Posts Tagged ‘money supply’

When to start speculating again?

Thursday, July 8th, 2010

As we wrote before in Notice the change of narratives in the financial markets?, the theme for the coming months is likely to be deflation (contraction in the supply of money and credit). The symptoms of deflation will include falling asset and commodity prices and appreciation of the US dollar.

The reason why deflation is gaining the upper hand is that governments are not renewing their appetite for maintaining the crutch (economic ?stimulus?) to keep the economy from sinking. In Europe, the government themselves are deleveraging (see Keep up spending- Who?s right? Europe or America?).

But as contrarian investors, we have to keep one step ahead. As deflationary forces gather steam, eventually the government will be spooked. Eventually, they will be pressured politically to do ?something? about the situation. That ?something? will ultimately boils down to turning on the monetary printing press.

For example, as this news article reported, there is an expectation that the Chinese government will do ?something? if stock prices continue its downward trajectory. In the US, RBS recently warned its clients to be prepared for a ?monster? money-printing operation from the Federal Reserve (long before RBS released this, readers of this blog already know beforehand that this will happen- see Bernankeism and hyper-inflation).

When governments do ?something? about the deflationary pain, it will be a signal to shuffle your money back into speculation.

Demand for money, inflation/deflation & its implication

Tuesday, December 2nd, 2008

Two years ago, we first covered the root cause of inflation in Cause of inflation: Shanghai bubble case study:

The mainstream economists? definition of inflation is rise in the general level of prices. However, according to the Austrian School of economic thought, the definition of inflation is the increase in the supply of money, in which the effect is the rise in the general level of prices.

As we have shown in yesterday’s chart in Australian money supply growth in September 2008, the supply of money in Australia had gathered momentum in the month to September 2008. In 12 months, the M3 money supply increased by 19.5%. The narrower definition of money, M1, increased by 8.3%. Does this mean that Australia is going to face runaway price inflation soon?

As a general principle, in the long run, there is a relationship between sustained monetary inflation and price inflation. In the same way, there is a relationship between a long-term lifestyle of eating excessive junk food and ill-health. In the interim, this relationship is more complicated. Using the junk food analogy, say that junk food eater dies of heart disease. What is the cause of death? Is it the heart disease? Or is it his sustained junk-food life-style?

Back to inflation, it is certainly possible to see continuing monetary inflation and slowing price inflation. In the US, the latest CPI figure even hinted of a price deflation! Therefore, in the short-term, there may not be a correlation between monetary inflation and price inflation. Part of the problem lies in the nature of how price inflation is measured and defined. As we said before in How much can we trust the price indices (e.g. CPI)?, price indices is a logically invalid idea. The implication is that it is possible to ‘define away’ price inflation and pretend that it is not a problem by torturing the statistics.

But setting aside the logical validity of price indices, what other dynamics is involved that can result in such non-correlation in the short-term? We will introduce one such dynamic- demand for money. This dynamic should not be confused with demand for credit. In lay-person’s terms, the demand for money is the desire for people to keep cash balance. As we wrote in The mechanics of deflation- increase in demand for holding cash,

Deflation happens when liquidity dries up. This can happen in a period of severe economic pessimism when the apprehension of the future drives people to increase their holdings of cash for the sake of peace of mind. When that happens, the quantity of money in circulation decreases, which means there are fewer money chasing after a given amount of goods and services. Consequently, prices have to decrease to accommodate for the decreased supply of money in circulation.

Let’s say the quantity of money increases in the system. But if people want to increase their holdings of cash due to fear and uncertainty of the future, they will withdraw these cash from circulation in the economy. Consequently, prices fall. As we wrote,

When deflation mentality gets a stranglehold on to the minds of the people, no one will dare to borrow money out of fear. Also, when prices are falling, the money that one borrows will be worth more by the time the debt is due. There is no point in spending money because if one waits a little longer, prices will fall further. Central bankers can print as much money as they can, but in such a deflationary environment, no one will want to borrow them.

Today’s credit crisis is an example of this. Banks are hoarding cash and are unwilling to lend while borrowers are repaying debts with every scraps of cash that they can get their hands on. As a result, liquidity dries up in the system even though the supply of money is desperately increased by the central bank. In such a situation, some broader measures of money supply will be shown to decrease.

The opposite can also occur. As we quoted Ludwig von Mises in What is a crack-up boom?,

But then finally the masses wake up. They become suddenly aware of the fact that inflation is a deliberate policy and will go on endlessly. A breakdown occurs. The crack-up boom appears. Everybody is anxious to swap his money against ?real? goods, no matter whether he needs them or not, no matter how much money he has to pay for them.

In such a situation, the demand for money collapses. People want to keep their cash balance as low as possible as they constantly want to get rid of their cash for ‘stuffs.’ In the extreme case (i.e. hyperinflation), prices rise by the hour as people rush out to buy things the moment they are paid their wages, for fear that if they do not do so, price inflation will render their cash worthless.

Now, let’s look at what’s happening in the world. Merely 6 months ago, when oil prices was threatening US$150 and soaring food prices was driving people in poor nations to riots, the fear was price inflation. Today, with oil prices below US$50 and hardly any news on food prices, the fear is price deflation. Such extreme volatility is unprecedented in the history of humanity. It is this volatility and madness in prices that will wreck the real economy in the longer term (see Real economy suffers while financial markets stuff around with prices).

Where is the source of such extreme volatility?

As you may have already guessed by now, governments and central banks, in their attempt to solve the global financial crisis, is creating all these volatility through their interventions against the free market. Ironically, their ‘solutions’ are sowing the seeds of economic hardships for the next generation.

Australian money supply growth in September 2008

Monday, December 1st, 2008

We had just taken a look at Australia’s money supply growth for September 2008:

Australia's money supply growth for September 2008

Notice that money supply growth seemed to have slowed down from May to June 2008 before resuming its rapid growth again from July 2008 onwards. The M3 money supply is at a record high of AU$1090 billion. For those who are new here, we recommend What is money? to understand the monetary jargon that we used in this article.

Australia’s money supply growth till August 2008

Thursday, October 16th, 2008

The last time we reported on Australia’s money supply growth was on April (see Australia?s money supply & credit growth in April 2008). Today, we have an updated chart:

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The year-on-year M3 growth is growing at a decelerating rate since November 2007. In August 2008, it was 18.9% when M3 was at the record high of $1065.9 billion. November 2007 had the highest year-on-year growth of 23.1%. Coincidentally, November 2007 saw the peak of the Australian stock market.

For those who are new here, we recommend What is money? to understand the monetary jargon that we used in this article.

Will deflation win?

Thursday, August 21st, 2008

In just a few months ago, the talk in town was price inflation. Oil, food and commodity prices were rising, as we wrote Who is to blame for surging food and oil prices?. Today, the talk is different. US house prices have never stop falling. Gold, oil and base metals are falling. There is even talk about the end of the commodity boom, the end of the commodity “super-cycle.” Economic slowdown and recessions are the expectations of the market.

Long time readers of this publication should never be surprised to see this is happening. As we said back in March last year in Inflation or deflation first?,

If you have been with us long enough, you may have heard us mulling over both the threats of inflation and deflation on the global economy (see Spectre of deflation and Have we escaped from the dangers of inflation?). You may be wondering whether we are contradicting ourselves. How can both threats exist simultaneously? Since one is a general rising of prices and the other is the opposite, are they not mutually exclusive?

At this current phase of the financial crisis, we are experiencing deflation. It is reported that the US M3 money supply is currently “collapsing.” A falling money supply is the definition of deflation, for which the symptoms will be falling asset prices, which if prolonged enough, will lead to falling consumer prices. But before we go off to celebrate falling prices, remember that this is an evil type of deflation because it is the type that is associated with bad debts, bankruptcies, unemployment, falling income, bank runs and so on. The angelic type of deflation is caused by rising output and production, which is clearly not the case in the debt-addicted Western economies but more true for China with its government-forced savings.

When the US money supply shrinks, it increases in value relative to the other currencies as the US dollar gets repatriated back to make up for the dwindling supply of cash back in the US. That’s why we are witnessing a rally in the US dollar and a fall in commodity prices as there is a mad scramble to liquidate whatever assets to raise cash.

With the current legal powers, the US Federal Reserve is quite powerless to stop deflation (see Are we heading for a deflationary type of recession?). It can cut interest rates, but it cannot force people to borrow. Even at 2% Fed fund rate, the shrinking M3 money supply is proof that monetary policy is still tight (see What makes monetary policy ?loose? or ?tight??). Will the Fed continue to cut interest rates? It had already tried but failed a few months, which resulted in skyrocketing oil and gold prices. We doubt Ben Bernanke is going to try it again.

Meanwhile, the US Treasury is preparing open up the bottomless coffers of the US government to nationalise Freedie Mac and Fannie Mae, who are essentially insolvent. The question is, with the US budget deficit already in the red (plus the massive current account deficits), where is the money going to come from to do that? If a savings-less individual spend more than he/she earns, that individual is basically bankrupt. But for governments, it is a completely different story. They can make up for the shortfall by borrowing from the public by selling newly issued government bonds. As a last resort, it can sell the bonds to the Federal Reserve, which is called “monetising debt” or printing money.

Will it get that bad? It can if the deflation threatens to shock and awe the entire nation into a Greater Depression. By then, as we said before in A painful cleansing or pain avoidance at all cost?,

Even if Ben Bernanke is an Austrian economist, political pressure alone will do the job of forcing him to act otherwise. This is the Achilles? heel of democracy. The mob will scream at the Fed to bail them out by ?printing? money (i.e. pump liquidity into the economy in the form of cutting interest rates). Should the Fed refuse to comply, we can imagine the mob storming the Federal Reserve to demand the head of Ben Bernanke. Therefore, the Fed will have no choice but to acquiesce to the desire of the mob, whose aim is to avoid immediate pain as much as possible.

Therefore, as we advised before in Recipe for hyperinflation,

Therefore, watch what the US government is doing with the monetary ?rules? in its attempt to fight deflation.

The difference between money and credit

Sunday, August 3rd, 2008

For our long-time readers, we often mention the word “money” and “credit” side by side in the context of money supply (e.g. our earlier article, 363 tons of US dollars to Iraqóhow much money will eventually be multiplied into the economy?). The problem with this is that it is a form of sloppy language that can lead our readers astray in their understanding of the economy. It leads to confusion between money supply and credit. Therefore, we are writing this article to address this issue.

Before you continue reading this article, please take a read at Introduction to banking corporate accounting and Effect of write-down on bank balance sheet because we will be explaining money and credit in terms of simplified corporate accounting.

Let’s suppose there are two banks in the economy that has an initial balance sheet that looks like this:

Bank A
Assets: 0
Liabilities: 0
Equity: 0

Bank B
Assets: 0
Liabilities: 0
Equity: 0

Now, say Tom has 100 gold coins. Therefore, the total supply of money in the economy is 100. He deposits the 100 gold coins into Bank A. The outcome will look like this:

Bank A
Assets: 100 (gold coins)
Liabilities: 100 (gold coins)
Equity: 0

Bank B
Assets: 0
Liabilities: 0
Equity: 0

Now Bank A lends 90 of the gold coins to Dick. The outcome will look like this:

Bank A
Assets: 90 (loan of gold coins) 10 (gold coins)
Liabilities: 100 (gold coins)
Equity: 0

Bank B
Assets: 0
Liabilities: 0
Equity: 0

At this point in time, the money supply has increase from 100 to 190 (100 in gold coin deposits and 90 in the hands of Dick). Credit, on the other hand, had increased from 0 to 90. Now, let’s say Dick then deposit the 90 gold coins on his hands into Bank B. The outcome will be:

Bank A
Assets: 90 (loan of gold coins), 10 (gold coins)
Liabilities: 100 (gold coins deposit)
Equity: 0

Bank B
Assets: 90 (gold coins)
Liabilities: 90 (gold coins deposit)
Equity: 0

At this point in time, the money supply is still 190 and credit still at 90. Now, Bank B then loan 81 gold coins to Harry. The outcome will now be:

Bank A
Assets: 90 (loan of gold coins), 10 (gold coins)
Liabilities: 100 (gold coins deposit)
Equity: 0

Bank B
Assets: 81 (loan of gold coins), 9 (gold coins)
Liabilities: 90 (gold coins deposit)
Equity: 0

At this point in time, money supply has grown from 190 to 271 (190 as gold coin deposits and 81 in the hands of Harry). Credit has grown from 90 to 171. Let’s say Harry lost all the coins in a fit of vice by splashing them all on drugs. He then lost his job due to his drug addiction and becomes insolvent as a result. What will happen next?

Bank B’s asset will have to be completely written down:

Bank B
Assets: 0 (loan of gold coins), 9 (gold coins)
Liabilities: 90 (gold coins deposit)
Equity: -81

Bank B is insolvent in this case because its equity has gone negative. For the sake of illustration, let’s assume that there’s a massive cover-up between the government and the banking system to keep this bad news from the public. At this point in time, the total credit in the economy has gone back down to 90. Thanks to the cover-up, both banks are still operating. Therefore, the money supply is still at 271 (190 as gold coin deposits and 81 in the hands of the drug dealers, who then spends it all on other things).

Now, here comes a twist. The government needs to secretly bail out Bank B but where is it going to find all the gold coins? Since Bank B has only 9 gold coins left, it is only a matter of time before Dick will realise that his deposits are amiss. Therefore, the government decide to come up with a scam. It will raise taxes and hauled in 20 gold coins as a result. Then it will dilute the gold in the 20 gold coins and produce 81 ‘gold’ coins. It then ship the 61 counterfeit ‘gold’ coins to Bank B. Now, the balance sheet of Bank B will look like this:

Bank B
Assets: 61 (‘gold’ coins), 9 (gold coins)
Liabilities: 90 (gold coins deposit)
Equity: -20

No one discovers this scam. Officially, the money supply still stands at 271 (190 as gold coins deposit, 61 gold coins dispersed in the economy by the drug dealers’ high spending ways and 20 supposedly at the government. Total credit still stands at 90. Now, Bank B decides to lend 40 ‘gold’ coins to Thomas, a pious and enterprising businessman.  The balance sheet will now look like this:

Bank B
Assets: 40 (loan of ‘gold’ coins), 21 (‘gold’ coins), 9 (gold coins)
Liabilities: 90 (gold coins deposit)
Equity: 0 -20

Now, the money supply swells to 311 (190 as gold coin deposit, 61 gold coins dispersed in the economy, 20 supposedly at the government, 40 ‘gold’ coins in the hands of Thomas). The total amount of credit has swelled from 90 to 130.  The monetary base in the economy is at 161 (9 gold coins in Bank B, 21 ‘gold’ coins in Bank B, 61 gold coins dispersed in the economy, 10 gold coins in Bank A, 20 ‘gold coins in the government and 40 ‘gold’ coins in the hands of Thomas). You can do a quick cross check on the figures- originally there was 100 gold coins and the government took 20 and dilute it into 81 ‘gold’ coins.

That’s the end of this simple story. In summary, money and credit are related but they do not refer to the same thing.

When will serious inflation catch up with us?

Thursday, July 31st, 2008

Recently, one of our readers asked us this question:

If, as you have reported, our money supply is still increasing at over 20% per annum, what is this likely to lead to in terms of price inflation in the years ahead? I suspect that it will somehow catch up with us one way or another, and the result will not be pretty. But this is just a generalised gut feeling, which is not as useful as a more particularised and detailed understanding would be for positioning oneself for the inevitable. Part of a clearer vision would be, of course, a better sense of the likely timeframes involved. How long before the ugly bits start to catch up with us, and how long will it be likely to last? What will be the signs of imminent danger? Or do we already have plenty of them now, as we speak?

First, for those who are new to this publication, we would highly recommend that you read Cause of inflation: Shanghai bubble case study before continuing reading the rest of this article. The reason is because mainstream economics and the Austrian School of economic thought have different definitions for inflation. To make our language more precise, we will refer to the former’s definition simply as price rise and the latter’s definition as monetary inflation. If you have time, you may want to read our guide, What is inflation and deflation?.

Next, the point of this article is about recognising the signs of inflation- we are not airing our opinion on what will happen in the future in this article. Our opinion for that can be found in Inflation or deflation first? instead.

Here are two considerations to think about when considering the future effects of monetary inflation:

  1. One troubling aspect when discussing the economic phenomenon of price rise is the indices used to measure it. As we argued before in How much can we trust the price indices (e.g. CPI)?, the whole idea of measuring general price levels is logically invalid. For instance, as we said in that article,

    … the world is experiencing unprecedented asset price inflation. In Australia, it is the housing price bubble. Since the Reserve Bank of Australia (RBA) does not have the mandate to prick asset price bubbles, then can we give them such a mandate by merely redefining houses as consumer durable goods and include them in the basket of goods in the price index calculation?

    That is, if we include houses as part of the basket of goods in the CPI, Australia will be suffering from severe inflation for the past 10 years! One way for governments to deny the severity of price rises is to fudge the figures and the composition of goods and services, which is what the US government is arguably doing right now.

  2. Also, as we said before in Introduction to the famous Quantity Theory of Money, according to the Austrian School of economic thought,

    Monetary inflation (or ?printing? money or increasing the money supply) results in the distortion of the relative price levels. That is, when money is ?printed,? prices will be affected in varying degrees for different things with different time lags (see How to secretly rob the people with monetary inflation?).

    Monetary inflation takes time to work itself out to the rest of the economy. Sometimes, the effect is not immediate. For example, for the past 10 years, monetary inflation did not result in visible price rises. In fact, thanks to the rise of Chinese manufacturing, we have price falls of manufactured goods, while at the same time, the price of houses sky-rockted (see The Bubble Economy). But lately, we see the rise in the prices of commodities, food and oil. To add to the difficulty, the effect affects prices of different things with different time-lags. Some goods and services are are susceptible to monetary inflation than others.

    Next, monetary inflation may not affect the price levels of of everything to the same degree. For example, the past rise in house prices was probably not going to be accompanied by as great rises in the price of funeral services.

In view of these two considerations, you can see why it is not easy to give a straight answer to our reader’s question. But before hyperinflation can develop, there will be plenty of warning signs. An exponential increase in the supply of money is one sign. The conditions that we described in What is a crack-up boom? is another. Governments turning towards populism and fiddling with the laws is another (see Recipe for hyperinflation). In other words, while you cannot know the precise time-frames of such development, you will have plenty of time to prepare for it as long as you keep your eyes and ears wide open. In addition, the initial stages of inflation are akin to a silent killer that is slowly doing its destructive work. But as it move towards the finale (i.e. hyperinflation), you will see the acceleration of developments.

Thus, we would encourage you to acquaint yourself with history in order to help you recognize the signs. We will be watching and listening too. You will get to see what we see and hear what we hear both in this publication and on our sister site: Contrarian Investors’ News.

Does bank asset write-down directly reduce the money supply?

Tuesday, July 29th, 2008

There is a very common misconception that when a bank writes down the value of its asset (e.g. due to bad debts), money supply will shrink. To be honest, we had this misconception ourselves before and we are writing this article to address this issue. The reality is that when bank assets are written down, there is no direct contraction in money supply. The contraction in money supply will be an indirect effect.

To see why, a basic understanding of corporate accounting is required. Therefore, we will recommend that you read Introduction to banking corporate accounting and Effect of write-down on bank balance sheet before continuing. As you read these two articles, what do you notice when a bank writes down an asset? You will notice that bank deposits are untouched when that happens. Since bank deposits make up part of the supply of money, there is no direct contraction of it as a result.

But money supply can contract as an indirect effect when banks becomes much more cautious in issuing loans or stop re-issuing loans when they get repaid. This can happen as their minimum capital and reserve requirements are breached, which means they have to either sell their assets or raise more equity.

Since a severe and sudden contraction of money and credit supply can have a devastating effect on the economy, the central banks and government will do anything to help banks to continue issue more loans. This may mean changing the laws to reduce the minimum capital and reserve requirements, swapping suspect assets for government bonds and so on.

Are we heading for a deflation or inflation?

Sunday, July 13th, 2008

In our previous article, Australia?s money supply & credit growth in April 2008, one of our readers asked,

I?m a little confused. I thought we had an inflationary problem here, not deflationary

For starters, let us all agree on the definitions of inflation and deflation. Our guide, What is inflation and deflation?, will be used for this article’s definition for inflation (expansion of money and credit) and deflation (contraction of money and credit). Please make sure you understand this guide well because this article assumes that you already know the pre-requisite knowledge contained in that guide.

So, where is the world economy heading? Inflation or deflation?

We read a story that Warren Buffett said that only 2 people in the world know where interest rates are going. Both of them are in Switzerland and both their views are diametrically opposed. We do not know how true this story is, but it underlies are very important point. The inflation and deflation debate is highly polarising, splitting the deflation and inflation camp right down to the deepest bone marrow. There is a very good reason for the deflation case (see Are we heading for a deflationary type of recession?) and there is also a very good reason for the inflation case (see Recipe for hyperinflation).

If inflation is just the expansion of money and credit and deflation is the contraction of money and credit, wouldn’t a reliable statistic of money and credit supply tell us whether we are heading towards the former or latter? Well, as we said before in What is money?,

… in this modern age of finance, money is far more complicated than what it was used to be. It has come to the point that it is very hard to even define what money is, let alone measure its quantity. Alan Greenspan, the former head of the US Federal Reserve was believed to have said ?We don?t know what money is, any more.?

Those in the inflation camp will point to one measurement of money, MZM, to support their case. Those in the deflation camp will point to another measurement of money, TMS, to support their opposing case. Between both of them, they will argue whether credit can be considered money and hence, argue whether MZM or TMS is the valid measurement of the supply of money.

It is no secret that we are more inclined to the latter case. You may have a different inclination than us and that is perfectly okay. The truth is that, no one really knows what will happen (of course, some people in either of the opposing camps will have strong convictions on what is going to happen). We see that the world is resting on a knife-edge between inflation and deflation- it can tip either way. Which way it will tip is not something that economics or finance alone can satisfactorily explain. To do so, we will have to venture into the murky world of politics, law and who-knows-what.

Amidst the arguments between the two opposing sides, we see symptoms of both inflation and deflation- rising gold, silver, oil, food and other commodity prices and falling asset prices. If these two symptoms continue, it will be the most damaging to investors because we will see the nominal value of our assets fall, along with the fall in their real value.

In any case, regardless of whether inflation or deflation will win, life will be very much more difficult for all of us in the years to come. Therefore, it is important to hedge against both.

Australia’s money supply & credit growth in April 2008

Thursday, July 10th, 2008

Continuing from Australia?s money supply growth in March 2008, we will report on the growth of Australia?s money supply for April 2008. In that month, Australia?s broad and M3 money supply has reach yet another record high of AU$1089.4 billion and AU$1003 billion respectively (see What is money? on the explanations of the various measures of money). Between April 2007 and April 2008 (i.e. the year-to-date), Australia?s M3 money grew by 20.4%. The year-to-date growth for March 2008 and February 2008 was 21.1% and 21.6% respectively. No doubt, Australia’s money supply is still growing to record highs. But there seem to be some tentative indications that the growth is slowing since January 2008.

Credit growth is also exhibiting the same behaviour. While total credit reaches a record high of AU$1826.9 billion in April 2008, its year-to-date growth was slowing since January 2008.

The data for May and June 2008 is not out yet. If we see a sustained deceleration in both money supply and credit growth, this will mean that Australia is moving towards deflation, which is very bad for asset prices.