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M3 Contraction

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My macro analyst and I just hung up the phone with Brian Reynolds, having an intense conversation about the current drop in M3. What sorry folk we are on Christmas Eve!

M3 is the broadest measure of the country's money supply. It includes savings and time deposits, currency in circulation, and money funds. M3 has dropped $120 billion in the last three months. The rate of change has only turned negative twice before in the last 40 years: 1969 and 1992, so this is a momentous occurrence.

A reduction as described by Brian in money funds does not necessarily reduce M3: money flowing out to buy existing stocks and bonds is returned to the system by the sellers of the stocks and bonds.

One way the money can leave the system is for money funds to be used to purchase new treasury debt: as the deficits have grown, the treasury has issued new debt. This has certainly occurred, and has allowed the process to occur with little increase in yields, but probably does not explain the entire drop in M3.

Another way is for capital to actually flow out of the country by, for example, purchases of non-dollar denominated bonds. Still another would be an overall contraction of debt, either by paying it down, delinquencies, or write-offs. Any of these the Fed does not want to see happen in the middle of an expansion.

A final way would be if the Fed actually reduced the money stock, something they have direct control over by stopping the printing presses. This is not occurring as the change in the money stock is still positive.

So this is not the end of the story and the story is significant. We are not sure exactly what is going on, but it is huge. In a debt based society, it is crucial for liquidity to continue to expand as the interest on the debt requires financing.

One other note: on December 13 Congress passed Patriot Act II. One of the amendments has given the Department of Justice under Ashcroft the authority to track sales and purchases of gold. For those of you that do not know it, the Federal government under FDR disallowed all sales, purchases, and holdings of gold.

Happy Holidays!


No positions in stocks mentioned.

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