Tom Hickey Reply:
April 3rd, 2010 at 12:38 am

MDM, the key here is the MMT concept of vertical and horizontal in relation to money creation. This is sometimes called exogenous (outside) and endogenous (inside).

When the government “spends,” the Treasury disburses the funds by crediting bank accounts. Settlement involves transferring reserves from the Treasury’s account at the Fed to the recipient’s bank. The resulting increase in the recipient’s deposit account has no corresponding liability in the banking system. This creation is called “vertical,” or exogenous to the banking system. Since there is no corresponding liability in the banking system, this results in an increase of nongovernment net financial assets.

When banks create money by extending credit (loans create deposits), this occurs completely within the banking system and results in a liability for the bank (the deposit) and a corresponding asset (the loan). The customer has an asset (the deposit) and a corresponding liability (the loan). This nets to zero.

Thus vertical money created by the government affects net financial assets and horizontal money created by banks does not, although its use in the economy as productive capital can increase real assets.

The mistake that is usually made is comparing what happens in the horizontal system with what happens at the level of government accounting. At the horizontal level, debt is the basis for horizontal money creation. Therefore, it is often assumed that debt must be the basis for the creation of money by government currency issuance. This is not the case.

Reserve accounting uses the standard accounting identities, but the meaning of “liability” is not “debt.” The husband-wife analogy for CB-Treasury accounting relationships is apt. Since a husband and wife are responsible for each others debts, neither can be indebted to the other. That is to say, reserve accounting is a fiction that does not represent real relationships, such as exist between a creditor and debtor in the horizontal system.

Moreover, government debt is not true debt either. At the macro level, the reserves that are transferred to banks through government disbursement are used to buy Tsy’s. That is, when a Tsy is bought, this involves a transfer of reserves from the buyer’s bank’s reserve account at the Fed to the government’s account (consolidating CB and Treasury as “government”).

When the Tsy’s are sold or redeemed, the reserves that were “stored” at interest are simply switched back, creating a deposit again. It’s pretty much the same as buying and redeeming a CD. It’s just a switch from demand to time back to demand in a bank account, and a switch between reserves and securities at the government level. That is to say, the government doesn’t have to draw on revenue, borrow, or sell assets to cover its “debt,” as households and firms do. It’s just a matter of crediting and debiting accounts on the (consolidated) government books, even though it may appear that there is a financial relationship occurring between the CB and Treasury due to the accounting. However, it’s just a fiction.

Therefore, the key to understanding MMT is this vertical-horizontal relationship. When one understands this, then Abba Lerner’s principles of functional finance become obvious. (1) Currency issuance through government disbursement is used to increase nongovernment net financial assets, and taxation withdraws net financial assets from nongovernment. (2) Debt issuance by the Treasury is a monetary operation for draining reserves to permit the CB to hit its target rate.

These principles are then applied to Y+C+I+G+NX to balance nominal aggregate demand with real output capacity in order to achieve full capacity utilization, hence, full employment, along with price stability. This is based not on theory requiring assumptions but on operational reality that can be represented using data, standard accounting identities, and stock-flow consistent macro models.

All of this and much more is explained in considerable detail at Bill Mitchell’s billy blog

42 Responses

  1. “…the government doesn’t have to draw on revenue, borrow, or sell assets to cover its “debt,”…”

    Assume that the Treasury has $0 in it’s account at the Fed and an interest payment on one of the Treasury’s bonds becomes due.

    How does the Treasury pay it without taxes or borrowing?

    1. #1, Bravo Tom!!!


      This here was a post I may have linked to before that I think shows where the numbers would land.


    2. “Assume that the Treasury has $0 in it’s account at the Fed and an interest payment on one of the Treasury’s bonds becomes due.

      How does the Treasury pay it without taxes or borrowing?”

      By issuing coins – or State Notes . which are issued exerting the state sovereign seigniorage right. Like “United States Notes” instead of “Federal Reserve Notes” (like JFK has done just before being killed).

  2. by ‘doesn’t have to’ i take it as operationally, in which case the Tsy balance in its Fed account simply goes negative.

    the no overdraft constraint is political, not operational

  3. Using the husband and wife analogy, Curious, suppose that the wife of the chairman of the bank overdraws her account at the bank. Do you really think that the bank is going to bounce her check?

    What ever the bank does to cover her check, they will account for it on their books somehow. It’s the similar in the case of the Fed and Treasury. The Fed is not going to let the Treasury “run out of money,” regardless of what President Obama thinks and says about the country “going bankrupt” when it can easily cover settlement.

    As Warren is fond of saying, “The government neither has not does not have money,” under a fiat system in which the government is the currency issuer. The accounting “behind the veil” has nothing to do with having money or not having money. Under a fiat system, a monetarily sovereign government never has to “get” money through revenue (taxation), borrowing (issuing debt), or selling assets, as do households, firms, and states in the US, because the US government is monetarily sovereign and can issue its non-convertible floating rate currency without financial constraint.

    Thus, unless Congress would legislate defaulting on the interest payment, the Fed will always make sure that the Treasury has the reserves it needs for settlement. As far as paying interest goes, there is already a law giving the government blanket power to cover its debts, including interest payments, adding to the budget deficit if required. Congress would have to repeal that automatic provision. This was discussed over at Bill Mitchell’s billy blog recently.

    This should be abundantly obvious now, since the Fed did all sorts of the things under its emergency powers to support the financial system. Certainly, it would be applies more aggressive in defending the Treasury from potential default. Congress, too, is unlikely to have the political will to default, especially when it is entirely unnecessary. This would be way beyond irresponsible, supposedly in the name of being financially responsible. It will never happen.

    The problem arises due to applying gold standard thinking when it is no longer applicable. This is simple to understand by comparing the present non-convertible floating rate monetary system to a convertible fixed rate regime in which the government is actually constrained by its reserves. The term “reserves” to convertibility and it is an anachronism under non-coververtibility.

    Under a convertible fixed rate system, the government can only create money in the amount of its reserves, e.g., under a gold standard, its gold reserves. This doesn’t apply under a non-convertible flexible rate system, aka a fiat regime. The amount of currency that the government can create is not fixed by any external standard. The only constraints on currency creation under a fiat regime involve real resource and external trade considerations.

    The analogy between household budgets and the government only applies under a convertible fixed rate system. It does not apply under a non-convertible floating rate regime, such as the one that the US is operating under at present. Thus, the idea that a monetarily sovereign government has or does not have money under such a system is false. Political constraints can be placed on the accounting that limits what the government can do operationally, but the government always has the financial power to create its own currency as it wishes. Moreover, the CB can often circumvent political limitations through emergency powers, as we have just seen.

    1. Tom Hickey, glad to see Warren highlighting your excellent comment. My understanding is that there’s law that forbids Ty from overdrafting its Fed account, also you noted above “there is already a law giving the government blanket power to cover its debts, including interest payments, adding to the budget deficit if required”.

      Do you have the US Code citations for either? Seem to me, the baby step to move Congress towards accepting the MMT/ “functional finance” model is to change the law to permit funding the deficit via Tsy ovedrafts on its Fed account instead of by new bond sales (beside new deficit spending, old debt has to be rolled over as it comes due). The savings in debt service alone would dramatically reduce the CBO’s projections of future government debt (and, consequently, the political demand for higher taxes).

      Finally, great point mentioning Abba Lerner. Since the Fed was loaning Tsy during World War II at near zero interest rates and inflation was kept in check by fiscal policy (high marginal tax rates, the war bond campaign and the price control regime established by John Kenneth Galbraith and his colleagues at the Office of Price Administration), it appears the wartime US government was operating on a functional finance basis, even if no one quite understood it (or labeled it) until Lerner’s 1943 article.

      1. I dont’ have chapter and verse, Beowulf. Here’s what Stan Collender says about it here at capitalgainsandgames.

        …interest on the national debt is paid as a result of a permanent appropriation and is the most mandatory of all mandatory parts of the federal budget. It was enacted at the insistence of Alexander Hamilton (yes, THAT Alexander Hamilton), who convinced Congress that no one would lend the new United States government money unless they were sure that they would get it back when the time came. Hamilton wanted to make it clear to the would be lenders (as I recall, it was mostly the Dutch at the time), that a future president and Congress couldn’t refuse to pay….

        Perhaps someone else has the citation?

        The debt itself has already been funded by the deficit that created it. It simply stores the reserves at interest so the Fed can just switch the securities back to reserves without the need for additional funding. The interest payments do add to the current budget, but they are pre-appropriated according to the above.

        Collender concludes:

        Because of this permanent appropriation, the only way a default could occur would be if Congress passed and the president signed legislation repealing it and making the interest payments discretionary.  While that’s technically possible, the political likelihood of members of Congress voting for legislation that would be characterized as the “Let The United States Default And Instantly Become A Banana Republic Act” is relatively small….

  4. Here’s some backfill on my point about Federal Reserve financing World War II spending, I’d note that post-war inflation (which led to the 1951 Treasury-Fed accords) didn’t kick in until the OPA price and wage control regime was phased outed 1946. In 1947, the inflation rate was 14%, higher than any year during the war (1944 was the year the US economy had the best year it ever had or will ever have, 1.2% unemployment, 28% GDP growth, 3.5% inflation. A pity it took a world war and so many lives lost to reach full employment). There was no way around abolishing wage and price controls in 1946 since they were a major factor in the GOP takeover of Congress that fall, but thereafter inflation was controlled (or not) by monetary policy.

    From the beginning of World War II until 1947 the Federal Reserve pegged the yield of Treasury bills at 3/8%. They also capped the yield on longer maturing bonds at 2.5%. They removed the peg on T-bills in 1947 and removed the cap on bonds in 1950. Inflation pressure was ultimately responsible for this change in policy. The Treasury was opposed to the lifting of these restrictions. The Federal Reserve held that inflation could only be controlled by increasing bank reserves and allowing the interest rates to rise. The Federal Reserve and the Treasury needed to reach an agreement. The Treasury-Federal Reserve Accord of 1951 usually referred to as the accord, formed the basis for all subsequent Federal Reserve activity.

    “The Treasury and the Federal Reserve System have reached full accord with respect to debt-management and monetary policies to be pursued in furthering their common purpose to assure the successful financing of the Government’s requirements and, at the same time, to minimize monetization of the public debt” (Moore, 2009, para. 9).

    This accord gave the Federal Reserve freedom to implement policy as a result of its own research.

    1. It’s interesting that the financial regime during the war was basically Warren’s program, plus wage and price controls (which were made necessary by real shortages in consumer goods due to war production) So our policymakers do know how to do it, they just will only do under duress…

      1. President Kennedy was a functional finance man (Scott Brown was very savvy to play Kennedy tax cut footage in his Mass. Senate campaign ads). In JFK’s 1962 Yale Commencement Address, the president went so far in the weeds in term of theory, you can tell he knew his economics (“The myth persists that Federal deficits create inflation and budget surpluses prevent it. Yet sizeable budget surpluses after the war did not prevent inflation, and persistent deficits for the last several years have not upset our basic price stability”).

        JFK’s speech to the Economic Club of New York in December 1962 reads like something our incumbent president would strongly disapprove of.

        Our true choice is not between tax reduction, on the one hand, and the avoidance of large Federal deficits on the other. It is increasingly clear that no matter what party is in power, so long as our national security needs keep rising, an economy hampered by restrictive tax rates will never produce enough revenue to balance our budget just as it will never produce enough jobs or enough profits. Surely the lesson of the last decade is that budget deficits are not caused by wild-eyed spenders but by slow economic growth and periodic recessions, and any new recession would break all deficit records.

  5. Would someone kindly direct me to the original post, in which Mr. Hickey’s excellent remarks here was among the comments?

  6. MMT creates a “fiat currency” (like the Civil War Greenback). The US has a “managed currency”. The volume of currency is dictated by the impersonal needs of trade & it is impossible for the non-bank’s holdings of currency to increase without the public giving up another type of currency, bank deposits (demand or time etc).

    To digress, it is impossible for an increase in currency held by the non-bank public to increase the money supply without the Fed offsetting the cash-drain factor (i.e., an increase in the volume of currency held by the non-bank public is deflationary).

    On the other hand with MMT, the volume of money issued is dictated by the deficit financing needs of the federal government. In the fiat system the volume of currency is not self-regulatory, or more accurately with MMT, the more issued, & or the more spent (the more credits & debits), the higher the prices.

    Aggregate monetary demand is equal to our means-of-payment money times its rate of turnover. MMT advocates don’t understand this (nor many others as well). That’s why economists can’t forecast.

    As in England in the 17th the goldsmiths comingled specie with all its other depositors for storage in its vaults. With MMT, digital dollars just invalidate the “law of probability” (the probability that deposits of specie would approximately offset withdrawals (as it did in the US prior to 1933).

    1. Flow5,

      Are you focusing on just the actual paper currency that is in circulation here?

      Is this not a meaningless number? At best just representing the level of “under the table” type of transactions that are taking place in the economy as no one legitimate uses paper money anymore these days, its all electronic.

      Why would anyone be concerned about this number other than perhaps IRS?


      1. No, the non-bank public determines it’s holdings of currency. The volume of currency held by the public needs no specific regulation since it is impossible for the public to acquire more of a given type of currency without giving up other types of currency, or else bank deposits (electronic). In other words, under our managed system it is impossible for the public to add to the total money supply consequent to increasing its holdings of currency.

        All currency gets into circulation, directly or indirectly, through the liquidation of time deposits, by the cashing of demand deposits. There is one exception in demand deposit creation; those historical instances when the U.S. Treasury borrowed from the Federal Reserve Banks. However it cannot be said, as of time deposits, that increases in the public’s holdings of currency reflect prior commercial bank credit creation. It is more appropriate to say that expansions of currency are accompanied by concurrent expansions of Reserve Bank Credit.

        An expansion of the public’s holdings of currency will cause a multiple contraction of bank credit and checking accounts (relative to the increase in currency outflows from the banks) ceteris paribus. To avoid such a contraction the Fed offsets currency withdrawals by open market operations of the buying type (e.g., purchases of governments for the portfolios of the Reserve Banks). The reverse is true if there is a return flow of currency to the banks. Since the trend of the non-bank public’s holdings of currency is up (ever since 1930), return flows are purely seasonal and cannot therefore provide a permanent basis for bank credit and money expansion.

        In contrast, in a fiat system (like MMT operations), the volume of currency and bank deposits issued is dictated by the deficit-financing requirements of the issuing government (like the Civil War Greenback).

      2. with floating fx, the demand for currency will reduce bank reserve account balances which *are* overdrafts/loans from the fed,
        the fed offsets the currency withdrawals to keep the marginal cost of funds for the banks at its target rate. if the fed did nothing the marginal cost would be the cost of borrowing at the window, which has been higher than the fed’s target.

        so it’s about price, not quantities

  7. Dear Tom,

    Points of clarification.

    1. Vertical relations are automatic such as stabilizers(cause/effect)of income generation and horizontal relations are voluntary(will/discretion)of income allocation as discretionary policy.

    2. Voluntary revenue constraints are not only political ideology induced but also come from impression effects of rating companies downgrades, media articles and speculators shorting public debt. All these factors, entangled by complexity create an entropy of illusion upon economic units and question fiscal sustainability that restrain fiscal policy.

  8. If you can’t measure money & its utilization rate you can’t theorize. MMT is just concealed greenbacking reconstituted. MMT references to WWII’s large deficits are for the uneducated.

    1. Flow5,
      I just measured a $20 bill I have in my wallet. It is 6 3/16″ wide x 2 5/8″ tall, landscape orientation. I plan on utilizing part of it to buy a sandwich for lunch today.

  9. Let the government pay all of our salaries, end world hunger, world poverty, and give us the endless summer.

  10. There is nothing “new” about Modern Monetary Theory (MMT). Regardless of the remuneration rate, anyone can still calculate the implied reserve ratio (total reserves to deposit & F.R. note liabilities combined; or now IOR’s to deposits). The high point for reserve ratios, (the weighed arithmetic average of reserve ratios applicable to deposit liabilities), stood at 91.1, in May of WWII (1941).

    A member commercial bank (depository institutions) only becomes a financial intermediary when there is a 100% reserve ratio, applied to all its deposit liabilities.

    Financial intermediaries (non-banks) lend existing money which has been saved, and all of these savings originate outside the intermediaries; whereas the CBs lend no existing deposits or savings; they always create new money in the lending process.

    The only difference is that with MMT, the bankers will get paid twice.

    1. Read the mandatory readings if you’d like to get a clue. You’re just writing a big pile of garbage.

  11. You have to understand money & central banking first

    First, there is no ambiguity in forecasts: In contradistinction to Bernanke (and using his terminology), forecasts are mathematically “precise” :
    (1) “Money” is the measure of liquidity; the yardstick by which the liquidity of all other assets is measured.
    (2) Income velocity is a contrived figure (fabricated); it’s the transactions velocity (bank debits – Vt) that’s important (i.e., financial transactions are not random);
    (3) Nominal GDP is the product of monetary flows (M*Vt) (or aggregate monetary demand), i.e., our means-of-payment money (M), times its rate of turnover (Vt).
    (4) The rates-of-change (roc’s) used by economists are specious (always at an annualized rate; which never coincides with an economic lag). The Fed’s technical staff, et al., has learned their catechisms;
    (5) Friedman became famous using only half the equation (the means-of-payment money supply), leaving his believers with the labor of Sisyphus.
    (6) Contrary to economic theory, & Nobel laureate, Dr. Milton Friedman, monetary lags are not “long and variable”. The lags for monetary flows (MVt), i.e. the proxies for (1) real-growth, and for (2) inflation indices, are historically, always, fixed in length. However, the FED’s target, nominal gdp?, varies widely.
    (7) Roc’s in (MVt) are always measured with the same length of time as the specific economic lag (as its influence approaches its maximum impact (not date range); as demonstrated by the clustering on a scatter plot diagram).
    (8) Not surprisingly, the companion series, non-seasonally adjusted member commercial bank “costless” legal reserves (their roc’s), corroborate both lags for monetary flows (MVt) –– their lengths are identical (as the weighted arithmetic average of reserve ratios remains constant).
    (9) The lags for (1) monetary flows (MVt), & (2) “free” legal reserves, are synchronous & indistinguishable. Consequently, with simple algebra, economic prognostications are infallible (for less than one year).
    (10) Economic bubbles (asset inflation), are of course, incorporated: including housing, commodity,,, etc. This is the “Holy Grail” & it is inviolate & sacrosanct: See 1931 Committee on Bank Reserves Proposal (by the Board’s Division of Research and Statistics), published Feb, 5, 1938, declassified after 45 years on March 23, 1983.
    (12) The BEA uses quarterly accounting periods for real GDP and the deflator. The accounting periods for GDP should correspond to the specific economic lag, not quarterly.
    (13) Monetary policy objectives should not be in terms of any particular rate or range of growth of any monetary aggregate. Rather, policy should be formulated in terms of desired roc’s in monetary flows (MVt) relative to roc’s in real GDP.
    (14) Note: combining real-output with inflation to obtain roc’s in nominal GDP, can then be used as a proxy figure for roc’s in all transactions. Roc’s in real GDP have to be used, of course, as a policy standard.
    (15) Because of monopoly elements, and other structural defects, which raise costs, and prices, unnecessarily, and inhibit downward price flexibility in our markets, it is probably advisable to follow a monetary policy which will permit the roc in monetary flows to exceed the roc in real GDP by c. 2 – 3 percentage points.
    (16) I.e., monetary policy is not a cure-all, there are structural elements in our economy that preclude a zero rate of inflation. In other words, some inflation is inevitable given our present market structure and the commitment of the federal government to hold unemployment rates at tolerable levels.
    (17) Some people prefer the “devil theory” of inflation: “It’s all Peak Oil’s fault”, ”Peak Debt’s fault”, or the result of the “Stockpiling of Strategic Raw Materials/Industrial Metals” & Soaring Agriculture Produce. These approaches ignore the fact that the evidence of inflation is represented by “actual” prices in the marketplace.
    (18) The “administered” prices of the world’s monopolies, and or, the world’s oligarchies: would not be the “asked” prices, were they not “validated” by (MVt), i.e., “validated” by the world’s Central Banks. Dr. Milton Friedman said it best: “inflation is always and everywhere a monetary phenomenon”.

    1. Flow5, Interesting stuff, I’m curious if there’s a web link to the Fed reports mentioned here and at your blog (that were declassified in 1983).

      If, “policy should be formulated in terms of desired roc’s in monetary flows (MVt) relative to roc’s in real GDP”, then why not control transactions velocity (and replace our current tax system in the bargain) by setting an adjustable transaction tax on bank debits (Vt)?

  12. A VAT derivation?

    I had trouble accessing it. Try:

    Pritchard’s Discussion:

    The transactions concept of money velocity (Vt) has its roots in Irving Fischer’s equation of exchange (PT = MV), where (1) M equals the volume of means-of-payment money; (2) V, the rate of turnover of this money; (3) T, the volume of transactions units; and (4) P, the average price of all transactions units. The “econometric” people don’t like the equation because it is impossible to calculate P and T. Presumably therefore the equation lacks validity. Actually the equation is a truism – to sell 100 bushels of wheat (T) at $4 a bushel (P) requires the exchange of $400 (M) once (V), or $200 twice, etc.

    The real impact of monetary demand on the prices of goods and serves requires the analysis of “monetary flows”, and the only valid velocity figure in calculating monetary flows is Vt. Income velocity (Vi) is a contrived figure (Vi = Nominal GDP/M). The product of MVI is obviously nominal GDP. So where does that leave us? In an economic sea without a rudder or an anchor. A rise in nominal GDP can be the result of (1) an increased rate of monetary flows (MVt) (which by definition the Keynesians have excluded from their analysis), (2) an increase in real GDP, (3) an increasing number of housewives selling their labor in the marketplace, etc. The income velocity approach obviously provides no tool by which we can dissect and explain the inflation process.

    To the Keynesians, aggregate demand is nominal GDP, the demand for services (human) and final goods. This concept excludes the common sense conclusion that the inflation process begins at the beginning (with raw material prices and processing costs at all stages of production) and continues through to the end…

    But we do know that to ignore the aggregate effect of money flows on prices is to ignore the inflation process. And to dismiss the concept of Vt by saying it is meaningless (that people can only spend their income once) is to ignore the fact that Vt is a function of three factors: (1) the number of transactions; (2) the prices of goods and services; (3) the volume of M.

    Inflation analysis cannot be limited to the volume of wages and salaries spent. To do so is to overlook the principal “engine” of inflation – which is of course, the volume of credit (new money) created by the Reserve and the commercial banks, plus the expenditure rate (velocity) of these funds. Also overlooked is the effect of the expenditure of the savings of the non-bank public on prices. The (MVt) figure encompasses the total effect of all these monetary flows (MVt).

    1. Feige’s APT is actually a turnover tax derivation, a Tobin tax on every financial transaction if you will. I came across an Australian website proposing a “Flow Taxation System”, using a guaranteed income payments and an APT tax regime to control the money supply.

      This paper examines the desirability and feasibility of implementing a small transaction based tax on the flow of money around the economy with an across the board welfare payment to every citizen. The purpose of which is to provide an automatic control on the money supply in the economy, and thus controlling inflation, and deflation, and eliminating the detrimental effects of loss of income through unemployment…

      The flow taxation system is based on the automated payment transaction tax (APT) propose by Edgar L. Feige which simply is a tax on all deposits and withdrawals to accounts held by financial and other institutions (other include super funds, investment trusts, gambling organisations, broking houses) (from white paper linked at this page)

      1. Since the publication of the white paper further research has lead me to a system that is two tiered, one for “normal” transactions those associated with the buying and selling of goods and services for people and the borrowing and lending associated with such. The other is for financial transactions, those hedging and arbitrage activities that turn over large sums, quadrillions.

        It works the rates I have are on and we can all receive $22,000 a year.

        This changes everything as you can imagine which is why the book around this idea has taken so long and is now 500 pages in length.

    2. To the Keynesians, aggregate demand is nominal GDP, the demand for services (human) and final goods. This concept excludes the common sense conclusion that the inflation process begins at the beginning (with raw material prices and processing costs at all stages of production) and continues through to the end…

      Nominal aggregate demand is money times velocity.

      1. that might work for fixed exchange rate regimes, but not today’s floating fx dollar.

        see ‘soft currency economics’ and the other ‘mandatory readings’ on this website thanks.

      2. No, aggregate monetary demand as defined by Keynesian economics is equal to nominal gDp which is different than equal to MVt.

  13. WSJ article 198x’s…they got it wrong but good example:

    New Measures Used to Gauge Money supply

    Money, to most people, is money, but things aren’t that simple to the economists who chart the ebb and flow of the nation’s money supply.
    The specialists recognize something called “true money” – money that is spent. And they have long kept track of various money supply categories know as M1, M2, M3, and L. Lately, though, some are paying increasing attention to several new indicators.

    “Divisia – aggregates” – and the “debit-weighted-money-index” are experimental money supply measures attracting growing interest at the Federal Reserve Board and among economists who are dissatisfied with the tradition al indicators.

    The familiar M figures, and the less familiar L, are the Fed’s official measures of which consists of cash and checking accounts, has unsettled financial markets and halted a decline to interest rates,. Some economists, reasoning that people will soon start spending the ballooning funds, believe the M1 figures portend new price increases.
    But opinions vary widely on what M1 and the other, broader Fed measures really mean. The experimental measures are designed to resolve some of the confusion by isolating money intended for spending, the money held as savings. The distinction is important because only money that is spent-so-called “true money” – influences prices and inflation.

    Growth in Savings?

    The alternative measures suggest that some of the M1 increases actually reflect a growth in savings.

    “They indicate that the recent growth of M1 is overstating the growth in “true money” says Dr. Paul Spindt, a Fed economist. Nancy Lazar, economists for the New York brokerage firm Cyrus J. Lawrence Inc. agrees that “M1 isn’t necessarily out of hand, and we aren’t threatened by new inflation.”

    Economists who are dissatisfied with M1 say the indicator is misleading because it now contains non-spending money. In the past, when people did most of their spending with cash or checking accounts that didn’t pay interest, an M1 consisting of just those forms of money reliably indicated the rate of spending in the economy. But financial deregulation has created accounts that simultaneously serve as checking accounts and savings vehicles, making it more difficult to obtain a pure estimate of spending money.

    M1 now includes, for instance, interest bearing checking accounts, such as “Super-NOW” accounts, which carry near-market rates of interest on balances above $2,500. But M1 doesn’t include savings-type accounts that can also be sued for spending such as money market funds and their bank counterpart, money market deposits accounts.

    Information Content

    M1 “has lost most of its informational content” according to Chase Manhattan Bank. The Fed’s broader measures of money, which add other assets to M1, similarly fall to isolate the spending components of money from savings, some economists say.

    Enter the Divisia aggregates. Named for an Italian mathematician, they were developed several years ago by Dr. William Barnett, then a Fed economists and now a professor at the University of Texas in Austin.
    Instead of totaling all types of money and treating them equally, the Divisia numbers assign different weights to assets according to the extent they serve as spending, rather than savings, vehicles.

    This can be done, according to Prof. Barnett, by looking at the interest rates paid on different assets. Assets that serve purely as savings, such as corporate bonds, pay the highest rates of all liquid assets. Moving down the scale toward assets with transactions features, interest rates decline because of the higher service costs to financial institutions. In effect, Prof. Barnett says, people pay a “user cost” to hold an asset that can be spent.

    The more an asset is used for spending, the higher its user cost, he says: Cash and checking accounts, which pay no interest, have the highest user costs of all assets, and thus are given the greatest weight in the Divisia figures. Now accounts have less weight because, while they have unlimted checking features, they earn interest, money market deposit accounts, which are limited to three checks a month, carry even less weight because they pay still higher interest.

    The Divisia figures suggest that money growth, since 1979 has been much slower than the Fed’s official numbers indicate. From the fourth quarter of 1981 to the fourth quarter of 1982, for instance, M2 grew 9.3% but its Divisia counterpart rose only 7.8%. During the first quarter of this year when M1 rose 14% and M2 grew 20.3%, the Divisia estimates for those two measures climbed 10.6% and 3.6% respectively.
    The Fed’s policy “has been much tighter than the board thought.” Prof. Barnett says.

    The “debit-weighted” money figures developed by the Fed’s Dr. Spindt, support Prof. Barnett’s conclusion. They assign different weights to various categories of money according to how often they turn over, or are spent.

    Fed figures show that checking account balances turn over about 350 times a year. They get considerably more weight than Now- accounts, which turn over only about 16 times annually. And now accounts are counted more than money market fund, and bank money market deposits, which turn over less than 3 times a year.

    Weighting the different parts of money according to turnover produces a money growth rate of only 7% from the fourth quarter of 1981 to last years’ final period and a 9.3% pace in the first three months of this year-again, less than the conventional money measures indicated.

    The alternative money measurements, however, wont’ resolve all debates about Fed policy. Burton Swick, a vice president of Prudential Insurance Co of America who is a monetarist economist, says the new methods “will become increasingly relevant.” But he adds that they still suggest that the Fed has been letting the money supply grow too rapidly.

    Many analysts believe the Fed and financial markets will be slow to accept the new money calculation techniques. “People find it difficult to accept there’s no simple definition of money,” says Charles Liberman, a senior economist for Morgan & Co. “People want simple answers, and they want to go on using what they’ve used to using.

    Still, the experimental figures may serve a useful purpose. Says Fed member Henry Wallich: “I’m always willing to look at them because at least they make you aware of the limitations of the simple “money” aggregates.

  14. Pritchard:

    The annual rate of turnover or transactions velocity (Vt) of commercial bank demand deposits (DD) has vaulted from 35 in 1964 (to an all-time annual high of 525 in Oct. 1996). For the year 1980, Vt was 135. That is to say each dollar in our checking accounts had, on the average, an annual impact in the markets of $35 in 1974 and $135 in 1980.

    The sharp increase in DD velocity since 1964 is the consequence of a variety of factors which include 1) the daily compounding of interest on savings accounts in commercial banks and “thrift” institutions, 2) the increasing use of electronics to transfer funds, 3) the introduction of negotiable commercial bank certificates of deposits, and 4) the rapid growth of ATS (automatic transfers of savings to DDs) and NOW (negotiable orders of withdrawal) accounts.

    But the most important single factor contributing to the increased rate of money turnover probably was those structural changes which made virtually all time deposits the equivalent of low velocity demand deposits. These changes included the virtual elimination of Regulation Q (interest ceilings on time deposits) and the introduction of interest bearing checking accounts know as money market demand accounts. Fortunately, these are one time events. High interest rates and expectations of higher prices have been both cause and effect of rising rates of Vt.

    The Depository Institutions Deregulation and Monetary Control Act (henceforth DIDMCA), by legalizing the use of the NOW type of checking accounts by Savings and Loans (S&Ls), Credit Unions (CUs) and Mutual Savings Banks (MSBs) immensely accelerated the rise in Vt, as did the introduction of money market funds (MMFs).

    All the demand drafts drawn on these institutions clear through DDs – except those drawn on MSBs, interbank and the U.S. government. 1) MSB balances in the commercial banks (CBs) are designated as inter-bank demand deposits (IBDDs) presumably because MSBs are call banks. MSBs always have been, and are intermediary financial institutions – intermediary between saver and borrower (also a money supply error).

    The rapid expansion of the ATS and NOW accounts also has been responsible for the precipitous decline of the money supply M1A (currency held by the nonblank public and DDs). As well as contributing to the extraordinarily sharp increase in Vt since November, 1980. Contrary to the conventional wisdom, the expansion of the various types of checking accounts offered by the intermediaries (non-banks) has not been at the expense of the CBs as a group. When the owners of (saved) DDs transfer these funds to the intermediaries, the funds are immediately invested in some type of earning asset – including CB negotiable CDs. If the saver transfers the funds to an ATS account, that too, simply results in a shift in the type of liabilities held by the CBs.

    It was not by happenstance that the $27 billion decline of DDs form November, 1980 to May, 1981 is almost exactly matched by the growth of CB ATS accounts and negotiable CDs. If the member CBs were operating with an excess volume of excess legal reserves, then it could be said that the volume of bankable investments was inadequate, and that the intermediaries were acquiring investments or loans the CBs would otherwise hold. But the Member CBs have no excess legal lending capacity, and the nonmember CBs are presumably operating at their economic limits.

    The legal reserves of the nonmember CBs exercise no constraint on their expansion as these reserves are defined under the so-called DIDMCA. On the other hand, the growth of any intermediary does deny investable funds to other intermediaries. Money Market Funds (MMF) growth has had , for example, a serve effect on the S&Ls and the MSBs and to a lesser extent, the CUs.

    The importance of Vt in formulating – or appraising monetary policy derives from the obvious fact that it is not the volume of money which determines prices and inflation rates, but rather the volume of monetary flows (MVt) relative to the volume of goods and services offered in exchange.

  15. Next year I’ll get a million dollars for the Nobel prize in economics, but it’s a buy, hold, sell, thing. I’m going to hold out for more money.

  16. “The importance of Vt in formulating – or appraising monetary policy derives from the obvious fact that it is not the volume of money which determines prices and inflation rates, but rather the volume of monetary flows (MVt) relative to the volume of goods and services offered in exchange.”

    Seems more obvious to me that Vt is a residual and not causal?

    Agreed that’s the stuff of nobel prizes nowadays


  17. Vt? principally – few absolutes & superlatives, but I’m not slinging, I’m going trout fishing.

    Joe Granville noted on April 1st (in the Granville Market Letter), that this might the be mother of all double tops. He mentioned Jan & Mar as tops though. I’ve always said Jan & Apr.

    Granville likened this to “Heisenberg Double Top”. This is what Wikipedia says: “In quantum mechanics, the Heisenberg uncertainty principle states that certain pairs of physical properties, like position and momentum, cannot both be known to arbitrary precision. According to Heisenberg its meaning is that it is impossible to determine simultaneously both the position and velocity of an electron or any other particle with any great degree of accuracy or certainty.”
    Personally, I don’t believe in the Heisenberg Uncertainty Principle.

    This is the current example – a “suckers rally” (stock market)

    I said: “Assuming no quick countervailing stimulus:

    Should see shortly. Stock market makes a double top in Jan & Apr. Then the real-output of final goods & services falls/inverts from (10) to (1) from Apr to May. Recent history indicates that this will be a marked, short, one month drop, in rate-of-change for real-output (-9). So stocks follow the economy down (with yields moving sympathetically?)”

    Go spread the Gospel:

Leave a Reply to beowulf Cancel reply

Your email address will not be published. Required fields are marked *