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Tuesday, May 12, 2009

How is M2 Calculated?

Previously, someone asked me:

How are M0/M1/M2 calculated?

Banks are required to report their total balances to the State every day. More specifically, they are required to report this to Federal Reserve auditors every day.

Here is how the bank clearing system works. Consider Bank of America and Citigroup. Suppose Bank of America customers wrote $50M of checks cashed by Citigroup customers today, and Citigroup customers wrote $25M of checks cashed by Bank of America customers. Then, $25M must be transferred from Bank of America to Citigroup. Bank of America reports a transaction of "$25M to Citigroup" to the Federal Reserve. Citigroup reports a transaction of "$25M from Bank of America" to the Federal Reserve.

Suppose there was an error. Bank of America reports "$25M to Citigroup" and Citigroup reports "$25.1M from Bank of America". Then, the discrepancy of $100k must be investigated and audited.

Without such transactions reported to the State, fraud would be easy. Bank of America could claim it had $1B more than it actually did. Without the Federal Reserve auditing deposits, banks could make up whatever number they wanted. Notice that such fraud is only possible with fiat money. With a gold standard, a bank cannot commit fraud because its customers would start demanding physical gold.

The Federal Reserve also audits bank balances to make sure they are not violating the "10x reserve ratio" requirement. As part of this auditing process, banks must report their balances to the Federal Reserve.

M3 was only slightly more work to collect than M2. The Federal Reserve stopped reporting M3 because they wanted to cover up how bad inflation actually is. Compared to M2, M3 includes balances over $100k and dollar balances in foreign banks. The Federal Reserve must still track dollar balances held by foreign governments. Otherwise, China could lie and claim it had $2T in dollar assets instead of $1T.

There's your answer. Banks are required to report all aggregate interbank transactions to the State. Banks are required to report their net assets to the State every day. This is a fraud prevention precaution. This also allows the Federal Reserve to calculate M2.

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