and later, when those checks are deposited by the sellers of those assets in their respective banks, completing the issuance by crediting those banks’ reserve balances at the Federal Reserve for the full amount of the checks.
• Private banks, via the issuance of uncovered money substitutes: the creation of on-demand bank deposit liabilities by private banks unbacked by any reserve cover, created through their issuance of loans and purchase of securities when they pyramid up those loans, securities purchases and deposit liabilities on top of their reserves.
• The Federal Reserve, via the largely passive issuance of currency: the issuance of Federal Reserve notes, created when the public chooses to redeem their on-demand bank-issued deposit liabilities for currency. In contrast to covered and uncovered money substitutes, the issuance of Federal Reserve notes is by and large neutral with respect to the total money supply, as it simply substitutes one form of money, namely covered and/or uncovered money substitutes for another, namely currency.

The combined total of covered money substitutes plus currency is what economists call the monetary base, and by definition completely under the control of the Federal Reserve. And the issuance of covered money substitutes is more popularly known as quantitative easing or QE.

Read the rest of the article

Michael Pollaro [send him mail] is a retired Investment Banking professional, most recently Chief Operating Officer for the Bank’s Cash Equity Trading Division. He is a passionate free market economist in the Austrian School tradition, a great admirer of the US founding fathers Thomas Jefferson and James Madison and a private investor. He is a columnist on the Forbes blog.

The Best of Michael Pollaro

As Republicans and Democrats slug it out over the future course of U.S. government spending, deficits and debt, we here at THE CONTRARIAN TAKE cannot help but wonder if Washington truly grasps the enormity of the government’s increasingly fragile financial condition, whether they truly are seeking a solution to the government’s mounting debt problem. So far Washington has done nothing to address these issues. We think time is running out…

The Republicans entered the year with their Pledge to America, to cut a $100 billion off of the government’s 2011 fiscal budget. Despite that paltry sum, the Democrats wanted nothing to do with it. So, after months of political grandstanding, including threats by the Republican leadership to shut the government down if their spending demands were not met, the Republicans got just $38.5 billion in spending cuts. To put this number into perspective, according the Congressional Budget Office (CBO), fiscal 2011 government outlays are projected to be $3.6 trillion, the government deficit a whopping $1.4 trillion. Washington’s answer to this fiscal malaise – a $38.5 billion spending cut, a spend itself some $175 billion more than fiscal 2010. Worse still, according to that same CBO, it seems now that that $38.5 billion spending cut will be largely negated by higher than estimated spending in other government programs. After all the hoopla, nothing.

So we ask… Is the U.S. government’s fiscal plight really without a solution?

The Republicans, at least on paper the champions of fiscal sanity, say there is. The solution they say is to attack the problem in the 2012 budget. Enter House Budget Committee Chair Paul Ryan’s The Path to Prosperity. That plan purport’s to cut spending by $5.8 trillion over the next 10 years while generally holding the line on taxes. $5.8 trillion is a pretty big number. But while we applaud the Republicans’ effort to meaningfully attack Washington’s borrow and spend largesse, including downsizing the financial time bombs that are Medicare and Medicaid, the fact is the plan doesn’t actually cut the government’s spending bill. You see, those cuts are merely cuts to the CBO’s projected baseline spend, a baseline that has government outlays growing at an annual average rate of $205 billion per year (4.6% compounded) through 2021. And while Ryan’s plan grows government outlays at a more modest annual rate of $110 billion per year (2.7% compounded), grow that spend it does. More to the point, given that the 10-year compounded growth rate in government outlays ending fiscal year 2010 was 6.8%, and that over the last 5 year, 10 year and 25 year periods that 10 year growth rate averaged 6.3%, 5.3% and 5.9% respectively, we cannot help but take these spending projections with a rather large grain of salt. As for those worrisome deficits and their long-term impact on the government’s debt footings, there is a lot not to like. Even on some optimistic revenue assumptions, Ryan’s plan will rack up $5.1 trillion in red ink over the next 10 years, bringing the government’s gross Treasury debt from today’s $14.3 trillion to plus $20 trillion by 2021.

In a dramatic turnaround from his February 2012 budget proposal, President Obama says not so fast Republicans, the Democrats have a plan too. In an April 13th speech that served as the Democrats’ opening bid for negotiations with the Republicans over the nation’s fiscal future, the President unveiled a plan to cut the U.S. government’s deficit by $4 trillion over the next 12 years. Not spending, the deficit. To do that the President would cut government outlays by $3 trillion and pump government tax receipts by $1 trillion. Putting those numbers on Ryan’s 10-year time horizon, this equates to $2.5 trillion in spending cuts and $833 billion in tax hikes. Not only does the President’s plan promise less in terms of top line spend savings, but the plan does little to reduce the government’s footprint in the economy. In fact, while the President concedes the need to make government more efficient, including citing the government’s massive entitlement programs, he essentially argues for the government’s continued reach underscored by his desire to fund that reach by increasing taxes on higher income Americans.

As to the efficacy of these plans, to really solve the U.S. government’s debt woes, we have these thoughts…

First, to state the obvious, under both plans spending is still going up, deficits still abound and as a result the government’s debt burden will continue to mount.

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Michael Pollaro [send him mail] is a retired Investment Banking professional, most recently Chief Operating Officer for the Bank’s Cash Equity Trading Division. He is a passionate free market economist in the Austrian School tradition, a great admirer of the US founding fathers Thomas Jefferson and James Madison and a private investor. He is a columnist on the Forbes blog.

What follows is an update to our recent essay — America, poised for a hyperinflationary event? – including an update to our supporting metrics through December 2010. We're calling it a Roadmap to an inflation supernova in America, this essay elaborating on the dynamics and possible triggers behind the supernova. Not the only way America could get there, but if present trends continue, a roadmap that we think should be high on the list. Let's get right to it…

The U.S. government borrows and spends, running up its debt obligations, ad infinitum. At trend growth of 1.5 times U.S. net private savings and rising, such borrow and spend policies are increasingly beyond the means of America to finance the obligations…

Foreign investors have though over the last clutch of years stepped into the financing mix in a big way, bailing America out…

Underpinning this foreign demand for U.S. government securities are what we call “print and buy” countries — the mercantilist-minded, exporting-driven trading partners of America in Asia and the emerging markets plus the dollar-based, oil-producing countries of the Middle East, Africa and Latin America. They are the countries of the world whose central banks buy U.S. dollars collected by their export businesses, by printing their own money with which to do it, and with those dollars turn around and buy U.S. government securities, not because they necessarily consider them good investments, but primarily because the U.S. government securities market is currently the only U.S. dollar repository big enough to take the bid. In so doing, they keep their currencies weak and their export driven economies strong…

The U.S. government relishes the help of any and all foreign creditors because the bid those banks provide — for the U.S. dollar and in turn for U.S. government debt — is a job that would be left largely to the Federal Reserve and their U.S. private banking partners. Said differently, without the help of these foreign creditors, given a savings starved America, the Federal Reserve and its private banking partners would be having to monetize a lot more of that government debt, we think at levels more analogous to the inflationary 1970s; i.e., to pump the money supply even more then they already have to keep interest rates and the cost of U.S. government debt in check. Indeed, with a Federal Reserve Chairman in Ben Bernanke loathe to see interest rates rise, in the case of the Federal Reserve, something we could almost guarantee…

Read the rest of the article

Michael Pollaro [send him mail] is a retired Investment Banking professional, most recently Chief Operating Officer for the Bank’s Cash Equity Trading Division. He is a passionate free market economist in the Austrian School tradition, a great admirer of the US founding fathers Thomas Jefferson and James Madison and a private investor. He is a columnist on the Forbes blog.

      Monetary Aggregates, Where We Are

After December’s blistering rates of growth, the U.S. money supply aggregates based on the Austrian definition of the money supply, what Austrians call the True Money Supply or TMS, slowed markedly in January, with narrow TMS1 posting an annualized rate of growth of just 2.1% and broad TMS2 an annualized rate of growth of 4.6%. That brought the annualized three-month rate of growth on TMS1 and TMS2 to 21.5% and 14.7%, respectively, still high, but down from December’s 22.3% and 18.1% rates. No doubt some of this pullback was seasonal, as was December’s surge, but as we discuss below it’s a data point worth watching, as private banking institutions were a total no show in January.

Turning to our longer-term twelve-month rate of change metrics – more indicative of the underlying trends – and focusing on our preferred TMS2 measure, we find that TMS2 saw another healthy increase in January, growing at an annualized rate of 9.9% for the second month in a row. As we said in last month’s Monetary Watch, we think that’s close enough to 10% to mark January 2011 as the 24th time in the last 25 months that TMS2 posted a twelve-month rate of growth in the double digits. That equates to a cumulative increase in TMS2 of some 26% over those 25 months. To put those numbers into perspective, the run-up to the now infamous housing bubble turn credit implosion turn Great Recession saw a string of 36 months of double digit growth for a cumulative increase of 48%. So yes, today’s inflationary largesse may be only 54% of that which brought on the Great Recession, but this one’s still going strong.

M2, the mainstream’s favorite monetary aggregate, is now decidedly up, in January posting a year over year rate of growth of 4.3%. That’s up 70 bps from December’s 3.6% and marks the highest year over year rate of growth since November 2009. As readers of this site are aware, although THE CONTRARIAN TAKE posits M2 as a grossly misleading measure of the money supply, the mainstream does not. They think M2 is a perfectly fine measure of the money supply, including the world’s most powerful money printer, Chairman Bernanke. And as we argued in The Bernanke Arbitrage, all other things equal, a rising M2 could at some point give Bernanke pause, a reason to slow his QE efforts and in so doing slow the growth in the money supply. But all other things are not equal to Chairman Bernanke. To the Chairman, unemployment is still too high, core inflation is still too low and housing and municipal bound problems are all around. In the Chairman’s mind, these all other things are the things that argue for more not less QE, especially with M2 growing at a still relatively low, although rising rate of 4.3%. Clearly though it’s a data point we’ll be watching.

True “Austrian” Money Supply (TMS), January 2011

A Look at TMS2 Internals

As we discussed in last month’s Monetary Watch, we put a lot of effort into analyzing the drivers behind the growth in the money supply, a component view we call TMS2 by Economic Category and Source. And while one month’s data point does not make a trend, this month’s component analysis reveals just how important the Federal Reserve’s QE II asset purchase program may be to the continued double digit growth in the money supply.

As a reminder, our component view zeroes in on the who and the how behind the ebb and flow of the money supply, reducing monetary inflation to two basic institutions and three primary venues:

• The Federal Reserve, via the issuance of what Austrians call covered money substitutes: the simultaneous issuance of on-demand bank deposit liabilities and bank reserves by the Federal Reserve, created through its purchase of assets, by writing checks on itself, and later, when those checks are deposited by the sellers of those assets in their respective banks, completing the issuance by crediting those banks’ reserve balances at the Federal Reserve for the full amount of the checks.
• Private banks, via the issuance of what Austrians call uncovered money substitutes: the creation of on-demand bank deposit liabilities by private banks unbacked by any reserve cover, created through their issuance of loans and purchase of securities when they pyramid up those loans, securities purchases and deposit liabilities on top of their reserves.
• The Federal Reserve, via the largely passive issuance of currency: the issuance of Federal Reserve notes, created when the public chooses to redeem their on-demand bank-issued deposit liabilities for currency. In contrast to covered and uncovered money substitutes, the issuance of Federal Reserve notes is by and large neutral with respect to the total money supply, as it simply substitutes one form of money, namely covered and/or uncovered money substitutes for another, namely currency.

The combined total of covered money substitutes plus currency is what economists call the monetary base, and by definition completely under the control of the Federal Reserve. And the issuance of covered money substitutes is more popularly known as quantitative easing or QE.

With those definitional reminders in mind (for a more thorough discussion see last month’s Monetary Watch), one look at the table above tells us exactly who gassed the money supply in January – the Federal Reserve via the issuance of uncovered money substitutes. Indeed, uncovered money substitutes grew at an annualized rate of 42.6% in January taking the three-month rate of growth to an annualized 30.1%. In contrast, after private banking institutions had been showing a marked willingness to grow their issuance of uncovered money substitutes over the last clutch of months, in January they were nowhere to be found, the result being the three-month rate of growth in uncovered money substitutes fell fairly sharply, from December’s rate of growth of 20.5% to January’s 13.4%.

To repeat, one month does not make a trend. Indeed, the more important twelve-month rate of growth in uncovered money substitutes is still growing at a healthy 12.9%, albeit down a bit from December’s 14.3%. And with $1 trillion plus in excess reserves sitting on banks’ balance sheets and – because of the Federal Reserve’s QE II asset purchase program – growing by the day, the fuel for these banking institutions to explode the money supply is certainly there, even if that only be through an asset purchases program of their own; i.e., through the purchase of U.S government securities. But that was not to be in January. Needless to say, we’ll be watching this space like a hawk as we move through 2011.

And that’s a perfect segue into this month’s topic du jour…

What’s Next on the Monetary Inflation Front – Obama’s budget, the GOP and its implications for inflation

As we discussed in an Essay we wrote back on February 8th, it’s a long standing proposition of many, and one which we wholeheartedly endorse, that the surest road to inflation, and a whole lot of it, is one grounded in a government whose answer to every economic and social problem is to borrow and spend the problem away, supported by a banking system able, willing and ready to finance the effort. That support is of course to simply print the money through which to buy the debt so issued by the government – what is euphemistically called monetizing the debt – thereby exploding the supply of money and eventually trashing its value.

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Michael Pollaro [send him mail] is a retired Investment Banking professional, most recently Chief Operating Officer for the Bank’s Cash Equity Trading Division. He is a passionate free market economist in the Austrian School tradition, a great admirer of the US founding fathers Thomas Jefferson and James Madison and a private investor. He is a columnist on the Forbes blog.

It is a long standing proposition of many, supported on both theoretical and historical grounds, that one of the surest roads to hyperinflation is one grounded in a government whose answer to every economic and social problem is to borrow and spend the problem away, supported by central bank able, willing and ready to finance the effort. That support is of course to simply print the money through which to buy the debt so issued by the government – what is euphemistically called monetizing the debt – thereby exploding the supply of money and eventually trashing its value.

We here at THE CONTRARIAN TAKE wholeheartedly agree with this proposition.

So, given the extraordinary borrowing needs of the U.S. government, currently being supported by a Federal Reserve whose QE II asset purchase program is large enough to finance 100% of the government’s funding requirements through at least June, we thought we would take a look at the prospects for a hyperinflationary event in America. And while we think hyperinflation – defined as the total destruction in the value of the U.S. dollar – is a low probability event, a lot, and we do mean a lot more monetary inflation most definitely is not. You see, when you have a government that seems reluctant to change its borrow and spend policies in any meaningful way – a subject we took on here – teamed up with a central bank chaired by a man who thinks that loose fiscal and monetary policies are the springboard for a downtrodden economy, you have a recipe for a whole heap of monetary inflation. Indeed, in the opinion of THE CONTRARIAN TAKE, never has a U.S. central bank been chaired by a man who is more certain that loose fiscal and monetary policies are exactly what an economy mired in excess productive capacity and high unemployment requires to make things right.

Before we discuss the prospects for hyperinflation, some preliminaries…

Preliminaries

First, U.S. government debt is being here defined as the debt of the U.S. Treasury plus the debt of the government-sponsored agencies Fannie Mae and Freddie Mac (popularly called agencies). Inclusion of the latter may appear to be a bit of a stretch, but as we discussed here, to us, its inclusion in the U.S. government’s debt footings is obvious. Creations of the U.S. government, these government-sponsored enterprises and their debt obligations have always been implicitly backed in varying forms by the full faith and credit of the U.S. Treasury, a backing made explicitly clear to any and all doubters when on December 24th 2009, in the depths of the credit crisis, the U.S. government gave the government-sponsored enterprises unlimited access to the Treasury essentially until further notice. We wonder why anyone would have thought anything different, that when push came to shove the U.S. government would protect its own, make this implicit guarantee an explicit one and the debt of Fannie Mae and Freddie Mac the defacto debt of the U.S. government.

Second, it is common practice to measure a government’s burden on the economy by comparing the government’s debt to the nation’s productive output or GDP. And while we agree that over the long haul it is a nation’s productive prowess that provides the means necessary to pay the government’s debt obligations, we think it is more instructive to compare those debt obligations to the nation’s savings. You see, it’s a nation’s savings, its willingness to defer consumption that makes the government’s borrow and spend programs possible. All other things equal, an economy that consumes much and saves little is an economy that cannot long afford a borrow and spend government. The crucial question then in any proper examination of a government’s burden on the economy is this… is the nation’s pool of savings large enough to fund the government’s borrowing requirements, for how long and at what rate of interest?

Third, the Federal Reserve is not the only stateside institution that has the power to monetize the U.S. government’s debt. Because of our government protected, fractional reserve banking system, they have a partner – the private banking system – which can and does buy U.S. treasury and agency securities, paying for those securities simply by crediting the bank accounts of the sellers. That’s right, by printing money just like the Federal Reserve.

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Michael Pollaro [send him mail] is a retired Investment Banking professional, most recently Chief Operating Officer for the Bank’s Cash Equity Trading Division. He is a passionate free market economist in the Austrian School tradition, a great admirer of the US founding fathers Thomas Jefferson and James Madison and a private investor. He is a columnist on the Forbes blog.

Our monthly Monetary Watch, an Austrian take on where we are on the monetary inflation front and what’s next…

Headline Monetary Aggregates, Where We Are

The U.S. money supply aggregates based on the Austrian definition of the money supply, what Austrians call the True Money Supply or TMS, continued their recent surge, in December posting an annualized rate of growth of 38.9% on narrow TMS1 and 24.6% on broad TMS2. That brought the annualized three-month rate of growth on TMS1 and TMS2 to 22.3% and 18.1%, respectively, 8.6 bps and 2.7 bps higher than those posted in the prior month. No doubt some of this surge is seasonal, but as discussed below, clearly underpinned by the money-printing efforts of not only the Federal Reserve but of private banking institutions too.

Turning to our longer-term twelve-month rate-of-change metrics – more indicative of the underlying trends – and focusing on our preferred TMS2 measure, we find that TMS2 saw another healthy increase, in December growing at an annualized rate of 9.9%. Not only was this a tick up from November’s 9.8%, but we think close enough to 10% to mark December as the 23rd time in the last 24 months that TMS2 posted a twelve-month rate of growth in the double digits. For new readers of the Monetary Watch, the last time TMS2 saw this kind of string was during the run-up to the now infamous housing boom turned credit implosion, a time during which TMS2 saw 36 consecutive months of double-digit growth.

In what could be a developing trend, M2, the mainstream’s favorite monetary aggregate, is finally starting to show some growth. In the three months ending December, M2 has grown at an annualized rate of 9.5%, bringing its twelve-month rate of increase to 3.6%. Yes, 3.6% is still a relatively low rate of growth, but it is up substantially from its March low of 1.3%.

As readers of this site are aware, THE CONTRARIAN TAKE posits M2 as a grossly misleading measure of the money supply. So the question is, why do we even care? The reason, because the mainstream cares. They think M2 is a perfectly fine measure of the money supply, including the world’s most powerful money printer, Chairman Bernanke. And as we argued in The Bernanke Arbitrage, when the world’s most powerful central banker, armed with the world’s largest printing press, the same central banker who seems to think that economic prosperity can be achieved by printing money, thinks that the rate of monetary inflation is “low,” even when its not, he’s apt to print even more. So, with M2 quite possibly on an upward trajectory, the question to ask is this – will an upward trajectory in M2 give Bernanke some pause, perhaps give him a reason to slow his QE efforts and in turn slow the growth in the money supply? We doubt it, not at 3.6%. In fact, given that core consumer price inflation is still low, the unemployment rate still high, the real estate market still on the ropes and, as Bernanke testified to the Senate Budget Committee on January 7th, municipal debt problems becoming a concern of the Federal Reserve, we could almost guarantee it. Clearly though it’s something to watch.

Money Supply Firing on all Cylinders?

At THE CONTRARIAN TAKE, we put a lot of effort into dissecting the components of TMS2. We think it’s an important tool in deciphering the underlying trend in the money supply. Our favorite component views are what we call TMS2 by Source and Economic Category, views which zero in on the who and the how behind the ebb and flow of the money supply. Under this view, monetary inflation can be reduced to two basic institutions and three primary venues:

• The Federal Reserve, via the issuance of what Austrians call covered money substitutes: the simultaneous issuance of on-demand bank deposit liabilities and bank reserves by the Federal Reserve, created through its purchase of assets, by writing checks on itself, and later, when those checks are deposited by the sellers of those assets in their respective banks, completing the issuance by crediting those banks’ reserve balances at the Federal Reserve for the full amount of the checks.
• Private banks, via the issuance of what Austrians call uncovered money substitutes: the creation of on-demand bank deposit liabilities by private banks unbacked by any reserve cover, created through their issuance of loans and purchase of securities when they pyramid up those loans, securities purchases and deposit liabilities on top of their reserves.
• The Federal Reserve, via the largely passive issuance of currency: the issuance of Federal Reserve notes, created when the public chooses to redeem their on-demand bank-issued deposit liabilities for currency. In contrast to covered and uncovered money substitutes, the issuance of Federal Reserve notes is by and large neutral with respect to the total money supply, as it simply substitutes one form of money, namely covered and/or uncovered money substitutes for another, namely currency.

The combined total of covered money substitutes plus currency is what economists call the monetary base. And the issuance of covered money substitutes is more popularly known as quantitative easing or QE.

Now, while the Federal Reserve can create money via the issuance of covered money substitutes at will and without limit, it can only do so on a one-to-one basis; i.e., one dollar of asset purchases or QE can only bring forth one dollar of money supply. So, even though the Federal Reserve’s money printing powers are unlimited, there is not much bang for the buck. In the case of private banks it works the other way around. Under the law of the land, the private banking system can create money – uncovered money substitutes – at a multiple of their reserves at current reserve requirements, at a multiple of at least ten to one. Bang for the buck. Problem is, the buck stops when those private banks max out their reserves. The trick then, to get the money supply firing on all cylinders, is to get everyone involved, everyone working together as a team – the Federal Reserve supplying the QE fuel, and the private banking system taking that fuel and pyramiding up the money supply.

Where are we today? Well, for the first time in quite a while, the Federal Reserve and the private banking system are finally teaming up.

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Michael Pollaro [send him mail] is a retired Investment Banking professional, most recently Chief Operating Officer for the Bank’s Cash Equity Trading Division. He is a passionate free market economist in the Austrian School tradition, a great admirer of the US founding fathers Thomas Jefferson and James Madison and a private investor. He is a columnist on the Forbes blog.

At THE
CONTRARIAN TAKE a lot of time and effort is spent compiling
money supply data, analyzing its drivers and charting its course.
The reason is quite simple. It is the ebb and flow of the money
supply that shapes the ebb and flow of the financial markets and
the economies in which they operate. This has been true throughout
history, never more though than today, a time dominated by activist
central banks the world over, central banks that can and regularly
do create money in vast quantities whenever they deem fit. Having
said this, all this data crunching would hardly be worth the effort
if we were tracking an incorrect measure of the money supply. Luckily
for us, we here at THE CONTRARIAN TAKE think we most definitely
are not.

So what money supply measure are we tracking? It’s
a metric called TMS, for True
Money Supply, a formulation based on the monetary insights of
the Austrian School of economics. Those mainstream M’s –
like M1, M2 and M3 – although widely followed, we submit, are
all seriously flawed, for their formulations are founded on a faulty
definition of money. Not so TMS. We’re convinced the Austrians
have it right.

Now, that doesn’t mean we aren’t all over
those mainstream M’s. We are, and for good reason. As Kevin
Duffy, co-manager of Bearing
Asset Management, said:

Investment management is simply capturing the
arbitrage available between perception and reality. It is paramount
to know both.

We couldn’t agree more, in this case the reality
that is TMS against the perception of reality that are those
mainstream M’s. And right now, in the case of the U.S. money
supply, the spread between perception and reality is huge. As a
consequence, so is the arbitrage opportunity.

Enter the Bernanke Arbitrage

Bernanke we surmise is not tracking TMS. We doubt
he even knows what it is. No, Bernanke we think is tracking those
mainstream M’s and in so doing hasn’t got a clue as to
the whereabouts of the money supply. Chairman Bernanke, perhaps
the world’s most activist central banker, who just so happens
to think that economic growth and financial stability can be achieved
by printing money, is living in the world of perception. Those mainstreams
M’s are telling him the money supply is stagnant. The reality
is anything but. The problem, or should I say the arbitrage opportunity
is this – Bernanke is acting in accordance with his perception
and he is gunning and apt to continue gunning the money supply.
The reality is the money supply is anything but stagnant
and because of Bernanke’s actions is set to go higher still.

What follows is the what, the why and the how of
the Bernanke Arbitrage…

Let’s start by dismissing any doubts you might
have that Chairman Bernanke is clueless as to the whereabouts of
the money supply. Have a read of this interchange between Bernanke
and Congressman Ron Paul at a July 9, 2009 House Financial Services
Committee Q&A. First Congressman Paul:

…it seems to me that you are in the midst
of massive inflation, but I guess you have a different definition,
when you double the money supply that’s not inflation itself.
Or are you looking at only prices.

And now Chairman Bernanke’s response:

Inflation is the change in the consumer price
level which is very stable right now. And the various measure
of money as you know, the broad measure of money… the measure
of money in circulation like M1 and M2 are not growing quickly.

Bernanke of course was quite right. At the time
of this Q&A, neither M1 nor M2 were growing quickly.
After posting sizeable growth for about a year, both had slowed
to a crawl. M2, the broadest and most popular of the mainstream
money supply measures, was in fact sporting an annualized 3-month
rate of change of a negative 1%. TMS was doing nothing of
the sort. Echoing Congressman Paul’s concerns, it was growing
at a 3-month rate of change of 12% and a year over year rate of
change of 14%.

Monetary inflation was alive and well and Bernanke
was clueless.

Read
the rest of the article

January
7, 2011

Michael
Pollaro [send him mail]
is a retired Investment Banking professional, most recently Chief
Operating Officer for the Bank’s Cash Equity Trading Division. He
is a passionate free market economist in the Austrian School tradition,
a great admirer of the US founding fathers Thomas Jefferson and
James Madison and a private investor. He is a columnist on the Forbes
blog.

Our monthly Monetary Watch, an Austrian take on where we are on
the monetary inflation front and what’s next…

Headline Monetary Aggregates in November

The U.S. money supply aggregates based on the Austrian definition
of the money supply, what Austrians call the True Money Supply or
TMS, were mixed in November, with our shorter-term one and three-month
rate of change metrics continuing their recent surge while our longer-term
twelve-month rate of change metrics showing some moderation. Focusing
on TMS2, THE CONTRARIAN
TAKE’s preferred money supply measure, we find that it
increased at an annualized rate of 15.6% in November, bringing the
three-month rate of change to an annualized 15.2%. That’s up
from October’s 14.5% rate and 13.3% rate, respectively. In
contrast, the twelve-month rate of change metric on TMS2, the measure
we watch most closely, went the other way, ending November at a
rate of 9.8%, down from October’s 10.5% rate, and marking the
end, albeit barley, of 22 consecutive months of double digit increases.

As has been the case throughout 2010, M2, the mainstream’s
favorite monetary aggregate, continues to show subdued growth, in
November posting a year over year rate of increase of 3.1%, down
from October’s 3.2%. As readers of this site are aware, THE
CONTRARIAN TAKE posits M2 as a grossly misleading measure of the
money supply, meaning the gap between the true and the perceived
rate of monetary inflation is a healthy 6.7 percentage points.

A Return to Double Digit Increases in the Offing?

We must say that we were a bit surprised by that 9.8% twelve-month
rate of change print on TMS2. As we argued in last month’s
Monetary
Watch, we were expecting TMS2’s 22-month string of double
digit rate of change increases to continue well into 2011. Yes,
it fell short by only 2 bps, but double digits it was not. We do
think though that a return to double digit rate of change increases
are in the cards, for three reasons…

First, the recent surge in TMS2 – up an annualized 10% the
past six months and 15.2% the past three – should be supportive
of higher twelve-month rate of change increases over the coming
months.

Second, the full impact of the Federal Reserve’s QE II asset
purchase program was not felt in the money supply aggregates. Coming
as it did mid-month, plus what appears to be a larger than projected
draw-down in the Federal Reserve’s Agency portfolio, QE II
yielded an annualized impact of just $600 billion in November instead
of the projected $900 billion.

Third, and most important, private banking institutions are not
only continuing to print money, but appear to be doing so at an
accelerating rate. In fact, Uncovered Money Substitutes, i.e., bank
deposit liabilities not covered by bank reserves, the issuance of
which is the result of the banking systems’ efforts to lever
up its loans and investments on top of what is currently a mountain
of excess reserves, is growing at a year over year rate of 19.9%,
a post credit crisis high.

Read
the rest of the article

December
22, 2010

Michael
Pollaro [send him mail]
is a retired Investment Banking professional, most recently Chief
Operating Officer for the Bank’s Cash Equity Trading Division. He
is a passionate free market economist in the Austrian School tradition,
a great admirer of the US founding fathers Thomas Jefferson and
James Madison and a private investor. He is a columnist on the Forbes
blog.

Didn’t
Chairman Bernanke say, “The Federal Reserve will not monetize
the debt.”

Yes he did,
as clear as day to the House Budget Committee back on June 3, 2009.
And yet 17 months later Bernanke gave us QE II, which not only means
the Federal Reserve will be purchasing about $75 billion a month
in assets for the next 8 months, but as it so happens, some $110
billion in Treasury Notes and Bonds too. That’s enough to finance
the U.S. government’s projected fiscal deficit right up through
June 2011, in full.

THE
CONTRARIAN TAKE says, what gives!

Echoing his
June 3rd testimony, said Bernanke to Congressman Ron Paul and the
House Financial Services Committee on July 21, 2009, “We
are not intervening, or actively trying to… make it easier
for the government to issue debt.” Well, QE II may or may
not be aimed at “monetizing the debt’ but monetizing the
debt, and in robust fashion, it nevertheless is.

We here at
THE CONTRARIAN TAKE love to crunch numbers. So we asked the question,
just how big are these debt monetization activities in the light
of historical precedence? Given the impact these activities have
on the currency and bond markets, we’re thinking its something
we all want to know. What we found is that these activities are
a whole lot bigger and a whole lot more pervasive than even we thought.

Before we show
you just how big and pervasive, some preliminaries…

Intro to
U.S. Government Debt Monetization, Our Take

The traditional
take on U.S. government debt monetization activities is centered
on U.S. Treasury debt and the Federal Reserve. To wit, the Federal
Reserve purchases or monetizes Treasury debt by issuing checks
on itself, in effect printing the money with which to purchase the
debt. Certainly true, but in our minds, too narrow a view for two
reasons:

• Treasury
  debt is not the only government debt.
• The Federal
  Reserve is not the only central bank actively monetizing government
  debt.

Treasury
Debt, Not the Only Government Debt

What other
government debt is there, you ask? The obligations of the government-sponsored
enterprises (Agencies) Fannie Mae and Freddie Mac.

On December
24th 2009, recognizing the dire state of the housing market, a market
that just so happens to be dominated by the Agencies, the U.S. government
gave the Agencies, already in conservatorship and under government
control, unlimited access to the U.S. Treasury, effectively making
them divisions of the U.S. government and their mounting losses
the government’s own. On that date, the long standing implicit
guarantee bestowed on Agency debt by the U.S. Treasury was turned
lock, stock and barrel into and an explicit one, making Agency debt
obligations the defacto debt of the U.S. government.

In our minds,
that means that when the Federal Reserve buys Agency debt, in a
very real way, it is monetizing the debt of the U.S. government.

Read
the rest of the article

December
6, 2010

Michael
Pollaro [send him mail]
is a retired Investment Banking professional, most recently Chief
Operating Officer for the Bank’s Cash Equity Trading Division. He
is a passionate free market economist in the Austrian School tradition,
a great admirer of the US founding fathers Thomas Jefferson and
James Madison and a private investor. He is a columnist for True/Slant
magazine.

All economists,
whether they are of an Austrian, a Keynesian or a Monetarist bent,
as well as nearly every investor, would agree that money plays a
vitally important role in the economy. And a correct measure of
its supply is an indispensable input into every economic and financial
forecast. How could it not, for money is one half of every economic
transaction.

Yet, despite
its importance, the money supply metrics used by the majority of
today’s economists and investors are seriously flawed, for
they are founded on a faulty definition of money.

I ask you,
are you using the wrong money supply metrics as input into your
economic and financial forecasts? If so, I submit to you, that is
a serious error. And if you are an investor it’s an error that
could cost you serious money.

So then, what
is money? And how does one properly measure its supply? Keynesian
and Monetarist formulations of the money supply, based as they are
on empirical correlations and inductive statistical techniques,
are not the way to go. A correct formulation of the money supply
must be based on a deductively derived, theoretically sound definition
of money.

Well it just
so happens that the Austrians have the inside track here, a track
that I invite you now to get on.

Defining
the Money Supply

Let’s
start with this simple definition of money. To quote Austrian economist
Murray Rothbard, from his essay Austrian
Definitions of the Supply of Money:

…money
is the general medium of exchange, the thing that all other goods
and services are traded for, the final payment for such goods
and services on the market.

Pretty straightforward,
a definition I think we can all agree.

Of primary
import, a point that can not be overemphasized is the requirement
that for a thing to be money it MUST serve as the FINAL means of
payment in all transactions. In other words, it must be the thing
which FULLY extinguishes the debt incurred in a transaction.

To bring this
point home, take the case of credit cards which facilitate the purchase
of countless goods and services but in no way should be classified
as money. Austrian economist Joseph Salerno, in his essay The
True Money Supply: A Measure of the Supply of the Medium of Exchange
in the U.S. Economy, explains why:

…credit
cards [should] not [be] counted as part of the [money supply]
because use of a credit card in the purchase of a good does not
fully discharge the debt created in the transaction. Instead,
it gives rise to a second credit transaction that involves present
and future monetary payments. Thus the issuer of the credit card
or lender is now bound to pay the seller of the good immediately
with money on behalf of the card-holder or borrower. The latter,
in turn, is obliged to make a monetary repayment of the loan to
the issuer at the end of the month or at a later date, at which
time the transaction is finally completed.

Even more to
the point and on similar grounds, consider the widely held view
that travelers’ checks, a component of the Federal Reserve’s
M1 money supply measure, are money. Again, to quote Salerno:

What a travelers’
check represents… is a credit claim on the investment portfolio
of the issuing company. The purchase of travelers’ checks
from American Express involves, in effect, a “call”
loan by the purchaser to American Express, which the latter pledges
to repay to the purchaser or to a designated third party at an
unspecified date in the future. In the meantime, most of the proceeds
of such loans are invested by American Express on its own account
in interest-bearing assets, while a fraction is held in the form
of demand deposits to meet anticipated payments of its travelers’
check liabilities as they “mature.” In exchange for
the foregone interest (and a small fee) the purchaser receives
access to an alternative payments system which avoids the risk
of loss associated with carrying cash payments and the potential
delay or non-acceptance involved with payment by personal check
drawn on a distant bank. But the travelers’ checks themselves
are not the final means of payment in a transaction: the sellers
who receive travelers’ checks in exchange quickly and routinely
present them for final payment at a bank and obtain either cash
or a credit to their demand deposit accounts, with the sums paid
out ultimately being debited to the demand deposit account of
American Express.

With these
concepts in mind, it’s easy to see why economists, of all schools,
would include currency – in the U.S. being Federal Reserve
notes and Treasury token coins – as part of the money supply.
What could be more basic, for what discharges a debt more fully
then the exchange of a good or service for currency.

But what about
demand deposits and other checkable accounts at banks? What about
savings accounts that permit the instantaneous transfer of your
money to a checking account. Or what about money market mutual fund
share accounts that feature checking privileges? Are these things
not money, things that all other goods and services are traded for,
the final payment for such goods and services on the market?

Indeed, the
Keynesian and Monetarist inspired mainstream measures of the money
stock as reported by the Federal Reserve Board – M1 and M2
and until discontinued in February of 2006, M3, diligently followed
by millions of economists and investors the world over, include
all these things (and more) in the money supply. And there are quite
a few things to say the least:

M1 Components

• Currency
• Nonbank
  Traveler’s Checks
• Demand Deposits
• Other Checkable
  Deposits (OCD) at Commercial Banks
• Other Checkable
  Deposits (OCD) at Thrifts

Non-M1 M2
Components

• Savings
  Deposits at Commercial Banks, including MMDAs
• Savings
  Deposits at Thrifts, including MMDAs
• Small Time
  Deposits at Commercial Banks
• Small Time
  Deposits at Thrifts
• Retail Money
  Funds

Non-M2 M3
Components

• Large Time
  Deposits at Banks
• Large Time
  Deposits at Thrifts
• RPS
• Euro Dollars
• Institutional
  Money Funds

So then, how
do we make sense out of all this in light of our definition of money?
Are all these things money?

The dean of
the Austrian School of Economics Ludwig von Mises in his classic
Theory
of Money and Credit laid out the framework:

Money supply
= standard money + money substitutes

In today’s
fiat money system, standard money is easy to define. It’s simply
Federal Reserve notes plus Treasury token coins, the combined total
popularly termed currency.

Money substitutes,
that’s the challenge.

To paraphrase
the Austrian masters, money substitutes are perfectly secure
and IMMEDIATELY convertible, PAR VALUE claims to standard money
which, by virtue of this immediate convertibility substitute FULLY
for standard money in individual’s cash balances, and as such,
are used by individuals as a surrogate for cash – namely, a
thing that all other goods and services are traded for, the final
payment for such goods and services on the market. On this basis,
not only are all the Federal Reserve’s M1, M2 and M3 components
not money, but some are not even money substitutes.

In a format
similar to Salerno’s essay on this subject, and with these
definitions firmly in mind, let’s build the correct formulation
of the money supply by “testing” each of the Federal Reserve’s
M1, M2 and M3 components against these definitions.

Currency

As we saw above,
in today’s fiat money system, currency is simply Federal Reserve
notes plus Treasury token coins. In Mises terminology, standard
money. It goes without saying that both meet our money test and
should be included in the money supply.

Demand Deposits
and Other Checkable Deposits at Banks

Demand and
other checkable deposits at commercial banks and thrifts are the
embodiment of money substitutes. Without question they pass the
money test and should be included in the money supply.

Rothbard makes
the case for demand deposits, at the same time explaining the essence
of a money substitute:

…demand
deposits [are] not other goods and services, other assets exchangeable
for cash; they [are], instead, redeemable for cash at par on demand.
Since they [are] so redeemable, they [function], not as a good
or service exchanging for cash, but rather as a warehouse receipt
for cash, redeemable on demand… Demand deposits [are] therefore
“money-substitutes” and [function] as equivalent to
money in the market. Instead of exchanging cash for a good, the
owner of a demand deposit and the seller of the good would both
treat the deposit as if it were cash, a surrogate for money. Hence,
receipt of the demand deposit [is] accepted by the seller as final
payment for his product.

Rothbard goes
on to highlight a key Austrian insight, that being the fact that
it is the subjective deliberations of market participants which
give a good or service value in the market. And nowhere is this
subjectivity more important than in the case of money substitutes:

It is important
to recognize that demand deposits are not automatically part of
the money supply by virtue of their very existence; they continue
as equivalent to money only so long as the subjective estimates
of the sellers of goods on the market think that they are
so equivalent and accept them as such in exchange.

Now, with FDIC
insurance behind every demand deposit, and Treasury guarantees behind
the FDIC, all supported by the Federal Reserve’s ability to
print Federal Reserve notes at a moments notice, to make good on
any shortfall that might exist in the FDIC or Treasury coffers,
is there any doubt that demand and other checkable deposits are
deemed by individuals everywhere as perfectly secure, and immediately
convertible par value claims to standard money which substitute
fully for standard money in individual’s cash balances,
and as such, perform all the functions that one expects of standard
money? The answer of course is no. And it’s why demand deposits
must be included in the money supply.

Nonbank
Traveler’s Checks

As we saw above,
travelers’ checks at first glance look like money substitutes,
but they are neither perfectly secure immediately convertible, par
value claims to standard money or a final means of payment. As such
they must be excluded from any money supply measure.

Small Time
Deposits at Banks

Small-denomination
time deposits are federally insured certificates of deposit (CDs)
at commercial banks and thrifts, with maturities ranging from a
few months to several years. In economic terms, they are credit
transactions, specifically loans made by the bank’s depositors,
where the depositor foregoes the use of his money for the length
of the loan in return for interest plus the return of his deposit
at maturity. So, while perfectly secure, CDs are not immediately
convertible claims to standard money and as such fail our money
test. On those grounds, they should be excluded from any money supply
metric.

The failure
of a time deposit to meet our money test speaks to the essence of
what is meant by immediate convertibility, that being the difference
between what Austrians call a claim transaction or warehouse receipt,
best represented by a demand deposit, and a credit transaction,
like a time deposit. Have a read of Austrian economist Frank Shostak’s
explanation of the difference between a claim transaction, in this
case a demand deposit and a credit transaction from his essay The
Mystery of the Money Supply Definition:

Once an individual
places his money in a bank’s warehouse he is in fact engaging
in a claim transaction. In depositing his money, he never relinquishes
his ownership. No one else is expected to make use of it. When
Joe stores his money with a bank, he continues to have an unlimited
claim against it and is entitled to take charge of it at any time.
Consequently, these deposits, labeled demand deposits, are part
of money…

This must
be contrasted with a credit transaction, in which the lender of
money relinquishes his claim over the money for the duration of
the loan. Credit always involves a creditor’s purchase of
a future good in exchange for a present good. As a result, in
a credit transaction, money is transferred from a lender to a
borrower.

The distinction
between a credit and a claim transaction serves as an important
means of identifying the amount of money in an economy…

Here’s
Rothbard, with the application of this concept to time deposits:

a genuine
time deposit – a bank deposit that would indeed only be redeemable
at a certain point of time in the future, would merit very different
treatment [from a demand deposit]. Such a time deposit, not being
redeemable on demand, would instead be a credit instrument rather
than a form of warehouse receipt. It would be the result of a
credit transaction rather than a warehouse claim on cash; it would
therefore not function in the market as a surrogate for cash.

You say, wait
a minute. Isn’t it true that banks stand ready to redeem these
small-denomination time deposit CDs at any time prior to their maturity?
In that case, couldn’t one make the case that these CDs, at
least on paper, are not credit transactions but instead money substitutes?
In theory, yes at current redemption value. But, given the fact
that banks typically charge depositors heavy redemption penalties
in addition to forfeiture of accrued interest in the event of early
withdrawal, depositors typically treat these CDs as true credit
transactions. And because CDs are insured by the government and
therefore backed by the Federal Reserve’s printing press, the
likelihood of early withdrawal owing to depositor concerns about
bank solvency is practically non-existent. In fact, during the depths
of 2008–09 financial crisis, small-denomination CDs actually
attracted depositor money likely because of this insurance.

In summary,
and a position universally shared in the Austrian camp, the weight
of the argument suggests that small-denomination time deposits should
be excluded from any measure of the money supply.

Retail Money
Funds

Because of
their check-writing privileges, money market mutual fund share accounts
(MMMF) look like demand and other checkable deposit accounts to
the naked eye and therefore appear to be money substitutes. But
because they are neither immediately convertible, par value claims
to standard money, nor a final means of payment, MMMFs fail our
money test and as such should not be included in any money supply
measure. Salerno lays out the case:

Each MMMF
share represents a claim to a pro rata share of a managed investment
portfolio containing short-term financial assets, such as high-grade
commercial paper, certificates of deposit, and U.S. Treasury notes.
Although the value of a share is nominally fixed, usually, at
one dollar, the total number of shares owned by an investor (abstracting
from reinvested dividends) fluctuates according to market conditions
affecting the overall value of the fund’s portfolio. Under
extreme circumstances, such as a stratospheric rise in short-term
interest rates or the bankruptcy of a corporation whose paper
the fund has heavily invested in, the fund’s investors may
well suffer a capital loss in the form of an actual reduction
of the number of fixed-value shares they own. Unlike a check drawn
on a demand deposit or MMDA, therefore, an MMMF draft does not
simply represent a direct transfer of current claims to currency,
but a dual order to the fund’s manager to sell a specified
portion of the shareowner’s asset holdings and then to transfer
the monetary proceeds to a third party named on the check. Note
that the payment process is not finally completed until the payee
receives money, typically in the form of a credit to his demand
deposit.

Savings
Deposits at Banks, including Money Market Deposit Accounts (MMDAs)

This is the
tough one, a debate even among the Austrians. Are savings accounts
(and their cousins MMDAs) at commercial banks and thrifts money
substitutes, like demand deposits, or are they credit instruments,
like time deposits? Let’s have a look at both sides of this
debate as represented by their most distinguished proponents and
see if we can come to a conclusion – in or out.

According to
both Rothbard and Salerno, savings accounts are money substitutes,
economically indistinguishable from demand deposits and should therefore
be included in the money supply. To quote Salerno:

Both demand
and savings deposits are federally insured under the same conditions
and, consequently, both represent instantly cashable, par value
claims to the general medium of exchange. The objection that claims
on dollars held in savings deposits typically do not circulate
in exchange…while not unimportant for some purposes of analysis,
is here beside the point. The essential, economic point is that
some or all of the dollars accumulated in, e.g., passbook savings
accounts are effectively withdrawable on demand by depositors
in the form of spendable cash. In addition, savings deposits are
at all times transferable, dollar for dollar, into “transactions”
accounts such as demand deposits or NOW accounts.

Salerno penned
these thoughts in 1987. In 2010, the transferability he speaks to
is near instantaneous, nothing more than a few taps on your BlackBerry
or iPod keypad.

Salerno goes
on to support his case for savings accounts with this quote by German
banker and economist Melchoir Palvi, a quote which speaks to the
importance of individual subjective valuations as cited by Rothbard:

In their
own minds, money is what people consider as purchasing power available
at once or shortly. People’s “Liquidity” status
and financial disposition are not affected by juristic subtleties
and technicalities. One kind of deposit is as good as another,
provided it is promptly redeemable into legal tender at virtual
face value and is accepted in settling debts. The volume of total
demand for goods and services is not affected by the distribution
of purchasing power among the diverse reservoirs into which that
purchasing power is placed. As long as free transferability obtains
from one reservoir to the other, the deposits cannot differ in
function or value…

Now, moving
to the other side of the debate, according to Shostak, savings accounts
fail the money test and should be excluded from the money supply.
In the final analysis, Shostak seems rests his case solely on the
premise that when one deposits his or her money in a savings account
he or she relinquishes “ownership” over that money. Shostak
writes:

The crux
in identifying what must be included in the money supply definition
is to adhere to the distinction between a claim transaction and
a credit transaction. Following this principle, it is questionable
whether savings deposits should be part of the money supply. According
to popular thinking, the inclusion of savings deposits into the
money supply definition is justified on the grounds that money
deposited in saving accounts can always be withdrawn on demand.
But the same logic should also be applied to money placed with
an MMMF. The nub, however, is that savings deposits do not confer
an unlimited claim. The bank could always insist on a waiting
period of thirty days during which the deposited money could not
be withdrawn. Savings deposits should therefore be considered
credit transactions with depositors relinquishing ownership for
at least thirty days. This fact is not altered just because the
depositor could withdraw his money on demand. When the bank accommodates
this demand, it sells other assets for cash. Buyers of assets
part with their cash, which in turn is transferred to the holder
of the savings deposit. The same logic is applicable to fixed-term
deposits like CDs, which are credit transactions.

Shostak’s
points are well taken, but in this authors opinion not enough to
warrant the exclusion of savings accounts from the money supply.

To see why,
let’s examine each of Shostak’s points.

His first point
– that savings accounts are not legally redeemable on demand,
the bank permitted by law to force the depositor to wait up to 30
days for his or her money – is certainly true. If enforced
it would indeed make such deposits more like credit transactions
and not money substitutes; in other words, it would mean the depositor
had relinquished ownership over his money. The argument though is
tenuous at best. As Rothbard asserts, it focuses on legalities rather
than economic realities:

…the
objection fails to focus on the subjective estimates of the situation
on the part of the depositors. In reality, the power to enforce
a thirty-day notice on savings depositors is never enforced; hence,
the depositor invariably thinks of his savings account as redeemable
in cash on demand. Indeed, when, in the1929 depression, banks
tried to enforce this forgotten provision in their savings deposits,
bank runs promptly ensued.

Never of course
is a strong word. Having said that, one could easily argue that
because savings accounts are insured by the government and therefore
backed by the Federal Reserve’s ability to print at will, clearly
not the situation in 1929, the reason for a bank ever having to
enforce its notice period is, for all intents and purposes, non-existent.
In fact, in this author’s opinion, the potential for such an
invocation would likely arise ONLY in the event of a system-wide
bank run, in which case the government would almost assuredly take
control over the entire banking system and ration the withdrawal
of depositor money across ALL deposit classes, making savings deposits
no different than demand deposits.

Shostak’s
second point – that even if no notice period existed, savings
accounts are still credit transactions because the bank can accommodate
a depositor redemption by selling other assets for cash, at which
time buyers of assets part with their cash, which in turn is
transferred to the holder of the savings deposit – is a
huge leap. Agreed, once the bank loans money entrusted to it by
a depositor it is no longer in the bank’s coffers, but instead
in the hands of the borrowers and/or the borrowers’ vendors.
But unless the notice period is enforced, contrary to Shostak’s
assertion, no ownership of money has passed from the depositor to
the borrower in this exchange. In the eyes of the depositor, that
money is still part of his or her cash balance, immediately convertible
at par to standard money whenever he or she so desires. In point
of fact, no money was ever transferred from the hands of the depositor
to the hands of the borrower in the first instance so no money needs
to be transferred back in the second instance. The result of this
entire transaction is this: if our depositor entrusted $10,000 to
the bank, and the bank loaned out the full amount, we have increased
the aggregate amount of money in individual’s cash balances;
namely, the money supply, by $10,000.

It is certainly
true, that in our fractional reserve banking system, banks can and
do make loans by creating demand deposits out of thin air at a multiple
of their cash reserves, while they can only loan out the money deposited
in savings accounts on a one-to-one basis. This does not mean, as
many in the Shostak camp seem to argue, that money deposited in
a savings account and then loaned out by a bank is any less of a
money substitute in individuals’ cash balances than if that
money had been deposited in a demand deposit or other checking account.
As Rothbard explains:

…this
distinguishes the sources or volatility of different forms of
money, but should not exclude savings deposits from the supply
of money… while each of these forms of money is generated
quite differently, so long as they exist each forms part of the
total supply of money…

Palvi, as Salerno
suggests, does an admirable job of explaining these issues in commonsense
terms when he writes:

A source
of confusion is the identification of savings deposits with savings.
The former are no more and no less u2018saved’ than are the funds
put on a checking account or the currency held in stockings. In
all three cases, someone is refraining from consumption (for the
time being); in all three, the funds constitute actual purchasing
power. And it makes no difference in this context how the purchasing
power is generated originally: dug out of a gold mine, ‘printed’
by a government agency, or ‘created’ by a bank loan.
As a matter of fact, savings banks and associations do exactly
what commercial banks do: they build a credit structure on fractional
reserves.

In the opinion
of this author, once it is agreed that savings deposits are immediately
convertible claims, at par to standard money, they are by definition
money substitutes and should be included in the money supply.

Non-M2 M3
Components

In February
2006, many Fed watchers were aghast when the Federal Reserve Board
discontinued publishing M3, claiming that the costs of collecting
the underlying components and publishing the series outweighed the
benefits. Well, if the purpose of M3 in the eyes of these Fed watchers
was to track the ebb and flow of the money supply, than this is
one time this author must agree with the logic of the Federal Reserve.
M3 is dominated by accounts that fall under the category of credit
transactions and by and large should not be included in the money
supply.

The Federal
Reserve’s Other Memorandum Items

The Federal
Reserve publishes several data series under what it calls “Other
Memorandum Items,” none of which it feels worthy of the status
of money. Oddly enough, several of these items are in fact money
substitutes and should be included in the money supply. These are
demand deposits at banks due foreign commercial banks and official
institutions and U.S. government demand deposits and note balances
held at commercial banks and at the Federal Reserve. As Salerno
writes:

The somewhat
mysterious exclusion of these items from money supply measures
is typically justified by one recent writer who claims that the
deposits of these institutions “…serve an entirely different
purpose than the holdings of the general public” or are “…viewed
as being held for ‘peculiar’ reason.” This overemphasis
on the particular “motives” for holding money, as opposed
to the importance of the quantity of money itself, is one of the
modern legacies of the Keynesian revolution.

The case for
inclusion of U.S. government demand and note balances is of particular
import today because of the growing size and volatility of these
accounts. As such, it’s worthy of some discussion.

Let’s
start with the theoretical case for the inclusion of U.S. government
deposits in the money supply. Salerno, quoting economist Harold
Barger:

The Treasury’s
deposits are not part of its reserve against money that it has
issued, but are rather part of the general fund of the Treasury
available for meeting general expenditures. Output is purchased
and taxes are collected with the help of these deposits, and they
would seem to be as much a part of the money stock with which
the economy operates as are the deposits of state and local governments,
which are included in adjusted demand deposits. Much the same
may be said of Treasury deposits at Federal Reserve Banks.

Treasury deposits,
whether held at commercial banks or at the Federal Reserve (the
latter known as the “General Account”), are simply demand
deposits owned by the U.S. government. They are clearly money substitutes
and should therefore be included in the money supply.

In September
of 2008, well after Barger and Salerno penned these thoughts, the
Treasury at the request of the Federal Reserve established a new
account at the Federal Reserve – the Treasury’s Supplementary
Financing Account (SFP).

In contrast
to traditional Treasury deposit accounts which were created for
the purpose of collecting the government’s taxes and paying
the government’s bills, the SFP was created as a special case,
“temporary” account under the control of the Federal Reserve
for the purpose of managing down the explosion in excess reserves
owing to the Federal Reserve’s en masse purchase of toxic securities
and special loan programs. The Federal Reserve Board describes the
SFP and the reasons for its creation as follows:

With the
dramatic expansion of the Federal Reserve’s liquidity facilities,
the Treasury agreed to establish the Supplementary Financing Program
(SFP) in order to assist the Federal Reserve in its implementation
of monetary policy. Under the SFP, the Treasury issues short-term
debt and places the proceeds in the Supplementary Financing Account
at the Federal Reserve. When the Treasury increases the balance
it holds in this account, the effect is to drain deposits from
accounts of depository institutions at the Federal Reserve. In
the event, the implementation of the SFP thus helped offset, somewhat,
the rapid rise in balances that resulted from the creation and
expansion of Federal Reserve liquidity facilities.

The SFP then
is really a reserve management tool, in fact, accounted for as such
on the books of the Federal Reserve; namely, as reduction in depositories
“Reserves Balances at Federal Reserve Banks.” Consequently,
the SFP is nothing like traditional Treasury deposits and in this
context should not be included in the money supply.

It should be
noted that the author is aware of differing opinions among practicing
Austrians with regard to the “moneyness” of the SFP. For
example, Shostak includes the SFP account in his measure of the
money supply while Sean Corrigan over at Diapason Commodities does
not. Indeed, as Salerno suggests, the emphasis by this author on
the particular motives of the Treasury and the Federal Reserve as
justification for the exclusion of the SFP from the money supply
is a slippery slope. Who’s to say that the SFP will be temporary
or will be used only by the Federal Reserve to manage down the excess
reserves amassed as a result of the financial crisis? The answer
is, no one knows. But as long as the SFP remains under the direct
control of the Federal Reserve for the specific purpose of managing
reserves, the author is inclined to believe that the SFP is not
a thing that all other goods and services are traded for, the
final payment for such goods and services on the market and
therefore should not be included in any money supply measure.

Austrian
Money Supply Metrics for the Economist and Investor

I happen to
believe that Austrian economics, properly applied, can give any
economist, financial forecaster or investor a competitive edge in
his or her deliberations. And if Austrian economics has taught me
anything, it’s the importance of the money supply’s ebb
and flow in the economy and financial markets. That’s why the
correct measurement of the money supply is so vital, for using a
flawed money supply measure is an accident waiting to happen.

So then, to
repeat my opening salvo, are you using the wrong money supply metrics,
as input into your economic and financial forecasts, or worse, your
investment decisions? If so, I’m here to help.

On THE CONTRARIAN
TAKE, I offer up the following Austrian Money Supply metrics,
three series updated each month:

TMS1.
A narrow definition of the money supply based largely on Shostak’s
AMS formulation of money – excluding savings deposits but adding
back bank deposit sweep programs (those monies banks “sweep”
out of demand deposit accounts and into savings and MMDAs to lower
effective reserve requirements).1,2

TMS2.
A broad definition of the money supply based on Rothbard-Salerno’s
TMS formulation of money, brought current in accordance with the
conclusions presented in this essay, and the most complete and most
correct measure of the money supply.

M2.
Federal Reserve Board’s broad money supply measure.

The composition
of each series is presented below:

Given the
conclusions presented in this essay – that TMS2 is the most
complete and most correct measure of the money supply – you
might ask, why track TMS1? Two reasons:

1. in recognition
of the fact that there exists a tenuous, legal right of a bank to
deny immediate convertibility for money deposited in a savings account
for up to 30 days, and

2. as Salerno
wrote, and to me the more important reason, that claims on dollars
held in savings deposits typically do not “circulate”
in exchange, making a TMS1 measure important for certain analysis.

Similarly,
why track M2? That’s easier to answer – as a means to
track the reality that is TMS against the perception of reality
that is M2. As Kevin Duffy, a co-manager of Bearing Asset Management
once said:

Investment
management is simply capturing the arbitrage available between
perception and reality. It is paramount to know both.

You will find
my Austrian Money Supply metrics here.

THE
CONTRARIAN TAKE tracks several other economic data series,
tables and charts with an Austrian slant, all of which can be found
here.

Notes

1. To quote
   Shostak, “Since January 1994, banks and other depository
   financial institutions have initiated sweep programs to lower
   statutory reserve requirements on demand deposits. In a sweep
   program, banks “sweep” funds from demand deposits into
   money market deposit accounts (MMDA), personal savings deposits
   under the Federal Reserve’s Regulation D, that have a zero
   statutory reserve requirement ratio. By means of a sweep, banks
   reduce the required reserves they hold against demand deposits.
   As a result of the sweep program one could argue that the money
   definition outlined above will not cover the total money supply.
   This criticism, however, is misplaced, for it has nothing to do
   with the definition as such, but with the difficulties of measuring
   money, which was transferred out of demand deposits by banks without
   the depositors’ consent.”
2. To clarify
   any confusion for those readers familiar with Frank Shostak’s
   AMS metric, note that (a) as is the case with AMS, TMS1 excludes
   savings deposits but adds back bank deposit sweep programs, and
   (b) in contrast to AMS, TMS1 does not include the SFP account.

References

• Rothbard,
  Murray, 1978. “Austrian Definitions of the Supply of Money.”
  in New
  Directions in Austrian Economics. Louis M. Spadaro, ed.
  Sheed Andrews and McMeel, Inc.
• Salerno,
  Joseph, 1987 “The
  True Money Supply: A Measure of the Supply of the Medium of Exchange
  in the U.S. Economy.” Austrian Economics Newsletter,
  Spring.
• Salerno,
  1994. “Ludwig
  von Mises Monetary Theory in Light of Modern Monetary Thought.”
  The Review of Austrian Economics, March.
• Shostak,
  Frank, 2000. “The Mystery
  of the Money Supply Definition.” Quarterly Journal
  of Economics, Winter.

This originally
appeared on True/Slant.

April
23, 2010

Michael
Pollaro [send him mail]
is a retired Investment Banking professional, most recently Chief
Operating Officer for the Bank’s Cash Equity Trading Division. He
is a passionate free market economist in the Austrian School tradition,
a great admirer of the US founding fathers Thomas Jefferson and
James Madison and a private investor. He is a columnist for True/Slant
magazine.

It’s not
talked about much, at least by mainstream analysts, but make no
mistake, it’s a time bomb, locked and loaded, and it’s
set to blow the U.S. government’s budget sky high.

That time bomb?
The interest cost on the government’s debt.

And what you
ask will light the fuse? The end of the 30-year bull market in U.S.
government debt, the end of record low interest rates.

In my opinion,
unless politicians decide to renege on the government’s obligations,
it’s not a matter of if, it’s a matter of when. And in
the end neither the U.S. government nor the Federal Reserve can
do anything about it.

First, some
preliminaries. At its most basic, the interest cost on the government’s
debt is determined by three factors:

• The outstanding
  debt of the government
• The interest
  rate paid on that debt
• The maturity
  distribution of that debt

At the risk
of stating the obvious, higher levels of debt mean a higher interest
cost. Lower levels of debt mean a lower interest cost.

Similarly,
higher rates of interest on that debt mean a higher interest cost.
Lower rates of interest mean a lower interest cost.

And finally,
shorter dated maturity distributions, leading to generally larger
and more immediate refinancing needs, means more exposure to interest
rates, and therefore, a higher interest cost when rates are rising
and a lower interest cost near when rates are falling. Longer dated
maturity distributions, leading to generally smaller and less immediate
refinancing needs, means less exposure to interest rates, and therefore,
a lower interest cost when rates are rising and a higher interest
cost when rates are falling.

With those
preliminaries out of the way, let’s go straight to the numbers.

Here’s
the 50-year trend in interest cost on U.S. government debt outstanding
through the government’s fiscal year 2009:

In 2009, the
government’s interest cost was about $383 trillion, 10.9% of
total government outlays. As a percent of total outlays, the government’s
interest cost is down 50% from the 1997 high of 22.2% and plumbing
lows not seen since the early 1970s.

Looks like
a pretty healthy trend, right? And a relatively small part of the
government’s outlays to boot.

So what am
I worried about?

Let’s
examine each interest cost determinant and see.

The outstanding
debt of the government. Charted below is the 50-year record
in U.S. government debt outstanding:

I would call
this high and rising levels of debt, wouldn’t you? At $12 trillion,
the U.S. government’s debt is at a 50-year high. What’s
more, with deficit spending largesse becoming more and more the
order of the day in Washington, first led by President Bush and
now led by President Obama, U.S. government debt has been growing
at an annual rate of 8.5% since 2000, with 2009 debt outstanding
up a whopping 19% from 2008. And as for the future, trillion dollar
deficits and trillion dollar borrowing needs are as far as the eye
can see. Not good.

The interest
rate paid on that debt. Now, take look at the 50-year record
in 1 year, 5 year and 10 year rates on U.S. government treasury
notes:

Rates are at
50-year lows and by the looks of it have nowhere to go but up. And
higher rates of interest do mean a higher interest cost, don’t
they?

The maturity
distribution of that debt. Finally, cast your eyes on the
average years to maturity on the government’s marketable debt:

Although not
at historical lows, at 4 years, the average maturity on the government’s
marketable debt is down 35% from the 2000 high and in the bottom
40% of this study. That means a whole heap of debt refinancing is
in the offing. In fact, the government must refinance a huge $2.6
trillion of its debt in fiscal 2010 and $4.7 trillion of its debt
in the next five years. This in addition to projected deficits conservatively
estimated by the Obama administration at $1.6 trillion in fiscal
2010 and a mega $5.7 trillion over the next 5 years.

Simply said,
for the sake of the U.S. government’s financial condition,
with these debt refinancings in the offing, interest rates better
stay at historical lows.

Let’s
put this all together and see what we have:

Now do you
see what worries me, and should worry every U.S. treasury note buyer
in the world? That’s right, rising interest rates.

To underscore
the importance of these historically low interest rates to the U.S.
government’s financial health, let’s have a look at the
ability of the government to cover its interest cost with government
receipts, in financial circles termed the coverage ratio:

Despite historically
low interest rates, the ability of the government to cover its interest
cost is not exactly at all time highs, is it?

To size the
scope of the problem, let’s have a look at the government’s
interest cost at interest rates more in keeping with history:

On the positive
side, it’s apparent what these low interest rates have meant
to the U.S. government. Despite an 8.5% annual growth rate in government
debt since 2000, the government has been able to increase its coverage
ratio from 2.8 to 5.5. The reason, a 52% fall in the composite interest
rate it pays on its debt, from 6.25% to 3.22%. Unfortunately, with
interest rates having practically nowhere to go but up, that may
be as good as it gets.

Observe, if
interest rates simply return to the long-term average rate in this
study (a good long-term mean proxy as it spans one full bear and
one full bull market), we are looking and an interest cost of $738
billion on 2009 government debt levels, 92% higher than in 2009.
That would put the government’s ability to pay for this cost,
as measured by the ratio of receipts to interest cost, at 2.9 against
a current ratio of 5.5. Said differently, 35% of the government’s
receipts would be going to pay the interest on the government’s
debt.

And if interest
rates were to overshoot that long-term average rate and return to
the rates seen during the inflationary 1970s and early 1980s, we
are looking at an interest cost of a huge $1.2 trillion, 219% higher
than in 2009 and giving us a lowly coverage ratio of 1.7. That would
mean near 60% of the government’s receipts would be going to
pay the interest on the government’s debt.

In other words,
not much left to spend on anything else.

Now, with projected
government deficits in the trillions for years to come and according
to some reputable sources as much as $100 trillion in unfunded liabilities
yet to be transformed into even more spending and in turn into even
more government debt, we could be looking at a virtual explosion
in the government’s interest cost.

Using the Obama
administration’s own conservative debt projections, take a
look at what the government’s interest cost could look like
in 1 year, 3 year and 5 year’s time:

Even with conservative
debt projections and simply a return to long-term interest rate
averages, we are looking at a coverage ratio of 1.8 in 2014 on 2009
tax receipts. That’s 57% of the government’s receipts
going to pay the interest on the government’s debt. And if
we see a return of the inflationary 1970s and early 1980s, a startling
91% of the government’s receipts will be going to pay the interest
on the government’s debt.

Ouch!

Yes, I know,
I haven’t allowed for any growth in government receipts. But
I can safely say, raising tax rates and growing the size of government,
like the Obama administration currently plans, is not going to help
grow the private economy; you know, the people that have to pay
for all this stuff. And as a result, it will only hamper the ability
of the government to grow its tax receipts, possibly even enlarging
Obama’s already huge deficit and debt projections.

OK, you say.
Yes, the U.S. government is exposed to rising interest rates. But
the Federal Reserve, isn’t it committed to keeping interest
rates low, as it loves to say for an extended period of time?
Low rates mean problem solved, right?

Well, that
is exactly what Bernanke and the Federal Reserve, along with the
U.S. Treasury, would like you to think. And it is indeed what they
are trying to do. The question is, how long can they do it? Certainly
not forever, for the market is bigger than even these mighty institutions.

In my opinion,
when it comes to keeping interest rates at bay, the Federal Reserve
and the U.S. Treasury are increasingly on borrowed time.

This originally
appeared on True/Slant.

February
20, 2010

Michael
Pollaro [send him mail]
is a retired Investment Banking professional, most recently Chief
Operating Officer for the Bank’s Cash Equity Trading Division. He
is a passionate free market economist in the Austrian School tradition,
a great admirer of the US founding fathers Thomas Jefferson and
James Madison and a private investor. He is a columnist for True/Slant
magazine.