Money Multiplier and Velocity

Can you have GDP growth without debt growth? Is debt contraction (monetary deflation) a sure sign of economic contraction? Apparently the common perception is no and yes: without debt expansion we are doomed. While we believe at SBC that these events can exist for a period of time, we don't believe they are forgone conclusions of some necessity borne out of some fundamental economic equation.

John Mauldin has produced for us some excellent analysis on this topic. We don't like predicting the future, but we conclude from his recent work that GDP growth does not have to be negative nor small.

First let's look at some conclusions from The Multiplication of Money. We believe it's a mistake to conclude a nation can't have economic growth without credit growth. If we understand the money multiplier correctly, it measures growth of debt; how much M0 money (reserves) gets converted into M1 money (via loan origination). It doesn't measure how many times the dollar from wages and income changes hands. In fact, if we pay cash for something and the business we trade with pays cash, and that business pays cash, and their business, and on and on down the line, all kinds of GDP is being created without any debt growth, either in M1 or M2. Economic activity without debt growth is very possible. It's how the world operated before fractional reserve banking was invented.

What we've described there is money velocity. Mauldin has another excellent description of that in the recent weekly newsletter titled The Implications of Velocity. In it he presents an example of one kind of GDP growth.

"Having learned from their parents, they immediately become successful and start doing $100,000 a month themselves. GDP rises to $14,000,000."

Wait, how did they get their hands on the money to conduct trade? If mom and dad gave them the money, mom and dad had to give up spending it themselves. If the bank loaned them the money from fractional reserves, the velocity doesn't have to change for everyone to stay at the same level of income, since everyone still has all their money to spend and the new kid on the block has newly created money from fractional reserves. For sure, this is how economies have grown in modern times, giving someone future money to spend today.

So let's take a look at the velocity equation. Notice P=MV does not have debt as part of the equation, except to the extent debt is a component of M. Since GDP transactions are conducted in real physical cash or checking deposits, the monetary metric to use is M1. The astute reader will notice immediately that one can conduct transactions with credit cards and bank loans. True, but since we are presuming an economy where debt is not growing, those don't count. They either get offset by someone paying down loans, or by the person paying off the loan (credit card) at the end of the month with cash or M1 money.

Furthermore, for those who spend cash on debt repayment (pay down car loans, mortgages, etc) we need to realize those payments are M1 asset transfers from debtor to creditor. They don't affect the M in the velocity equation, either.

In fact, Mauldin shows M2 is not growing as M1 has recently. Since M2 is not directly spendable money, it appears the nation is churning the money in demand deposits and cash (GDP is not zero) instead of loading it into savings vehicles (M2 is not growing with M1). Unwinding debt would do this. As pointed out above, debt pay-down is nothing more than an M1 asset transfer from debtor to creditor. If the creditor then uses it to pay down their own debt, it too is another asset transfer of M1 from debtor to creditor. This creditor to debtor pay-down cycle can go on for some time. It can happen any number of times, all the while reducing "total debt". Does that alter velocity or GDP? Not necessarily.

At some point a creditor is payed and decides not to reduce debt, either because they don't have any in the first place or they are comfortable with the debt they have. If they save it, the money appears as M2 growth. If they spend it, it appears as a contribution to velocity and GDP.

It seems apparent, then, that if M1 is growing and M2 is not, and GDP is not contracting, that M1 money is being used to buy things with cash or pay down debt (or bury the bills in a can in the back yard.) There really aren't any other things one can do with money but to spend it, save it, or pay off debt.

People don't spend M2. It might be a funding source for spending, as people cash in the CD or transfer money out of a money market. It may also form the basis of confidence for spending, since one can buy on credit and pay it off when the CD matures or when they chose to redeem Money Market funds. But M2 itself is not directly spendable. It only represents the confidence of spending what is available in M1 or new debt. One can think of it as a source of "respending". If one writes a check today and something else comes along to entice the person later, one always has that M2 savings to use for the purchase. Nevertheless, all commerce takes place with M1 money.

We conclude that it is not a forgone conclusion that we must have economic stagnation if we have debt contraction. It's not even certain that we will have weak economic growth. Whether we do or not really depends on the velocity of money. If those with money have confidence to spend it, and if they relearn how to live within their means, we could have very healthy GDP. The problem we have with the common public data is that they predominantly provide statistics representative of the Losers; those who've botched it; those who are financially illiterate. While we have no hard data to prove it, we believe those people make up the minority of the American public.

Isn't it interesting how many advocate that people live within their means and that the nation would be stronger if we didn't rely on debt for economic well being? Has anyone even provided a picture of what that transition would look like? We don't want to sound too proud or arrogant, but maybe we just did.

Now what fiscal policy can do to this aspect is another matter. We'll have to look for evidence to that effect somewhere else.

Before you scoff at our conclusion, take another clue from chaos theory. Mauldin points out a very useful lesson from the book Ubiquity: Why Catastrophes Happen. The conclusion is that stress points are built into the fabric of human existence. The implication is that it almost doesn't matter how one responds to a crisis. The long term consequence is that complacency and comfort will set in, preparing the way for the next build up of critical mass to produce another crisis. Now if you can't tell when you are there at the precipice, how can you tell what the fundamental change is that is setting up the next generation for a fall? If you knew when the fundamental change was taking place, one presumably could prepare a plan for the consequences of the complacency that follows. But in fact these things are never clear until they become hindsight.

How Can Stock Market Asset Prices Fall?

For the stock market to drop in value, something else has to be in greater demand. In the realm of paper assets, the only competition for equity is debt or debt-money, and the non-paper competition is commodities and real-estate. Let's look at each one, except real-estate, which should be clear without saying in the spring of 2010 is a non-starter.

It's been clear for about three years now that money does not flee to hard assets when paper assets are in jeopardy. Those hard assets experience a sell off, too, as money flees in a crisis for the stability of U.S. dollars. This should be expected for some of the reasons we pointed out in November. So if the stock market has a significant sell off, don’t expect a commodity price spike. Whether one thinks it should or shouldn't is irrelevant. That fact is it hasn't done so for the last three years. If you think it should, then take the sell-off as a chance to take a position at steep discounts. We address the fallacy of the counter-argument for deflation at the end.

We are then left with the realm of paper-assets: debt-money (currency) or debt instruments. Debt instruments can get very complicated because there are many types with a variety of risk and valuation models. However, we can simplify that into a few commonalities: short term and long term, corporate and government. There is another debt instrument that doesn't quite fit that simplification: debt derivatives. Of the collateralized debt types, they essential represent the same fundamentals as bonds, except risks are slightly lower as default risk is diversified among autonomous entities. The other common derivatives can be grouped as options, futures, or credit default swaps. Virtually all of those by definition are relativity short-term bets.

If one is worried about equity valuations (the theme of this writing) corporate bonds would be of interest to some as bonds receive the first-fruits of cash flows and stand ahead of stock in bankruptcy (government usurpation notwithstanding). But if equity prices are at risk, corporate default risks rise, too, so prudent investors won't flee to corporate bonds in a crisis. We find ourselves left with short and long government debt, or debt derivatives, competing with equity for capital investment.

Let's take debt derivatives now, particularly the CDS type. The only intelligent reason to sell equity for CDS is a credit crisis. This is in fact exactly what we saw in February. As the credit crisis that precipitated the change subsides, money flows back out of short term CDS instruments and back into longer term assets. While we don't have access to CDS price charts, we can certainly see the equity markets didn't stay low for long, which is consistent in fact and in theory with crisis of the past. So CDS competition is necessarily sudden or short lived, especially as CDS contracts are temporal by nature.

The next type of debt instruments we look at are short term parking places: short-term government bonds, and short-term derivatives other than CDS. All are havens for capital in times of uncertainly. All are temporary parking places where one then reallocates into something of greater risk with more reward potential as the precipitating event subsides. The certainty of that movement is assured by monetary low-interest rate policies of central banks. No serious money manager can sit on ROI assets below 2% for long unless in fact the world experiences price deflation of all asset classes across the board. The Austrian theory of inflation arising as a consequence of money creation suggests in this season of 2010 that is an absurd expectation. The arguments to the contrary are addressed below.

Like real-estate, it should go without saying that holding long term government bonds in an era of Keynesian expansion with extremely low interest rates as one of the most high risk (to asset price) low-yield investments of capital. Just as rolling short term bond holdings into short term bond holdings for an extended period is only sensible in an era of broad-based systemic price deflation, holding fixed rate long bonds when currencies are threatened by increasing debt, and interest rates have no where to go but up, is asking for capital loss.

Finally, the last paper asset vying for attention of investor and speculator capital is currency. In a crisis, even after all the liquidity measures and deficit spending in the U.S., the U.S. dollar is still the target of those fleeing for safety. Again, we aren't concerned about whether that is a long term good bet, but simply recognize it as the status quo. If indeed one believes such moves are unwise in the long run, take it as an opportunity to buy more reliable dollar based assets at a discount if it should transpire. But keep in mind, when this flight to safety takes place, money that isn't secured in currency derivatives will be parked in government bonds of the currency of choice, and we’ve demonstrated those arguments only have temporary extremely short value propositions. So the fundamentals of holding "cash" (pseudonym for currency), is really just another name for a bond position, and hence currency moves will follow the fundamentals of bond investments. Since bonds of all substantive nations are basically in the same boat, we don’t expect significant changes in currency price ratios as much as we’ll see in equity positions, and of course foreigners’ demands for equities ultimately translates into foreigners’ bias for currency price ratios. We covered that topic to some degree in our September piece titled "Where is the Next Bubble?"

Given the choices money managers have in allocating capital, there appears to be only one reason to expect any kind of significant decline in equity prices in the near term, and that's a flight to safety. Just as the financial crisis of the past faded into history, there's every reason to believe this one will play out the same. We pointed out some of those reasons in November under the title "Contagion: Been There, Done That"

In that piece we also point out how the latter sub-crisis had less effect than the instigating crisis. We've seen this take place recently with Greece's crisis, where there was some quick and noticeable reaction to flee to dollars and push down equities and commodities, but it was short lived and of little significance. Many have tried to build the case that "this time it's different" and pull some data out of a hat that appears different. Typically what we find is that they simply were unaware of similar data that did appear last time, or they miss the similarity of essence and difference only in nomenclature of the old and new data.

So we are left with the only variable that could explain a protracted equity bear market - positive or negative inflation. Positive inflation usually gets improperly discounted by the established world view in one of two ways -- they pick a measure of money that hasn't grown well and then conclude we'll see tame inflation or deflation, or they pick a secondary influencing factor (velocity is popular these days) and argue that it will overcome the creation of money. We've provided some links on the velocity argument back in July '09 and revealed how money supply and velocity can take some interesting forms. It is our belief that the contradictions between the Austrian school theory that inflation is a monetary phenomena, and the new school that it is a velocity issue, is simply missing the point that the Austrian school theory carries with it an inferred premise that the time between the money hitting the street and the prices showing up at retail are delayed by several months to a few years. In order for monetary inflation to not eventually show up in price inflation (either consumer or capital asset price increases), one has to permanently and systemically keep the velocity low. For nations whose people have consumer goods in abundance, inflation most likely appears in financial asset prices. For nations whose people have a higher portion of earnings going toward basic goods and services, inflation most likely appears in consumer goods.

One could achieve low monetary velocity with an economic collapse, but no substantial and influential market participant in the global economy is working toward that goal. Every policy choice and operation is designed to get people to dump their cash for something that will provide a return. All policies are designed (intentionally or accidentally) to make holding cash a losing proposition. It's the essence of both kinds of capitalism; traditional theoretical capitalism and corrupted modern capitalism. The former objective is to use one's financial capital to produce value in goods and services to reap a return on investment. The latter objective is to use one's financial capital to make other people's money work for you. The latter is the fundamental basis of the debt-money system used by every nation on earth: leverage. With every segment of every population save a few fringe radical thinkers working toward the same objective (i.e. maximum return on investment) something global and earth shaking will have to occur to put everyone off their agenda. We aren't suggesting that can't happen, just that the most likely expectation is that it won't happen until this next round of business cycle expansion pops sometime in the teens of the 21st century.

For the stock market to drop in value, something else has to be in greater demand. At this juncture in 2010 it goes without saying that real-estate and long bonds are non-starters. Other hard assets have proven themselves unattractive as replacements (albeit good co-equals) for equities. Being left with nothing other than short-term non-performing parking places and short term quick gains made attractive by temporary sudden shocks, there simply isn’t any real long-term asset class competition to distract the global investment community from demanding more equity positions. The prudent scholar, historian, and investor should be prepared for another cyclical equity bull market in the coming few years.

Credit Spreads Expected to Narrow

This Time Is Not Different

The business cycle is alive and well. If you read the blogs and mainstream media you'll see a lot of bearish sentiment about the destruction of the American economy. Certain things won't be exactly like they were, but the interesting thing we see often is those bearish pessimists keep trying to discredit the optimists by pointing out the fallacy of "this time it's different", meaning this bubble isn't going to thrive any more than the last one.

Well, they're right on one count. The bubble won't thrive better than the last. But the one guilty of clinging to a fallacy are the bears. The "this time it's different" fallacy really points back at them. See, the bears are trying to sell us on the idea that "this time" the business cycle isn't going to happen. No sir, this time we've really shot ourselves and the stock market is just going to go right back down until the entire economic system of the world resets.

Well, maybe we exaggerate their point of view a little, but the essence is there. We contend the business cycle is alive and well and the prudent person will plan accordingly.

So how then do we interpret the budget deficits in light of the business cycle? For background on the business cycle of boom and bust one should go dig around at some of our favorite economic sites:

The Mises Institute
The Foundation for Economic Education
Cafe Hayek

Budget Deficits For Fun and Profit

Budget deficits necessitate a rise in interest rates. To attract money to Treasuries, the price has to fall since people will be competing for better returns in riskier assets. A lower price for Treasuries will attract that money to that instrument along some continuum of risk/reward which differs from one person to another. Meanwhile, the supply of Treasuries is going to be growing. To attract buyers then, the market has to push down the price of Treasuries.

On the off chance (slim as it is) that the government can’t attract buyers from the open market, the central bank will have to monetize the debt to prevent failed auctions. Hence, gold would be a good buy against U.S. dollar dilution by the central bank. This is not only true because of the recent past liquidity measures, but even more so for potential future liquidity efforts, if they arise.

Nevertheless, even if there are no more waves of quantitative easing, the last stimulus will be enough to create a wave of price inflation in the next five years. The recent sell-off in gold was simply profit taking and flight to cash on fears of Euro defaults, accentuated by program trading on the momentum and short term hysteria. Now that has subsided, we can get a wave of movement back toward long-term fundamental expectations based on centuries-old historical expectations of the boom-bust business cycle.

The beauty of this setup is that it implies higher risk in Treasuries than historical norms. Higher risk between Treasuries and corporate bonds means the spread between Treasury and corporate will narrow to the extent that businesses still know how to run a sound business. This translates to basic business-cycle fundamentals acting in opposite directions on the two sides of the spread.

Even though Keynes may not have had the big picture well understood when it comes to long term health of the economy, he was not wrong that government deficit spending stimulates demand for goods and services in the marketplace. Demand for goods and services in the marketplace is good for “business”, which translates into improving business credit default risk as cash flows improve for them.

Given then improving business credit default risks with degrading government credit default risk, we have a nice scenario that translates into narrowing credit spreads between so called "risk free" Treasuries and business risk corporates.

We're not trying to sell the value of the business cycle, or suggest it's a good thing. We simply want to point out it is alive and well. The fundamental factors that create it in the first place aren't gone. Names change and leaders switch places, but the same system that brought us all the other booms and bubbles is going to give you another one. We happen to think the global Q/E policies of every modern nation on the planet is going to make this next one a doozie. The good news is you have plenty of time to prepare for the pop and chaos that ensues from the bust.

For a more entertaining perspective, check out the viral video "Fear the Boom and Bust".

Why Everyone Is So Bullish on Gold

Cliff Wachtel at Seeking Alpha asked the question today, why are "speculators" buying so much gold while "professionals" are shorting?

It appears to us he fails to realize (or he's obfuscating his real understandings for some journalistic reason) the broader fundamental nature of where prices and value come from. By that we mean the fundamental nature as described by Ludwig von Mises' in Human Action.

In the fall of 2008, the Federal Reserve made it abundantly clear that they would stop at nothing to ensure they could control all financial markets and keep dollars flowing. Finally, after the success at keeping security markets open, they found themselves with functional markets but little or no demand for debt. As money piled up in accounts of all kinds, they then had to worry about the collapse of money velocity.

There is absolutely only one way to make money moving -- punish anyone who doesn't trade it (spend it) in exchange for non-money. Since they have no legislative power, the only tool is debasement and negative interest rates (charging savers for storing money instead of rewarding them with interest payments).

Debasement was easy -- in Dec '08 and Jan '09 they announced unprecedented (in the U.S.) money creation schemes in the purchase of agency debt and U.S. Treasurys. Negative interest rates seemed to manifest themselves by the nature of the credit crisis.

So we now find ourselves in an environment where holding cash carries a risk that has to be weighed against the risks of buying bonds, stocks, commodities, or anything else. Furthermore, add to the equation the necessity of businesses of all kinds to produce a ROI above single digits, and the natural inclination is to buy something that has potential for price appreciation or income. It's no surprise to us in this light, that equities and bonds are showing price strength in spite of so many macro-economic weaknesses and the fragility of all those green shoots.

Enjoy for now the fact that institutions are doing the buying of equities, bonds, and commodities. When the higher costs of the latter start squeezing business profits, they will either have to raise producer and consumer prices or suffer systemic business losses.

In the former case, PPI and CPI go up, which means the risk of "holding cash" now hits consumers with inflation -- they will start spending their cash before it's purchasing power disappears, empowering producers to raise prices (the ultimate feedback loop). In the case of the latter, shrinking profit margins will be bad for equities, which religiously motivates another round of policy changes to "stimulate" the economy, further devaluing (diluting) cash (i.e. dollars).

Very few choices today will provide price support for purchases in either scenario of inflation or economic stimulation (i.e. more currency debasement). One of them is precious metals and their centuries-old reliability as a store of value. It's not a coincidence that some sovereign nations are thinking of gold again as they did before the prevalence of fiat currencies and floating exchange rates. The only major institutions who seem to be bucking that trend are the biggest institutions in traditional western industrial regions who pin all their hopes on fiat currencies. They are the bankers and commercial traders Cliff refers to in his post.

Update Sept 22:
ColdCore now reports at SeekingAlpha some details about those other sovereign nations and their interest in acquiring the "real money" that the west shuns.

The Business Cycle Continues

The last 12 months have seen unprecedented political, financial, and legal change in America and the world. Anyone who thinks they can make a 5-year expensive financial commitment today and go golfing is fooling themselves. Everything needs to be hedged and watched closely with a highly critical eye, with a strategy to get out and reverse course quickly.

The deleveraging angle so often touted as the required outcome from our recent past excesses is moot. There are two ways it can happen and the Fed has predictably chosen the unnatural path. The first way (the natural way) is credit contraction. Not just your favorite metric, but the entire scope across the globe. One thing the recent generation gets out of the new free-trade global economy is spreading of the costs of managed economies. No longer can one central bank destroy a nation through lousy policy as happened in the 90s. Now the consequences of lousy policies are dispersed globally.

The second way, the artificial way, is the course all industrial and developing nations are doing today: debasing the currency. This method works by keeping current-dollar credit values constant from artificial central-bank stimulated demand (see monetarism), but reducing the purchasing power of those dollars by dilution of the currency.

That's precisely why the U.S. economy is stabilizing, and that in turn stabilizes bonds across the spectrum. Oh yea, we will pay for it, but the piper isn't going to come calling in the next 12 months. He's lining up his resources to come charging in sometime in the next 3 or 4 years. The details of the intervention are different this time, but the pattern of replacing wealth destruction with new money (whether by fractional reserve credit expansion from absurdly low rates or direct injections of new reserves when rate intervention is insufficient) has been used over and over with the same outcome every time: economic boom followed by economic bust.

The boom is just starting. The really horrible bust that everyone is ranting about today won't hit us until about 3 or 4 years. You can see that pattern in any of your favorite long-term macro-economic charts.

Corporate Bond Rally May Stall Now

Today high-rated corporate bonds are trading just barely above government guaranteed bonds.

Yesterday we got a glimpse through Seeking Alpha just how far we've come in the last year.

At least at the top end of the rating scale, there's hardly room for any more contraction in spreads. The long term prospects for high-rated corporate bonds doesn't look good unless in fact Bernanke can actually overcome the forces of monetarism and keep real inflation at historical lows.

The best bet in bonds is the lower grade issues at this point. If high-grade rates remain low on a recovering economy from central bank purchase demands, those lower rated investment grade bonds will see continued contraction in spreads as default risk subsides. If high-grade rates rise while the economy recovers, lower rated investment grade bonds may not see declining yields, but contraction in spreads can still produce stable prices and above-inflation yields.

There are two primary risks, one of which is almost ignorable. The first is demise of the global economy, which is most unlikely but theoretically possible. For that scenario you better have backup food supplies, loads of currency (legal and barter) tucked under your mattress, and a plan for wilderness survival. The second is inflation rates rising to the point where low grade bonds fall in value with or without contracting yield spreads. This is much more likely than the former, and highly probably if Governments around the world don't back off their stimulus programs in rapid fashion.

The good news on the inflation story is monetarism reveals this kind of inflation takes 12 to 24 months to find it's way into consumer prices. At that point one will have to switch to inflation investing.

Until then, high yields, contracting spreads, and green shoots are the fundamentals one should be keeping their eyes on, and high yield investment grade bonds provide a tempting opportunity not often available with fundamental support like we have today.

How Ben Bernanke Saved the World

Subtitle: "How I Learned to Land a Helicopter", by Ben Bernanke

The title is past-tense for posterity's sake. This link needs to be remembered in the future when reality testifies on Ben's behalf. Fortunately for Ben we can never know what might have been -- we only know what he claims would have been if not for his policy, and must believe reality is better no matter how bad it is in fact, when the facts are in.

This, though, is his expose on how he plans to keep the world from hyperinflation after the biggest creation of fresh dollars the world has ever seen. Download a copy for posterity before the Wall Street Journal archivists cut off the link.

This isn't very reassuring: "we can raise the rate paid on reserve balances as we increase our target for the federal funds rate."

It's reassuring if all one cares about is ensuring that interest rates rise. We'd really like to know how the next upward move in fed funds isn't going to create a financial shock like all the others in this present generation. Granted, inflation is under control as measured by CPI and a few other choice tools, but 9+% unemployment is approaching historic levels, so this last fed funds move failed on the employment objectives. And apparently wiping out American investors' wealth is an acceptable outcome (as happened in the dot-com bust and now the real-estate bust) since it isn't a policy mandate to target preservation of American 401(k) accounts.

Furthermore, it doesn't address the bank's fiduciary duty to shareholders. How are banks going to justify tiny ROI when fed-funds level of yields are earned on an ever growing pile of reserves? This is going to pressure banks to use reserves for higher-yielding assets. To keep bank stockholders from rebelling, the rate on reserves is going to have to be higher than fed funds. This program will create a ceiling for fed funds, not a floor. Small banks without large in-house investment departments like Goldman and Morgan (recently converted to banks) are going to demand yields that match ROI garnered from their securities market operations. Equity investors will not stand for ROI in single digits. If banks can't make loans to business, they will seek out returns in other markets like securities.

As taxpayers, we're not very reassured. It is certain this board of governors won’t make the same mistakes as their predecessors, but equally certain the mistakes they do make will be costly. One can always offer the blind assurance that it would be worse with any other option. But of course you can’t prove what might have been. You can only have faith. When it comes to faith in the central bank policies, our only faith is that they will create a boom-bust cycle just like they have for generations. As for us, we’ll prepare for the inevitable disaster in what ever form it comes in the next business cycle bust, including the potential of having to pay 80% tax rates on inflation-induced capital gains for the "rich" (where rich is defined as anyone not a ward of government social programs) to pay for the next Keynesian stimulus devised for the consequential bust of present-day quantitative easing.

Velocity of Money

We're going to have to do some serious research on the Velocity of Money. This topic keeps coming up, but there doesn't appear to be a good discussion of the fact that Velocity can't be measured; it can only be calculated.

Furthermore, the fact that it exists (though some think it doesn't) doesn't mean it is the cause of inflation. Most posts appear to interpret it that we.

We at SBC believe velocity is a consequence of the psychology driven by theories expounded on by monetarism and Austrian economics. Until we get the in-depth analysis, we'll have to suffice for a few comments on the web.

See today's note on Seeking Alpha.
And another on Across the Curve.
And what appears to be one of the first arguments discussing Velocity and Monetarism. Mauldin has good analysis, but we don't think it discredits the view of V as a symptom rather than cause. Rather, it simply explains why there is a 12 to 18 month delay between monetary expansion and price expansion.

If you have more background and commentary, please put them into the comments so we can consider them in our analysis.