Tuesday, October 27, 2009
This is the longest-running theme on this blog: whatever problems the economy has, a shortage of money is not one of them. I've used it to counter the widespread belief at the end of last year that the economy faced the threat of deflation. When money is plentiful, deflation is nearly impossible. We know money is plentiful, because the price of money, as reflected in the exchange rate of the dollar and the price of gold, has fallen. The Fed has tried very hard to ensure that its supply of dollar money meets and/or exceeds the world's demand for it, and it looks like they have succeeded.
I've also used this theme to explain how the cause of last year's recession was a sudden decline in money velocity; people scrambled to increase their money balances by spending less and by effectively stuffing dollars under their mattress. This meant the recession was a giant shock to confidence which resulted in a huge increase in the demand for dollars. As confidence returned, I argued, money that was hoarded would get spent, and the economy thus had the ability to rebound rather quickly from its slump. All the signs I see suggest that the economy is pretty much following this script closely.
We now have the data for M2 money growth in the third quarter: -1.9% (annualized). This is not a fluke, since M2 growth has been effectively zero since the end of March. The initial estimate of third quarter GDP is due on Thursday, and the consensus calls for nominal growth of 4.6% (3.2% real growth plus 1.4% inflation, annualized). Thus we can estimate that M2 velocity in the third quarter rose at a 6.7% annualized rate. (see chart above) I think GDP probably did a little better in the third quarter, which would make the increase in velocity even more impressive. Bottom line: money that was hoarded is now being spent, and this is driving the recovery.
Money velocity (GDP divided by M2) is the inverse of money demand (M2 divided by GDP). So we can say that the big news in the quarter that just ended was a significant decline in money demand, after a major rise in money demand that dominated the economic news last year and earlier this year. Lots of evidence comes together to support this: as money demand has fallen, the dollar's value on the foreign exchanges has also fallen; growth in dollar currency has also fallen; and commodity and equity prices have risen as the world attempts to reduce money balances and increase exposure to more risky assets. It's all tied together with confidence: as evidence accumulates that the economy is not falling off a cliff and banks are not going to disappear massively, money comes out of hiding. Dollars that were stored are being spent, converted to other currencies, and/or exchanged for more risky assets.
I still see lots of people worrying that the U.S. could end up like Japan—unable to pump up the economy no matter how hard the central bank tries to ease monetary policy. I don't see many parallels to worry about, however. For one, the yen's value has been rising for decades, which is prima facie evidence that the Bank of Japan hasn't really tried all that hard to increase the supply of yen relative to the world's demand for yen. In contrast, the dollar is very near its all-time low relative to other major currencies, so we know the Fed has been far more accommodative, historically, than the BoJ. Second, M2 velocity in Japan has been declining almost nonstop for the past 30 years, whereas M2 velocity in the U.S. has been relatively stable on balance (though quite volatile at times). This suggests strongly that there are some big structural differences between the two economies. The BoJ has traditionally been much more cautious than the Fed, and the Japanese have been much more willing to hold on to their currency (e.g., by saving more and borrowing less) than U.S. consumers.
All the evidence points to rising money velocity in the U.S. This, coupled with the Fed's continued willingness to supply tons of money to the system, strongly suggests that 1) the U.S. will avoid depression, 2) the U.S. economy is very likely to continue growing, and 3) rising inflation, not deflation, is the most relevant concern for investors. For the time being, this should translate into continued weakness for the dollar, and continued strength for commodities, gold, and equity markets.
Posted by Scott Grannis at 2:10 PM