Thursday, June 3, 2010

The Murphy Submarine Attack

Like the edgy truce between North Korea and South Korea, you just knew that the occasional verbal Wenzel-Murphy battles  would eventually flare up again. And they have.

Murphy, in a role not far from that of  North Korean president Kim Jong II,  demonstrates a certain lacking with regard to understanding of the free market system, but has none the less fired off a torpedo.

In my post, Shostak Inconsistencies,where I discuss why money market funds should be considered a part of the money supply, Murphy questions this thesis by stating in the comment section of the post that it would not boost the M1 money supply if someone withdraws funds from a money market and puts the funds in a bank checking account. Oh really?! It would. Here's why.

First, Murphy is assuming that some non-cash obligation would have to be sold off by a mutual fund in order to meet the demand of a mutual fund shareholder. This does not have to be the case,  a mutual fund will always tend to hold cash to meet any expected withdrawal demands. Thus, what happens when a shareholder moves money from an MMF into a checking account is that the cash supply stays the same in that the MMF transfers the cash it holds over to the bank. This part of the money supply, thus is not impacted up or down. There is a decrease in the cash held by the MMF, and an increase in the amount a bank can loan out.

But suppose that the MMF did not hold cash and had to liquidate some asset to raise cash. This agian results in no net change in cash levels. If the MMF sold off an asset for x dollars, then the purchaser of the asset no longer has the cash but the MMF has the cash that will soon be transferred to the MMF shareholder that will end up at the bank. Nothing is disturbing the quantity of money at all here. It is net neutral as far as money supply adjustments are concerned.

But the picture is very different for the former MMF shareholder who now has his money in a bank checking account (as opposed to the MMF). Not only is the cash he has deposited with the bank part of the money supply (since the bank will loan it out) BUT the checking account of the former MMF shareholder is now part of the money supply. Viola M1 has increased.  Remember that when it was registered as just an MMF account it did not show up in M1, just M2. Now by being transferred, it is boosting the M1 figure. This  has confused a lot of those watching money supply, who don't realize that it is just being transferred from one type of money form to another. To them the huge boost in M1 that was caused by a withdrawal of funds from MMFs is an inflationary indicator, to me it's misunderstood accounting.

The second point Murphy raises is how does an MMF shareholder actually pay a bill with MMF shares and not cash. The answer is, it is done all the time. MMF provides shareholders with checks. The MMF shareholders use these checks to pay bills. The "check" is actually the passing of x number of shares that the shareholder owns to the payee. The thinking behind such a transaction would be an instruction to the MMF along the lines: "By issuing this 'check' I am turning x number of shares over to payee, that will be redeemed by the payee for cash". I suppose you could argue the technical legal point of when does the check represent cash and when is it shares, but the de facto point is that the payee has taken the check as cash and the shareholder views it as money being paid from his MMF account.

For this second point we could again go through the exercise of following the real cash around that goes up in one account and down in another, and whether the payee ultimately puts the funds with a bank (which would boost M1) or with a MMF of his own (which would not boost M1). But the key point remains, MMFs should be considered part of the money supply, and movement of funds from MMFs to bank demand deposit accounts distorts the M1 money supply growth numbers.

1 comment:

  1. I'm 95% sure you're going down on point #1, Wenzel. (Did you see Kim Jong Il vs. Hans Blix in the movie Team America? Be afraid.)

    I am willing to believe point #2, I said as much in the original comments. My biggest expense is Whole Foods so I wouldn't know.