It was another unsettled week for the U.S. equity market. For the week, the Dow finished largely unchanged, while the S&P500 added about 1%. The Morgan Stanley Cyclical index was marginally higher, the Morgan Stanley Consumer index marginally lower, and the Transports and Utilities ended both down about 1%. The broader market was slightly in the negative column, with the small cap Russell 2000 and the S&P400 Mid-Cap indices both declining about 1%. The technology sector was mixed, with the NASDAQ100 adding 2% and the Morgan Stanley High Tech index declining 1%. The Semiconductors dropped 4%, the NASDAQ Telecommunications index dipped 2%, and The Street.com Internet index declined 1%. The Biotech index added 1%. The financial stocks performed strongly this week, the S&P Bank index jumping 5% and the AMEX Securities Broker/Dealer index adding 4%. Although gold added a dollar this week, the gold stocks took it on the chin, with the HUI index sinking 8%.

The credit market rally continued this week, with 2-year Treasury yields dropping 7 basis points to 3.90%. Five-year Treasury yields dropped 9 basis points to 4.60%, while the key 10-year yield declined 11 basis points to 5.12%. The long-bond saw its yield drop 10 basis points to 5.58%. Mortgage-back securities underperformed, with yields declining 8 basis points. Agency yields declined about 12 basis points. Corporate bonds underperformed, with Junk bond yields generally widening six to eight basis points. The dollar gained marginally this week. The benchmark 10-year dollar swap spread widened 3 to 86. Commodities suffered another poor week, with the CRB index declining almost 2%.

The Office of the Comptroller of the Currency reported this week that total U.S. commercial bank derivative positions increased $3.4 trillion (8%) to $43.9 trillion during the first quarter, the largest increase since the tumultuous fourth quarter of 1998. Interest rate derivative positions increased $2.8 trillion to $35.7 trillion, including swaps that increased $1.7 trillion to $23.6 trillion. Total interest rate derivative positions grew 18% during the past year. J.P. Morgan Chase easily leads the pack, with total derivative positions of $24.6 trillion, including $14.3 trillion of swaps. Bloomberg quoted Michael Brosnan, OCC comptroller for risk evaluation: "These numbers are rather eye-popping. It's difficult to grow at that pace when you have such a large underlying base." Yes it is, although derivative growth is necessarily consistent with the continued expansion of financial sector borrowings.

During May, Freddie Mac expanded its portfolio at an 18% annualized rate to $438 billion. Total outstanding Freddie Mac mortgage exposure also increased at an 18% rate to $1.026 trillion. With the ultra-availability of mortgage credit, housing starts are on pace for the second-strongest performance since 1986. So far this year, over $350 billion of mortgage-backed securities have been issued, on track to challenge 1998's record $727 billion. Yesterday, the Commerce Department reported a $110 billion current account deficit for the first quarter (more than 4% of GDP), up from the $105 billion during last year's first quarter.

"Personal savings has been a major problem in this country for a protracted period of time. As you know, as a consequence we are effectively borrowing a significant amount of savings from abroad, which is our current account deficit. The reason it hasn't shown up as a significant economic problem is that we have really an extraordinary degree of productivity from our savings in the sense we have managed to use it in a very - our limited amount of savings in very effective ways. The type of capital that we are producing tended to be the high productivity-producing capital. So in part, because of our financial system and, indeed, our banking system in general, we have been able to direct the limited savings that we do have into the most effective uses. So in that regard, one must look at the American banking system as a very major player in our ability to improve productivity with, as you point out, a quite diminished level of domestic savings. Part of that is a result of the fact that we have created a very flexible system and we are able to allocate resources in a most effective manner." Fed Chairman Alan Greenspan, testimony before the Senate Banking Committee, June 20, 2001

Troubling confusion with the most critical issues of savings, money, credit and investment go to the very top of the Federal Reserve. To associate savings with resource allocation within the context of the contemporary U.S. credit system, is poor analysis. To claim effective management of savings and resource allocation is absolutely bizarre considering the recent implosion of the Internet sector - with the pilferage and reckless waste of valuable resources and consequential enormous financial losses - and now the widespread bankruptcies engulfing the telecommunications industry. Besides, the U.S. boom has been driven by an unprecedented explosion of money and credit, as is made patently clear from the Fed's own data.

The continued espousal of nebulous notions, such as the efficient use of savings and the major role played by the U.S. banking system in improved productivity, is most unfortunate. To us, this is only further indication that the Greenspan Fed is lost in a sea of flawed thinking and concepts. We continue to view the Fed's obvious and serious lack of understanding of some significant subtleties of contemporary money and credit creation as a major obstacle to sound and effective policy. I also cannot help but to view Chairman Greenspan's previous admission that it is neither possible to define nor manage the nation's money supply as at the very heart of the Fed's momentous failure to protect the soundness and stability of the U.S. financial system and economy.

I will begin my latest exploration of money and credit with a quote from Joseph A. Schumpeter: "The error involved consists in a confusion between the historical origin of money - which, in very many cases, although perhaps not universally, may indeed be found in the fact that some commodities, being particularly saleable, come to be used as the medium of exchange - and its nature or logic - which is entirely independent of the commodity character of its material." (Background and several of this week's quotes were drawn from Riccardo Realfonzo's excellent book, Money and Banking - Theory and Debate (1900-1940))

When it comes to analyzing contemporary money, I often feel like I spend about half my time focused on the realities of this extraordinary monetary environment, and the rest trying to better comprehend the path that has led to today's quite inadequate monetary doctrine. As such, I think a clearer understanding of the complexities of modern money requires a dual approach of logic and historical analysis. Money is as money does, and it is a residual of lending. It is very much a dynamic social convention, and is evolutionary in character. Contemporary money is credit, but a very special type of credit. To gain clearer insight requires a multifaceted perspective, diligently addressing institutional, structural, and historical aspects. However, the deeper I dig, the more I believe that perhaps today's conventional view of monetary matters suffers from too much ideology and an emphasis on how things have operated in the past. At this critical juncture in history, profound financial system developments dictate that logic and critical assessment become a much greater force in monetary analysis.

Early economic theorists generally placed only marginal emphasis on money, seeing it as a variable determined by economic activity and non-monetary factors. Almost as an afterthought, money was viewed as the consequence of savings - the positive outcome of productive undertakings. In the economic process, savings was always required prior to lending and productive investment; every loan was viewed as the result of a previously saved deposit. Money was seen as mainly impacting the general price level, with little lasting influence on either economic activity or relative prices. In many respects, money was a mere technicality of the exchange process, a "lubricant" bringing a more efficient payment mechanism to what had been a barter economy. And since gold and silver had been commonly used as money for generations, analysis was, not surprisingly, centered on a commodity-based monetary regime with a generally defined quantity of metal coins. Most saw money as necessarily possessing intrinsic value, but its main role was as an expedient for transactions - "medium of exchange." As an economic issue, money was certainly subordinate to production. The vestiges of this early framework remain to this day.

The late 1800's saw incredible growth, both in economic output and financial power. International trade flourished and capital flowed freely. It was a period of relative tranquility for a global financial system buttressed by gold convertibility. It was also a period of phenomenal growth in banking globally. Monetary theorizing began to more clearly focus on the mechanisms and implications of expanding bank deposits, notes, and "paper money." The nature and characteristics of money were more thoroughly explored, not as a metallic standard with intrinsic value but, importantly, as being merely a created symbol of available purchasing power. I will highlight quotes from the great economists Alfred Marshall and Knut Wicksell, both long ago raising issues that remain of great relevance today. They both brilliantly appreciated the evolution of money and the significance of the developing credit-based economy.

"I should consider what part of its deposits a bank could lend, and then I should consider what part of its loans would be redeposited with it and with other banks and, vice versa, what part of the loans made by other banks would be received by it as deposits. Thus I would get a geometrical progression; the effect being that if each bank could lend two-thirds of its deposits, the total amount of loaning power got by the banks would amount to three times what it otherwise would be. If it could lend four-fifths, it will then be five times; and so on. The question […] has not yet been thoroughly investigated by economists in any country." Alfred Marshall (issues raised in the 1880s, published 1926)

"[Banks] do nothing more than enter a figure into the account of the creditor under the heading 'credit granted', or 'deposit'. Thus, if cheques are presented against this credit, they merely enter the amount, as a deposit paid in (or a paid debit), into the account of the owner, in fact, this constitutes precisely the 'money supply'." Knut Wicksell, Interest and Prices, 1898

Recognizing bank journal entries as "money" was a radical departure at the time. It had taken decades for a consensus to develop that accepted bank checking deposits as money, appreciating deposits' effect on spending and economic activity. It was to take more time for the profound ramifications of the "multiplication" of bank deposits to be fully appreciated. Even then, it was generally accepted that bank "money" was only a surrogate for true metallic money, with most holding stubbornly to the doctrine that savings created deposits. Not surprisingly, it was the great Joseph Schumpeter that brought clarity to the analysis:

"It is much more realistic to say that the banks 'create credit,' that is, that they create deposits in their act of lending, than to say that they lend the deposits that have been entrusted to them…The theory to which economist clung so tenaciously makes them out to be savers when they neither save nor intend to do so; it attributes to them an influence on the 'supply of credit' which they do not have…Nevertheless, it proved extraordinarily difficult for economists to recognize that bank loans and bank investments do create deposits…This is a most interesting illustration of the inhibitions with which analytic advance has to contend and in particular of the fact that people may be perfectly familiar with a phenomenon for ages and even discuss it frequently without realizing its true significance and without admitting it into their general scheme of thought." Joseph A. Schumpeter, History of Economic Analysis (published 1954, but discussed much earlier)

Schumpeter understood clearly that the "nature" of money was found in the purchasing power afforded from bank journal entries and promises of payment - "credit money". But despite such great advancements in monetary theory, traditional notions nonetheless held firm that banks were merely collectors of deposits - purely operating as middlemen between savers and borrowers. Many still argued vociferously that banks could not create money. When it became clear that bank lending created the potential for a problematic multiplication of deposits, it was seemingly only the argument that changed. From A.C. Pigou (A Study in Public Finance, 1928): "In all circumstances the [credit] structure is limited by the size of the base, and this is not under the control of the bankers." Following this line of reasoning, banks did in fact expand deposits, but with mandated reserve requirements and a monetary based under the tight control of the central bank, this power was quite limited. And since it could be assumed that banks would always lend fully to the reserve-mandated limit, it was argued that the money supply was thus dictated not by bank lending but by the central bank supplying the system with additional reserves to lend against. Banks were seen as remaining merely "passive agents" of central bank policy and economic activity.

The following definition of an intermediary remains close to the consensus view:

"A financial intermediary is defined as an enterprise whose assets and liabilities consist almost exclusively of financial instruments. Such instruments would include loans and mortgages, stocks and bonds, bank deposits, savings and loans shares, insurance and pension contracts, commercial paper, shares in investment companies, and so forth. The function of financial intermediaries is to act as middlemen between savers and investors. They gather savings from individuals and businesses that make more than they spend and lend these savings to individuals, entrepreneurs, and government agencies that spend more than they make. Thus the liabilities of financial intermediaries are associated with 'savers,' and their assets tend to define 'investors.' From the social point of view, the chief problem associated with financial intermediation has always been how to bring in touch with one another the man who has capital funds and no enterprise and the man who has enterprise but no capital." (A History of Financial Intermediaries, Herman E. Krooss and Martin R. Blyn)

From the above quote, one could certainly incorrectly view intermediaries as passive participants in the economic process. The description does appear reasonable, notwithstanding the fact that it is flawed. Intermediaries are anything but simply "middlemen." And while there is today recognition of the significance of bank lending to economic performance, it has been like "pulling teeth" to get people to appreciate the powerful credit creation capabilities of the non-traditional intermediaries that have risen to great prominence. While off economists' and policymakers' "radar screen," non-bank credit creation has played a momentous role in fueling the current bubble. And just as theory was surprisingly slow to appreciate the power of banks to create money through journal entries and note issuance, it will apparently take time for proper recognition that a similar process now holds true for the entire expansive U.S. financial sector. In particular, the economic community has yet to appreciate the profound implications for the powerful positions attained by Wall Street and the GSEs in the nation's credit system. Moreover, few have explored the significance of this incredible power being intricately intertwined with their partners in the money market fund industry.

The contemporary monetary system, as detailed in the past, is largely one massive electronic ledger encompassing a myriad of institutions, securities, arrangements and vehicles. It is a pyramid of credit built on a base of credit. In past commentaries I have gone through journal entries, attempting to illuminate the current extraordinary capacity for monetary expansion. My sense is that I have only been somewhat successful. My presentations, often specifically excluding the banking system, were generally constructed for the purpose of dispelling the notion that only banks create credit. I hope that point has been adequately presented. Please bear with me as I work to refine this analysis, coming this time from a somewhat different angle and, hopefully, making this a more illuminating example of the Power of Money Market Intermediation.

Let's say Mr. Smith receives a $100 bill as a tax refund. Desiring interest on his "savings," he immediately deposits this $100 bill with the Bank of Morgan. Morgan accepts the $100 bill, and issues Mr. Smith a deposit ticket (Morgan accounting entries: debit $100 Cash; credit $100 Deposit Owed to Mr. Smith). Faced with paying interest on this deposit, Morgan immediately seeks to lend this $100 bill. Mr. Jones, seeking $100 for the purchase of a new home, borrows this $100 bill from Morgan (Morgan accounting entries: debit Mortgage Loan Owed from Mr. Jones $100; credit Cash $100). Mr. Jones then presents the $100 bill to Mr. Roberts in payment for his house. Note that if this example had incorporated a traditional reserve requirement, say 10%, Morgan's initial loan would have been limited to a $90. The succeeding loan (after the $90 was deposited) would be limited to (approx.) $81 dollars, and so on. Hopefully it is clear in this example how the money supply was expanded by the $100 loan, resulting in an increase of $100 of "immediately available funds"/purchasing power for Mr. Roberts.

Now, let's assume that Mr. Roberts deposits his $100 bill in Money Market Fund (MMF) (MMF entries: debit Cash $100; credit Deposit Owed to Mr. Roberts $100). The fund manager, seeking to place these "immediately available funds" in short-term credit market instruments, quickly contacts Fannie Mae. Always looking to obtain short-term financing to expand its portfolio, Fannie Mae agrees to borrow the $100 bill for one year. For this transaction, Fannie Mae issues MMF an IOU for $100 in exchange for the $100 bill. (MMF entries: debit IOU Owed from Fannie Mae $100; credit Cash $100 - Fannie entries: debit Cash $100; credit IOU Owed to MMF $100). Fannie is now in possession of the $100 bill ("immediately available funds"), which makes it possible for a mutually beneficial transaction between Fannie Mae - seeking to expand its mortgage portfolio - and Bank of Morgan - seeking to obtain liquidity for additional lending. Fannie then uses the $100 bill to purchase Mr. Jones' $100 mortgage loan held by Morgan. (Fannie entries: debit Mortgage Loans $100; credit Cash $100 - Morgan entries: debit Cash $100; credit Mortgage Loan Owed from Mr. Jones $100).

With the $100 bill received from Fannie, Morgan now has immediately available funds to loan $100 to Ms. Williams to purchase Ms. Case's home. (Morgan entry: debit Mortgage Loan to Ms. Williams $100; credit Cash $100). At this stage, the community Money Supply has increased to $300: $100 bank deposit held by Mr. Smith, $100 MMF deposit held by Mr. Roberts, and the $100 bill now in the possession of Ms. Case. Ms. Case could deposit her $100 bill in either MMF or Morgan. In the case of a $100 deposit with MMF, it should be clear that this then presents Fannie Mae with the opportunity to acquire $100 additional "immediately available funds" through the issuance of an additional $100 IOU (an increase of "financial credit"), allowing the lending and monetary creation to run unabated.

Now let's use a more complex example that includes Goldman Sachs. Smith Corp. receives a crisp new $100 bill as a tax refund. Smith immediately deposits these funds into Institutional Money Market Fund (IMMF) - (IMMF entries: debit Cash $100; credit Deposit Owed to Smith Corp. $100). Goldman's client Mr. Jackson wishes to borrow $100 of immediately available funds for the purchase of Ms. Hudson's home. Goldman issues an IOU to IMMF for $100, and takes possession of the $100 bill - immediately available funds (IMMF entries: debit IOU Owed from Goldman $100; credit Cash $100 - Goldman entries: debit Cash $100, credit IOU Owed to IMMF $100). Goldman then lends these funds to Jackson (Goldman entries: debit Mortgage Loan Owed from Jackson $100; credit Cash $100). The immediately available funds - $100 bill - are then presented to Ms. Hudson, who for our purposes immediately deposits the money into IMMF (IMMF entries: debit Cash $100; credit Deposit Owed to Ms. Hudson).

All is swell as real estate and stock prices rise and the economy booms. Eventually, heightened financial stress leads the Fed to lower interest rates, while Fannie Mae moves aggressively to expand its mortgage portfolio. Here, Fannie issues an additional $100 IOU and again borrows "immediately available funds" - the $100 bill - from IMMF (Fannie entries: debit Cash $100; credit IOU Owed to IMMF $100 - IMMF entries: debit IOU Owed From Fannie Mae $100, credit Cash $100). Fannie then proceeds to use these immediately available funds to purchase Mr. Jackson's mortgage held by Goldman Sachs. (Fannie entries: debit Mortgage Loans $100; credit Cash $100 - Goldman entries: debit Cash $100; credit Mortgage Loan Owed from Mr. Jackson $100). Goldman then has $100 of immediately available funds ($100 bill), which it uses to purchase stock from IPO Client. IPO Client then deposits the $100 bill in IMMF (IMMF entries: debit Cash $100; credit Deposit Owed to IPO Client $100). IMMF now holds deposits for Smith Corp, Ms. Hudson and IPO Client.

Fannie Mae then issues another IOU for $100 to IMMF, takes possession of the $100 bill (Fannie entries: debit Cash $100; credit IOU Owed to IMMF $100 - IMMF entries: debit IOU Owed from Fannie $100; credit $100 Cash) and purchases $100 of new refinanced mortgages, replacing old mortgages held by Hedge Fund. (Fannie entries: debit Mortgage Loans $100; credit Cash $100). Hedge Fund then accepts the $100 bill and deposits these immediately available funds with IMMF (IMMF entries: debit Cash $100; credit Deposit Owed to Hedge Fund $100). The $100 bill is then again available to Fannie, or perhaps it will provide immediately available funds for Hedge Fund to take a leveraged position in higher-yielding mortgage-backs, CDOs (collateralized Debt Obligations), corporate bonds, or credit card securities. Goldman may decide to increase its leverage, borrowing the $100 bill short-term and taking a speculative position (interest rate arbitrage) in long-term securities such as a Fannie Mae bonds. Here, Goldman would issue a short-term IOU to IMMF backed by these bonds (repurchase agreement), and the seller of the securities would then possess $100 of immediately available purchasing power.

It is not important to tabulate the total deposits created (increased money supply) in the above examples, but only to appreciate that the contemporary U.S. credit system possesses the extraordinary capacity for unlimited monetary expansion through the process of unfettered issuance of financial sector IOUs. Lending unconstrained by reserve or capital requirements creates what I refer to as an "infinite multiplier effect" for money fund deposits. In truth, these "IOUs" are electronic journal entries, but hopefully this illustration using a $100 bill demonstrates the creation of additional purchasing power through financial credit creation (financial sector leveraging). Any institution or entity with the ability to create liabilities acceptable as money market fund holdings possesses the capacity to create "immediately available funds" - an expansion of deposits creating additional purchasing power. This includes the banks, finance companies, captive finance companies such as GE Capital and GMAC, the Wall Street brokerages, and the GSEs, as well as sophisticated "structured finance" vehicles such as "funding corps" and asset or mortgage-backed security trusts. Today, there is $1.228 trillion of outstanding financial sector commercial paper, with the vast majority of the $2.1 trillion of total money market fund assets backed by financial sector liabilities.

The "old days" of money market funds financing high quality short-term and liquidating corporate credits (financing seasonal inventory expansion, for example) has evolved into the current role of funding an ever-expanding inventory of security holdings. Importantly, the money market fund intermediation mechanism (transforming financial sector liabilities into deposit money) has become a most critical aspect of the contemporary credit system, whereby financial institutions create immediately available funds as they expand borrowings and security positions. It is truly "money" out of thin air - the monetization of risky financial claims (financial sector IOUs). Perhaps it is helpful to think of money market funds as indicative of the contemporary credit system's evolution to the point of "efficiently" monetizing the ballooning liabilities of financial sector intermediaries - "ballooning" necessary to sustain the historic U.S. financial bubble. Or, one could certainly make the case that this is but a very sophisticated system of "wildcat finance," whereby virtually any institution is afforded the opportunity to issue "notes" (electronic IOUs) to be accepted by the money funds, which are then transformed into homogenized system deposits sought by all - "money"! For sure, this process has absolutely nothing to do with savings, but instead has everything to do with credit expansion and financial leveraging, as well as sophisticated and risky "intermediation".

Again, when a financial intermediary borrows in the money market to take a position in financial assets, this is an expansion of financial credit that creates immediately available funds (deposits) for the seller of those assets. Recent extreme monetary expansion is largely the residual not of savings or real economic activity, but directly from the financial sphere with its unprecedented expansion of financial sector leverage. Interestingly, this process of asset monetization apparently goes completely unrecognized by some of the more adept and sophisticated monetary theorists that today focus on production as the avenue of money's infusion into the economy - the "monetary circuit" of firms borrowing and paying wages and the household sector spending and investing. Others would argue that no net private sector "wealth" is created in this process of credit expansion, as additional financial assets are offset by corresponding financial liabilities. My retort would be that this is not a "zero sum game" of journal entries, as this massive creation of financial credit is inflating household sector asset prices (perceived net worth). Moreover, while private sector financial assets and liabilities do "offset," increased liabilities/leveraging for the financial sector is creating additional quantities of financial assets/perceived wealth for the household sector.

It is tempting to marvel at the apparent "velocity" of the $100 bill as it moves through the system. Certainly, the "multiplication" process functions with much greater celerity (some would use "efficiency") when lending is used for acquiring financial assets, as compared to corporations borrowing to finance capital investment. I would argue, however, that more meaningful analysis is provided by examining the nature of lending and the monetary liabilities created. Is it more illuminating that the $100 of "narrow money" is unchanged while "velocity" has increased, or to recognize the mechanism and process for the creation of significant additional monetary assets (bank and money fund deposits) through increased financial sector borrowings? I hope the latter.

Many maintain that banks hold their traditional dominant position within the credit system, while also stipulating that only bank deposits represent money for transaction purposes. Some would argue further that the non-banks are simply intermediating "bank money." I disagree on all counts, but these points are certainly worth exploring. I have argued that money market funds have developed into the "Fountainhead" of the Great Credit Bubble, and that there is today little differentiation between the economic functionality of bank deposits and money market fund deposits. Indeed, these deposits are perceived by their respective holders as "money," providing absolute liquidity and safety of nominal value (safe and immediately marketable "stores of value"). There is certainly no disputing the fact that banks continue to play a major role in direct lending. I would, however, argue that the money and capital markets have come to play the key role in creating the financial credit that provides unlimited availability of loanable funds. In particular, the money market has been vitally important in creating the liquidity necessary to fuel an historic asset bubble (equities, real estate, credit market instruments), especially in the face of collapsing household savings. Not only do banks procure liquidity by securitizing and selling loans to the money funds, they also enjoy open access to borrowings directly from the money market to fund lending growth and security purchases.

Money fund deposits, of course, can be easily used to purchase securities, or transferred to a traditional bank account. Such transactions are handled quite efficiently in our very sophisticated payment system, with extensive netting between financial institutions. Traditionally, banks dominated the clearing process, with various payments first netted amongst banks. Necessary adjustments were then made for final settlement to individual reserve positions held with the Federal Reserve. If banks were caught short, they would borrow temporarily from banks with excess reserves or directly from the Fed, and perhaps be forced to call in loans. Accordingly, with the Fed tightly managing the quantity of total system reserves, the clearing process was an instrumental factor dissuading individual banks from lending excessively.

Today, clearing takes place with payments netted between the myriad of financial institutions, in a process that assimilates the relative financial positions of participating banks and non-banks. In stark contrast to the traditional bank-based clearing process with limited quantities of reserve balances and base money, the distinguishing feature of the contemporary payment mechanism is the unlimited availability of borrowings to finance payment shortfalls. I would actually argue that the newfound prominence of money funds and the corresponding "infinite multiplier effect" has profoundly changed the payment clearing process. Today, any deficit can be met easily and inexpensively by tapping the money market. No longer do limited reserves and the clearing process restrain lending; and no longer do bank deposits govern the payment system. Individual institutions can lend freely and with little concern for "final settlement," choosing instead to simply increase liabilities as necessary. This peculiar process within the domestic financial system is matched globally, whereby massive U.S. current account deficits need not be "settled," but can be left to run uncontrolled through the unprecedented increase of inter-institution financial liabilities. Domestically and internationally, contemporary credit and payment systems are not conducive to prudence for market discipline.

I believe it is also worth noting that payment clearing in our contemporary credit-based economy at the consumer spending level is dwarfed by the settlement of financial market transactions. Especially with the momentous growth of the GSEs, Wall Street firms, and special financing vehicles that rely so extensively on the money market for liquidity, these financial asset-based lenders have become the "epicenter" for this critical payment clearing process. Consequently, the money market funds have become the heart and soul of the clearing process. And particularly with the unrelenting GSE borrowing and expansion, these institutions dominate the clearing process as they disperse an unrelenting flood of immediately available funds (deposits) to institutions throughout the system ("reliquefication"). One cannot overstate the role of the GSEs.

I have purposely used the terminology "immediately available funds," language traditionally associated with reserves held at the Fed. While our first deposit was made possible by the Treasury's issuance of the $100 bill for the payment of a tax refund, the other deposits ("immediately available funds") were all created through the lending process, and made possible by the expansion of financial sector liabilities. As we have witnessed, if this purchasing power is directed to mortgages, an inflationary effect will be apparent in the prices of these securities (lower interest rates), with a resulting heightened availability of credit and rising home prices. As important, the creation of immediately available funds provides general liquidity for the financial markets. As Fannie Mae issues IOUs - repeatedly borrowing the $100 bill - the expansion of its mortgage portfolio creates new system deposits. These immediately available funds then create demand for other financial assets, including stocks. I have in the past argued that one of the key aspects of the GSE-induced mortgage refinancing booms is that additional borrowings create purchasing power for both consumer goods and securities.

Importantly, it is the creation of new deposits (flows), not the total money supply (stock) that provides financial sector liquidity. There may be the perception that the $2.1 trillion of total money market deposits or the almost $7.6 trillion of broad money supply is available savings waiting to liquefy the marketplace. This is a misconception. While it is confusing, it is critical to appreciate that the "old" deposits have already been spoken for, with buying power previously exhausted in the purchase of financial sector IOUs and other liabilities. To sustain financial sector liquidity requires additional borrowing and concomitant financial sector leveraging, with the resultant creation of new deposits/"immediately available funds." Yes, a depositor or fund manager may redirect holdings, but buying power must first be procured from the liquidation of other positions or through additional borrowings - a new buyer or lender must be found with "immediately available funds." This is why I have also argued that this bubble will be sustained only as long as the financial sector continues its borrowing and leveraging. So far, it has done so in spades.

But is this unprecedented financial sector leveraging sustainable? Well, we would argue only so long as the GSEs are issuing enormous quantities of IOUs and ballooning their portfolios of financial assets - the massive creation of financial credit and "immediately available funds." This feverish operation has run uncontrolled since the 1998 financial crisis, with GSE liabilities expanding by almost $1 trillion and total money supply surging more than $2 trillion. As I have detailed on a weekly basis, this "reliquefication" has been in overdrive since last fall, with incredible liquidity creation providing the backdrop for a momentous period of security issuance. No doubt about it, this unprecedented manufacturing of deposit money has created insatiable demand for securities and the resulting collapse in mortgage, agency, and high quality corporate spreads. Today, however, it appears we have passed the peak in the mortgage refi boom, making it reasonable to expect GSE balance sheet expansion to soon begin to wane. This could provide quite a sea change for the financial system, and perhaps we have already begun to witness the initial signs of a reversal in liquidity conditions. We will watch these developments closely going forward.

Hopefully it is clear that savings has very little to do with this whole process. The U.S. bubble has been possible, on the one hand, because of the incredible capacity of the U.S. financial sector to leverage and extend credit, and, on the other hand, by its ability to create unfathomable amounts of assets perceived as risk-free money. It is the most amazing "intermediation" process ever. In this regard, it is worth noting the recent $19 billion loss reported by Nortel. Somewhere along the line, incredible economic wealth was destroyed, requiring enormous write-downs and a drastic reduction of the company's net worth. So far, the trillions of dollars of money created over this reckless boom have escaped any reduction in value. It is certainly not because the economic wealth backing this money remains unscathed.