March 1, 2010 – As the financial crisis has unfolded over the last two years, the Federal Reserve has been responding in a variety of unprecedented ways. Therefore, it is logical to assume that these never-before-used actions have altered long-established ways of viewing things. One area that has been impacted is the US dollar money supply.
The quantity of dollars in circulation is being underreported by relying upon the traditional and now outdated definitions used to calculate M1 and M2. These ‘Ms’ are calculated and reported by the Federal Reserve based on the following guidelines that identify the several different forms of dollar currency used in commerce:
M1: The sum of currency held outside the vaults of depository
institutions, Federal Reserve Banks, and the U.S. Treasury; travelers
checks; and demand and other checkable deposits issued by financial
institutions (except demand deposits due to the Treasury and depository
institutions), minus cash items in process of collection and Federal
M2: M1 plus savings deposits (including money market deposit
accounts) and small-denomination (less than $100,000) time deposits
issued by financial institutions; and shares in retail money market
mutual funds (funds with initial investments of less than $50,000), net
of retirement accounts.
These esoteric definitions can be confusing, so let’s bring US dollar currency back to basics as the first step to explaining why these definitions are no longer adequate.
There are two types of dollar currency comprising the money supply – cash currency and deposit currency. Both are used in commerce to make payments.
1) Cash Currency
The cash currency we carry around in our pockets is issued by the Federal Reserve. Take a look at one of those green pieces of paper, and you will see that they are labeled as a “Federal Reserve Note”. A note is a debt obligation, and a few decades ago one could take that note to a Federal Reserve Bank and ask them to make good on their debt by redeeming it for silver, or until 1933, gold.
These liabilities of the Federal Reserve are no longer redeemable into anything, and are therefore “I owe you nothing” currency, a phrase made famous by legendary advocate of sound money, John Exter. Nevertheless, Federal Reserve notes remain a liability of the Federal Reserve.
2) Deposit Currency
Deposit currency is comprised – as its name implies – of dollars on deposit in the banking system. These dollars circulate as currency when payments in commerce are made with checks, wire transfers, plastic cards and the like. In contrast to cash currency which circulates from hand-to-hand, deposit currency circulates from bank account to bank account.
Bank deposits take three standard forms – checking accounts, savings accounts and time deposits. They have different maturities, or tenor, to use a banking term.
Dollars in checking accounts are considered to be the most liquid because they are available on demand. Therefore, they are part of M1 because they are the most likely deposit currency to be used to make a payment in commerce. Dollars in savings accounts are less likely to be used to make a payment, but nonetheless are currency because they are spendable. So they are part of M2, which comprises those dollars less frequently used as currency.
The dollars in time deposits are used even less, but are currency and therefore available for use in commerce when they mature, or immediately if the tenor of the deposit is broken. They are – depending on the size of the deposit – included in M2 or M3, which is no longer disclosed by the Federal Reserve.
Having provided this background information, we can now get to the heart of the matter by looking at how currency is created ‘out of thin air’ by the Federal Reserve and banks and the impact of their actions on the monetary balance sheet of the US dollar.
Cash currency of course is simply printed, but every note issued is recorded on the Federal Reserve’s balance sheet. Basically, the Fed ‘monetizes’ an asset by turning it into currency.
If, for example, a bank sells a $1 million T-bill to the Fed, the Fed ‘pays’ for it with $1 million of newly printed cash currency. The Fed records the T-bill as an asset and the cash currency it issued as its liability. These Federal Reserve Notes are the “currency” component in the definition of M1 above.
The creation of deposit currency is similar. When a bank makes a loan or purchases a security, it records the loan or security as its asset and creates deposit currency as its liability. Simple bookkeeping entries increase the bank’s assets and liabilities by the same amount.
New deposit currency is created because the bank deposits the amount of the loan in the borrower’s checking account, or similarly, credits the account of the seller of the security it is purchasing. These dollars are now available on ‘demand’ of the borrower or the seller of the security.
Regardless whether deposit currency is created by the banking system or the Federal Reserve, the net effect is the same – the quantity of dollars increases. The total amount of deposit currency in checking accounts is the “demand and other checkable deposits” component in the definition of M1 above.
Measuring the Quantity of Dollars
As of January 31st, the quantity of cash currency in circulation (i.e., not in bank vaults) was $860 billion. This amount comprises 51.3% of M1, which equaled $1,676 billion on that date. As of January 31st, the quantity of demand and checkable deposits in circulation was $810 billion. This amount comprises 48.3% of M1.
For historical reasons unimportant to the point of this analysis, the Federal Reserve in the past has only created cash currency. However, the unprecedented changes it has engineered over the past two years have resulted in a vast amount of deposit currency being created by the Fed. Instead of purchasing paper from the banking system solely with cash currency – its traditional form of payment to ‘monetize’ assets by turning them into currency – the Federal Reserve since the start of the financial crisis has increasingly relied upon deposit currency to purchase paper.
Regardless how the Federal Reserve pays for the paper it purchases – cash currency or deposit currency – it is creating dollar currency and perforce expanding the money supply. But the traditional definition of M1 does not accurately capture this process when the Fed uses deposit currency to pay for its purchase. In fact, it is totally excluded. Because the Federal Reserve did not create deposit currency in the past, none of the Ms take it into account.
Consequently, the traditional definitions of the Ms are outdated because they do not capture the total quantity of dollars in circulation. Because M1 is underreported, so too is M2.
Unprecedented Deposit Currency Creation by the Fed
There has been an unprecedented amount of deposit currency created by the Fed over the past two years. The following chart illustrates this point. It shows the quantity of demand and checkable deposits, i.e., the amount of deposit currency, at the Federal Reserve since December 2002.
From December 2002 until the collapse of Lehman Brothers in September 2008, the quantity of deposit currency created by the Fed averaged $11.8 billion, an amount that is relatively insignificant compared to total M1. Presently, it stands at a record high of $1,246.2 billion, which of course is highly significant.
More to the point, none of this deposit currency is captured in the traditional definition of the Ms. The quantity of dollar currency is therefore significantly underreported, which is illustrated by the following chart.
The Federal Reserve reports M1 to be $1,716 billion as of February 15th. When deposit currency created by the Federal Reserve is added to the traditional definition of M1, M1 after adjustment is actually 170% higher at $2,918 billion. Its annual growth increases to 29.5%, nearly 3-times the rate reported by the Fed and more importantly, is an annual rate of growth in the quantity of dollar currency that is approaching hyperinflationary levels.
This restatement of M1 explains why crude oil is back at $80 per barrel; copper is $3.25 per pound; and commodity prices in the main are rising in the face of weak economic conditions. The US dollar is being inflated and worryingly, the rate of new currency creation is approaching hyperinflationary levels. Unless the Federal Reserve changes course, the US is headed for a deposit currency hyperinflation like those that plagued much of Latin America in the 1980s and 1990s.