The M3 Question Posted by: Dale Franks
on Thursday, December 07, 2006
Sigh. Still sick. I've got this horrific coughing/laryngitis thing that I picked up at the end of last week. I'm starting to feel better, but the coughing has been keeping me up to the point where I haven't gotten more than 30 minutes of sleep at a single stretch for the last four nights. There's no chest congestion, or runny nose, or anything like that, just the constant irritation in my throat and this dry cough, that, at this point, has pulled just about every muscle in my torso. And the laryngitis, which makes it hard to speak.
Today was much better, though. I coughed less, and my voice was a little closer to normal. Still, blogging hasn't been the top priority for me for the past week or so, and I'm still pretty whacked out on (over-the-counter) drugs.
And yet, after my brief post defending Paul Krugman's possibility of being right, then Billy Beck's little question about the M3 money supply, I've gotten several emails from readers asking about the whole M3 deal, including this one from Jon:
I'm curious what will happen if the US enters a recession — especially with the dollar so low — and foreign investment starts to dwindle. If ROI is higher elsewhere, we could have a problem. Did you see the chart of M3 I linked in the comments to your post? What happens to all that liquidity if assets depreciate and the heathen foreigners stop buying up our debt?
Additionally, at least three people asked me whether the foreigners would start repatriating US assets in a significant way. So, I thought I should take a stab at answering. Now, I realize that only about 1 in 20 of you will even care about any of this, and of those, only 3 in 5 will agree. So, if your eyes glaze over at talk about money supply, international investment flows, and whatnot, you should probably stop reading now.
For the remaining 20 or so readers, the second question is a bit tougher than Jon's question, so I'll tackle that first.
Now, despite the fact that there are all sorts of people out there who are quite sure they know exactly what will happen, and they will assure you that—depending on their preferred monetary policy leanings—it will a) be an unqualified economic disaster, or b) have no serious effect at all, I honestly don't think anyone really knows the answer. Look, the financial markets are full of cranks. You've got some people who are absolutely convinced that M3 has some deep mystical meaning that we ignore at our peril. You've got CRB junkies who are positive that commodity prices, and commodity prices alone, reveal the secret inner workings of the economy. You've got your gold bugs, who proclaim daily that you are doomed—doomed!—unless you buy krugerrands.
Moreover, this is a seriously complicated subject, so I'm not sure there are any pat answers that can be relied upon. There's a completely different level of complexity to discussing the international implications of liquidity changes in M3 to what is still, as a practical matter, the world's reserve currency, than there is is discussing the domestic inflationary and economic impacts of changes to M2 growth.
So, you gotta take a lot of what you hear with a grain of salt, including what follows. What follows is how I think things work, and, like all the other cranks, I could be wrong, too.
First, the reason why the world invests in the US is that it has by far the largest, most transparent, and most accessible financial markets in the world. That's important to remember, because, frankly, you're not gonna have a whole bunch of institutions pulling out tens of billions of dollars each in US investments, and pouring them into the Frankfurt Exchange, the Paris Bourse, or the FTSE 100. While there are certainly some nice things to invest in there, overall, the aggregate number of investment vehicles is far more limited than that found in the US market. So, as a practical matter, the amount of money you can pour into those places is more limited than in the US. So, even if it were possible to dump huge amounts of money into Singapore or Hong Kong...what would you buy with it? I mean, what are you gonna do, drive the price of €10,000 French bonds to €150,000, with a yield of 0.016%? Drive the price of Siemens GmbH stock to €4,000 with a P/E of 895? Really, if you're looking for Return on Investment (ROI), where are you gonna go to find capital or debt markets that can absorb a huge transfer of investment, and still retain a higher ROI than the US?
We like to talk about the global economy, and the easy movement of capital back and forth across borders. But, it isn't really true as a practical matter, however theoretically true it might be. To move that money back and forth, there has to be something to invest in at the money's destination. And for the most part, the one place in the world where there's lots of stuff to invest in is the US.
Sure, there are a lot of other markets, and, maybe you could dole all that money out in penny packets all across the world. But then, you now have to worry about the currency risk of 100 different currencies, rather than one. And it becomes a lot harder to maintain liquidity by doling out your holdings so widely. And, of course, your transaction and accounting costs spiral, and your currency exchange risks multiply. There's simply a built-in inertia to repatriating US assets, because your options—and risks—for investment after repatriation become a lot more complex.
Second, there are some big players, especially China, that simply can't repatriate their US-denominated investments without endangering their own economies, either because their economies are export led, or because their own currencies are...uh...less than reliably convertible in the FOREX. If China dumps its US currency holdings, the price of the renmimbi will skyrocket as the dollar collapses in the FOREX. Now, Chinese exports will cost an arm and a leg, which means China will get substantially fewer export orders. Now, there's no doubt all sorts of domestic capital projects the Chinese could make with the renminbi they repatriate, but, China is an extremely poor country on a per-capita basis. It's not like they have a huge domestic market that just straining at the bit to buy stuff. So, where's the ROI in killing the export market for an export-led economy? I mean, I guess the Chinese could use the money to try and build a consumer economy, but I doubt that even with the size of their dollar holdings, there's enough money to actually do that in a country of 1.3 billion dirt-poor farmers and factory workers.
In association with this, what would all the eurodollar holders do if the price of the dollar collapsed? Again, some state bank in Vietnam might sell off its eurodollars in order to escape the price deluge, and convert them back into Vietnam's national currency. Once they've done that, they're holding their dong in their hands. What are they gonna do with their dong? Because, let's face it, nobody wants a lot of Vietnamese dong. (Note to Vietnam: You simply must come up with a less embarrassing name for your currency. Even the "ho" or the "nammie" would be better choices.) Which brings us to the next point...
Third, the US economy is the 800 pound gorilla of the world's economy. The US alone produces 31.2% of global GDP (Remember that, by the way, when some hippie moans at you that "the US uses a quarter of the world's resources, man"). If the US economy tanks, let's not all kid ourselves that the economies of Germany, France, Britain, Italy, et al. will just go along swimmingly. They aren't going along swimmingly in many cases now. US recessions are felt globally, and that affects global ROI. So, even if the first two points above weren't true, you'd still have a bit of a conundrum about what eurodollar holders are gonna do with that money. If they don't want to stand around with their dong in their hands, what they really have to do is find a...uh...reserve reserve currency other than the dollar. What would that currency be? The only other candidate is the euro, and why would you buy it if the European economies were tanking in a global recession led by the US?
Fourth, when you're talking about the people holding Eurodollars, huge CD Deposits, and holders of US Securities, you are, in the main, talking about institutions. They know, as well or better than anyone, that economies are cyclical. If the US economy goes into recession—and everyone else does, too—why would they make all these investment moves in the first place? They know that recessions end, asset prices rise, and that, except for what they might need for short-term liquidity, it's better to hold fast rather than try and scramble around and find some short-term ROI that's better in Kaplokistan. Unless there's some situation where the US economy tanks while the rest of the world experiences good economic growth, I don't see how you come out with better ROI—transaction costs of asset shifting included—than just letting the investments ride.
Fifth, if the above is true, then the amount of liquidity measured by M3 is simply not the overriding factor. The really important factor for M3 is the velocity of money, i.e. the speed with which the money is used for transactions. You know, back in the late 70s and early 80s, Paul Volcker committed the Fed to the use of monetary targets for money supply growth, rather than interest rates. Essentially, what Volcker's Fed did was set targets for money supply growth, and tailored the Fed's Open Market operations to expand or contract the money supply based on those targets, and letting interest rates just flutter about willy-nilly. So, every Thursday, traders would stare transfixed at the Dow Jones newswire waiting for the M1, M2, and M3 numbers to be released, then they would frantically make buy or sell calls based on how close the report was to the targeted money supply growth rate.
That was all cool and Milton Friedman-y until 1982, when the Fed felt that money supply growth coming out of the 1981 recession was too robust, and was massively exceeding their target. They tightened up again, and sent us right back into an extremely deep recession. Yes, money supply growth was quite brisk indeed, but nobody was doing anything with that money. They were essentially stuffing it into mattresses; hoarding it. Sure, there was a lot of "liquidity", but the velocity of money was so slow that there wasn't actually enough money to supply the demand for it. The Fed over-reacted, and, hello 11% unemployment.
Is it possible that an excess of M3 liquidity could become massively inflationary? Sure, its possible. But is it likely? I'm not so sure. Because the US is the world's reserve currency, international operations don't work in lockstep in the same way as domestic money supply operations work. People, and countries, hold dollars for different reasons, many of which do not have ROI as their primary impetus. So, I think there is a greater inertia against inflation than a simple look at the M3 money supply might suggest. If you're the central bank of Kaplokistan, and you're holding dollars to prop up your own currency, because the Kaploki isn't worth a bucket of warm spit on its own, or your economy depends on exports to the US market to survive, repatriation isn't a very good option.
Again, the simple question the heathen foreigners have to answer is, "if we repatriate our us-denominated securities, what will we buy with the money?" The answer to that question isn't very obvious, unless you're just absolutely convinced that the euro is the bee's knees.
Where I would have concern over the inflationary implication of M3 for the domestic US economy, is in the use, by both the Fed and the Treasury Department, of repurchase agreements to US banks. As it happens, the US Treasury has been very active in repos lately, and it doesn't do much good in terms of restraining the domestic money supply for the Fed to nudge up the Fed Funds rate on one hand, while the Treasury pours money into repos. But, I think my worry there would be less about inflation than the Fed being forced to substantially increase the cost of money to make up for the extra liquidity, which would push us into an unnecessary recession. I think that's more likely than the Fed just sitting idly by while Treasury repos jump-start inflation.
So, finally, back to Jon's question, which is, what would happen if the foreigners stop buying into US debt? Once more, the big question is, OK, what will they buy then? In what markets? Will those markets actually offer a better ROI if those countries slide into recession, too? Again, I'm not sure there are that many places to go to conveniently invest.
But let's assume it does happen. If so, it could be uncomfortable, because then you'd see major tension between the Fed, which would be dropping interest rates like crazy, and the bond market, which would be dropping face values of bonds like crazy—and hence increasing yields—to attract buyers. The sheer size of the bond market simply dwarfs the Fed's ability to control the money supply through interest rates. Remember, the Fed only has direct control over the Fed Funds rate, and, no matter how quickly they reduce that rate, they can only reduce it to 0%. After that, the Fed has pretty much shot its wad. Bond yields, on the other hand, effectively have no top rate.
So the first question would be how deep into the bond market would the effect be?
I think the most likely outcome of investor shyness would be higher interest rates overall as bond yields rise, perhaps to the point where the bond market might overcome the Fed's ability to add liquidity. The bond market could simply push us into a deeper recession than would otherwise be the case. The federal government's ability to borrow more money would be compromised, to some extent. Who knows, it might even force budget cuts. Don't get me wrong, it would be a fairly nasty recession, but it wouldn't be a disaster.
The worst case, of course, is a massive flight from us securities, which would cause massive deflation. But, again, how likely is it that this will happen? If people stop buying US Securities, what will they buy? Moreover, if investors defect from the US market, deflating asset prices, isn't that cutting their nose off to spite their face? I mean, how good will the world economy be, and how many investment opportunities will there be anywhere if the US market craters? It won't just be US asset prices that would deflate. We'd have another global depression on our hands.
But, absent that kind of scorched-earth cratering, then in terms of the us bond market, new issues would probably still have to have significantly higher yields to attract purchasers. But new issues are pretty small compared to the bond market as a whole. Not too many people would get a crack at them. So, would existing bond issues see a lot of price movement? That would depend on whether existing investors bailed, or simply held their bonds. If you're already getting 7.75% yield, are you gonna dump your current holdings in a recession where ROIs are reduced worldwide, except for new US bond issues? If not, then, while bond yields might move noticeably higher, they probably wouldn't be disastrously so.
But, fine, let's say that the recession is confined to the US, and there are greater ROIs available elsewhere. Then, we have to ask how sustainable the higher ROI elsewhere is if cash flows, especially large ones, start moving to it. For instance, the French bond market is much smaller than the US bond market. So, the movement of bond prices and yields is proportionally much higher in the French market than the US market in response to moving $X from the US to France. As investors stop buying US bonds, their prices fall and their yields rise. But, as that money is funneled to France, French bond prices rise and yields fall, and by a proportionally greater amount. So, even a relatively small outflow of cash from the US to the French bond market drives down the yield on French bonds far more than US yields rise. So if you're just parking that money into bonds for income anyway, your window of catching that higher yield in French bonds is relatively small.
And, of course, if you're already an existing bond holder, why would you dump the bond anyway? You already own the bond. Changes in the yield for new bond purchases doesn't affect the yield you're receiving. You've already bought the bond. You're already getting your coupon payment. So, aren't you going to need a significantly higher yield to dump that US bond to pursue a replacement in France?
And, even if you do want to make a play to capture higher yield on a 30-year treasury, why not simply convert the bond to a CD or cash, then wait a while in order to jump right back into another 30-year later, when the price is lower, and the yield is higher?
At the end of the day, I think the overriding factor when it comes to foreigners financing our debt, or holding dollar-denominated investments, is the long-term stability of US markets. As long as bondholders are confident that the US will pay off its bonds, and stockholders feel that US companies will continue to return long-term profits, despite periodic recessions, hugely significant moves out of US Markets simply aren't in the cards.
That doesn't mean a coming recession will be easy, however. Billy Beck points me to this piece in The Telegraph, which isn't a very cheerful projection. I think it's a bit overly tendentious to make reference to the 1930s, but references to 1982...well...that might not be too far off the mark.
The US offers many types of investments other than bonds. If China were to shift its holdings from bonds to equities or other asset classes, their reserve balances would decline accordingly. That would take pressure off the yuan and significantly increase China’s maneuvering ability.
Also, can’t China use foreign reserves to increase imports of non-consumer items? Power plants, construction equipment, engineering services, etc. Most countries can’t do such infrastructure projects without creating enormous foreign debts (see Argentina) but China doesn’t have that problem.
Lots of good stuff in there. Parallels a lot of what I have been thinking about (and I get paid to do it.)
That is a really good point. One of the reasons I am not as concerned about the growth of reserves due to our trade deficit in other countries as the data might indicate is that I believe China and the various victims of the 1998 Asian crisis want to build up their foreign exchange reserves. That made sense. Anyway, at a debate on trade at my place I left this as a part of a comment for glasnost:
Now the US is a special case because we get the advantage of a form of seignorage. Since other central banks use our “hard currency” as a bank reserve, to the extent that they hold reserves and do not spend that money on US goods and services, we in essence actually do export money in return for goods. This is very fortunate for us as long as it lasts.
The fear of course is that they will eventually stop accumulating our currency (or bonds purchased with that currency) and demand goods and services in return. Let me make that explicit, they might actually want to spend it here! Given all the trade banter in the US one would think that would be a good thing, but exporting money is really profitable and has made us have higher living standards. It wouldn’t be a great crises,as long as it isn’t a sudden and massive shift. If it is, then using Friedman’s logic on money (which I do) more money means chasing the same, or (since we might have a boom of production from all that new spending) almost the same amount of goods and services, we get inflation.
Thus while we might be working like dogs our actual living standards decline because we are shipping stuff overseas (which manifests itself as inflation and a falling dollar.)Meanwhile the adjustments in trade flows are likely to take a while (as Keynes would predict) and therefore everybody would suffer through a recession as goods that were in demand in some places ceased being demanded and capital and labor is shifted to other enterprises. Thus we all hope it isn’t sudden and it works itself out over time so that capital and labor can move at a pace that doesn’t leave so much idle at one time that it causes a downward spiral.
That is assuming that the accumulation of the existing reserves isn’t actually desirable but a product of exchange rate manipulation by amongst others the Chinese (who by the way actually account for very little of our imports.)
I think the bold statement is key. If in fact the accumulation of reserves is not a real need, but based on a massive misunderstanding of the purpose of trade (a common problem) there is the possibility that a panic dumping of US assets could occur as the Chinese decide it makes no sense to keep so much US cash and debt in hand. My guess, and as Dale says it is a guess, is they aren’t stupid and are not over accumulating. They will slow the accumulation and allow their currency to slowly appreciate and start spending their earned dollars. That will allow the US to shift to a more export oriented model. We may have a recession, but it will not be due to the Chinese (or solely the Chinese) and we have done pretty well in the meantime. We will continue as the worlds reserve currency and therefore still earn our little cut on world trade but it will not be so lopsided. It does mean a trade and current account deficit is pretty much baked into the cake. Inflation will become a bit harder to contain so our government will need to control the issuance of debt (reduce the deficit.)
You’ve got your gold bugs, who proclaim daily that you are doomed—doomed!—unless you buy krugerrands.
Krugerrands, although certainly an inexpensive way to invest in gold, are considered garbage by many numismatists. Most of the industry pros that I know would much prefer to deal in the US Gold Buffalo and Gold Eagle. The rest of the post is entirely beyond my very limited command of economics. I’ll let the experts fight it out here, but kudos to you, Dale, for producing such an in-depth article on the technical aspects of our monetary system. I’ll have Lance explain it to me later in small words.
"and therefore everybody would suffer through a recession as goods that were in demand in some places ceased being demanded and capital and labor is shifted to other enterprises."
Pardon my ignorance, but would I be correct in thinking that a recession is caused at least in part by a mismatch between supply and demand? Why would there be such a sudden and large change? I am assuming, of course, that some change is normal and accomodated.
"We will continue as the worlds reserve currency"
I have read that the US dollar is also used by ordinary people world wide as a substitute for local currencies, since their own is not as desireable. Is it true, and if so, how influential, and where do I find out more?
DALE RESPONDS: Actually, a recession is caused when the demand for money—cash, to be more precise—is greater than the available supply.
People get nervous, so they decide to build up and hold their cash reserves, rather than spend money. This is why the Fed pours money into the economy during a recession, so that people can satisfy their demand for cash reserves, and begin spending the extra cash they obtain.
Are you sure about this? Wikipedia gives numbers from the IMF, World Bank, and CIA World Fact Book (all broadly similar, at least for the US and GWP) which has US GDP at about 20% of the world’s. (Though they’re all PPP— maybe it’s different if measured using exchange rates?)
DALE RESPONDS: Yeah, I’m sure. PPP calcuations are pretty subjective, so I’m using the nominal numbers, not the PPP numbers. Using nominal numbers, even Wikipedia shows the US with 28% of world GDP.
And even that is calcuated using a fixed exchange rate for all of 2005, which, of course, is less accurate since the Euro echange rate has varied wildly. My numbers actually came from a print issue of The Economist from several months ago.
Currencies are commodities and commodity prices are purely a function of supply and demand. The Fed has a monopoly on supply so any analysis that doesn’t begin and end with the Fed will inevitably be wrong (or right for the wrong reasons).
A fairly logical argument, Dale, but it sort of depends on gut. I’m not prepared to take it on with the pretense of certainty, but it doesn’t hurt to raise some contrary thoughts.
Actually, I’ll stop first and lavish some praise: this is the sort of economic argument I like, because it’s a great argument all kinds of theoretical scenarios where everyone supposedly wins from trade.
For instance, the French bond market is much smaller than the US bond market. So, the movement of bond prices and yields is proportionally much higher in the French market than the US market in response to moving $X from the US to France. As investors stop buying US bonds, their prices fall and their yields rise. But, as that money is funneled to France, French bond prices rise and yields fall, and by a proportionally greater amount. So, even a relatively small outflow of cash from the US to the French bond market drives down the yield on French bonds far more than US yields rise.
A lot of the argument you make that, essentially, we’ll be the only ones who don’t have to pay in spades for decades of trade and budget deficits during continuous consumption beyond savings, relies on a combination of market psychology, inertia, and structural advantages. I agree with you that those forces exist, and they do count for quite a bit. And they may keep us going this year. But it defies basic logic to suggest that they can continue literally forever...
In the long run, our days of being the world’s reserve currency are numbered as our share of the world’s actual production of goods - and services - declines. It will be a gradual shift.. but none of that needs to happen right now in order to see a sudden decline in investment entering the US. East Plokistan may stay in dollars for a while, but China’s GDP has been growing at several times our speed for decades now. Their internal domestic consumption has been growing by leaps and bounds. They are already in the process of buffering against export-led growth. Furthermore, when you add Japan, South Korea, various rich asian small states together, there are plenty of places for Chinese currency to go, that probably add up to assets equivalent to ours.
The chinese keep investing in order to ship us exports, but we don’t dominate their export shipments by a catastrophic margin. They can handle a decline in exports to US by some percentage that would occur under our catastrophic reccession, and increase exports to any other domestic economy that is still growing. China, as you suggested, isn’t looking for a killer ROI, just a stable place to dump it surplus.
It’s hard to argue against a killer US recession from an asset collapse and general capital flight causing problems for the rest of the world. Having said that, if it ever happens, Asia is positioned to essentially break away from the West trend and recover first, quickest, and more permanently.
There is the possibility that a panic dumping of US assets could occur as the Chinese decide it makes no sense to keep so much US cash and debt in hand. My guess, and as Dale says it is a guess, is they aren’t stupid and are not over accumulating. They will slow the accumulation and allow their currency to slowly appreciate and start spending their earned dollars.
Very ironically, it is the heavily interventionist position of China that might allow this happy ending to come to pass. If it was private Chinese investors buying US dollars for ROI reasons, like it was for Argentina, the market panic would be very likely. Since it is in fact state-controlled investors concerned with the potential consequences to the larger macroeconomy, they may be able to so some amount of gradual redirection, even though the value of their reserves will gradually decline as they redirect, they not accelerate that pullout, anyway. Hey, look, Lance, another example of anti-microeconomically-rational behavior to the macroeconomic good.
That will allow the US to shift to a more export oriented model.
Now, this part just won’t be that simple. We’re a very large country, relative to the global economy. There are a number of positives to that, but one negative is that it’s rather unlikely that the rest of the world will have the available growth to subsidize, say, a quadrupuling of our exports. We are simply due for a serious contraction in consumer spending in this country, and we won’t be able to slough the decline into commesurate increased exports. Alternatively - and this is the best-case scenario - we might get a long period of flat spending, with a gradual reacquisition of some consumer savings.