Is This Recovery? Part II

by: Econophile

<<< Click here for Part I

Where are we going and why?

Part II

The role of money supply

If much of our positive economic data, especially manufacturing, employment, and price inflation is tied to monetary policy, then that begs the questions of where is money supply (MS) now, where is it heading, and what will the Fed do?

The Fed has been trying to stimulate the economy by making credit available to banks, by keeping interest rates (Fed Funds) at near zero (ZIRP), and by direct injections of money into the economy (QE, quantitative easing). Those policies as anticipated by the Fed have largely failed. In a truly recovering economy, credit would be expanding because businesses would be borrowing in order to expand and hire. Interest rates would be so attractive to borrowers, they couldn't resist expanding through borrowing. The problem is that it hasn't worked.

What is happening instead is that economic gains are coming largely from quantitative easing, a once-in-a-lifetime policy of last resort. While Chairman Bernanke denies it, creating money out of thin air (QE) has the same effect as printing new currency and throwing it out of the Chairman's proverbial helicopter.

Look at how QE has expanded the Fed's balance sheet from securities purchased on the open market, which is how the Fed creates new money:

click to enlarge

As you can see, its balance sheet exploded during the Crash (QE1) and has continued to grow (QE2). The Fed has injected about $2 trillion into the economy since 2008. One can't deny that such injections have impacted the economy. It has rewarded the financial markets (S&P500: 3/6/09=666; 2/14/12=1,350), it has rewarded the multinationals and exporters, and it has caused a positive CPI despite massive deflationary forces.

MS itself has been on a rocky track, but it has expanded in response to QE. Bank credit expansion (loans) is the easiest way to cause MS to grow. While the Fed has made massive amounts of credit available to banks, without loan demand lenders are satisfied to keep it locked up at the Fed (excess reserves). Without landing activity, in order to make MS grow, the Fed has found it must inject new money directly into the economy via QE .

To measure MS, I use the Austrian concepts of money supply, what is called "Austrian" or "True" money supply. Specifically I use what I consider to be the most accurate "Austrian" data which is from Michael Pollaro's The Contrarian Take (with his kind permission), which looks like this:

As you can see the percentage YoY change of TMS2 (bright blue line), the data which I think is most accurate, is actually declining. What does this mean?

Let me try to explain this with a more detailed, and unfortunately, a more complicated chart. This is the same chart as above with an addition of the QE events (vertical salmon and blue bars), the addition of GDP data (black line), and the addition of the NBER's dates for the Great Recession as a vertical gray bar. The scale on the inside of the chart on the left shows quarterly changes in GDP from 2006 to Q4 2011, and it is shown on the black line. I have exaggerated GDP by showing percentage changes of GDP on a quarterly basis to make it fit to Pollaro's chart and to make my point clearer. Another chart below shows GDP alone.

What I believe this chart shows is that, after a delay, quantitative easing has caused much of the "recovery" by increasing MS which in turn has increased GDP .

In terms of measuring money supply, I use the bright blue line (TMS2) which shows annualized changes. If you are a believer in M2, Pollaro shows that as well (dark blue line). QE1, starting in November 2007 and ending in March 2008, brought a huge infusion of new money into the economy, about $1.3 trillion in only 3 months. The Fed, as you recall, went on a massive buying campaign which including a lot of "bad" assets (GSE debt, etc.). GDP is a lagging indicator, but as you can see it was well on its way down by Q1 2007 as real estate values collapsed and Lehman went under. By Q4 2009 GDP started to pick up which was a 6-month lag from the end of QE1.

As the effects of QE1 wore off, as one would expect it to do in the face of massive deflationary forces, GDP began to stall out and unemployment continued to climb. By October, 2009 unemployment reached 10%, and people were talking about a jobless recovery. GDP peaked in Q4 2009 and started declining again in Q1 2010. The Fed took action starting in November 2009 through June, 2010, and QE2 brought another $600 billion of new fiat money into the economy over a four month period. GDP bottomed out in Q1 2011 and since then it has been expanding but at a snail's pace. On a YoY basis GDP is stagnating, but not declining. Again, there was about a 6-month lag between the end of QE2 and GDP turnaround.

Here is a chart that makes it easier to see real GDP:

To those out there who see this as an exercise in curve fitting, faulty logic (post hoc ergo propter hoc), or Monetarist theory, these data are consistent with Austrian Business Cycle Theory (ABCT) and one would expect to see these results after flooding the economy with fiat money. I believe that the gains, such as they are, are not "real" in the sense that they are not based on real savings, but on fiat money which always redirects capital into projects that eventually will become malinvestments.

When money is injected in the QE fashion, it takes longer for the money to get into the farther reaches of the economy. When you think about it, the cash initially goes to the Fed's Prime Dealers and they use it to make investments, which indirectly leads to productive activities, but takes time to expand beyond, say, New York City. Bank credit expansion through loans is a more direct transmission into productive activities rather than investment activities (businesses borrow to expand business, consumers borrow to buy homes and cars).

The thing about GDP is that it is not necessarily a very good measure of economic activity in the sense that it measures what we spend. If you inject more fiat money into the economy it means there will be more spending and a higher GDP. More spending doesn't always mean that those activities will be productive and lasting. That is especially the case with QE. But, for whatever it's worth, the world pays attention to GDP and so will we; it's just very tricky footing for forecasters.

It appears that TMS2 MS growth is declining. One look at the above chart will confirm this. This has to do with a lot of factors, but mainly it is occurring because QE2 is wearing off. This is occurring despite the fact that we are finally seeing modest increases in bank lending activity:

The above chart shows total loan activity (blue line) and the components that are business loans (red line) and consumer loans (green line). Ignore the straight line increase in Q2 2010; that is a recalculation based on a change of the government's methodology. While it shows recent modest improvement, loans have not grown since April, 2010. The latest Fed data (H8) shows that consumer loans actually declined 0.7% YoY in 2011 and business loans only grew 1.7% YoY. The commercial and industrial (C&I) portion of business loans were up a very positive 9.6%. The problem is that there are fewer potential borrowers, and the value of C&I business loans has actually declined (blue line):

Another MS factor to consider is what is happening in Europe. The European Central Bank and the Bank of England are inflating: the ECB with purchases of sovereign bonds and LTRO (Long-term Refinancing Operations), and from QE with the Bank of England. According to Michael Pollaro, some of this money is finding its way back to U.S. Treasurys.

That being the case, declining MS growth is likely a stronger trend than is apparent.

Where are we?

QE has finally given the economy a bit of a ride, but it appears that it is running its course, otherwise, we would see healthier bank credit expansion, and an increasing MS without Fed money steroids, and that isn't happening yet.

Exports are the other thing to be watched as the EU, China, and the rest of the world slow down. Whatever one thinks of the role of U.S. exports, this is a serious negative factor. Recall that exports are about 10% of our economy and are seen by most analysts as an important driver of our economy.

Based on these data, it is likely that the U.S. will start to see more weakness in the economy during Q2-Q3 2012. The timing is based on the fact that this "recovery" is fragile in the sense that it has been supported more by fiat money stimulus rather than real capital/savings. The data show that as MS declines, the economy, at least as represented by GDP, reacts rather quickly and negatively.

The issue really comes down to whether or not bank credit will take off again. If we consider the present state ofdeleveraging and liquidation of malinvestments, we are about half-way to the end zone. (This will be the subject of my next article.) Also, while C&I loans are growing, modestly, real estate loans and consumer loans are still weak. The NFIB reports that small business credit demand is still tepid, relatively unchanged for 2011. Small businesses represent about one-half of the U.S. economy. Thus it is unlikely that MS will expand from an orgy of borrowing.

That leaves the Fed with only one effective tool in their proverbial toolbox. That is, of course, QE3.

What other tools do they have? They could pay no interest on excess reserves, or even charge interest on reserves, but I don't think it will force banks to lend because there isn't enough demand to drain reserves. As Michael Pollaro pointed out, it is more likely that banks will run into loan limits because of capital ratio constraints before they tap into excess reserves. As well, while there is some easing of credit terms, it is unlikely that consumers will go on a spending/borrowing binge for the reasons mentioned above. More Operation Twist? Unlikely. Low interest rates aren't the problem, ZIRP has seen to that.


Quantitative easing has only been used once before in U.S. history, and that was during the Great Depression. You might wish to ponder that bit of information. What that is telling us is that we cannot compare what is occurring now to our experience in prior recessions.

With all due respect to Rogoff and Reinhart, this time is different for the U.S., at least in terms of our modern experience. Fed policies employed in previous recessions which were then thought to work, have failed in our current cycle. Those policies were mainly forms of lowering the Fed Funds rate, reducing bank reserve requirements, and discount window operations. We now have ZIRP and that has done nothing to stimulate the economy as the Fed had hoped it would.

This time we have persistent high unemployment, economic stagnation, a "liquidity trap", high civilian and government debt, low savings, flat to declining wages, and substantial asset devaluation. This has been going on since 2008, a full four years. If it all sounds familiar, these same things happened in the 1930s.

This time is far worse than any other modern recession. What we are seeing now is a depression, despite what the NBER would have you believe. If you are still looking for the "Big One" to happen, you are too late. It happened here and it is still happening here and in Europe. They, like us, have tried to paper over most of the effects of the boom-bust business cycle malinvestment, and they have failed and the piper is at their door.

Within that context, let me sum up my thinking:

1. The economic "good news" is largely based on fiat money steroids and will not last without continuous injections of new fiat money into the economy.

2. The last injection of fiat money (QE2) is already wearing out and money supply is most likely declining.

3. A declining MS will result in further economic weakness (stagnation) and flattening-to-increasing unemployment.

4. This is likely to occur in Q2-Q3 2012.

5. As soon as unemployment goes up again, the Fed will announce QE3.

6. The dollar will continue to be weak.

7. It is likely that price inflation will continue to be "modest" (as the Fed sees it) in light of ongoing real estate related asset devaluation. This depends on the amount of QE.

Thanks to DoctoRx and Michael Pollaro for their help with this article.

This article originally appeared in The Daily Capitalist.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.