Steve Saville: Market Value, Money and Credit
Let me preface these things (like I always do) that I am trying to be unbiased when I post them. I have posted articles from analysts with an inflationary slant and those with a deflationary slant. The purpose is not to try to convince anyone with my take on the situation, but to add good arguments that I read on both sides of the debate.
So, this is another good article about Steve Saville in the ongoing inflation / deflation debate. Saville often talks about a "deflation scare", that falling asset values in the midst of rising total money supply does not constitute deflation. But also that these times are politically easy times to spur on inflation.
A few key concepts that run through Savilles work:
-- Inflation and Deflation are always characterize and monetary phenomena and have little to do with asset prices
-- Money supply growth and inflation do not go hand in hand. There is often a lag of many months to a couple of years before increasing trends in the money supply work its way to rising asset prices
-- M3 is not a good indicator of money supply, but True Money Supply (TMS) is.
This is a good article because it spells out the definition of TMS (he references TMS without definining in several of his recent articles). He also talks about recent comments on his article that Mish critiqued.
March 17, 2009
Market Value, Money and Credit
by Steve Saville
One of the arguments regularly made to support the claim that deflation is underway goes like this: "While the supply of money is expanding rapidly, the amount of additional money created is miniscule compared to the reduction in the market value of assets." In our opinion, this is not a valid argument.
The amount of new money created over the past year is certainly dwarfed by the reductions in market values, but a rise in market value does not constitute inflation and a fall in market value does not constitute deflation. Rises and falls in market value can be effects of inflation and deflation, but only in those cases when they are rising/falling in response to changes in the total supply of money. In particular, if asset prices are plunging and the money supply is rising at an accelerating pace then we know that something other than deflation is causing the price change.
Just to be clear, even though the money supply is inflating we accept that the current situation looks and feels as if deflation were occurring. A situation such as this, which is characterised by rapid monetary inflation in parallel with the superficial appearance of deflation and rising fear of deflation, is what we refer to as a "deflation scare". Under the current monetary/political system deflation scares happen periodically because the combination of falling asset prices and economic weakness prompts the government and the central bank to implement counter-measures, including the borrowing into existence of a lot more money.
Are we just splitting hairs? After all, if it looks and feels like deflation shouldn't we just say that deflation is occurring and have done with it?
Well, if your investment timeframe is 12 months or less then any difference between genuine deflation and a deflation scare will probably be immaterial, but if your goal is to understand the longer-term risk/reward balances for the various investment alternatives then the difference isn't just academic. The reason is that every large and sustained money-supply increase in history has led to significantly higher prices somewhere in the economy. At least, we aren't aware of any exceptions. Even during the Great Depression of the 1930s prices stopped falling and began to rise after the money supply started to trend upward in 1933, despite the fact that there were no meaningful increases in private sector debt and bank lending (the total amount of private sector credit fell during the early 1930s and was then essentially stagnant until 1945). As is the case today, banks during the 1930s accumulated reserves but did not loan these additional reserves into the economy. And as is also the case today, the government from 1932 onwards borrowed so much new money into existence that prices began to rise even though private sector credit was stagnant.
Another way of stating the above is that a motivated government will always be able to reduce the purchasing power of a paper currency because the government's ability to create additional currency supply is, for all intents and purposes, unlimited. And no one can accuse today's US Government -- and most other governments, for that matter -- of not being "motivated". (Side bar: Japanese officialdom didn't increase the broad supply of Yen to a meaningful extent during the years following the bursting of Japan's credit bubble, which is why Yen-denominated prices maintained their downward drift).
On a related matter, we feel the need to address some comments made by Mike "Mish" Shedlock in a discussion posted at his web site a few weeks ago, because these comments do not accurately represent our views. In the article of ours that Mish was commenting on we said "a lot of confusion on the inflation/deflation issue is caused by the lengthy and variable time delays between changes in the monetary trend and changes in prices." Mish responded: "Another way of phrasing Saville's theory is that growth in credit (and prices) follows the creation of money, with a lag. This is the money multiplier model." By drawing from an essay written by Steve Keen titled "The Roving Cavaliers of Credit" Mish then goes on to explain that increases in "base money" (the fiat currency created by the Fed) generally follow, rather than lead, increases in credit money.
That's all well and good, except that we were NOT referring to the "money multiplier model". Furthermore, when we talk about time delays between changes in the monetary trend and changes in price we are not talking about "base money". We showed a chart of the monetary base in the article that Mish was commenting on, but only to make the point that the Fed's response to last year's asset price crash was very different from its response to the 1929 crash.
Our preferred measure of money supply is TMS (True Money Supply), a monetary aggregate developed by Murray Rothbard and Joseph Salerno. TMS includes currency in circulation, demand deposits and savings deposits. It does not include money held in reserve at the Fed, or, for that matter, time deposits and money-market funds.
According to the money multiplier model, "base money" is created by the central bank and then multiplied, through fractional reserve lending, by commercial banks. We are in agreement with Steve Keen that this is not the way today's system usually operates. Rather, the private banks usually create additional credit money (savings deposits, primarily) and the central bank later responds by adjusting base money to maintain a targeted short-term interest rate. This is why, when analysing the monetary situation, we don't automatically assume that bank reserves will be loaned into the economy. It is a virtual certainty that excess reserves will eventually be loaned into the economy, but there is no telling how long it will take for that to happen. We therefore don't count bank reserves as part of the money supply.
The point we were trying to make, as opposed to the point that Mish argued against, is that major financial-market and economic trend changes can often be explained by the preceding major trend changes in TMS. For example, the major upward trend in TMS that extended from the mid 1990s through to around 2004 explains the tech/internet boom and the housing market boom that followed it (TMS's 'correction' during 1999-2000 preceded the end of the first of these booms), while the downward trend in TMS that extended from 2004 through to 2007 explains the housing-market bust and its knock-on effects. Due to the lengthy and variable time delays involved, as well as the impossibility of knowing in advance exactly how changes in the monetary trend will affect different markets and economic sectors, the relationship between the monetary trend and prices is not the "Holy Grail" of the investment world. However, it is certainly possible to understand what's going on right now without kidding yourself that deflation is happening.
The following chart shows that TMS is currently about 10% higher than it was at this time last year. In other words, there is about 10% more money in the US economy today than there was 12 months ago (EXCLUDING the huge build-up of reserves at the Fed). Interestingly, the latest "Flow of Funds" report produced by the US Federal Reserve shows that the total supply of credit within the US economy is also still expanding (refer to Doug Noland's latest Credit Bubble Bulletin for analysis of the Q4-2008 "Flow of Funds" report). In other words, the total supplies of both money and credit are expanding.
The supply of money has grown rapidly over the past 12 months and the supply of credit has continued its expansion despite what has happened to the banking system and private borrowers, for the same reason as in 1933-1945: increased borrowing by government and government-sponsored agencies. In a horribly misguided attempt to stimulate the economy the government is now borrowing new money into existence at a fast enough pace to more than offset the retrenchment in the private sector. The private sector credit bubble has burst, but it is being replaced by a public sector credit bubble.
It can, of course, be argued that the total supply of money and credit would appear to be falling if the value of all outstanding credit were marked to market. This is an argument that can be neither proved nor disproved because the total market value of all outstanding credit is unknown. Moreover, we don't see a good reason to invent new and imaginative ways of defining inflation/deflation when the classic definition (a rise/fall in the total supply of money) continues to serve its purpose. As an aside, the reason that some analysts wrongly thought that an inflation problem was imminent during the first half of last year is that they were, in most cases, using M3 as their preferred measure of money supply. M3 has a history of giving 'major league' false signals at important monetary turning points.
The bottom line is that an inflation problem is in the works unless this time proves to be different from every other time throughout history when the money supply rose rapidly over an extended period. Due to the typical delays between changes in money supply and changes in prices we doubt that the inflation problem will bubble to the surface this year, but it will probably begin to make its presence felt during 2010.