02/15/2002 Money, Monetary Policy and the Structure of Debt *

It was just another “typical” volatile week. For the week, the Dow added 2%, while the S&P500 and Transports gained 1%. Economically sensitive issues (with clean accounting) outperformed, with the Morgan Stanley Cyclical index jumping 3%. The Morgan Stanley Consumer index added 2%, while the Utilities were unchanged. The broader market mustered small gains, with the small cap Russell 2000 and S$P400 Mid-Cap indices up less than 1%. Technology stocks were generally under pressure, with the NASDAQ100 declining 1% and the Morgan Stanley High Tech index dipping 3%. Accounting and cash flow issues continue to dog the telecom sector, as the NASDAQ Telecommunications index sank 7% and the Street.com Internet index dropped 3%. The Semiconductors continue to outperform, with this week’s 4% rise increasing y-t-d gains to 6%. Accounting and risk issues also weigh on the financial stocks, with the AMEX Securities Broker/Dealer index declining 3% this week. Bank stocks ended generally unchanged. The HUI gold index, declining 1%, was resilient in the face of a $5.50 decline in bullion prices.

It was a battle of countervailing forces of stronger economic data verses corporate bond problems, with systemic Credit issues seeming to prevail. For the week, 2-year Treasury yields rose three basis points to 2.93% and 5-year Treasuries one basis point to 4.18%. Ten-year yields declined two basis points to 4.86%, while long-bond yields were unchanged at 5.37%. Corporate bond problems benefited mortgage-back and agency securities, as yields generally declined eight and four basis points respectively. The spread on Fannie Mae’s 5 3/8 2011 note narrowed 3 to 68. The benchmark 10-year dollar swap spread narrowed 5 to 71. The dollar remained resilient considering the circumstances, ending the week with a marginal decline.

Broad money supply declined $6 billion last week. Fannie Mae reported that it expanded its retained mortgage portfolio at a 20% rate during January, the strongest growth since July. The Congressional Budget office reported January receipts were down 6.8% y-o-y, while spending jumped 15.4%.

The week’s release from the National Association of Realtors confirms the real estate Bubble is alive and well. Nationwide prices increased 6.2% year over year, up from the third quarter’s 5.7% y-o-y increase. All regions experienced gains, with the South’s 7.6% increase the strongest. Key markets continue to demonstrate eye-opening price gains, with the Nassau-Suffolk, New York area gaining top honors with median prices up 23.2% y-o-y to $269,900. The nationwide nature of the inflation remains paramount, with key metropolitan areas experiences huge gains. Prices surged 22.3% in Minneapolis, 19.9% in Washington DC, 17.4% in Sacramento, 17% in Oklahoma City and Ft. Meyers, FL, 15.9% in South Bend, IN, 14.8% in Providence, RI, 13.5% in Trenton, NJ, and Norfolk, VA, and 13.2% in Baltimore. Fully 29 of 120 metropolitan statistical areas enjoyed double-digit gains, with Melbourne Florida’s negative 3.7% the worst of the 11 areas with very marginal price declines. Other key markets included Chicago up 11.6%, Miami up 12.4%, and Greater New York up 12.2%.

The California Association of Realtors also reported interesting data, as “80.4 percent of California cities and communities showed an increase in their respective median home prices for the fourth quarter.” Year over year, median prices throughout the Golden State jumped another 13.9% to $286,410, although total sales for 2001 declined 5.8% (with inventories remaining low). The story continues to be that, with the backdrop of ultra-easy mortgage finance, the lower end is on fire while the highly inflated upper end remains resilient. By region, prices in Palm Springs/Lower Desert were up 20.1% and Central Valley prices increased 16.3%. Coastal markets remain very strong, with North Santa Barbara County prices up 25.8%, Ventura 13.4% and San Luis Obispo 9.6%. Prices throughout the expansive greater Los Angeles market were up 12.6% and Orange Country prices increased 11.6%. There has been some isolated weakness, with Bubble prices in Santa Clara dipping 8.7% to $494,000 (sales down 28%!). Greater San Francisco prices inched 1.3% lower to $463,930. As a region Northern California remains resilient, with prices up 6.2% y-o-y.

It is worth our time, as well, to dig below the surface of Wednesday’s stronger than expected retail sales report. Year over year, total January sales increased 3%. By category, “health and personal stores” jumped 8% y-o-y, “sporting goods” 9%, “electronic and appliances” 6%, “building materials and garden” 6%, and “general merchandise” 5%. “Motor vehicles” were up 4% from last January, while “clothing and clothing accessories” lagged at up only 2%. With prices having declined sharply, “gasoline station” sales dropped 13%. “Non-store retail” sales declined 7%. It appears February sales are building on January’s momentum, with Redbook same store sales for the first week of the month up 4.2% y-o-y and Bank of Tokyo-Mitsubishi’s survey up 4.1%. Redbook’s 4.2% gain is only the second 4% plus weekly y-o-y increase reported over the past 14 months. The Association of Home Appliance Manufacturers today reported that January appliance shipments were up 4.9% y-o-y.

We are going to dive, once again, into the gritty nuts and bolts of money and Credit creation. Let’s begin pondering briefly a primitive barter economy where goods are traded for goods. The essence of economic endeavor is sustenance and the accumulation of wealth through the acquisition of commodities, capital goods, land and such. Next, development sees the introduction of money into the economic system in the form of gold coins. Here, gold functions as the medium of exchange, as well as a source of wealth accumulation providing future exchange value (“store of value”). Money has intrinsic value with limits as to how quickly it can be added to the economy. The introduction of gold money significantly augments productivity, fostering beneficial specialization and enhancing trade.

Next, we’ll introduce a simple gold-backed convertible banking system. Banks accept gold deposits (issuing gold depository receipts) for safekeeping. While much of this gold is held in reserve, the profit-seeking banker also lends gold coins to borrowers seeking purchasing power to employ resources for capital investment. “Deposit banking” provides an expansion of the effective money supply (gold in circulation plus gold receipts), although this growth is matched by an increase in capital assets/wealth creating capacity. In this system gold remains the “medium of exchange” and it is not unreasonable to do a “velocity” calculation, taking total output divided by the quantity of money (gold). As gold depository receipts become increasingly accepted for exchange, it is similarly not unreasonable to state that the “base” of gold money is being used more efficiently and that “velocity” is rising. The quantity and nature of lending becomes increasingly important, as lending profits become a key motivation for monetary expansion. If confidence in the convertibility of deposits wanes, the system becomes vulnerable to run against financial claims and dislocation.

Over time, an “efficient” book entry deposit banking evolves. No longer is “money” (gold, gold receipts, currency or even checks) the dominant payment mechanism. Credit vehicles increasingly are used for a preponderance of transactions, with settlement made through book entries and expanding financial claims. At this point, the essence of money is altered markedly from its traditional role as a “medium of exchange.” As new Credit provides the purchasing power to consummate a larger portion of trading, analysis shifts to focus on a broader definition of money as the residual of the lending process – with the issue of money as a “store of value” increasingly paramount. In an integrated Credit-based payment system, traditional concepts of “base money” and “velocity” are of little analytical value. Rather, a broad Credit theory of finance is required. It also becomes necessary to differentiate between the demand for Credit and the demand for money. By definition, money enjoys virtually insatiable demand as a liquid and safe “store of value” – the perceived “moneyness” of money. This character of money and the contemporary Credit-based system’s ability to create uncontrolled quantities is a crucial ingredient in precarious financial excess.

Let’s now complicate matters by moving to a traditional “fractional reserve” banking system with reserves held at the Fed against deposits. Let’s assume we have two banks, Smith Bank and Jones Bank. For our example, we will assume a 20% reserve requirement. Both banks have $1 million of assets - $180,000 of reserves held at the Fed, and $820,000 of business loans. Both banks have $900,000 of deposit liabilities and $100,000 of Equity.

Widget Company comes to Smith Bank for a $10,000 loan. The initial journal entries at Smith Bank are to debit $10,000 (increase) assets - “Loans – Widget Company” and credit $10,000 (increase) liabilities - “Deposits – Owed to Widget Company.” Both assets and liabilities increase $10,000. Widget Company then writes a check for $10,000 to Larry Liquidator Co. (LLC) that is deposited with Jones Bank. Journal entries at Jones Bank: Debit $10,000 (increase) assets - “Receivable - Due From Smith Bank,” credit $10,000 (increase) liabilities - “Deposits – Owed to LLC”. Journal Entries at Smith Bank: Debit $10,000 (decrease) liabilities – “Deposits - Owed to Widget Company,” credit $10,000 (increase) liabilities – “Payable to Jones Bank.” That same week, Jones Bank lends $8,000 (holding 20% of its new LLC deposits to add to reserves) to Wally World Industries. Jones Bank entries: Debit $8,000 (increase) assets – “Loans – Due from Wally World,” credit $8,000 (increase) liabilities – “Deposits – Owed to Wally World.” Wally World immediately writes checks to Bob’s Bricks that are deposited at Smith Bank. Jones Bank entries: Debit $8,000 (decrease) liabilities - “Deposits – Owed to Wally World,” credit $8,000 (decrease) assets - “Receivable - Due From Smith Bank.” Journal Entries at Smith Bank: Debit $8,000 (decrease) liabilities – “Payable to Jones Bank,” credit $8,000 (increase) liabilities – “Deposit - Owed to Bob’s Bricks.”

At the end of the week, the $2,000 (net of $10,000 Payable Owed to Jones, against $8,000 Payable Owed to Smith) owed by Smith Bank to Jones Bank is “settled” through “Reserves Held at the Fed.” Entries at Smith Bank: Debit $2,000 (decrease) liabilities - “Payable – Owed to Jones Bank,” credit $2,000 (decrease) assets – “Reserve Held at the Fed.” Jones Bank entries: Debit $2,000 (increase) assets – “Reserve Held at the Fed,” credit $2,000 (decrease) assets – “Receivables – Due From Smith Bank.” At this point, total money supply has increased by the $18,000 of new loans (Smith’s $10,000 to Widget and Jones’ $8,000 to Wally World). Smith Bank ends the period with total assets of $1,008,000 – “Loans” of $830,000 and “Reserves at Fed” of $178,000. Smith’s Liabilities and Equity also total $1,008,000, with “Deposits” of $908,000 and Equity of $100,000. Jones Bank ends the period with total assets of $1,010,000, with “Loans” of $828,000 and “Reserves Held at Fed” of $182,000. Deposit liabilities total $910,000 with Equity of $100,000. Jones Bank is fully reserved at 20% ($182,000/$908,000), while Smith Bank is under reserved. The Federal Reserve, however, fully accommodates bank lending by doing open market operations. The Fed adds $3.6 billion of reserves by purchasing loans from Smith Bank. Journal entries for Smith Bank: Debit $3,600 (increase) assets - “Reserves Held at Federal Reserve,” credit $3,600 (decrease) assets -“Loans.” Entries at the Fed: Debit $3,600 (increase) assets – “Loans Discounted,” credit $3,600 (increase) liabilities - “Reserves – Owed to Smith Bank.” Smith, with Reserves of $181,600 ($178,000 plus $3,600) and deposits of $908,000 is now fully reserved at 20% ($181,600/$908,000). It is worth noting that the Fed could just as well have purchased loans from Jones Bank. In this case Jones’ Reserves held at the Fed would have increased $3,600 that it could then have lent to Smith Bank for satisfaction of reserve requirements.

The preceding example is merely the old “textbook” illustration of fractional reserve banking and the money multiplier. Yet it is important to recognize that reserve requirements do not provide the mechanism to “multiply” deposits, but only act to limit the banking systems capacity for creating additional financial claims through the lending process. Such constraints have been a pivotal aspect of financial stability since the issuance of gold depository receipts. Consensus opinion holds that the Fed today generally maintains control of the money supply through traditional means - reserve requirements and open-market operations operating on bank lending. Doctrine likewise sticks with the presumption that bank lending is overwhelmingly directed to profitable business investment, and that Fed policy augments this healthy process. A (traditional) controlled Credit (banking) system would have limited lending capacity, with the interaction of supply and demand for “money” determining interest rates and finite investment profit opportunities. If the economy appears to be overheating, price pressures developing, or imbalances building, increased demand for money will tend to foster higher rates and diminished business profit opportunities. The theoretical Fed response to overheating would be to sell securities into the market, thus decreasing reserves and imparting constraint on bank lending. Accordingly, the Fed would respond to a weak economy by reducing interest rates and increasing open market purchases. Lower rates and heightened Credit availability would increase the universe of profitable investment opportunities. Added bank reserves would then be lent and deposits “multiplied.” Again, the Fed’s transmission mechanism is through bank reserves and interest rates, either stimulating or retarding bank lending for business investment.

With that refresher course at the front of our minds, let’s get to our model of a contemporary New Age financial sector. I am again attempting to illuminate what has truly been a paradigm shift in the structure of the Credit system and the role and transmission mechanism of monetary policy. The financial apparatus has evolved almost completely to a Credit-based system, with a complex settlement process incorporating financial claims of banks, money funds, brokerages, finance companies, special purpose vehicles, etc. The essence of contemporary money is a very sophisticated electronic accounting system of myriad of interrelated institutions, securities, and vehicles. It is not easy to follow the following journal entries, but I nonetheless believe it is a worthwhile intellectual exercise.

Here we will start with two full-service “Super Banks” – Morgan Bank and City Bank - that over years have evolved into institutions offering deposit services, full-scale lending operations, investment banking, investment management, and financial insurance. We will begin with both holding total assets of $1 billion. Morgan has “Business Loans” of $600m, “Bond Holdings” of $350m, and “Reserves Held at the Fed” of $50m. City has “Business Loans” of $600m, “Mortgage Holdings” of $350m, and “Reserves Held at the Fed” of $50m. Both have combined Liabilities and Equity of $1 billion, split between $600m “Deposits Owed” and $300m “Bonds Issued” and “Equity” of $100m.

With pronounced deregulation, financial innovation, and a secular decline in interest rates, the financial landscape is evolving rapidly and radically. City Bank, deciding it would be more advantageous to “subcontract” its loan origination business, decides to spin-off Nationwide Credit Industries (NCI). This company is structured with total assets of $200m – “Deposits – Due from City” and liabilities of $200m - “Short-Term Debt Owed to City”. (For our “simple” example, we will assume no equity). City Bank entries at spin-off: Debit $200m (increase) assets – “Loans – Due from NCI,” credit $200m (increase) liabilities - “Deposits – Owed to NCI.” Unlike a bank that books revenues over the life of a loan, Nationwide will seek profits from originating loans and selling them into the marketplace. It immediately hires an aggressive sales force and begins targeting sectors and groups where it believes it can get the largest volumes - asset-based lending and lower-tiered borrowers previously “underserved.”

Morgan’s restructuring takes a vastly different approach, as management sees a major business advantage from having its deposit banking operation a separate entity. Morgan spins-off “JPM Money Market Fund” (JPMMM). This company is initially structured with $200m of total assets – Morgan’s portfolio of short-term business loans – and $200m of liabilities – one-third, of Morgan’s “Deposits Owed.” Morgan entries at spin-off: Debit $200m (decrease) liabilities – “Deposits Owed,” credit $200m (decrease) assets – “Business Loans.” JPMMM entries: Debit $200m (increase) assets – “S-T Business Loans,” credit $200m (increase) liabilities – “Deposits Owed.”

To summarize before we commence our maze of entries: Morgan Bank assets are now $800m, “Business Loans” of $400m, “Bond Holdings” of $350m and “Reserves” of $50m. Liabilities of $700m comprise $400m of “Deposits Owed” and $300m of “Bonds Issued”, with Equity of $100m. JPMMM has assets of $200m – “S-T Business Loans,” and liabilities of $200m – “Deposits Owed.” City total assets actually increased by $200m (to $1.2b), the size of the new “Loan - Due from NCI.” City Bank assets now comprise “Business Loans” of $800m, “Mortgages” of $350, and “Reserves Held at Fed” of $50m. Liabilities and Equity of $1.2b include “Deposits Owed” of $600m, “Deposits – Payable to NCI” of $200m, “Bonds Issued” of $300m, and Equity of $100m. NCI assets of $200m, “Deposit – Receivable from City,” offset by liabilities of $200m, “Borrowings – Owed to City.”

Let the money and Credit creation begin! The process will begin with NCI lending $50m to Alpha Company. Alpha then uses this purchasing power to acquire an office building from Beta Company, directing NCI to transfer $50m to Beta’s account at JPMMM. NCI instructs City to make payment to JPMMM on its behalf. Let’s follow the entries. For NCI: Debit $50m (increase) assets - “Loans – Due from Alpha Co,” credit $50m (decrease) asset “Deposit – Due from City.” City Bank entries: Debit $50m (decrease) liabilities – “Deposit – Owed to NCI,” credit $50m (increase) liabilities - “Payable to JPMMM” for payment to Beta Company. For settlement in this case, the Fed debits $50m (decreases) City’s assets – “Reserves Held at Fed,” and credits $50m (increases) JPMMM’s assets - “Immediately Available Funds.” City settlement entries: Debit $50m (decrease) liabilities - “Payable to JPMMM,” credit $50m (decrease) assets - “Reserves Held at the Fed.” JPMMM settlement entries: Debit $50m “Immediately Available Funds” due from the Fed, credit $50m (increase) liabilities – “Deposit - Owed to Beta Co.”

With “Immediately Available Funds” of $50m and no reserve requirements, JPMMM offers and NCI accepts attractive short-term financing (at much better terms bank loans!), that it immediately uses to fund an additional $50m loan to Alpha Company, which Alpha then uses to purchase another office building from Beta Company. JPMMM initial entries: Debit $50m (increase) assets - “Commercial Paper – Due from NCI Company,” credit $50m (increase) liabilities - “Deposit – Owed to NCI.” NCI initial entries: Debit $50m (increase) assets - “Deposits – Due from JPMMM,” credit $50m (increase) liabilities – “Commercial Paper Borrowings - Owed to JPMMM.” NCI’s next entries: Debit $50m (increase) assets - “Loans – Due from Alpha Co,” credit (decrease) assets - “Deposits – Due from JPMMM.” JPMMM’s next entries: Debit $50m (decrease) liabilities - “Deposit – Owed to NCI,” credit $50m (increase) liabilities - “Deposit – Owed to Beta Co.” Not only have JPMMM assets and deposits increased another $50m, it retains the $50m of “Immediately Available Funds” to lend. The lending and money creation process is in full swing.

With short-term rates low and confidence high the Fed will maintain accommodative rates and a steep yield curve, Masters Hedge Fund seeks to increase leveraged speculation in the Credit market. With the assistance of its business partner Morgan Bank, Masters establishes a repurchase agreement purchasing $50m from Morgan’s bond portfolio with funds borrowed by Morgan from JPMMM. JPMMM entries: Debit $50m (increase) assets – “Repurchase Agreements – Due from Morgan,” credit $50m (decrease) asset “Immediately Available Funds” payable to Morgan Bank. Morgan Entries for JPMMM transaction: Debit $50m (increase) assets – “Immediately Available Funds” from JPMMM, credit $50 (increase) liabilities – “Repo – Owed to JPMMM.” Morgan entries for Masters transaction: Debit $50m (increase) assets – “Receivable – Due from Masters,” credit $50m (decrease) assets – “Bond Holdings.” Morgan decides to hold its “available funds” as an institutional deposit at JPMMM, with JPMMM again retaining $50m (no reserve requirements!) of “Immediately Available Funds” to lend. Morgan entries: Debit $50m (increase) asset – “Deposit – Due from JPMMM,” credit $50m (decrease) assets – “Immediately Available Funds.” JPMMM entries: Debit $50m (increase) assets – “Immediately Available Funds,” credit (increase) liabilities – “Deposits – Owed to Morgan.” Again, lending and deposits have increased, while JPMMM has retained the $50m “Immediately Available Funds.” In this case hedge fund speculation through a “repo” transaction increased “money” supply by expanding institutional money fund deposits.

Meanwhile, City Bank spins off (with no assets or liabilities) its mortgage finance unit, Cici Mae. CiciMae immediately borrows the $50m “Immediately Available Funds” from JPMMM, using this liquidity to acquire $50m of City’s mortgage loans. JPMMM entries: Debit $50m (increase) assets – “S-T Borrowings – Due from CiciMae,” credit $50m (increase) liabilities - “Deposit – Owed to City.” CiciMae entries: Debit $50m (increase) assets – “Mortgage Holdings,” credit $50m (increase) liabilities – “S-T Borrowings – Owed to JPMMM.” City Bank entries (choosing to hold its funds as a JPMMM deposit): Debit $50m (increase) assets – “Deposits – Due from JPMMM,” credit (decrease) assets “Mortgage Portfolio.” Again, a non-bank - borrowing through the money market – is, through the creation of additional liabilities to money market funds, creating additional institutional deposits.

Morgan is increasingly anxious to get a better piece of the action. It establishes an off-balance sheet “special purpose vehicle,” with the intention of profiting from leveraged holdings in “spread product” – using top-ratings to borrow cheap short-term, while lending dear long-term to lower-tier Credits. Morgan creates Octagon Fund, issuing $50m of commercial paper to JPMMM, tapping the “Immediately Available Funds.” This “liquidity” provides the means to acquire from NCI $50m of high yielding loans. For this “credit arbitrage,” Octagon “structures” these loans into top-rated securities with the purchase of interest rate protection and incorporating a sophisticated “default swap.” Octagon also procures liquidity protection with guarantees of back-up Credit lines from Morgan. With Octagon closely following the “laundry list,” the rating agencies automatically extend a top rating. The transaction is consummated. Octagon Entries for JPMMM transaction: Debit $50m (increase) assets - “Immediately Available Funds,” credit $50m (increase) liabilities - “Borrowings – Owed to JPMMM.” Octagon Entries for NCI transaction: Debit $50m (increase) assets - “Loan Holdings,” credit $50m (decrease) assets - “Immediately Available Funds” to be paid to NCI. NCI entries: Debit $50m (increase) assets - “Deposit – Due from JPMMM,” credit $50m (decrease) asset – “Loans Receivable – Alpha Co.” JPMMM entries with Octagon: Debit $50m (increase) asset – “Asset Backed Commercial Paper – Due from Octagon,” credit $50m (increase) liabilities “Immediately Available Funds - Payable to NCI.”

NCI now has $50 million available to lend, but, for our example, let’s assume the company chooses to hold its funds as a bank deposit at City. JPMMM entries: Debit $50m (decrease) liabilities – “Immediately Available Funds – Payable to NCI,” credit $50m (increase) liabilities – “Immediately Available Funds – Payable to City Bank.” City Bank initial entries: Debit $50m (increase) assets – “Immediately Available Funds – Due from JPMMM,” credit $50m (increase) liabilities – “Deposits – Owed to NCI.” NCI entries: Debit $50m (increase) assets – “Deposit – Due from City,” credit $50m (decrease) assets – “Immediately Available Funds due from JPMMM.” Later, NCI decides to transfer this $50m to Masters Hedge Fund, and instructs City to transfer these funds to Master’s account at JPMMM. Such a transfer is easily accomplished, as City holds institutional deposit balances at JPMMM. City Bank Entries: Debit $50m (decrease) liabilities – “Deposits – Owed to NCI,” credit (decrease) assets – “Deposits – Due from JPMMM.” JPMMM entries: Debit $50m (decrease) liabilities – “Deposits – Owed to City Bank,” credit (increase) liabilities – “Deposits – Owed to Masters Hedge Fund.” NCI entries: Debit $50m (increase) assets – “Investment – Masters Hedge Fund,” credit $50m (decrease) assets – “Deposit – Due from City.”

These final two entries hopefully demonstrate the ease with which deposit balances are transferred between the myriad institutions. Importantly, money markets are a vital mechanism for the banking system, as the purchasers of bank loan securitizations, as a direct lender, and, on the other hand, as a holder of institutional deposits. Some seem to be hung up on the issue of money market fund deposits as a “medium of exchange,” which they differentiate from bank deposits. But this is not an issue as money market funds are at the epicenter of the contemporary book entry financial system with a Credit-based settlement process. It is worth conceptualizing the stark differences from this “settlement” process of financial claims versus how transactions would be settled with a gold-based system. I will add, however, that such a system should not be expected to function as swimmingly (appearance of endless liquidity) with any serious contraction of lending. The expansion of money market deposits certainly creates inflationary purchasing power, although much of this fuel is contained within the sectors where lending is most prevalent – financial assets and real estate.

Hopefully the above examples somewhat demonstrate how the introduction of new “specialized” financial institutions virtually by design fosters heightened Credit availability and self-reinforcing asset-based lending. Additionally, the demand for loans and securities from non-banks such as finance companies, aggressive mortgage lenders, hedge funds and the “special purpose vehicles” have in real life led to a competitive bidding up of prices throughout the debt securities market and a resulting explosion in money and Credit. Importantly, lending dynamics were forever altered once boring old bank loans were transformed into the precious hot commodity for fabricating securities that, marked- to- market on a daily basis, generate coveted trading and speculative profits. And as trading, “structured products,” and leveraged speculation turned endemic, the availability of the enormous financial Credit to sustain such endeavors became a critical systemic issue. There is then no mystery why the money market, enjoying the unencumbered ability to “multiply” deposit money, now commands its place at the epicenter of the U.S. securities-based Credit mechanism.

Nonetheless, many steadfastly hold to the erroneous notion that only banks create money and Credit. Contemporary money and Credit is created largely through the expansion of myriad financial sector liabilities, something that many non-banks have been engaged in aggressively and conspicuously. I also continue to read analysis that money market fund deposits are different in kind from bank deposits, with the inference that these deposits are in some way deficient to bank deposits and, hence, generally impotent in influencing economic and financial market performance. I could not disagree more, and I only wish there was appreciation as to how money market fund claims are created. They are “multiplied” through the process of financial sector lending and liability expansion, albeit through banks, the GSE, “special purpose vehicles,” securitization trusts, Wall Street securities firms, finance companies, captive finance units, Credit card lenders, etc. I would even go so far as to argue that money market funds, as the chief mechanism for financing the holdings of Credit market instruments, become only more critical and vulnerable by the day.

Economists have a long history of clinging to traditional and outdated notions of what functions as money, too often blindly ignoring financial system “evolution.” Consensus opinion held for decades (best illustrated during the heated 19th Century Currency School vs. Banking School debates in Britain) that bank notes, and not deposits, impacted prices and the economy. Not viewed as money and thus with little concern for the consequences of rapid deposit expansion, this error led to a dangerous inflation of these claims and resulting financial fragility. We have witnessed a replay of history. I hope the above analysis helps to illustrate how money market fund deposits are, like bank deposits, the residual of the lending process. The issue is not what constitutes a bank (or bank deposit), but the nature of liabilities of the institutions, instruments, vehicles, and mechanisms of contemporary lending. I also hope the above examples illuminate how the explosion of non-bank entities easily explains the relatively slow growth of bank assets (loans) in the midst of historic Credit excess – non-banks are doing much of the lending, while many bank loans are securitized and sold into the marketplace where related liabilities become the assets (intermediated) held by money market funds. With the ballooning of GSE assets, special purpose vehicles, and securitizations, it is today not very useful to focus exclusively on bank assets as a measure of lending or liquidity.

I have referred to money market funds as a parallel financial system that has evolved as the key financing mechanisms for the securities markets. The similarities of these respective booms are no coincidence. Many have convinced themselves that money market funds do not have intrinsic liquidity for transactions, say as checking accounts enjoy. But this view completely misses the essence of money market funds and the explanation for the explosive growth of industry assets. Money market accounts are THE transaction accounts for financial markets. Whether it is the millions of online traders, millions that hold IRA or defined contribution retirement accounts, the millions that have brokerage accounts, the thousands of hedge funds, the Wall Street firms or the banks themselves, securities transactions are settled with transfers in and out (debits and credits!) of money market fund accounts. The expansion of money market claims (deposits) should be recognized as the undisputed inflationary fuel for the financial markets, markets that today dominate the economy. And having become a leading source of finance for the GSEs, commercial mortgage, Credit card, auto and home equity lenders (through securitizations), this fact alone goes a good way in explaining the resiliency of retail and automobile sales, as well as the unrelenting mortgage finance Bubble. Would we have zero percent financing without a booming securitization market? Would “structured finance” be viable without the money markets? How about the housing Bubble? If it were only the banks, would we have seen more pull back in consumer lending by now? I will take the other side of any argument as to the crucial role now played by money market funds in the U.S. economy.

I will highlight a quote from Hyman Minsky that I found very interesting and, I believe, strikingly pertinent. It is extracted from his comments to a Milton Friedman and Anna J. Schwartz article - “Money and Business Cycles” - from The Review of Economics and Statistics, 1963, p. 69

“Friedman and Schwartz state: ‘The most important [evidence in support of the monetary explanation of business cycles] is the fact that the relation between money and business has remained largely unchanged over a period that has seen substantial changes in the arrangements determining the quantity of money. During part of the period, the United States was on an effective gold standard, during part, on an inconvertible paper standard with floating exchange rates, during part, on a managed paper standard with fixed exchange rates. The commercial banking system changed its role and scope greatly. The government arrangements for monetary control altered, the Federal Reserve System replacing the Treasury as the formal center of control. And the criteria of control adopted by the monetary authorities altered.’ …(From Minsky:) Throughout that period, the largest part of the increase in the money stock was associated with the acquisition by the banks of newly created financial assets; almost always, the largest portion of these financial assets were the liabilities of private units; and almost always these financial assets, acquired in exchange for net changes in the money supply, were linked with investment expenditures or the holding of capital goods or financial assets. No matter how substantial the institutional and organizational changes have been, they have not seriously affected the economic relations underlying a change in the money supply: the largest part of the change in the money stock throughout the period was the result of commercial loan operations by commercial banks.”

It is worth carefully pondering Minsky. Throughout incredible economic growth and development, historic financial system evolution, the breakdown in monetary regimes, various booms and busts, and major alterations in the control over the financial apparatus, bank lending to finance commercial investment remained the heart and soul of the Credit system and the dominant transmission mechanisms to the real economy (with money a key residual). Nowadays, this simply no longer holds true. Lending to the asset markets – largely securities and real estate – dominates the Credit system and provides the “backing” of money. Marketable securities have transplanted loans, with profound ramifications for such a radical departure in the financial transmission mechanism.

Edward Shaw penned a 1954 American Economic Review article “Monetary Policy and the Structure of Debt.” He and John Gurley were early pioneers in monetary analysis, particularly in regard to the expanding role of non-bank financial intermediaries. I would like to follow in their footsteps as a proponent of an “enriched” broad “finance theory” or Credit theory. Their work is very rich in cogent analysis, and invaluable for illuminating key variables in today’s financial system (and for exposing crucial flaws in current monetary theory). Non-bank financial intermediaries were expanding rapidly in the fifties and sixties, but their liabilities (insurance policies, savings & loan shares, etc.) remained accurately recognized as inferior financial claims to bank deposit money. Not only did non-bank liabilities not function as a “medium of exchange,” they generally suffered from inadequate liquidity while maintaining some risk of loss of nominal value. Non-bank liabilities did not function as money. Such claims simply cannot be made today in regard to money market deposits, and the consequences have been momentous.

Importantly, it is today critical to recognize that non-bank liabilities - transformed through money market fund intermediation into deposits – are in some cases “superior” liabilities. The lack of reserve requirements and their “moneyness” (perceived liquidity and safety of nominal value, hence virtually insatiable demand) provide a most powerful mechanism for Credit excess, as we have witnessed. And in a time where the opportunities for bank lending (and deposit creation) to profitable enterprise is increasingly limited, money market fund intermediation of asset and consumption-based lending runs unabated. Not only does this Credit sustain spending, it also, importantly, creates the liquidity life blood for our New Age market-based Credit system.

The “moneyness” of non-bank liabilities has been evolving for decades, although it clearly came into full fruition during the past decade. Four related key developments come to mind: First, the rapid acceptance, growth, and integration of money market funds within the financial system. Second, the explosion of securities issuance – debt, equity and particularly asset and mortgage-backed securities – concomitant with Wall Street’s (as Master of the securities markets) rising prominence. Third, the ballooning of GSE balance sheet liabilities and off-balance sheet guaranteed securities. Fourth, the proliferation of Credit insurance, derivatives, liquidity arrangements, “special purpose vehicles,” CDOs, and such – the enormous growth in “structured finance.” As we have discussed repeatedly, these profound Credit system developments created a paradigm shift in regard to risk intermediation and systemic Credit availability, especially in the securities markets. Such momentous developments absolutely beckoned for diligent analysis and careful consideration by the Greenspan Fed. The Fed’s erred by responding to this paradigm shift with full support and accommodation.

Recently Greenspan made the comment that it is the Fed’s role to react to the structure of the markets. I read this as confirmation of our view that of the Fed’s new priority of managing market “liquidity.” Admittedly, having over years fully accommodated the securities markets and Wall Street as they supplanted banking system predominance, the Fed has little alternative. But this concession to Wall Street goes much beyond just ultra-fine tuning. No longer is Fed policy seeking to influence control through bank lending to commercial enterprise – adjusting interest rates and lending capacity in a transmission mechanism operating on real economic returns. Rather, policy acts on interest rates and spreads, largely impacting securities markets and aggressive financial players. Financial and speculative “profits” provide the key (dysfunctional) transmission mechanism to the real economy. Interestingly, in some of the earliest discussions of the role of central banking in Britain, it was recognized that one of the dangers of allowing central bank discretionary powers was that previously misguided policies would only create the opportunity for only greater discretion and the precarious compounding of errors. Wow, we have witnessed precisely this risk play out in spades.

Thinking back to Minsky’s above comments, Fed policy and financial system developments have profoundly and negatively affected economic relations and debt structures. And that is precisely the insuperable dilemma. The Fed missed its opportunity to preserve its limited control over a rapidly evolving market-based Credit system, while also failing to squelch insidious leveraged speculation and resulting asset Bubbles. Indeed, instead of squelching it nurtured, and the monetary disorder genie was let out of the bottle. Today, leveraged speculation has become “too big to fail.” This regrettably ensures that flawed policy is locked in nourishing dysfunctional processes, with reverberations throughout the financial system and economy. And as long as expanding mortgage and consumer debt provides the securities of choice for the leveraged speculators, apparently that’s what the system’s going to create in excess – the powerful financial infrastructure and indelible processes assure it. That the nature of this Credit excess does anything but promote long-term economic growth or financial stability doesn’t even factor into the equation. The bottom line is the system is impaired and the transmission mechanism hopelessly perverted, with failed policy frozen in the headlights. But we’ll be the first to admit that the U.S. financial sector maintains its extraordinary capacity to create its own liquidity. The outcome is, however, only further impairment to an already acutely fragile U.S. debt structure.