The "new" Y2K Crisis

June 27, 2000

The transition from 1999 to the Year 2000 was a smooth one. Contrary to the calamitous expectations and dire forecasts of Y2K "scare-mongers," the lights stayed on and the world didn't screech to a halt. More importantly, the global computerized financial system continued to function smoothly, thus negating predictions of widespread financial collapse and panic. Y2K was a non-event…or was it?

After the midnight hour had successfully passed without a glitch on January 1, 2000, the civilized world breathed a collective sigh of relief, forgot about the problem and went on with their lives. Yet far beneath the seemingly benign veneer of the technological and financial infrastructure lies a problem equal in size and significance to the predicted Y2K calamity. Only this time, the problem is of a more abstract and less noticeable variety. The problem we are referring to concerns the U.S. monetary base—the very lifeblood of our financial system and economy. We first brought this developing scenario to your attention in April, and the brewing crisis has only worsened since then. Compounding this problem is a new development, which promises to add fuel to the coming conflagration.

The troubling development we are referring to is the rapidly contracting money supply, which is regulated by the Federal Reserve Board. The available above-ground supply of money and credit, after rising in exponential fashion from 1998 through 1999, promptly reversed in January 2000 and has been virtually collapsing ever since. Since the U.S. financial system is predicated on a highly liquid profusion of credit winding freely through the veins of commerce and banking, this stunning credit contraction—the first such decline since 1994, and the most severe restriction in the money supply since 1929—guarantees we will witness a corresponding restriction in trade and commerce beginning this year. Since our booming "New Economy" is predicated on ever-expanding levels of credit, it won't be long before the very concept of an economic boom and a "New Economy" are called into question by the mainstream financial press. But you heard it here first.

The accompanying chart shows the sharp reversal in money supply momentum—defined as the rate of change in money supply growth—from 1980 to the present. Notice how the growth in the money supply, which began in force in late 1998, reversed course precisely in January 2000—the first month of the new millenium. This represents the real "Y2K Crisis." Money supply momentum (the proper measure of available money and credit supply) continued to drop in the months February through May, with the latest statistics for June (through the 16th) showing even more erosion of the monetary base.

The question remains, who or what is responsible for this decline in liquidity? Since the monetary base represents money available through the banking system, a decline in this figure does not necessarily mean that liquidity in the financial system is drying up. It can mean, as it did in 1995, that the investing public is removing funds from the bank and transferring it to another sector in the economy—like the stock market, for instance. This is precisely what accounts for the profound decline in the monetary base in 1995, even as the Dow soared throughout the year. The simple explanation for the decline in measurable money supply in 1996 was that investors were taking money out of the bank and putting into the stock market (this is further confirmed by the fact that the yield on the 30-year Treasury fell throughout the year, indicating that the Federal Reserve was a net buyer of bonds that year, thereby keeping the financial system liquid). While this presents a potentially dangerous problem for the banks, it doesn't necessarily put the entire financial system in jeopardy since the money is still there "for the taking." As long as it doesn't completely disappear from the financial system, liquidity is not an issue.

When, however, money supply momentum decreases rapidly (as it has so far this year) and there is no corresponding increase in stock market volume (as has also been the case thus far), it points to the fact that the Fed alone is acting to curtail liquidity from the financial system for whatever reason. The result has always been a crash in equity prices and a deep economic recession. Historically, it has taken anywhere from six months to a year before the effects are felt. In 1987, for instance, the year of the October crash, money supply declined for a good eight months before the effects were felt. In 1929, the Fed slammed the brakes on credit in February or March of that year, with the crash coming in October—about eight months. As of this writing, the decline in money supply has been ongoing since January, so we could see a stock market crash as early as September. Early warning signs already point to a coming economic slowdown.

As if that weren't bad enough, the Fed has embraced a hawkish interest rate policy over the past year. Fed Funds interest rates recently hit 6.5%, while the prime lending rate presently stands at 9.5%, the highest since 1990 (about the time the last recession began). The long-term chart for interest rate yields shows a distinctive bowl-shaped pattern, portending a rising trend in the years immediately ahead. History shows that whenever the Fed carries out a strategy of continually raising interest rates while diminishing bank liquidity, the economy is always worse for wear. And for those who are unfortunate enough to be debtors, things only promise to get worse.

Another unexplained aspect to this developing story is how this situation came about. Has the Fed actively decided to pull the plug on the financial system, in effect saying to investors and consumers, "The party's over"? Is this an election-year ploy aimed at downing the economy just in time for Clinton to step out of the picture and avoid blame, while pinning it squarely on the Republicans (assuming George Bush wins the election)? More far-fetched, perhaps, but equally worthy of consideration: Did Y2K have something to do with this (i.e., computer-related disappearance of funds, or perhaps an ex-post-facto reaction on the part of the Fed)? All of these questions and more will soon be asked by the mainstream media, but only after it is too late. We can only hope that acceptable answers will be provided, enabling us to at least learn a lesson and hopefully avoid a similar circumstance in the future.

At any rate, the Year 2000 promises to be exciting in eventful in ways that few expected. The Year 2000 isn't over yet—not by a long-shot. When all is said and done, perhaps the Y2K "doomsayers" were right after all.

Clif Droke is the editor of the three times weekly Momentum Strategies Report newsletter, published since 1997, which covers U.S. equity markets and various stock sectors, natural resources, money supply and bank credit trends, the dollar and the U.S. economy.  The forecasts are made using a unique proprietary blend of analytical methods involving cycles, internal momentum and moving average systems, as well as investor sentiment.  He is also the author of numerous books, including “2014: America’s Date With Destiny.” You can view all of Clif's books here. For more information visit www.clifdroke.com.

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