Our economy is struggling to gain momentum and break away from the grip of the financial crisis. It is growing slowly, but without enough strength to reach full potential or to significantly lower unemployment. In such an economy it will be difficult for corporate profits to grow. Behind our weak economy is the slow growth of the money supply. The picture painted by the media depicts a money printing government and out-of-control deficit spending. But, this is not backed up by the data. Investors will make better predictions if they focus on the data.
To make investment choices based on economics, investors need to keep it simple. The economic information presented in the media is so politicized and complicated it is difficult for the layman to develop an understanding of where the economy is headed and why.
A simple way to understand our current problems is to focus on the money flows within the economy. By tracking money, investors can make better predictions and choose better investments.
There are two major flows within the economy to watch, the change in government deficit spending and the change in the level of bank credit.
The simple model of the economy is summarized as:
1) government deficits and bank credit create money and increase the money supply
2) a growing money supply builds pressure and drive the wheels of commerce
3) expanding monetary pressure increases GDP when below potential, but can create inflation when above potential
4) rising GDP drives corporate profits and corporate profits influence stock prices.
Why the Economy Must Grow?
Our economy must continually grow to accommodate an increasing population and to increase our standard of living. Over the long-run our economy grows at about the rate of population growth.
Exhibit 1: Total U.S. Population (blue) and Gross Domestic Product (red)
Since GDP also equals our national income, when GDP grows faster than the economy there is more income per person within the economy, when it grows slower there is less income per person.
Exhibit 2: GDP or Income per Capita generated
Before the Financial Crisis, the economy grew faster than the population, and during the crisis, collapsed below population growth.
Exhibit 3: Population Growth and GDP (red)
Since 2009, we are back to growing at the same rate as the population, but we haven't made up for the initial loss of Domestic Product.
Exhibit 4: GDP growth (red) and Population growth
Money Makes the World Go Round
The economy can't have income without money. Most of us think a lot about income and money, but not as much about where the economy gets the money. The economy is a closed circuit where money is continuously transferred from one agent to another, without leaving the circuit. But, how does money get into the circuit to begin with?
For the most part, the money gets in the circuit from new government deficit spending and new bank credit. Because of the way our banking system is structured, when banks make loans they create new credit money in the economy. When the government runs a deficit, it spends more money than it taxes back and the untaxed difference stays in circulation inside the economy.
A useful way to analyze the economy is to look at two factors. The sources of money - the federal deficit and bank credit and the output generated by production, GDP.
The Economy is Now Below Potential
When everyone who wants a job has a job and all the machines are switched on and running, the economy is running a Potential GDP. Currently, our GDP is growing, but at below potential. The gap in the below graph shows how much we have left in our gas pedal. How much we can accelerate before the car starts to shake and cause inflationary pressures. We are about 16 trillion in GDP now, versus a potential of 17 trillion, if we were at full employment and capacity.
Since, GDP is also National Income, with 300 million people and another one trillion, we would be generating an addition $3,333 per person. So it's significant.
Exhibit 5: Nominal GDP versus Nominal Potential GDP (red)
The Government Deficit is Shrinking
Money is injected in to the economy by government deficit spending. Since, the deficit is the amount spent minus the amount taxed, the difference stays in the economy as circulating money. Everything else equal, a larger government deficit means more money in the system and less deficit equals less money. More money means more pressure in the economic boiler.
Exhibit 6 is a graph of government expenditures and the government receipts. The difference between the blue line and the red line represents the deficit. An increasing gap represents an increase in monetary pressure; a decreasing gap is a decrease in pressure. During the financial crisis, this gap or deficit widened as receipts declined. It is currently closing as expenditures have flattened and receipts have increased. This narrowing gap is a decrease in pressure.
Exhibit 6: government expenditures (blue line) and the government receipts (red line). The area between the two lines equals the government deficit.
There is a lot of chatter in the media about an increasing deficit, but in reality it is shrinking.
Exhibit 7: The level of government deficit is declining.
Bank Credit is Flat
The other major source of monetary pressure is bank credit. When banks issue loans they add new money to the economy. When bank loans increase, monetary pressure increases and when it declines the pressure releases.
Looking at the deficit graph alone it would make seem the deficit was increasing, therefore the money pressure should increase and the economy should improve, but it didn't. The reason is bank credit. As shown in the below graph, today, bank loans are increasing very slightly They are more or less, flat. There is no increasing pressure from bank credit.
Bank credit growth is significantly off trend. During the crisis, the deficit spending was not enough to overcome the reduction in bank credit and GDP declined. Now, we have a situation with a decreasing deficit and flat bank credit. These two factors conspire to create a low pressure economy. It will be all but impossible to reach capacity in this situation.
Exhibit 8: Bank Credit Money
Monetary Growth is Flat
A decreasing deficit and flat bank credit lowers money growth and decreases monetary pressure. These factors have caused the money supply growth to flatten as shown in the below graph. In a sense, Exhibit 9 can be viewed as the pressure gauge on our boiler.
Looking back, the economy tends to expand when the money growth is strong and shrink when it is low or negative. The loss of pressure during the financial crisis was significant, it has turned around and is improving, but not enough to overcome the past damage. Compare the money growth now to where it was in the 1980s and late 1990s. Clearly, we've never had enough steam to pull ourselves out the decline.
Exhibit 9: Year over Year Growth of Money Supply
There's plenty of media chatter about "money printing" but ignore the claims of the press and look at the data. Money growth is awful. It should at least keep up with population growth. If money growth is flat and population growth is increasing, it means there are fewer dollars per person in the economy. Fewer dollars per person is deflationary.
Exhibit 10: Divisia Money Stock
The Current Situation
Budget sequestration will not improve this situation. It will make it worse, further reducing government spending, further shrinking the deficit and further slowing money supply growth.
Without an offsetting increase in bank credit, these reductions will further lower monetary pressure as more money is taxed out the economy, then is spent back in by the government. This will put downward pressure on the money stock and downward pressure on GDP.
Without an increase in either the government deficit or bank credit, the money supply will remain flat for a long time and there will be little steam to drive the turbines of the economy.
Putting the data into our model, we now have:
1) Low pressure from flat money growth and increasing population growth. This means a deflationary environment where there are fewer dollars in circulation per person.
2) Decreasing money pressure means less pressure to turn the wheels of commerce.
3) Less pressure slows GDP growth.
4) Lower GDP means less potential for corporate profit growth.
Investors accepting this logic should plan on a low-pressure economy continuing to grow slowly for years to come. This will be an economy with high unemployment, low inflation, and low interest rates.
Stocks (NYSEARCA:SPY) (NYSEARCA:VTI) - The low-pressure economy will make it difficult to maintain growth in corporate profits. In an environment of slow or declining profits, the only way stocks can increase in price is through an increasing Price to Earnings ratio.
Much of the recent gain in profits is from an increase in efficiency or worker productivity, not increased revenues. As shown on the below graph, profits (blue line) have been driven in part by using fewer workers (red line). After a quick post crisis recovery profits are flattening. It will be difficult to push them higher without an increase in the amount of money in the economy. It takes money to make money.
Exhibit 10: Corporate Profits (red) and Labor Force Participation
Treasury Inflation Protected Securities (NYSEARCA:TIP) (NYSEARCA:TIPZ) - With slow money growth and below potential GDP, it will be difficult to generate any inflationary pressure within the economy. There may be isolated cases of food or fuel inflation, but across the board inflation will be unlikely.
Corporate Bonds and Preferred Stocks - Corporate bonds do well in flat economies where the profits generate enough cash flow to pay off preferred shareholders and bond holders. As a hedge, aim for high-coupon bonds that are less volatile if rates should start to move up.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: This article is for informational and educational purposes only. The views expressed in this article are the opinions of the author and should not be interpreted as individualized investment advice. Investment objectives, risk tolerances and the financial situation of individual investors may vary. Please consult your financial and tax advisors before investing.