Money Supply: 'If You Start a Fire, Put it Out'

OK. I admit it. Neither Ben Bernanke nor Hank Paulson looks like Smokey the Bear. But like firefighters trying to save the forest, and the dynamic duo are feverishly trying to save the U.S. economy from an economic wildfire by drowning the crisis with liquidity.

Every week I write blog articles on money supply and its growth (or lack thereof). This week’s data again showed no real money supply growth and it has been approximately 6 months since money supply has materially increased. On an inflation adjusted basis, money supply has actually shrunk.

I am pretty sure that writing about money supply is the most boring and technical topic that anyone can imagine. So, why am I flogging money supply and M2 (and to be clear, it isn’t because I like being boring)? Set forth below is why, in the current environment, monetary policy and money supply are the most critical economic indicators we have.

Why does money supply matter to the economy?

Money is the medium of exchange for the purchase of goods and services in our economy. It is the grease that allows our economy to function and a primary measuring stick for how well the economy is performing. Too much money causes inflation (and a weakening Dollar) while too little money causes deflation (and a strengthening Dollar). Growing money supply (after adjusting for inflation) is necessary for economic growth. Shrinking money supply will result in a recession. A dramatic fall in money supply will cause a depression. Money is also used to ration credit. When money is tight, rationing is severe (i.e., high risk premiums) and not all firms can survive.

What should we look at when we look at money supply?

The Federal Reserve publishes two measures of money supply, M1 and M2. M2 is the broadest reliable measure of money supply and the better statistic.

The weekly money supply report is published every Thursday afternoon and discloses detailed information on M1 and M2. It is a report card of monetary policy and economic activity. While movements in any given week are usually not significant (the past week could be an exception to that rule), multi-month trends are very relevant.

However, money supply has its limitations as an economic statistic. It is not a precise instrument to measure economic activity and normally has limited predictive value.

But we aren’t in “normal times” and currently money supply statistics are the most accurate instrument of measurement that exists.

Why is money supply so important now?

Deleveraging is destroying the U.S. money supply and is the most obvious “symptom” of the underlying credit crisis. Troubled financial firms are “diseased” with bad assets, too much leverage and not enough equity. They are trying cure themselves by shedding assets so that their equity is large enough to support their remaining business. However, a side effect of shrinking balance sheets is money supply destruction. When one or two financial institutions simultaneously shrink their effect on money supply is immaterial. However, when all the banks and brokerages attempt to simultaneously shrink money supply falls at a catastrophic rate and a meltdown results.

How much is money supply shrinking?

Without Fed and Treasury intervention, the deleveraging of financials will result in at least $2 trillion of money supply shrinkage. That estimate has been calculated by university economists, the Fed and major private forecasting departments. Just this week JP Morgan published research on the $2 trillion shrinkage issue.

As an aside, I think I was literally first to publically estimate $2 trillion of shrinkage and its implications when I blurted it out FOX Business in February. 

What does $2 trillion shrinkage in money supply mean?

If left unchecked, $2 trillion shrinkage in money supply will result in a depression. GDP will quickly drop by more than 10% and a deflationary spiral will result. Paulson and Bernanke are using every means possible to prop up money supply and avoid this fate. So far, they have been able to stop money supply from dropping.

What are the Fed and Treasury doing to stop the $2 trillion shrinkage?

First, Bernanke and Paulson are fixing the underlying disease by injecting government equity into failing financial companies. Government equity slows the deleveraging process until the private sector is able to recapitalize itself.

Second, the Fed is injecting liquidity into the banking system so that adequately capitalized entities have cash to transact business in the ordinary course and don’t get caught up in the maelstrom of uncontrolled meltdowns at other firms.

What do I think of Fed and Treasury policy to date?

The Fed has done a pretty good job but is struggling to stay ahead of the crisis. Once it engaged in crisis management, Treasury has done a good job but they should have fully engaged a long time before they did.

The Bernanke and Paulson had a “breather” during the 5 months from the time of the Bear Stearns failure until the Freddie/Fannie failure and they should have used that time to implement a “forward leaning” policy which might have prevented some of last week’s hysteria. They talked about setting up an organized system for resolution of non-bank financials and then dithered while the economic forest fire burned in the distance. We still don’t have that system and they are now playing catch up.

After all, as Smokey says, “If you start a fire put it out. Only you can stop a forest fire.”

Comments

[Alan von Al...:]

Treasurys are money, too. The metric is called L, total Liquidity.

2008 Sep 21 11:15 AM