Keep a very close eye on the money supply

The chain of events that led to the Great Depression were extremely similar to the ones that led to the ‘lost decade’ in Japan. Firstly loose monetary and fiscal policy led to real estate and stock market bubbles. Then the bubbles popped, which resulted in a sharp fall in demand for housing (and a fall in housing investment), bank failure (since the banks had become reliant on asset prices rising), a credit crunch, a sharp drop in consumer spending, and recession.

In both cases, the authorities’ reaction to the crisis served to turn what would probably have been a ‘normal’ recession into something a lot worse. The US government of the early 1930s tried to stick to a balanced budget and this fiscal tightening resulted in the US money supply falling 25% from 1929 to 1933. The drop in the money supply caused deflation, which is the worst thing that can happen to a heavily indebted economy since it increases the real value of debts.

Quite unbelievably, the Japanese didn’t learn the lessons from the 1930s. They too tried balancing the budget in the face of a sharp economic slowdown and actually increased taxes (John Maynard Keynes would have been turning in his grave). The result? A drop in Japanese money supply, deflation, followed by a prolonged and severe recession.

The global economy today is following a very similar path to that which led to the Great Depression and Japan’s woes, but there’s one big thing missing – money supply is still rising. Ben Bernanke, one of the world’s leading authorities on recessions and depressions, has slashed rates to maintain liquidity in the system and US money supply has held up so far. The European Central Bank hasn’t cut rates yet, though, which could spell trouble for the Eurozone.

Why has the ECB been so slow? The reason is that its sole mandate is to control inflation and at the moment inflation indicators (which includes ‘M3’ money supply) are suggesting that, if anything, higher interest rates are needed. Figures this week show that the money supply is growing at a healthy clip, with the ‘M3’ measure rising by around 11.5% at the last release. This seems to more than contradict those that fear the supply of credit is falling, doesn’t it?

Well, a UBS analyst questioned the meaningfulness of this measure at the moment, for very interesting reasons: all these SIVs, CDOs, VIEs etc that have long been ‘hidden’ away in the Cayman Islands, Bermuda and Jersey and have been off European banks’ balance sheets, are now rapidly finding their way back onto banks’ books. And thus, as they come back onshore, the ‘M3’ money supply figure is rather artificially showing an inflation in the amount of corporate credit being provided to the economy.

So, let’s watch and see what happens, but it wouldn’t be that surprising for someone at the ECB to discover that this ‘growth’ in credit is not actually growth in any real, prospective sense, but is backwards looking credit growth. It may be that actual loans being made to corporates and people in the EU are not quite as healthy as the figures suggest. This realisation could cause a very quick about-turn in the rhetoric coming from the ECB regarding the future direction of inflation and hence interest rates.

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.

Categorised as: credit

Discuss Article

  1. Bond investor says:

    Ben, are you referring to the Feb. 8 piece where UBS tried to account for non-borrowed reserves? If so, they've already retracted that. They didn't account for the Term Auction Facility (TAF). Bloomberg's Caroline Baum also debunked this supposed spike in M3. If it's something else, can you source it or give more details? Thanks!

    Posted on: 03/03/08 | 12:00 am
  2. Ben Lord says:

    Thanks for your comments. I haven't seen the UBS note – this was from a meeting we had with UBS' European economist Stefan Deo towards the end of February.

    Posted on: 04/03/08 | 12:00 am

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