This week I published an article at TheStreet.com (here) which asked some questions about what the stock and bond markets are predicting. Do markets predict anything? Well, the way stocks and bonds are priced reflect the expectations of investors: Expectations are "priced in".
The 50%+ rise in the major stock averages has priced in an economic recovery. The rise in bond prices over the past 2-3 months has priced in deflation. It is easy to jump to the conclusion that these two indicators are contradicting each other. The article at TheStreet.com discusses that relationship in detail and asks the question: Can we have a deflationary economic recovery? The question isn't completely answered, but the reader will probably reach the conclusion it is possible.
In this article, I examine in detail what inflationary/deflationary expectations are going forward, and how economic activity appears to be unfolding right now. We start with some startling projections regarding deflation over the next 2-3 years and then move on to indicated economic activity based on flow of money analysis.
Quoting SocGen's Albert Edwards, The Pragmatic Capitalist cites evidence (here) that we are about to fall into a deep deflationary period lasting about two years with a cumulative core deflation exceeding 7%. The 7% figure is my calculation from the data in the the following chart showing the two year delayed correlation of core inflation with the ECRI leading indicator.
It is important to emphasize that core inflation does not include the food and energy components of CPI. These are the most volatile components of the consumer inflation measurement and, at times, are larger than the changes in all of the other components. (There is a joke: If you don't eat, need medical attention, heat your home or drive to work, there is no inflation.)
Declining Velocity of Money
To bolster the argument, The Pragmatic Capitalist gives the following graph, showing the continuing depressed velocity of money in spite of a 50% stock market rally.
Looking at the M1 multiplier over a longer period of time gives a better perspective of how unusual the current situation is.
The change in the M1 Money Multiplier has been continuously declining, showing expected increases in the "sweet spots" of the business cycle, for most of the time shown in the graph. At the end of 2008 and in early 2009, there was a monstrous discontinuity. Following this cataclysmic event, there have been very large after shocks, larger and much "sharper" (quicker) than anything else seen in the graph.
Printing Lots of Money
The velocity of money in circulation can be compared to the amount, shown in the following graph.
The amount of money in circulation, M1, has surged by approximately 22% since the beginning of 2008. Broader measurements of money supply have increased more, but cash in the hands of consumers is represented by M1. Much of the new money in the broader classifications (M2 and M3) is going into balance sheet repair for our crippled financial institutions, increased consumer saving and credit reduction.
Economic activity is proportional to the product of the amount of money in circulation and the velocity of money. This has collapsed, as shown in the following graph developed from the data in the two preceeding graphs.
The graph above is based on the classical equation relating money to exchange value or economic activity:
MV = nQ
where M is the amount of money, V is the velocity of money and nQ represents the economic activity. The equation is often interpreted as Q representing what MV has purchased (GDP) and n is a proportionality constant. For non-mathematicians, this equation is saying than MV/Q is a constant; if MV changes, Q must change in the same proportion to maintain the constant value, n.
Readers can find more complete discussions other the theory of money and transactions in text books. Wikipedia has a readable summary here.
Effect of Credit
Of course, economic activity can also be driven by credit, so we need to look at the level of commercial credit, which is shown in the following graph.
This has been increasing at an annual rate between 2.5% and 3%, hardly enough to make a dent in the 30% drop in economic activity from money in circulation.
According to the St. Louis Fed, there was a total of $9,186.2 billion outstanding commercial bank credit as of August 26. That means the current growth rate is between $230 and $275 billion.
There is a $700 billion hole in economic activity in 2009. The stimulus package is a little more than $700 billion, but the tax cut portion of that (approximately $144 billion in each year 2009 and 2010) is going substantially, so far, to savings and personal credit reduction. The spending of the bulk of the remaining $450 billion is spread over a period of 2-3 years. A back of the envelope estimate is a spending rate of $200 billion per year.
Filling the Hole
The above analysis indicates we have the following things to pour into the $700 billion hole over a one year period of time:
- Up to $275 billion in commercial bank credit;
- Up to $200 billion in stimulus money.
That means we are at least $225 billion underwater a year from now. And no consideration has been given to the mounting bank problems documented elsewhere by this author and others that could negatively impact the already low commercial bank credit issuance. All other factors being equal, the hole could be filled by early 2011.
All Other Factors Are Not Equal
This is why there is a debate. The greenshooters cite leading economic indicators predicting a recovery, the slowing of unemployment growth, depletion of inventories, a hesitation in or bottoming in home price declines, an uptick in new housing construction, improved consumer sentiment, and a recently improving ISM manufacturing index.
The brownshooters cite increasing home foreclosure overhang, record length of unemployment, still declining employment numbers, a still declining ISM services index, and decreasing median and average incomes.
I am sure both of the above lists are too short, but it is not my purpose here to weigh those various factors. I just want to be sure to recognize that a lot of other things are changing, both positively and negatively, and they will have an influence on money flows. If the net effect is not positive, the flow of money problems will be aggravated.
What magic powder can be sprinkled on this mess to make a recovery stick? If the deflationary surge predicted by Albert Edwards does materialize, the outlook may not be equal to the economic pit of 1932, but we will definitely be in over our head.
Deflation is the biggest enemy of debt. Borrow a dollar that buys a loaf of bread and pay back a dollar that buys two loaves is a specification for economic collapse. If deflation as sharp as predicted by So Gen's Albert Edwards occurs, the possibility of deflation and recovery coexisting are greatly reduced.
Geithner says he will be pulling back on accommodation for financial sector firms. He must think he has loaded dice. With this load of crap (pun), honest dice will lose. Or maybe he thinks this is all a confidence game; he just has to proclaim confidence is restored and everything will work itself out.
With all the uncertainty evident in the numbers, this is too early to start reining in accommodation. Unless, of course, we are going to finally follow the path that seemed most reasonable to me in the first place: Put the failures into receivership, quickly separate the bad assets and put reorganized, sub-divided healthy banks back into private hands. The reorganization and break-up process should be designed to produce no banks too big to fail.
Note added after completion: John Mauldin has a full discussion just out in this week's Thoughts from the Front Line (here) discussing the longer term effects of the low velocity of money. The title of the article is "Elements of Deflation, Part II". This is highly recommended reading.