M3 Death Watch

The “M3” measure of money is almost gone. At least, it’s probably almost gone. Its last publication is due to happen on March 23, which means that M3-related reporting requirements for financial firms end this week. However, there remains an outside chance that Congressional interference could yet scuttle the Fed’s plan to terminate the M3 series.

Various observers have been unhappy with the Fed’s decision to stop publishing data on M3. Some simply argue that more data is always better – for example, see yesterday’s post by Barry Ritholtz. But the bulk of the complaints are from people who subscribe to old-fashioned monetary economics (i.e. the belief that inflation is a simple function of the amount of money created by the central bank), including full-blown conspiracy theorists who think that the Fed is trying to hide something.

But the concerns of people who are worried about the loss of a useful monetary indicator are unfounded. The reason is simple: M3 is not a useful monetary indicator.

M3 is the sum of everything in M2, such as most bank accounts and retail money market accounts, as well as a few extra things, such as assets held in institutional money funds, large time deposits, repurchase agreements, and Eurodollars. The complicating factor for M3 is that there has been a secular trend in money management toward the sorts of assets included in M3. Put another way, financial firms typically manage money very differently today than they did 20 years ago, and hold more of their assets in the forms included in M3.

One example is institutional money funds. If a large corporation actively manages its liquidity, each day investing excess cash in Treasury bills, for example, this wealth is not measured in M3. But if a wave of cost-cutting and outsourcing takes place and the firm decides to let a money market mutual fund do the investing for it instead, then all of a sudden M3 has increased, even though there has been no actual change in anything real.

This type of increase has happened in waves, causing sharp rises in M3 that are unrelated to anything other than the internal practices of large corporations. As a result, movements in M3 over the past couple of decades have been dominated by these changes in cash management practices, rather than by trends in the amount of “money” in the economy. This has rendered M3 useless as an indicator of money creation.

Economists who study and practice monetary policy have found that M3 has been of no empirical value for a long time. It’s easy to see why, even to the untrained eye. M3 has grown quite rapidly in recent years, particularly since the mid 1990s (see David Altig for a good picture of this). If this reflected rapid money creation, and if one believed in the monetarist view of inflation, then one might expect that the US should have been experiencing a major bout of inflation. Yet inflation (other than due to higher oil prices) has remained low and stable.

Since M3 no longer tells us what it was designed to tell us, the Fed has decided to stop spending time and money (both their own and that of the private sector) on it. As Chairman Bernanke put it during his testimony before Congress last month:

BERNANKE: [W]e have done periodic analyses of the various data series that we collect to see how useful they are. And our research department’s conclusion was that M3 was not being used either by the academic community nor were we finding it very useful ourselves in our internal deliberations.

Now, one of our obligations is not just a question of our own costs — although, of course, we do want to be fiscally responsible on our own budget — but it’s also, I think, important for us to recognize the burden that’s placed on banks that have to report this information.

And so when we can reduce that burden, we would like to do so. And that was one of the considerations in the decision that was made about M3.

So while the costs of maintaining M3 may be relatively small, there are real costs, and the benefits are even smaller. Perhaps even worse, since M3 doesn’t do what it is supposed to, it can be a potentially dangerous source of misunderstanding and misinformation (as the gold bugs’ recent fascination with it attests). As a side note, William Polley reminds us that this decision has substantial precedent; the Fed discontinued M4 and M5 long ago, once they estimated that those series no longer contained any useful information.

Unfortunately, the story isn’t quite over, as I alluded to in the opening paragraph. To understand why, we need to return to the monetarists and conspiracy theorists who think that the Fed is trying to hide some damning evidence (of what, I’m still unclear about).

Their hero on Capitol Hill is Congressman Ron Paul (who I try not to confuse with RuPaul). Despite being trained as a physician, Ron Paul boasts that he is “a congressional expert on monetary policy”, who took it upon himself during the last Congressional hearings to teach Chairman Bernanke that inflation is a monetary phenomenon. In the past Ron Paul has proposed legislation in Congress to abolish the Fed, but now Paul is apparently preparing a bill that would compel the Fed to continue to publish M3.

Such micromanagement of the Fed by Congress strikes me as the height of absurdity, on many levels. Obviously, having the Fed’s economists take their marching orders from a physician cum politician is ridiculous to begin with. And obviously, having a country’s central bank subject to the whims of its legislature seems like a pretty good recipe for disaster in general.

But silliest part of this whole story is that the concerns about the end of M3 are largely misplaced in the first place: M3 does not tell us anything useful about money creation in the economy, and so keeping it will not achieve anything but a waste of time and energy.

Some other time I’ll explain why I think the other indicators of money supply are also pretty much useless. But for now I’ll be content to simply see M3 fade into history.

Kash