The Muddy Tea Leaves of M2
When the Fed moved to lower interest rates on Aug. 6, the reason most frequently given was that M2, which measures the nation's holdings of cash and in checking and savings accounts, seemed to have stopped growing.
To many minds, this monetary hiatus portends a doubledip recession, for the accepted wisdom is that economic activity follows M2 changes with a time lag of perhaps six months (or one year, or two years, or whatever is necessary to make the curves fit).
But M2 may have become as meaningless a monetary aggregate in the United States as it was in Britain in the early 1980s, when the Bank of England abandoned it as a policy tool, and perhaps everybody should stop worrying about it.
Times Have Changed
M2 has become an erratic predictor because the banking system in which it is created has been buffeted by so many winds and shifting tides. The S&L industry, if not dead, is sick enough to be losing a lot of weight. And S&L deposits are part of M2.
Depositors in banks are feeling what one of the bonds-to-the-people investment houses calls "CD shock" and are moving their money to collateralized mortgage obligations, which are offering 9% returns.
The banks don't miss the CDs, because the banks are selling off assets to improve their capital ratios without actually raising new capital or retaining earnings.
"Disintermediation" used to refer to money-market funds taking money out of bank deposits. Now it refers to banks selling off to companies and households as "asset-backed securities" the sort of loans they used to make with corporate and household deposits.
Repercussions of Resolutions
Meanwhile, the Resolution Trust Corp. and its kissing cousin the Federal Deposit Insurance Corp. have changed the mix of assets in many banks and S&Ls in ways that reduce their need to increase their deposits to make new loans.
When the RTC or the FDIC sells a busted S&L or bank, as part of the deal it buys back from the acquirer the most moribund (and hence the most illiquid) assets in the shop. The government becomes the proud owner of all those bad loans and unsallable real estate, and the purchaser of the defunct S&L or bank gets cash for the full book value of the garbage.
Under the new capital adequacy rules, however, the acquiring bank or S&L may not be able to use this money to expand its portfolio of commercial and industrial loans.
In theory, such loans must be backed with almost $8 in the bank's own equity and subordinated debt for every $100 loaned, and the bank may not have enough capital to expand in that way.
The New Appeal of CMOs
The solution is to buy federaly-guaranteed collateralized mortgage obligations from the Federal National Mortgage Association or the Federal Home Loan Mortgage Corp., which require only $1.60 of capital for each $100 owned.
In the year after it acquired First Republic in Texas, with immense government subsidy, NCNB became the nation's largest holder of Fannies and Freddies.
If the bank chooses to hold Treasury paper, or government bonds from any of the Organization for Economic Cooperation and Development countries, it can expand its asset portfolio without adding any capital at all, because such paper carries a zero-risk weighting in the regulators' bookkeeping.
Subtracting One Step
None of these activities extinguishes money. Not even the repayment of deposits does that, because the repaid depositor puts the money into another bank or buys a piece of paper, giving the cash to the seller, who will put it into another bank.
Money disappears only when the government runs a surplus and the Federal Reserve sells from its portfolio.
But the purchase of government paper does take a step out of the multiplier process by which Fed purchases in the open market are supposed to generate eight times their weight in M2. This is why we could finance half the cost of World War II by borrowing - selling Treasury paper to banks that bought it with funds supplied by the Fed - without major inflation.
But banks that are now lending into the early phases of the recovery do not have to raise new deposits to fund the loans. This is because the banks are once again heavy with paper that they can sell.
Lesson of the 1950s
Economic activity rose in the 1950s without comparable growth of M2. A theory at the time purported to explain this. It held that as a society became more prosperous the velocity of money declined, because people growing wealthier kept more cash in their pockets.
The real reason was that the banks had come out of the war heavily stocked with Treasury paper and could fund new lending by selling Treasuries.
The good news is that the securitization of bank assets may restore some of the Fed's faded macroeconomic powers, because securities holdings for any but regulatory purposes are worth their market value rather than their face value.
Thus the Fed, by lowering interest rates, can make banks eager to sell paper from their portfolios (earning a profit) and lend the money to business - and by raising interest rates can choke off lending by banks that are reluctant to sell paper at a loss. William McChesney Martin's Fed of the 1950s and 1960s was able to slow or start the economy with much less effort than Paul Volcker's or Alan Greenspan's Fed.
Seeking Government Security
But for the time being, a banking system watching insurance companies fall prey to illiquidity wants to use the cash created by the RTC and by the Fed to build a growing security blanket of government and government-guaranteed obligations.
And because the Fed has as a first objective the profitability of the banking system, it hesitates to press the banks to lower the rates they charge when lending.
To the extent that we want lower interest rates to stimulate the economy, the best course for the Fed now is clearly to jawbone the banks into passing on to borrowers the enormous benefits received from the decline of the federal funds rate - a decline that expresses the high degree of liquidity in the system.
The Bank Reform Bill
What the big banks want this fall, of course, is legislation that gives them added powers and a federal safety net that extends to their funding of the subsidiaries that will use these powers.
This is roughly what they have under the bills introduced by the Treasury and mostly approved by both the Senate and the House banking committees. The famous "firewalls" that are supposed to separate the insured banks from the uninsured subs are strictly paper, and pretty flimsy paper at that.
"In times of stress," E. Gerald Corrigan of the Federal Reserve Bank of New York warned a House committee in April, "firewalls will become firestorms."
Bill Martin could regulate by lifted eyebrow. Given the political situation, Mr. Greenspan right now could probably get the banks to change their behavior by blinking.
If public policy calls for lower interest rates for borrowers in the nonfinancial sectors, the Fed can easily arrange them without pumping up the money supply. If it would be desirable to shift some of the banks' portfolio from Fannies and Freddies to commercial-and-industrial loans, the easiest procedure would be to let these mortgage derivatives carry the same 50% risk weighting allotted to mortgages themselves. This might even make M2 grow faster.
But the problem is not M2. The problem is the banks' portfolios. Unless the administration and key congressmen and commentators understand that M2 ain't what she use to be, and that the future is not to be found at the bottom of this teacup, we could soon find ourselves again deep in the hole that the Carter Treasury and Fed Chairman William Miller dug in 1978.
Mr. Mayer is the author of "The Greatest-Ever Bank Robbery," published by Charles Scribner's Sons.
