"GDP" is Complete Nonsense.

[Gumby]

My counter point (really just trying to clarify my own understanding) is I’m not sure M1 truly reflects the full expansion (or now contraction) of money&credit (combined) in the economy as it measures primarily only commercial banks and hence my attempt to use MZM.

I am viewing money from a practical standpoint of money/credit that is held/available as one available lump which is spendable and I think the whole lump expands/contracts with fractional reserve lending, and moves the economy with it.  While I understand MZM does not reflect true money, I believe it is close in showing the broadest measure of money, money&credit, in the economy that is still available.

I need to work on making clearer the expansion of spendable money&credit and better show the link/effect that fractional lending has in driving it.  

I appreciate discussion and help clarifying thoughts.  One question, where does the 40/1 leverage that Wall Street uses come from?

Great conversation. I too am in the process of clarifying my own understanding. We all are!

I'm just not sure that we should confuse fractional reserve banking with the Shadow banking system. They are very different.

Fractional reserve banking is highly regulated and rather boring — I don't see any risk of an out of control multiplier there.

The shadow banking system is far more dangerous. It's where the 40:1 leverage comes from:

By definition, shadow institutions do not accept deposits like a depository bank and therefore are not subject to the same regulations.
...
Shadow institutions are not subject to the same safety and soundness regulations as depository banks, meaning they do not have to keep as much money in the proverbial vault relative to what they borrow and lend. In other words, they can have a very high level of financial leverage, with a high ratio of debt relative to the liquid assets available to pay immediate claims. High leverage magnifies profits during boom periods and losses during downturns.

Shadow institutions like investment banks borrowed from investors in short-term, liquid markets (such as the money market and commercial paper markets), meaning that they would have to frequently repay and borrow again from these investors. On the other hand, they used the funds to lend to corporations or to invest in longer-term, less liquid (i.e., harder to sell) assets. In many cases, the long-term assets purchased were the mortgage-backed securities sometimes called "toxic assets" or "legacy assets" in the press. These assets declined significantly in value as housing prices declined and foreclosures increased during 2007-2009.

In the case of investment banks, this reliance on short-term financing required them to return frequently to investors in the capital markets to refinance their operations. When the housing market began to deteriorate and the ability to obtain funds from investors through investments such as mortgage-backed securities declined, these investment banks were unable to fund themselves. Investor refusal or inability to provide funds via the short-term markets was a primary cause of the failure of Bear Stearns and Lehman Brothers during 2008.

In technical terms, these institutions are subject to market risk, credit risk and especially liquidity risk, since their liabilities are short-term while their assets are more long term and illiquid. This creates a potential problem in that they are not depositary institutions and do not have direct or indirect access to the support of their central bank in its role as lender of last resort. Therefore, during periods of market illiquidity, they could go bankrupt if unable to refinance their short-term liabilities. They were also highly leveraged. This meant that disruptions in credit markets would make them subject to rapid deleveraging, meaning they would have to pay off their debts by selling their long-term assets.

The securitization markets frequently tapped by the shadow banking system started to close down in the spring of 2007 and nearly shut-down in the fall of 2008.
Source: http://en.wikipedia.org/wiki/Shadow_banking_system

I may be wrong, but when I think of MZM, I think of Money Market Funds just being used to multiply credit/liquidity within the shadow banking system — and artificially multiplying the size of other people's money market funds with profits from Wall Street shadow banking leverage. My limited understanding of the shadow banking system is that it really isn't "money" at all — it's just an enormous pile of credit/liquidity backed by money market funds invested in Commercial Paper, repos, etc. But, if the shadow institutions don't actually hold any deposits, then where do our us dollars actually live when you put them into a Money Market Fund? Don't my dollars in a Money Market Fund have to live in M2?

This is usually where my head explodes. I think that when you put dollars into a Money Market Fund, your dollars are exchanged for Commercial Paper, repos and some T-Bills. Well, the T-Bills are no longer a deposit anywhere, since you just handed the money back to the government to be re-spent as new money. When you exchange dollars for Commercial Paper, the dollars have to go somewhere. I imagine the dollars are exchanged for Commercial Paper and briefly transferred to the issuing company's bank account and then the money is spent on payroll and then it finds its way into the bank accounts of employees. Or its deposited into a bank account and leveraged 40:1 into toxic assets and that money is exchanged for securities on the open market and people take that money and some of it finds its way into bank accounts as deposits. And of course Repos are loans.

So, it seems reasonable to me that when you put money into a Money Market Fund, you are basically feeding the shadow banking system. But, I believe that the actual "dollars" that go into a Money Market Fund have to live in some kind of bank account somewhere. I don't know where else the dollars would live unless they are returned to the Treasury as T-Bills.

When you put your money into a bank, as a deposit, there's not much risk of it being lent many times over in a reckless fashion. Though, I'm sure the money invested into Bank CDs are invested into bonds and the shadow banking system for higher yield.

In any case, I think you are (or should be) lamenting the shadow banking system, but perhaps unfairly blaming the fractional reserve banking system.

Of course, if it weren't for the shadow banking system, there would be a big shortfall of liquidity for companies.

[align=center][/align]

The big problem of course is that the government still needs to bail out this highly leveraged and unregulated shadow banking system if it implodes.

[stone]

Are we all talking slightly at cross purposes? "Fractional reserve banking" is being used as a description of credit creation "bank created money". We all agree that increasing bank reserves does not lead to more "bank created money" so the money multiplier idea is bunk. What we don't seem to agree on is whether "bank creation of money" is a good or bad thing. "Bank creation of money" can occur because banks have  government endorsed permision to lend money that they do not have and the Fed stands by to fund any settlements via the discount window if needs must. As Gumby has pointed out, that bank action does not increase M1 all that much (only 3x) but it DOES increase M2 massively and also supports credit fueled asset bubbles.
What is the point of this bank mediated money creation? It is to ensure that banks decide who is entrusted with purchasing power rather than savers making that decision. The justification is that savers would be too careful and so valuable enteprises would not get funded. I think that is bunk. I can see that if "savers" meant a handful of oligarchs then that might be worse than the banks. To my mind the answer to that is to make sure that savings are very widely and evenly distributed amongst everyone. Then what does and does not get funded will reflect what everyone wants.

[Gumby]

As Gumby has pointed out, that bank action does not increase M1 all that much (only 3x) but it DOES increase M2 massively and also supports credit fueled asset bubbles.

I'm still not sure I follow. M2 is certainly much larger than M1 — after all, it includes more assets. But, it's not like M2 grows that much each year:

[align=center][/align]

On average, I think the PP has grown by a higher annual percentage than M2 has! I don't see a problem with M2. On the other hand, China's M2 growth is off the charts — and that is a big problem.

I still think the highly leveraged shadow banking system is the biggest culprit of our asset bubbles.

What is the point of this bank mediated money creation? It is to ensure that banks decide who is entrusted with purchasing power rather than savers making that decision. The justification is that savers would be too careful and so valuable enteprises would not get funded. I think that is bunk. I can see that if "savers" meant a handful of oligarchs then that might be worse than the banks. To my mind the answer to that is to make sure that savings are very widely and evenly distributed amongst everyone. Then what does and does not get funded will reflect what everyone wants.

I agree. I think it all comes down to having an easy way to satisfy the demand for loans.

[stone]

Gumby " On the other hand, China's M2 growth is off the charts — and that is a big problem."

To my mind what matters is if money grows faster than real economic activity. If somewhere starts off from a position of no-one having electricity or running water etc etc and moves to everyone having a refidgerator, a bathroom and regular bus travel etc etc, then massive  M2 growth might be entirely in step with price stability. On the other hand, if real economic activity is stagnant, then even modest M2 growth could indicate rampant bank expansion with increasingly unsustainable indebtedness.