by Alasdair Macleod, GoldMoney:
How reliable is the link between money supply growth and the economic outlook?
Monetarists are warning now that money supply has stopped growing and even turned negative, so we are heading for a recession. This article examines the position for US dollar M2 money supply and the prospects for the US economy.
But monetary growth, or the lack of it, doesn’t only affect GDP, but a large element of economic activity which is not included in it, principally financial activities, and the acquisition of assets such as property.
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This raises the question: is the downturn in money supply due to financial activities, or the non-financial economy? What is its actual relevance?
In this article, I delve into the relationship between credit and the economy. I examine the process of credit contraction. I conclude that rather than relying solely on the monetarist’s favourite indicator, an understanding of the credit cycle and loan officer surveys are more valuable evidence.
The credit cycle
In the current economic climate, there are increasing fears of recession. Because the definition of a recession is imprecise, I prefer to call it a downturn in economic activity, or if it is significant, a slump. Either way, it begs the question as to what the cause is. Other than the consequence of the withdrawal of bank credit, all other explanations are unsatisfactory.
Before Keynes discredited markets in favour of government intervention, it was commonly understood that intervention was not the solution. Austrian economists had perfected their business cycle theory, which explained the relationship between variations in credit and economic activity. But no matter; Keynes was determined that government intervention was preferred to the boom and bust under free markets. He observed the failure of free markets, failing to understand it was the consequence of credit cycles.
Perhaps the Austrians should have called it a credit cycle, instead of a business cycle. It is credit which drives business activity, and perhaps a wider appreciation of credit cycles would have made Austrian business cycle theory more widely understood. Indeed, the best way to counter the Keynesians who rewrote economics to suit their statist sponsors is to explain the role of bank credit. And with legal money removed from the picture, which is physical gold, all economic transactions are settled in credit — bank notes which are central bank credit and deposit accounts which are the counterpart to credit created by commercial banks. Together, they are erroneously described as money, as in the phrase “money supply”.
The point about real money is that its value was recognised across jurisdictions by everyone. But apart from smaller amounts settling transactions in silver and copper coin, money was always less convenient than money substitutes, which we can define as credit where its value differed from money only in respect of counterparty risk. The amount of this credit or currency rapidly became considerably greater than the money it represented, but so long as its expansion was within credible limits, it retained the value of money as its substitute.
Credibility, and not the quantity was key. Where monetarism originally erred by tying a currency’s purchasing power to its quantity was in dismissing human confidence in the purchasing power of gold, and so long as people believed the link with currency was sound, they would accept it as a substitute, despite changes in its quantity. But how could this be, when mathematics clearly indicate that the expansion of a currency’s quantity would dilute its purchasing power?
The answer is that the tendency for prices to rise as the quantity of a gold substitute is expanded is countered by individuals deciding not to pay the higher prices, preferring to hold onto their money substitutes instead. In other words, they place values on not only goods and services, but on gold as well. But when the link between money and a currency is broken, this confidence is displaced by confidence in the currency. And that is the case today, with the state now telling everyone that its currency is money, and not gold. We are commanded to use it by fiat. Instead of a globally accepted money without counterparty risk, we now must rely on faith and credit in our state as issuer and guardian of its value, and everyone else is equally reliant on their government currencies as well.
Consequently, the current monetary system is inherently unstable in terms of its purchasing power. No longer are changes in its quantity automatically absorbed by its users as if it was a credible gold substitute. The issue has become more complex. We only use our currencies as if they are gold substitutes by way of habit. People hold onto their deposits in the banks and are prepared to accept a gold-like return on their government bonds, which is why with CPI roaring ahead US Treasuries’ ten-year maturities are acceptably priced for a yield of 3.5%. Underlying this backwardation between the Federal Government’s obligations and reality is a legacy of faith, that when the dollar and the entire global currency system abandoned the Bretton Woods agreement, nothing actually changed. Really? The history of the relationship between gold’s purchasing power and the major fiat currencies tells us otherwise.
Eventually, government abuse of their fiat currencies always leads to their demise — that is the lesson of history, and we are currently observing the process. This is the big-picture background against which today’s central banks are tasked with managing the upcoming recession. We know from official monetary policies that central banks rely on the expansion of credit to prevent recessions.
More specifically, they rely on credit at the central bank level to kick-start things. Originally it was pure Keynesianism, with deficit spending being the means of stimulation, but that has now evolved into attempts at wider economic management by suppressing interest rates, quantitative easing, and even direct injections of central bank credit into individuals’ bank accounts. And now there are even plans to bypass commercial bank credit by the invention of an entirely new class of central bank liability, central bank digital currencies, not as a replacement for central bank currency but an addition to it.
