M3 Resurrected

September 3, 2007 – M3 has been resurrected, so I have my trusty roadmap back. We can once again closely track what is happening to the dollar by watching the annual growth rates of M3, which is the total quantity of dollars in circulation.

I have been extremely critical of the Federal Reserve and time and again derided its decision announced back in November 2005 that it would stop reporting M3 after February 2006. The Fed’s reasons were that banks would save $1 million of administrative costs annually and further, that M3 according to the Fed was no longer needed. By any rational test, both of these reasons come up short. They just do not seem plausible.

In today’s age of computer-based accounting and reporting, are we to believe that banks manually process by hand reports for the Federal Reserve, Office of the Controller of the Currency, FDIC and other agencies? No, it doesn’t seem believable that reporting this one statistic is a burden or a significant cost. And how can the quantity of money and its rate of growth remain important to European central banks but not the Fed? No, the Fed’s stated justification did not make sense.

Clearly there had to be some other reason for the Fed’s decision to stop reporting M3, particularly given the reality that central banks only tell you what they want you to hear. What did the Fed not want us to hear?

My view has been that the Fed does not want anyone watching it inflate the money supply. The Fed does not want anyone to see the true growth in the quantity of dollars in circulation. Here’s what I wrote early last year about this important point: “What is the real reason the Federal Reserve stopped reporting M3? The answer is very simple. The Federal Reserve wants to hide the truth. They want to hide the fact that they are inflating the dollar.” (The end of M3 – Hiding the Truth About Inflation)

In other words, if the quantity of dollars increases faster than the demand for dollars, the price of goods and services rise. We get inflation when there are simply too many dollars chasing those goods. Now with M3 having been resurrected we can once again see those dollars being created, but is not the Fed to whom we owe our thanks. Rather it is John Williams of Shadow Government Statistics (SGS) www.shadowstats.com who is now calculating and making this M3 information available. Here are John’s own words to explain how he does it:

“M3 consists of M2 plus institutional money funds, large-denomination time deposits, repurchase agreement liabilities and eurodollar holdings at foreign branches of U.S. banks. More than 70% of the non-M2 components of M3 are accounted for by institutional money funds and large time deposits. The Fed has continued reporting institutional money funds as a memorandum item in its H.6 report on Money Stock Measures. Large time deposits at commercial banks is reported regularly in the Fed’s H.8 report on Assets and Liabilities of Commercial Banks. These numbers allow modeling of a good estimation of the large time deposit number used in M3 calculations. Representing less than 30% of non-M2 components of M3 and less than 10% of total M3, the repos and eurodollars are being modeled by SGS econometric models.”

We have to ask ourselves, is John’s methodology valid? Yes, I believe it is a good estimation of the total quantity of dollars. If anything, it probably understates M3 if eurodollar deposits are growing faster than historical trends as I believe, but that’s another story. The main point is that we once again are able to monitor M3, and in particular, to calculate its annual growth rate, which is what I have done in the above chart.

This chart will be familiar to long-term readers of these letters. The blue line plots the annual growth rates of M3 at each month end, and we can see a clear picture of what happened to the dollar over the past 32 years – inflation, disinflation, and even deflation for that brief period in 1992 when M3 had a negative growth rate (i.e., M3 was less than it was the year before).

Note that the blue line ends in February 2006 because it is based on data provided by the Federal Reserve. The period since then – which is noted by the red line – is based on the data available from SGS. And while that red line is an eye-opener, it should not be too big a surprise to the readers of these letters. I’ve been writing about the “Bernanke inflation” since he was first appointed Federal Reserve chairman.

It has been my expectation that Ben Bernanke will go down in history with Rudolf Havenstein, the hapless manager of the Reichsbank during the horrific hyperinflation of Weimar Germany. They speak the same language. Bernanke drones on about adding “liquidity”, but that is the same thing Havenstein used to say.

Here is a useful and insightful quote by Murray Rothbard in his excellent book, “The Mystery of Banking“. It provides a detailed explanation of what happened in Weimar Germany, which also provides us with some guidance as to what is now happening and will continue to happen to the dollar:

“When expectations tip decisively over…to inflationary, the economy enters a danger zone. The crucial question is how the government and its monetary authorities are going to react to the new situation. When prices are going up faster than the money supply, the people begin to experience a severe shortage of money, for they now face a shortage of cash balances relative to the much higher price levels. Total cash balances are no longer sufficient to carry transactions at the higher price. The people will then clamor for the government to issue more money to catch up to the higher price. If the government tightens its own belt and stops printing (or otherwise creating) new money, then inflationary expectations will eventually be reversed, and prices will fall once more—thus relieving the money shortage by lowering prices. But if government follows its own inherent inclination to counterfeit and appeases the clamor by printing more money so as to allow the public’s cash balances to “catch up” to prices, then the country is off to the races. Money and prices will follow each other upward in an ever-accelerating spiral, until finally prices “run away,”…Chaos ensues, for now the psychology of the public is not merely inflationary, but hyperinflationary, and [the] runaway psychology is as follows: “The value of money is disappearing even as I sit here and contemplate it. I must get rid of money right away, and buy anything, it matters not what, so long as it isn’t money.“ A frantic rush ensues to get rid of money at all costs and to buy anything else. In Germany, this was called a “flight into real values.“ The demand for money falls precipitously almost to zero, and prices skyrocket upward virtually to infinity. The money collapses in a wild “crack-up boom.” In the German hyperinflation of 1923, workers were paid twice a day, and the housewife would stand at the factory gate and rush with wheelbarrows full of million mark notes to buy anything at all for money. Production fell, as people became more interested in speculating than in real production or in working for wages. Germans began to use foreign currencies or to barter in commodities. The once-proud mark collapsed.

The absurd and disastrous way in which the Reichsbank—the German Central Bank—met the crucial clamor for more money to spend immediately in the hyperinflation of the early 1920s is revealed in a notorious speech delivered by Rudolf Havenstein, the head of the Reichsbank, in August 1923. The Reichsbank was the sole source of paper money, and Havenstein made clear that the bank would meet its responsibilities by fulfilling the increased demand for paper money. Denominations of the notes would be multiplied, and the Reichsbank would stand ready to keep its printing presses open all night to fill the demand. As Havenstein put it:

“The wholly extraordinary depreciation of the mark has naturally created a rapidly increasing demand for additional currency, which the Reichsbank has not always been able fully to satisfy. A simplified production of notes of large denominations enabled us to bring ever greater amounts into circulation. But these enormous sums are barely adequate to cover the vastly increased demand for the means of payment, which has just recently attained an absolutely fantastic level, especially as a result of the extraordinary increases in wages and salaries. The running of the Reichsbank’s note-printing organization, which has become absolutely enormous, is making the most extreme demands on our personnel.”

In contrast to Havenstein, Bernanke doesn’t need a printing press to create ‘money’; he has a computer to do that. And that is exactly what he has been doing, as is clear by the page-1 chart. The result is also clear from what he has been telling us. We all know that the Federal Reserve is just one of the central banks that have been adding “liquidity” over the past few weeks as the subprime mess worsened, and adding “liquidity” is just another way of saying adding newly printed currency.

So is hyperinflation in our future? At this stage, no one of course knows, but we do know that more inflation is in our future. After all, the above chart is telling us that message loud and clear.