Who Killed M3?

Not long ago I wrote a post about a National Bureau of Economic Research study that blamed the Great Recession on a bank panic rather than that usual suspect, the sub-prime mortgage crisis. There was a sub-prime crisis, sure, but it was just the catalyst for the much more damaging bank panic that followed.

All this relates back to a little-noticed structural change in the U.S. banking system where Nixon-era deregulation led to the growth of money market funds that killed the savings deposits that had traditionally backed most bank lending. Rising to replace savings (and make a lot more profit) was loan securitization and REPO collateralized inter-bank lending enabled by Reagan-era deregulation. The Great Recession was caused by the banks all losing faith in each other, with commercial lending grinding to a halt as it continues to in many places even today.

Heck of a story, eh? Now that I had a better understanding of the actual crisis, I immediately began to wonder how we can avoid it happening again?

We can't.

Government doesn't have the tools to do so, which it hates to admit. At best, the efforts of Paulson, Bernanke, and Geithner reduced the severity of the crisis and helped the economy get back to something closer to equilibrium. In practice, not even the Fed has enough financial clout to fix a $20 trillion problem. They pretended they did, and continue to pretend so, but the truth is that all the balance sheet expansion and stimulus spending was a bandage just intended to reduce panic in the markets until they could regain natural equilibrium. And none of the reform proposals being floated in Congress do much to change this in the future. So if Geithner and Bernanke look like dopes because their efforts haven't handily solved the problem, returning us to positive economic growth, it isn't really their fault. Nobody else could do it, either, with the tools they have available. And that's the rub, because to admit so is to embrace anarchy, which is not part of the platform of either party.

I also wondered why we didn't we see this coming? As Michael Lewis explains in his new book, "The Big Short", plenty of people did see it coming and backed that vision with investments against the mortgage market that made them billions. But that was the mortgage market. Who saw the whole REPO problem emerging?

We all did, but then we deliberately shut our eyes.

The REPO, or repurchase, market had been growing strongly since 1990 -- growing at a rate high enough to cause concern for both markets and governments. We could see it growing in a number called M3, which was one of three measures of the total money supply, along with M1 and M2, which were released by the Fed in a report every quarter.

Notice I said were released -- past tense. M1 and M2 still are released every quarter, but M3 -- the only public measure of the REPO market available anywhere, stopped being published by the Fed on March 23, 2006, ostensibly to save money.

M3 was one of the oldest statistics released by the Federal Reserve, dating almost all the way back to the bank's founding. It was the only financial index ever retired by the Fed. Yet killing M3 seems to have been important to the George W. Bush Administration -- so important it was used as a loyalty test for Fed chairman nominee Ben Bernanke during his confirmation hearings in the Senate.

Bernanke supported the idea of dropping M3, saying it wasn't very useful and getting rid of the index would save $1.5 million per year.

Aren't we glad we saved all that money?

M3 would have shown us the asset bubble growth in 2007 and 2008 and taking the second derivative of that growth could have predicted approximately when that bubble would pop.

By dropping M3 the Bush Administration was deliberately blinding both itself and the markets -- poking out eyes apparently to keep the good times rolling for a few months longer. Only research will reveal the nuances of this decision, but it is research that should be done.

M3 offered an inconvenient truth about financial deregulation as it was done in the 1980s -- that it was leading us ultimately toward disaster -- but the Bush White House viewed that truth as inconsequential or they simply didn't care.

If there is a smoking gun here it is the end of M3. How did it happen? Why did it really happen? What would things have been like had M3 survived? And since the only part of M3 to actually die was its public report, how did the Fed of 2007-2009 feel about the data formerly known as M3, which it still holds closely to its vest?

Why didn't the Fed, itself, sound an alarm?

We had a dozen or more chances to avoid the Great Recession but we didn't. The lessons it has taught us include the fact as things stand now that we won't be any better prepared to deal with it the next time.

And as a long succession of bank panics have shown us, there will always be a next time.

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