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Eyes Wide Open


Several Minyans continue to query me on the shrinking money supply and to its causes. I have commented before on this, but because it is so important and so unusual, I thought I should comment again.

In a debt ridden (my word) society, it is a very unusual and disturbing thing to see the money supply not grow commensurately with debt: there is higher and higher debt and less liquid money to pay for it. It is pretty safe to say that the Fed is not the cause of this, and although they have downplayed this occurrence, my guess is that they are probably pretty concerned about it.

The rate of change in the money supply as measured by M3 has dropped by 2% over the last three months. A recession would cause the money supply to slow as the economy slows; the last time the rate of change in M3 went negative was in 1990-1991. The last time before that was in the late 1960's. The current slow down is remarkable compared to these two periods.

One possible cause would be that people are taking money out of money markets to buy riskier assets like stocks that are not counted in M3. Brian Reynolds has commented on this and although I believe that not as much of this occurs over time as he suggests, it is certainly part of the equation. I may also be wrong about the current degree: nothing would surprise me anymore as to peoples' new propensity for risk.

Another probable cause is the slow down in re-financings. Re-financings have become such a huge part of our economy that change in this rate could significantly affect the money supply. The size of the GSE's like FNM and FRE and the huge leverage that they employ have changed the way to look at the money supply from ten years ago. These behemoths alone could account for the current drop in money supply growth depending on the amount of credit they create (FNM is in effect a second Federal Reserve). Of course since they won't tell us much about how they operate, we can only guess as to what they are doing. If the government regulators are quietly telling FNM and FRE to lower their leverage (we guess it is anywhere from 60 to 100 times), they alone could be the cause. Another way for these companies to lower their leverage would be to issue new stock. Either course would be dilutive.

Money supply can change erratically over short periods of time, so this situation may change rapidly and rebound. But the significance of the change and the fact that it is occurring when the economy is supposedly recovering is disconcerting and warrants attention.

As I write this industrial production was slightly weaker than expected and capacity utilization came in LOWER at 75.8%, all this after incredible growth in Q4 2003. I still have a dinner bet with a Minyan that Q2 2004 GDP will be below 2%.

Keep your eyes open.
Positions in FNM and FRE.

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