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.

Now YOU Can Have Bank Reserves, Too.

"As an additional means of draining reserves, the Federal Reserve is also developing plans to offer to depository institutions term deposits, which are roughly analogous to certificates of deposit that the institutions offer to their customers."
(Source: Ben Bernanke's exit strategy testimony)

We have to hand it to this guy, he is one of the most creative bankers in history. In just two sigmas the American people can sink their claws into Federal Reserve excess reserves. Now all we need are 15 million savers willing to lock up their full FDIC insurance allocation in these new instruments, which will probably pay diddly-squat interest.

Of course money market accounts will have direct access, too, so the consumer angle is actually not that important, provided consumers feel compelled to put their money into money markets paying diddly-squat instead.

The real problem with bank reserves is that they don't provide a rate of return. The only way to entice the free market to park their money in reverse repos is to make them more attractive to alternative investments. So this plan can only work if interest rates rise (to attract capital into these instruments) or velocity of money remains low (velocity being the basis for high reserve balances as a threat). If velocity picks up, price inflation will also, and rates will naturally rise. The trillion dollar question is how quickly can rates stifle inflation forces, or will the lag between price increases and rate increases be a kind of self-accelerant of velocity. The feed-back loop could be phenomenal.

But that's all just speculation, isn't it? No doubt the creative genius of Bernanke will devise a plan for that at the right time. Of course Greenspan didn't stop the dot-com bubble, and Bernanke didn't stop the real estate bubble, so it's pretty hard to imagine what will provide Bernanke with the incredible insight and forethought to recognize how to prevent the next bubble. One thing is for sure, it ought to be interesting.

In July of last year we had similar comments on the exit strategy. One might want to compare notes, both ours and Ben's, to see how things have changed.

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.

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.