The money supply wave which peaked near the end of 2013 has been ebbing ever since. As we now by the looks of things are fast approaching low tide we will soon discover who's been swimming naked.
The decay in real economic indicators relative to the money supply
The vast monetary expansion orchestrated directly by the Federal Reserve from 2008 to 2014 and indirectly ever since as banks again took over the role as chief money creators, will not be without major economic repercussions of the negative kind.
The QE programs implemented by the Federal Reserve came at grave costs, perhaps the greatest one being a rapid decline in consumers' purchasing power.
Incomes are simply nowhere near keeping pace with monetary inflation. As a result, the many have become even more dependent on debt rather than income to pay for the rising costs of living. This situation is sustainable only to the extent government programs can be sustained and bank lending can continue to expand. Especially the latter is now showing signs of strain.
Increased uncertainty for businesses is another great cost as a relative decrease in business investments hurts private sector productivity. This is a major problem perhaps surprisingly Alan Greenspan recognises.
Since GDP growth over the longer term is largely a reflection of increases in the quantity of money, investments as a proportion of the money supply are also at record lows.
Combined the two charts above help shed light on why productivity growth has been heading nowhere but down since the early 2000s.
Arguably though, the reduction in saving the highly inflationary policies have induced especially since 2008 is of even greater importance as such policies greatly hurt capital formation. Profitable investments over the longer term require prior voluntary saving. Investments financed by any other means (e.g. through expansion of bank credit and forced saving) are unsustainable as they create the business cycle. That saving has declined in relative terms for quite some time should therefore come as little surprise.
From a moral aspect, those who failed (mostly banks) were rewarded at the cost of those who had managed their affairs prudently (including savers). The negative consequences of such vast transfers of purchasing power (redistribution of wealth), not to mention the moral hazard created by rewarding failure and penalising thrift, can have lasting effects on economic behaviour that certainly does nothing to support nor incentivise economic progress. As Richard A. Fink explained in the early 1980s when explaining the adverse consequences of government's inflationary policies,
Effort and expenditure, normally devoted to production, is diverted into avoiding losses from unfavorable regulations and clamoring for subsidies and favorable regulation. All of these distortions have serious consequences both for the quantity of savings and for the uses to which there savings are put. - Economic Growth and Market Process in Supply-Side Economics: A Critical Appraisal, 1982.
The Money Cycle
No economic policy can swiftly or painlessly undo the economic damages caused by decades of inflationary policies. Bar some miracle, economic growth (i.e. an increase in living standards) must be at best expected to remain low over the foreseeable future.
Investors must therefore turn their heads decisively toward monetary developments, the one "tool" truly capable of postponing an inevitable, and long overdue, economic correction. The economy is now dependent, arguably more so today than in a very long time, on further increases in monetary injections.
Specifically, to avoid triggering an economic reaction and a GDP recession, money and credit need to expand at an ever-increasing pace. Why?
There are many reasons, but the primary one being to avoid interest rates rising more than the economy can handle without triggering a crisis. As I've explained elsewhere,
This risk of interest rates increasing is perhaps the single most important reason why credit and money simply must grow at an ever-expanding rate to avoid an economic bust. Credit expansion would thus need to be higher than previously and higher than expected to maintain the effect inflation had earlier. In short, credit expansion needs to reach a speed at which economic agents cannot completely anticipate it. - Money Cycles - The Curse of an Elastic Money Supply.
When the rate of monetary expansion declines, problems start revealing themselves. The intensity of the economic reaction depends among other things on the size of the monetary expansion that preceded it, the extent to which market participants manage to replenish savings lost during the expansionary phase, as well as how quickly the money supply growth rate later falls. A long period of rapid growth in the money supply followed by swift declines will therefore result in a sudden crisis. This is the reason central banks aim for stable price inflation, a policy which from the outset is doomed to fail, at least when it comes to supporting economic growth.
Since it takes time for money supply changes to filter through the economy, longer term trends in the growth rate of the money supply play an important role in forming an opinion on where markets are heading.
Historically, the money supply always expand over the longer term simply because the elastic money supply employed today is capable of doing exactly that and also of course because monetary expansion is an implicit Federal Reserve policy ("stable price inflation"). Note that this does not imply that the money supply is incapable of falling over the longer term. But based on these features of the money supply and the importance of the growth rate mentioned above, we can define the money cycle in terms of expansions and contractions of the longer term growth rate of the money supply;
Increases in the money supply growth rate represent the upward swing of the money cycle, while decreases represent the downward swing.
And this is where things are starting to look worrying, even for the usual beneficiary of monetary inflation; GDP growth. After hitting high tide in late 2013 the money cycle, defined here as the 5-year annualised growth rate of the money supply, has decisively turned. Based on the run-ups to the previous two major financial crisis (early 2000s and 2008) and the theory introduced above, another crisis is now fast approaching.
Adding bank reserves to the money supply, the picture looks even bleaker.
Bank reserves are here added since a decrease in reserves could signal a tightening of lending standards going forward and a corresponding reduction in bank credit- and hence money creation.
Who's been swimming naked (i.e. those businesses and industries dependent on cheap and plenty access to credit) might soon enough be revealed should the current monetary trends continue.
The drop in both real- and inflationary indicators
A major economic issue now unfolding is therefore the combination of relative declines in real indicators of economic growth (saving, investments, and productivity) with declines in the key indicator of inflationary growth (i.e. a money cycle that has decisively turned and evidently heading for low tide).
Economic aggregates previously fueled by money supply growth (instead of real economic growth) will suffer accordingly if the current trends continues.
This development also presents a dilemma for the FOMC as further monetary injections (QE4, which might at some stage be "needed" to avoid an economic bust and a banking crisis) combined with relatively low levels of production could prove highly price inflationary, even more so than what is already the case. The risk of stagflation is therefore ever-present.
Though the relatively low levels of business investments might have had a dampening effect on the business cycle, which has been great news for especially stocks, the combination of lower monetary inflation with previously low level of investments could now finally prove to be the demise of the long-running bull market in stocks.
Time will show, but as monetary developments can change faster and sooner than the real economy, the former is of particular importance for the time being in my opinion.
Disclosure: I/we 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.