Where is the money coming from?
Cliff Droke
As the great inflation versus deflation debate rages on, one fact remains undeniable: there is still an awful lot of money out there in the U.S. economy and it must be coming from somewhere. The question is, where? To that end I'd like to make a few inputs and even make amendments to my previous article on M3 money supply.
To begin with I'd like to share the insights from a reader response sent to me recently, "I have followed this money supply issue closely. Jim Sinclair, Harry Schultz, you and Lawrence Kudlow are all stating that the Fed is not pumping [money supply] hard enough to keep us from another 1929 style money crunch, while Dick Russell and others state that the Fed is pumping like crazy. That money supply chart from your [last] article looks like a Dow/NASDAQ chart. The market tops in 2000 and then plunges into October 2002 and then rallies, so the money supply follows. So if the biggest factor in M3 money supply is stocks then look to stocks to be your guide -- if stock prices go higher then your rate of change M3 goes up. It seems reflexive and if there is no real way to get the NASDAQ back to 5000 soon then it seems that the M3 will be lacking. It seems that no amount of pumping can [do that]."
This very astute observation, coupled with some inner hunches I've had in recent weeks in examining the economic data, leads me to believe that this reader is one the right track (although the Dow/M3 correlation may not be as reflexive as he suggests). Let's face it, the M3 money supply rate of change is no longer the useful guide to gauging the overall state of the economy it once was. It was once thought that the rate of increase in M3 was 1:1 with the rate of inflation. But this relationship no longer exists due to a variety of influences. The enormous increase in financial instruments as well as the subtle shift in Federal Reserve monetary policy in recent years certainly has much to do with it. But the bottom line is that M3 is no longer the reliable guide it was in years past.
It is true, as the M3 rate of change chart highlighted in my previous Gold-Eagle article suggests, that M3 money supply has dropped sharply in the past several months. Yet can anyone doubt the still mind-boggling quantities of money that are still keeping the economy afloat? Where is the money coming from to push real estate prices to the dizzying heights they have now
reached? Where did the money come from that allowed the stock market to post an impressive spring rally? Is the Fed embarking on an inflationary course or a deflationary one? How can we know one way or the other? I believe the answer, in part, lies in at least three major factors: interest rates, bank credit (debt creation), and securities lending. Most of the assets of the banking system are bank credit -- loans and securities. Bank loans to the nonfinancial sector and bank holdings of securities issued by the nonfinancial sector are part of nonfinancial debt. Implicitly then, a good part of M3 is represented in
nonfinancial debt.
While the chart for M3 rate of change has been declining, take a look at what the chart for bank credit (data courtesy of the Federal Reserve) has been doing lately. As you can see, it has been sharply rising all year. This shows, in large measure, where the money is coming from to keep the economy afloat.
Here's another very telling chart that shows real estate loans outstanding. This is probably the highest-flying chart of them all and shows what sector of the economy most of the money has been created in since last year.
Below is an updated Fed securities lending chart compared with the Dow Jones Industrial index. Note the sharp spikes in interventionism over the past six months. They say "a picture is worth a thousand words," and I believe these charts speak for themselves. These three charts show where all the money is coming from.
Concerning interest rates, Michael Jenkins, writing in a recent issue of Stock Cycles Forecast, writes, "The Fed believes if rates are too low people can borrow and that will prevent forced selling. The flip side of too much liquidity is that a debt bubble forms with overextended first time home buyers, 2nd and 3rd home mortgage borrowers and incomes of pensioners being destroyed with little or no bank account interest incomes." This observation is precisely along the lines of current Fed thinking, namely, an
aggressive interest rate reduction and debt expansion policy.
Bernie Schaeffer, editor of the Options Advisor newsletter, has remarked that "While the Fed's 13 rate cuts since 2000 have not succeeded in breaking the grip of the bear, I believe we may be entering a period...in which economic growth and earnings will matter little and 'overbought' technical indicators and 'complacent' sentiment indicators will throw off false signals. Instead, this period will be one in which liquidity will rule." Schaeffer points out that the sources of this liquidity include the Fed's
aggressive program of money creation, money flowing from bonds back into stocks, and money flowing back into equity funds, among other things.
Have we seen a bottom in the interest rate spiral? In a March 28, 2001 speech presented by before the Fed by Governor Laurence H. Meyer, the stunning admission is made that rates will eventually be driven to zero here in the U.S. In the speech Meyer draws on parallels from the deflationary experience of Japan and states emphatically that the U.S. will repeat this
experience of 0% interest rates, adding that "I believe we have more to learn about the role that monetary policy can play once the [interest] rate is driven to zero." Interestingly, in that speech he references an article entitled "Zero Bound in an Open Economy: Escaping a Liquidity Trap." It is obvious from reading Meyer's speech that the Fed is gearing up for battle again long-term deflation.
Along these lines, Richard Russell in a recent issue of Dow Theory Letters, points out that the U.S. economy is actually set up for inflation, not deflation, and that if deflation became a reality it would obviously wreak havoc. "One problem today," he writes, "is that 'everything is debt.' Homes are mortgaged to the hilt, cars are bought on time, clothes are bought on time and furniture is bought on time. The estimate is that there's a total of $38 trillion of debt outstanding in the U.S. The debt has to be carried." Russell further states, "What's safe? What isn't a product of debt? What can I hold that can't go bankrupt? The answer -- gold, jewelry, a house owned free and clear."
It is obvious that the Fed is planning to try and "soft land" the economy by any means necessary. As the U.S. economy is debt-based, the key is to keep consumers spending and don't give them a chance to think about their money (e.g, whether to save or spend). Through the artificial stimulation of demand (saturation advertising, discussed in one of my previous Gold-Eagle
essays) and through its economic policies, the Fed hopes to keep the consumer -- and the economy -- afloat. But the question is "how long will they succeed?" Only time will tell.
July 7, 2003
Clif Droke is the editor of the Bear Market Report newsletter, a 3-times weekly forecast and analysis of stocks, markets, gold stocks, and equity cycles. He is also the author of numerous books on finance and investing, including the top-selling "Moving Averages Simplified." Visit his web site for free samples of his analysis at www.clifdroke.com
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