Will Higher Money Supply Growth Help?

The chorus calling for the Fed to facilitate higher money-supply growth has become deafening. Jude Wanniski and Larry Kudlow have been long-term members of this chorus, while gold market commentator and veteran trader Jim Sinclair has just added his voice. Apparently, as opined by Mr Sinclair in recent commentary at his web site (www.jsmineset.com), faster money-supply growth is needed now in order to avoid a 1930s-style deflationary outcome and depression. To support his view he uses charts of money-supply growth and 'money velocity', where the velocity of money is calculated by dividing the GDP growth rate by the M2 growth rate. We disagree with this chorus, and here's why.

Firstly, dividing the money-supply growth rate into the GDP growth rate tells you nothing about the velocity of money. All it tells you is how much effect money-supply growth is having on GDP growth. For example, M2 money supply has expanded by 16.8% over the past 2 years (an 8%/year compound growth rate), but this high rate of money-supply growth has had only a modest impact on GDP growth. Hence, the sharp drop in the GDP/M2 ratio shown on the below chart. This doesn't mean that the velocity of money has been low over the past 2 years, but it does indicate that money is being spent in a way that does not give a significant boost to GDP.

Further to the above, rather than interpreting the fall in the GDP/M2 ratio as a signal that we need even higher money-supply growth a more logical line of thinking would be as follows: The 16.8% increase in M2 money supply over the past 2 years has had only a minimal effect on economic growth, so the problem clearly isn't a lack of money. Higher money-supply growth is therefore not likely to make things better.

By the way, there is a positive correlation between money-supply growth and economic growth, but the correlation is based on real (inflation-adjusted) M2 growth. That is, an increase in the money supply only boosts GDP growth (with a significant lag) to the extent that it does NOT boost prices. Increases in the money supply that cause goods and services prices to increase are NEGATIVELY correlated with real economic growth.

Secondly, sustainable economic expansions are based on savings and production, not on debt and spending. One of the biggest problems facing the US at this time is that the savings rate is extremely low. Unfortunately, those who advocate monetary stimulation and other measures designed to increase the velocity of money are, in effect, advocating policies that will decrease the savings rate even further and thus DELAY the time when a sustainable economic expansion can begin. The thing that must happen now is that individual balance sheets get repaired. This is always painful in the short-term, but is absolutely necessary.

As an aside, a high savings rate alone is not enough to bring about an economic expansion. For example, the Japanese have had a high savings rate for the past decade, but economic growth has been slow. One of the problems in Japan is that a lot of the public's savings have been loaned to the Government and used unproductively as part of the Government's absurd Keynesian attempts to stimulate growth by spending huge sums on public works projects.

Thirdly and most importantly, it is a mistake to think that deflation is the problem. Deflation wasn't the problem in the 1930s and it is not the problem now. The problem in the 1930s, and the problem now, is that there was a massive asset price bubble fed by an even more massive credit bubble. Once you have allowed a massive credit bubble to form there is no 'inflating your way out of trouble'. The US money supply has expanded at a rapid rate over the past 2 years and all that has been achieved is that an even bigger problem has been pushed into the future. Read the interview with 89 year-old investment legend Seth Glickenhaus in last week's Barrons magazine, because he says it better than we do. To paraphrase Mr Glickenhaus, all the Fed does when it tries to inflate its way out of the mess it helped create is cannibalise the future. It seems as though the chorus clamouring for higher money-supply growth wants the Fed to cannibalise the future at an even faster rate.

On a related matter, in his above-mentioned commentary Mr Sinclair expressed concern about what would happen if the US stock market were 'allowed' to drop below last October's lows. However, all markets are mean reverting and over the long-term the stock market oscillates between levels of over-valuation and under-valuation. Furthermore, once it reaches one extreme and reverses course it continues in the new direction until the opposite extreme is reached. The greater the level of under- or over-valuation reached during any cycle, the further the market must move in the opposite direction once the mean-reversion process gets underway.

There are no instances in history where a government, or anyone else, has been able to prevent an over-valued stock market from following this mean-reversion process through to its logical conclusion, although governments often try. When they try, all that happens is that the bear market turns out to be longer than it would otherwise have been and each hope-rekindling bear-market rally sucks in more of the public's money. As such, the public ultimately loses more money as a result of government attempts to support an over-valued market, including the attempts to indirectly support the market by increasing the supply of money.

2 posted on 07/19/2003 4:30:08 PM PDT by sourcery (The Evil Party thinks their opponents are stupid. The Stupid Party thinks their opponents are evil.)

More money in people's pockets doesn't help the American economy any more. It just helps the Chinese, Mexican, etc.

That's the missing part of the equation...

Geez, a lot of complicated math and hi-q experts disagree. I wonder if we could just get the government out of the money business and leave it in the voluntary sector.

The "engine of discovery" works best in other areas, perhaps here as well.

[ Japan ] Government's absurd Keynesian attempts to stimulate growth by spending huge sums on public works projects.

There's a lesson to be learning in there, with all our major cities footing the bill for larger sports stadiums.

government out of the money business and leave it in the voluntary sector.

You mean like trading cigarettes in prisons? While that might seem laughable at first, they're not going to experience the bubble bursting like we are. Maybe it is time to stock up on them as we're all going to be sent to debtor's prison. Wait, they're a $1.50 tax a pack. Maybe the government has predicted this already?

Higher money supply will cheapen the value of the dollars you now have. It will cheapen further the value of the dollars you earn in the future. Does this sound like a good deal for you? You be the judge.

Hmmm ... right now we have "regular" "light" and "ultra light" cigarettes. You can't really translate that to $10, $5, and $1 as each person has their own cigarette preference. I suppose that's the free market at work: if you're selling a magazine you'll take 10 lights or 8 regulars on one day. Tomorrow you might be in the need for some more nicotine so the price changes to 12 lights or 6 regulars.

But what about different brands of cigarettes? Some people won't touch Camels after getting hooked on Marlboros. How many Camel hardboxes will they take for a piece of fried chicken? What if there's a prison wide crash in the price of Lucky Strikes as a new cache was smuggled in?

Don't even get me started on problems with menthols.

If more money helps the economy, then Latin American countries should be R-I-C-H!

Let's review Article 1, Section 10, Clause 1 of the U.S. Constitution. No State shall...; make anything but gold and silver coin a tender in the payment of debt.

Can't inflate gold. Can only mine it.

Given this evidence that a) increases in M2 are not doing much for GDP now, and b) the trend is for them to do even less in the future, why do smart people think higher money supply growth could possibly be a solution?

1) They aren't that smart. Never confuse knowledge with wisdom.
2) When a fix is tried repeatedly and the problem worsens, logic dictates the 'fix' is contributing to the problem.
3) "Insanity is doing the same thing over and over and expecting different results." -- Albert Einstein