That’s So Money

I wanted to be a littler more explicit about my last post.

My core position is that the money supply is determined not only by the quantity of instruments that can be used as money, but by their quality. If a privately issued financial instrument is held in high enough regard, held by enough participants and priced quickly and easily then it is natural for it to become used as money.

What makes money “good” is that I can readily turn it into stuff. What makes legal tender really, really good is that the entire system of property rights in the United States is backed by a judiciary that will accept legal tender as payment. However, legal tender is not magic.

If for some reason people began to question the veracity of the judicial system’s enforcement of property rights settled in legal tender or, if rapidly rising prices made it next to impossible to actually establish property rights in the legal tender then its use as money would collapse.  Cash would lose its liquidity.

Consequently, it is possible for the money supply to fall even if the quantity of monetary aggregates stays constant. We could witness all the signs of severe monetary tightening even when we see no weird behavior in M1, M2, MZM, etc. This is because the quality of the components is falling.

Now alternatively one could simply argue that I am not describing a fall in the money supply but a rise in money demand. In this case we are fixing the definition of money as one of the aggregates.

Analytically this is fine so long as we now allow that money has a derived demand coming out of the market for liquidity generally. As substitutes for money collapse in supply, the price of those substitutes rises and hence the demand for money rises. You get the same answer.

However, I think it makes more sense to think of money generally as a provider of liquidity and to see a collapse in the liquidity of certain instruments as a fall in the supply of money.

The key is that we can have a monetary shock that comes not from a change in the aggregates but a change in the quality of financial instruments.

Going to the tape, we see nothing particularly abnormal going on in the aggregates leading up to the fall of 2008.

I’ll stop the chart right at September 15th, 2008 to highlight that there was no noticeable pre-Lehman change.

Now stretch the timeline to October 1st.

Certainly there is no contraction evident. This is also 5 days before the Federal Reserve announced that it would pay interest on reserves, so this looks like genuine increases in the aggregates.

Now lets look at measures of the quality of some instruments. Here is the interest rate on financial paper vs. the Fed Funds rate.  Again this first graph stops on September 15th, 2008.

As we can see they traditionally move in lock step. Indeed, part of the reason there is any offset at all prior to the crisis is that these are weekly series and one counts the week ending Friday, while the other counts the week ending Wednesday.

However, we do see trouble brewing as we move through the Summer and into the Fall of 2008. Financial Paper is trading consistently higher than reserves. Questions about its quality are being raised.

Now lets move to Oct 1st, 2008.

Oh, now that’s not good. They are moving in completely opposite directions. The quality gap between financial paper and cash is exploding. Financial paper is losing its money like properties.

Another way we could say this is that there was a run on the financial paper markets. I don’t see this as being in any different than a traditional run on a depository institution or traditional bank. Runs on the banking system occur when checkable deposits lose their money like properties.

Thus, a credit crisis that destroys trust in the financial system spawns a liquidity crisis because the financial system generates privately produced liquidity. This is why the idea of separating out excess demand for money, bonds and credit quality seems inappropriate to me. These properties are mixed up and depend on each other.