I heard a commentator on the television today mention that there is “mountains” of cash sitting on the sidelines, and that eventually it will find its’ way in to the investment markets. I say fat chance.
Allow me to explain a bit.
When a central bank releases money into the system, it does so with the expectation that money has a certain “velocity” and that the amount of economic activity produced will be a multiple of the dollars released into the system. To give a simple example, $1,000 released into the system is borrowed by a bank and lent to a company. The company then purchases $1,000 worth of manufacturing equipment and sells the equipment for $1,200, the manufacturer of the equipment takes the $1,000 and books $200 in profit and spends the rest on wages, raw materials and other costs, which creates more economic activity. That first $1,000 makes the rounds a few times. And most often it works! That’s been the miracle of the growth of the developed and developing economies over the past 50 years. Of course as economies grew the central banks could justify increasing the money supply based on the increase in productivity and GDP.
During a recession the private sector pulls back on spending – usually unemployment increases so consumer demand is lower prompting businesses to cut back on expansion and production. In order to avoid a self sustaining cycle the central bank injects money (euphemistically referred to as liquidity) into the system in order to bridge the gap until the private sector can regain it’s footing. Usually a recession is a normal part of the economic cycle that rolls from an overheated economy to an under preforming one and eventually back starts working it’s way back to normal. These are what I refer to as your father’s recessions – they come along every few years, and eventually we muddle our way through it.
But then there’s what I refer to as your Grandfather’s recession – called a depression. These are caused by monetary contractions – that is, a reduction in the total amount of cash and credit in the system. And because there’s less money available, there’s less people working, less spending, and prices of most things actually go down. Interest rates stay low but it doesn’t matter because no one can borrow. And guess what? The velocity of money heads towards negative. So with all of the talk of hyper-inflation, central bank irresponsibility and the coming economic disaster, what I see it something much worse than inflation – I see deflation.
Let’s take a look at the numbers. Here is the U.S. Federal Reserve’s publication of M1, a simple measure of money supply that measures the total amount of money in currency, checking accounts and demand deposits.
Federal Reserve doing it's best to bolster the economy.
Now let’s take a look at M3, which includes everything that M1 does, but also includes savings accounts and time deposits.
Seems to tell a bit of a different story!
M3 goes negative.
And why is this? In the face of all of the ‘liquidity” that the Fed is piling into the system, why is the money supply decreasing? Simple- the velocity is now at an all time low….
Velocity drop
Here’s another chart that shows velocity of MZM (a slightly different measure of money supply in very broad terms).
Heading to negative territory
So where is the money going if the central banks are indeed flooding the system with “liquidity”? It’s going into the coffers of financial institutions who, instead of lending it out to productive businesses are simply re-investing it in financial instruments. Thus we have the anomaly of an inflated stock market, inflated commodity prices and a weakening economy. Don’t forget – this is your Grandfather’s recession. Wages will drop, unemployment will continue to rise and prices will stay low. There simply won’t be enough economic activity to support higher prices. The U.S., the largest economic driver in the world, is headed for a second, more severe economic pullback. Why? Because the government and the Central Bank are actually pulling back on economic stimulus, reducing activity and employment. Europe is on the brink of collapse, and the economic austerity measures that have been mandated on the economies of the PIIGS (Portugal, Ireland, Italy and Spain) will have a negative impact on GDP for years. Negative GDP in North America and Europe means lower exports for emerging markets, lower commodity demand for resource countries. In fact, it would seem fairly certain that a global slowdown is in the works.
