There can be little doubt that an economy can still progress during the course of monetary inflation. The last 100 years have delivered tremendous improvements in productivity, driven by new technologies and a surge in consumer and producer goods despite ongoing monetary inflation.
Economic progress is, however, not made possible because of inflation, but rather in spite of it. An economy can only truly grow through increased production (in real terms) and increased capital investments based on prior saving. An economy can hence only prosper to the extent these three factors manage to progress in an inflationary environment.
In this article, I discuss the money supply to saving ratio, its importance, and why the current record high ratio signals troubles ahead for the U.S. economy and stock market investors.
The Money Supply to Saving Ratio: Theoretical background
Monetary inflation causes headwinds to economic growth as a higher proportion of resources becomes more easily misdirected and as the risk of overconsumption, to the detriment of saving, increases. Given a choice between monetary inflation and deflation, the economic risks associated with the latter are noticeably smaller, precisely because it reduces the risk of overconsumption.
The rate of saving is a crucial determinant of economic growth as investments can only be undertaken on a sustainable basis when financed with prior saving. A sufficient amount of savings is also a safeguard for economic stability as it provides a cushion against adverse economic developments, including natural disasters. A higher saving rate over time thus can reduce the level of risk in an economy as it can help smooth out economic downturns.
At all times there are naturally both savings and debt present in an economy. But, economic problems arise whenever the debt issued is not fully based on prior saving. It is therefore the level of debt relative to the level of savings, rather than the absolute amount of debt or savings (which are both influenced by the quantity of money) that is more relevant for the purposes of this article.
As money is created as debt under the current monetary system, we can replace debt with the money supply and compare this with the amount of savings at any given time as one indication of the "degree of risk" present in an economy. By the degree of risk I mean the likelihood that an economy will not only experience adverse economic developments in the first place, but also the degree to which it is unable to cope with them when they do happen. For example, an isolated economy with plenty of excess food in storage would cope better with, and recover quicker from, a disastrous harvest than one with no food supplies stored at all. Naturally, due to the complexity involved, allocating an absolute degree of risk to any economy is futile and certainly beyond the scope of this article. All I am trying to achieve here is to introduce a very important indicator of an economy's health in my opinion and the theory underpinning it.
The ratio presented below, the money supply to saving ratio, is partly based on an insight Hayek initially provided generations ago. It should be added that the theoretical foundations of this ratio are more generally based on what used to be common sense, namely, that saving money is prudent and something to be strived for, while falling into debt is something to be avoided or at least minimised.
The costs of monetary inflation include debt increases, price distortions, overconsumption and malinvestments. It's, therefore, most warranted that Hayek once wrote that (Hayek F. A., 1975, p. 168),
...saving at a continuously high rate is an important safeguard of stability
and that a high rate of saving would also
...tend to mitigate disturbances arising from fluctuations in credit.
Hayek here basically points out that saving is a good thing (a "safeguard of stability") while monetary inflation is the opposite (as it creates "disturbances"). The relation between the two is therefore of utmost importance.
Though an ever-expanding money supply tends to put downward pressure on the saving rate as credit is made artificially cheap and instant gratification is hence made possible, it does not necessarily mean the rate of saving will actually contract. As price inflation increases with monetary inflation, individuals just might, assuming they see an end to the price inflation further down the road, actually save more now to be able to afford the higher expected prices in the future. Inflation can hence lead to a higher saving rate, though the general tendency is toward overconsumption.
In either case, the amount of savings is likely to increase in absolute terms during the course of monetary inflation as savings, as with most aggregates measured in money terms, will tend to be inflated, too. This is another reason why it is the ratio between the money supply and saving that is of importance.
Therefore, economic problems inevitably arise when money supply growth outpaces saving growth as the former tends to bring about not only overconsumption, but also price rises for consumer goods and, arguably even more important, producer goods. If accumulated savings are at insufficient levels in an inflationary environment, both consumers and producers will sooner or later discover they have not set aside enough money to sustain their current spending and necessary investment levels. This becomes evident when new credit becomes difficult to come by or whenever the costs of that credit rises as both spending and investment then must fall as a result. It is at this stage the economic distortions are revealed and become obvious for most to see (see The Austrian Theory of The Business Cycle).
Money supply growth is, therefore, not a panacea for economic growth. Since economic growth can only come from increased voluntary saving and the factors that make the act of saving possible in the first place (increased production or decreased spending), the money supply to saving ratio cannot continually increase in the long term. The ratio must eventually drop as an ever increasing money supply will ultimately either produce high price inflation rates that will not be tolerated by central banks and the public at large, or by banks that simply will have to slow down lending as ever more borrowers default (which may trigger a banking crisis).
As for the denominator in the ratio (saving), people and businesses will increase the proportion of income saved when there is general uncertainty in the markets. This may take place in tandem with, or even induced by, a declining money supply growth rate (as the latter can trigger a GDP recession).
The drop in the ratio is, therefore, brought about by a decrease in money supply growth relative to growth in saving or an increase in saving relative to money supply. The drop in the ratio will reveal the distortions brought about by the rise in the ratio and possibly provoke an economic crisis (see the link to the business cycle above).
The Money Supply to Saving Ratio Hits Another Record High Signaling Economic Problems and Stock Market Woes Ahead
As the money supply to saving ratio indicates the extent of resources committed above that made available through voluntary saving (which thereby also indicates the extent of overconsumption and malinvestment), an ever expanding ratio is, therefore, impossible over the longer term as the economy will eventually run out of available resources, which are, after all, scarce.
Comparing the trend of the money supply versus saving may, therefore, provide important clues about general economic developments.
Which brings us to how the U.S. economy is faring based on the money supply to saving ratio. And it is not looking great. Never before, based on data since 1959, has the ratio been higher than it is today. The current reading based on data for Q4 2016 released today, clocks in at 3.47. This is 26.4% higher than the average since 1959 and 15.4% and 11.6% higher, respectively, than the previous cycle peaks back in Q4 2001 (almost identical to Q4 2000) and Q1 2008.
I usually apply the Austrian definition of the money supply. However, the M2 money supply data has, in this case, been used as the data goes back further. Here's what the ratio looks like using the Austrian True Money Supply going back to 1986.
Looking at the longer term growth rates of the ratio, the cycle peaks become even more pronounced.
As becomes apparent, peaks in the ratio (based on both charts above) have a decent track record in signaling that economic problems have built up and that a GDP recession is on its way.
Though this ratio is not meant as a tool to predict stock market peaks and troughs, previous peaks in the ratio did coincide with the onset of a stock market correction.
But the ratio can be applied as an economic risk gauge since the ratio is an indicator of economic imbalances that have built up. The current levels of the ratio and the fact that the 5-year growth rate appears to have already peaked, therefore, do indicate a substantial risk of a stock market correction and arguably at best poor returns going forward, especially given the high valuations.
Additionally, given that the ratio has now been in record territory for the last four years (yes, ratio not meant to time market turns), this could suggest the U.S. economy and its stock market are perhaps facing the most difficult times for generations. The ratio certainly does support the concerns of stock market bears, hard currency advocates, and investors and economists basing their insights on the Austrian school of economics.
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.