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What do we Learn from History?

June 25, 2001

After years of worldwide high broad based monetary growth (M3) many investors ask themselves in what direction the economy will go. Are we headed for hyperinflation, depression or will goldilocks come back soon?

The Japanese economy is an interesting example for high M3 monetary growth from 1980 to 1992. In the first chart we can see that nearly 10 % M2+ growth did accelerate inflation only over a brief time span. In the following years the economy ended in a steep and prolonged deflation..

The same effect of high M3 growth could bee seen in the US. Very high M3 growth from 1980 to 1988 (Reagonomics) ended up in an only brief surge of inflation around 1992. The same in the last decade. Very high M3 growth increased inflation. Nevertheless, all signs are already in the cards that inflation will go down in the next future.

So, high M3 growth leads in the long term to lower inflation and has rather a deflationary effect on the economy.

As we look at the correlation between M3 and the gold price, which has a well established reputation as inflation indicator, this view is once again confirmed.

Strong growth in M3 leads to a lower gold price and lower inflation.

This sounds really odd as high monetary expansion should always lead to high inflation i.e. more money is available than goods and then inflation will rise at a certain point.

The explanation lies in the fundamental difference between the broad monetary aggregates (M2 and M3) and the narrow monetary aggregate M1. Broad money includes long term commitments such as bonds and mortgage rates and other securities. Bonds and long term securities represent nothing more than a promise of the seller of such a security to pay cash in the future to the investor. It is not yet real money, it is just a promise for the future to pay the agreed interests and the principal. In an extreme case (if the security holder defaults on its payment) this money growth does not realise at all. If this happens in an economy to a high degree (many defaults on bonds and other securities) the economy slips in a depression as we can see it now in Japan. Despite very high M3 growth over one decade the Japanese economy is now in a deep depression at low inflation and low economic growth.

Nevertheless, what causes then inflation as we have seen it in the seventies. My research has shown that the real indicator for future inflation is M1 growth.

M1 represents practically real money or cash and 'near cash' items. If this aggregate starts growing future inflation will occur.

As an economy which has grown through high M3 monetary expansion falls over time into a depression, central banks have to step in and monetize bonds and securities.

The process of monetizing is a conversion of M3 money into M1 money. Central banks just buy bonds and other securities on the open market and turn these monetary items into cash. This is what central bank do not like to do as they know the inflationary impact of these actions. This is all about the struggle between the Japanese government and central bank. Politicians want the Japanese central bank to buy more government bonds and thus monetize these bonds. Nevertheless as the economic pain increases, the political pressure increases as well on the Bank of Japan to monetize bonds and thus turn M3 money into cash M1 money. Especially as nobody can see inflation at present in Japan.

As the economic effect of high M3 growth starts to feel also in the US, for the first time in nearly a decade, the US Fed is forced to monetize money as it could be seen in the now rising M1 aggregate. This bodes well for the precious metal markets. The current pressure and economic difficulties will force the Fed to increase the monetization process and thus increase future inflationary pressure. The deeper the depression the more central banks are forced to monetize M3 and the higher the future inflation risk - and the higher the precious metal prices.

To the astonishment of many observers the precious metal prices will rise just when M3 growth slows down. As at the same time M1 will rise strongly the gold price will rise in line with inflation expectations. This process starts now due to the monetization process and due to the funding of capital from the federal funds rather than from the capital market. The period of 1992/1993 has been such scenario. This has been also the last time when precious metals rose significantly.

This process happened already in the Great Depression, which has forced central banks to monetize M3 aggregates. This process is going on now in Japan and this process just starts in the US. First we will have a depression, which forces central banks to monetize (print real cash), which in turn forces very high inflation in the future.

It is very tempting for central banks to engineer an entirely M3 lead economic expansion as this ensures a long period of practically inflation free economic growth (remember 'goldilocks'). Nevertheless, they have to pay the price later as they have to monetize bonds and securities in a depressed economy especially when the economy has experienced many mmisguided investments, which causes defaults and under performing assets.

Central Banks are running now into the same trap as 70 years ago. This is all over once again the 30' and the Great Depression followed by high inflation. First Japan, now the US and Europe will soon follow. Despite all research and huge economic departments in banks, governments and universities, nothing has really changed.


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