- An expanding economy requires money.
- Money comes from two places: government deficits and bank lending.
- Individuals and businesses should not have to pay for the war against CV-19 from their existing supply of money.
- The government must fund this particular war just like they would fund any other war.
- This idea was discussed in more depth with members of my private investing community, Away From The Herd. Get started today »
We expected a pullback, and we expected it to last longer and go deeper because of the virus, but the straight and vertical drop of the last week was breathtakingly unexpected. The fundamental metrics of the economy, however, look sound and not at all like they would ahead of a recession. In this piece, we look at the most "fundamental of fundamentals" of the economy - money - and how it can prevent CV-19 from causing a serious economic slowdown.
An expanding economy requires money, and money creation comes from the Federal Government's deficit spending and from private bank credit.
Recessions are preceded by decreasing deficits (red lines on the chart below), and recovery from recessions, by increasing deficits. The decreasing deficit between 2011 and 2014 would have caused a recession in 2015 if the deficit had not been increased again (green line below). The deficit continues to increase and fund the economy to the present day.
Source: FRED, ANG Traders
The deficit eventually is securitized as the National "debt", which is the record keeping of the funding of the economy (stock of Treasuries) and correlates with the size of the economy. (Note: Since the US is monetarily sovereign, this "debt", unlike household debt, is not "owed" to anyone). The debt correlates positively with the SPX (chart below).
Source: ANG Traders, stockcharts.com
All money is created through the System Open Market Account (SOMA) which is operated by the New York Federal Reserve. As my friend and fellow SA author, Alan Longbon, writes:
SOMA Operations are money creation in action. The basic stages of SOMA money creation are as follows:
1. The Fed detects a future need for more bank reserves in the payments system from bank credit creation and/or Federal government deficit spending.
2. The Fed offers the Primary Dealer banks cheap SOMA funding. This is the new money being made.
3. The Primary Dealer banks use the SOMA loan to buy treasury bonds off the US government. Are indeed legally obligated as Primary Dealers to do this.
4. The Fed then buys the US treasury bonds off the Primary Dealer banks. The banks have cash from the bond sale and buy other assets. So, as the debt grows, assets prices rise with the growth in overall system liquidity.
If the SOMA and the debt are both increasing, then the stock market tends to grow as well. If SOMA stalls - as it has since the start of the year - then the SPX drops until the rising debt allows recovery. The recent crash was expected to be a shallow and temporary pullback since there was still a $1.2T deficit forming which would maintain the expansion. Unfortunately, the fear of CV-19 has overpowered the market, despite the continuing growth in debt (chart below).
Private banks also create money 'out of thin air' whenever they make loans. This debt-money grows the economy - like sovereign money creation, but unlike sovereign-money, it has to be paid back; a feature that limits the size of the bubbles it creates. Like sovereign debt, bank credit continues to grow.
The chart below shows the regular seasonal reduction in bank credit, car loans, and Treasury agency debt held by banks.
A closer look shows that all three measures rose in the latest week (chart below).
Loans and leases accelerated their growth the most in three months (chart below).
Money growth, the fundamental underpinning of the economy, is not responsible for the drop in the SPX, and the economy continues to expand. The stock market is pricing in a severe slowdown in the US (and Global) economy because of CV-19. The virus is not out of hand in the US (yet), but even the fear of it is already causing problems.
It was no surprise that the Chinese PMI for February came in at a record low, but we don't think this represents a permanent decline in the Chinese economy. Remember that the period includes the New Year and the height of the quarantine. This is the price that had to be paid to slow the virus down. It will not be permanent.
Our economy was and still is on the verge of a massive green-tech expansion not dissimilar to the latter half of the 1990s tech bubble. The virus is a short-term setback. However, if the Central Banks do not act this week to distribute money into the various world economies, then we could be in trouble. Dealing with the virus has a cost. If the government leaves it up to individuals and businesses to pay for the war against the virus - to limit the spread, people must stay home from work, but that costs money - from the existing money supply, then a contraction is almost unavoidable. Individuals and businesses would not be expected to pay for any other type of war from their own pockets (existing money supply), so the government better not expect that in this war either.
Adding money to the economy would lessen the fear and increase the resilience of the economy in the face of a temporary slowdown. A financial crisis can be avoided if the US government and the Federal reserve act appropriately and immediately.
The following is what we consider appropriate action:
- An immediate rate cut by the Fed. While a rate cut is necessary, it is not sufficient; fiscal policy (increased spending and decreased taxation) is also required.
- The suspension or elimination of tariffs on Chinese goods. It is the American economy that pays these tariffs, not the Chinese.
- A reduction in income taxes, retroactive to the 2019 tax year. This would mean sending tax rebates to all tax-payers.
- Reduction in, or suspension of payroll taxes (FICA). These taxes do nothing but remove money from the private sector - in reality, they don't fund anything.
- Send money to every resident in the country. Delivering money straight to the base of the economic pyramid (like President Bush did) means it will be spent in the economy. Hong Kong is doing this.
The first point above has already been implemented, and the market let it be known, in-no-uncertain-terms, that monetary policy is not going to be enough. Fiscal policy - outright money creation - must be implemented, and soon, if a recession and bear market are to be avoided. We are not buying the dip until (unless) a sufficient number of the points above are implemented... or at least planned.
During the 2018 correction, our analysis showed that we were not at the start of a new bear market and that the bull market was not in the process of ending.
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This article was written by
ANG Traders is an investor with 40+ years of experience and has degrees in math, science, and education. He believes that Modern Monetary Theory analysis provides the best predictions for market action and staying with the primary trend is key to wealth accumulation.He leads the investing group Away From The Herd, along with David Huston and Alan Longbon. Their working-hypothesis is that, in addition to Federal fund flows, the only other constant in the market is the human emotion of fear, the fear of losing and fear of missing out (greed). These emotions leave repetitive patterns in the pricing history of the market which informs investors about probable futures. ANG Traders and team act on their research with stocks, index ETFs, and options - according to the risk/reward dynamics they find in the market. Features include real-time trade alerts, weekly market analysis, technical analysis, and a chat room. Learn more.
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