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Cash is King! Wait a minute …

November 7, 2018

In 1913, on the heels of the then-worst financial crisis in U.S. history, Congress created the Federal Reserve. At the time, the Fed was conceived principally as a ‘lender of last resort,’ a source of liquidity (cash) in the event of widespread bank runs like those that erupted in the Panic of 1907.

Over time, the importance of this beast for the supply of money and credit, and, in turn, interest rates, became increasingly apparent. In the 1977 Federal Reserve Reform Act, Congress developed a directive for the Fed in conducting monetary policy that still exists today.

Section 2A of the Federal Reserve Act is a one-sentence section titled “Monetary Policy Objectives.” It reads:

The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.

So our Congress, in its infinite wisdom, has seen fit to direct 12 people to control the total amount of money and credit for more than 300 million people.

Faced with such a task, you have to try to count all that stuff up somehow. The Fed has developed accounting for money in its ‘monetary aggregates,’ which are also referred to as measures of the ‘money supply.’

Last week, Steve Hanke of Johns Hopkins University penned an article for Forbes titled “The Fed’s Misleading Money Supply Measures.” Hanke is a monetarist, someone who believes in the central importance of money as a driving force in economic growth and inflation. Hanke thinks money is important, and also thinks that the Fed doesn’t do a good job adding all that stuff up.

In his article, Hanke introduces the work of William Barnett, an economist who has led the development of alternative monetary statistics. In his 2012 book “Getting It Wrong,” Barnett tells the history of his work in this area as an economist at the Federal Reserve Board of Governors, as well as the story of his departure from the Fed.

Barnett makes a case that the Fed wrongly adds different things up at the same weight when accounting for money. The Fed’s narrow M1 aggregate basically includes cash circulating outside of banks as well as demand deposits in bank accounts. From there, the Fed produces (at least historically) progressively broader (and larger) aggregates of money. For example, M2 adds savings deposits and individual savings in money market mutual funds to M1. And the Fed used to report M3, which added other stuff (like institutional money market funds, Eurodollars, repos, and time deposits) to M2.

Barnett’s concern has been that the Fed has been accounting for all these different types of money at equal weights, when different types of money have different degrees of ‘moneyness.’ He has developed statistical measures adjusting different types of money at different weights, and believes they are a more valid representation. Hanke’s summary of his argument is that broader measures of money supply are important, but they should also discount the weight of progressively broader types of ‘money.’

I’m going to argue that this argument should matter, fundamentally, for ‘narrow’ measures of money as well – and in the line item at the top of the balance sheet for companies as well as state and local governments. That line-item is called “Cash and cash equivalents.”

Cash includes two main things – currency circulating outside of banks, and deposits in banks.

And speaking of adding up unequal things at equal weights, consider what people thought of these two things at the time of the Panic of 1907. Did they think they were equal? Far from it. People were panicking! They wanted the good stuff, not the bad stuff.

From there, generally accepted accounting principles enshrined a fundamental falsehood at the top of the balance sheet, inviting decades of government subsidies, interventions, regulations, and bailouts designed (in principle) to try to make these unequal things equal. In turn, these interventions generated moral hazard driving our latest and greatest financial crisis, and continued risk in our financial system today.

Question: If “cash” is not equal to itself, how can “cash equivalents” even exist?

“Cash is King!” they say. Perhaps Cash really is king-like, given that arbitrary tyrannical authority ends up determining if it is really cash or not.

More to follow …

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