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  • Writer's pictureAnthony J. Combs

Hidden Catalyst of the Dot-Com Bubble

I was reviewing some Federal Reserve data the other day and wanted to see what the components of the TMS2 money supply were and how they have changed over time. This is the result I came up with:

Created with data from the Federal Reserve

What stuck out to me almost immediately was the huge shift in the make-up of the money supply in the mid 1990's. For whatever reason, savings deposits at commercial banks had gone from making up roughly a third of the money supply to over 60%! What caused this huge shift and what consequences might it have had on the economy?


Luckily, I eventually stumbled upon the source of the problem! I started by reading some definitions provided by the Fed and found an interesting footnote that lead to an old web-page on the St. Louis Fed's website. On that web-page, I then googled the reference found at the bottom of the page:


Richard Anderson and Robert Rasche, "Retail Sweep Programs and Bank Reserves, 1994-1999," Federal Reserve Bank of St. Louis Review, January/February 2001.


I was able to find the article here. This is a fantastic article that goes into tons of detail on the mechanics of what went on and their effects. I highly recommend reading at least the first few pages as it provides incredible insights into how the sweep program works.


I will do my best to summarize the findings. In 1994, the Federal Reserve enabled banks to use software to reclassify customer checking accounts into "shadow" money market deposit accounts (MMDAs). The Federal reserve classifies MMDAs as "savings deposits at commercial banks". The reason banks wanted to do this was to reduce their amount of required reserves and increase their financial flexibility. The reserve ratios of checking deposits were roughly 10%, while MMDAs were at 0%. Banks were able to reclassify so much of their deposits that the authors in the article referenced above state the following:

"In addition, many depository institutions have reduced their required reserves to such an extent that the lower requirement places no constraint on the bank because it is less than the amount of reserves (vault cash and deposits at the Federal Reserve) that the bank requires for its ordinary day-to-day business. For these banks, the economic burden of statutory reserve requirements has been reduced to zero."

Banks were able to reduce the amount of required reserves that needed to be held and instead they were able to loan out or invest those additional funds. This lowering of the effective reserve ratio in the economy is one of the ways the money supply can grow. This served as a catalyst of credit expansion in the economy at a pivotal point in time. This also explains my initial questions regarding the huge increase in savings deposits at commercial banks as a component of the money supply. The following chart shows the increase in the TMS2 money supply and the dramatic increase in the savings deposits at commercial banks:

Created with data from the Federal Reserve

Next I have included the year over year change (YoY%) in the NASDAQ and we get the following results:


Created with data from the Federal Reserve & Yahoo Finance

There are two y-axis to make the data more comparable as the NASDAQ saw such high returns that it makes any other data look like a straight line. So it is important to remember that the NASDAQ is seeing regular 20% to 40% returns from 1995 until the end of 1999. Then in 2000, NASDAQ returns go parabolic exceeding over 100% YoY% in one month. The growth in the money supply data ended up fitting pretty nicely with the NASDAQ data. When the money supply growth increases, the NASDAQ growth tended to see increases. And vice versa, when the money supply growth contracted, the NASDAQ saw declining or negative growth. The Federal Reserve can be seen easing at the end of the graph as the NASDAQ is suffering 60% YoY% declines in 2001.


So there are many factors that caused the dot-com bubble, but bubbles are ultimately limited by central bank credit expansion. I think I may have stumbled upon one of the key factors contributing to the central bank credit expansion. That factor relates to the significant increase of savings deposits at commercial banks caused by the banks reclassifying checking deposits into MMDAs to reduce their required reserves and thereby expanding credit creation in the economy.


In conclusion, I want to leave the readers with an extremely relevant quote from the Federal Reserve article linked above (font emboldened to add emphasis):

"...MMDA-based sweeps may be implemented for most, if not all, transaction-deposit customers and may be invisible to the customers. Finally, MMDA-based sweeps do not directly change the bank’s total assets, liabilities, or deposits. Rather, like changes in statutory reserve requirements, they allow the bank to deploy funds from noninterest- bearing deposits at Federal Reserve Banks into loans and other investments."
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