Face The Music: Road Back To Prosperity Is Through Shared Sacrifice
Comment of the Day

February 15 2012

Commentary by Eoin Treacy

Face The Music: Road Back To Prosperity Is Through Shared Sacrifice

This interview of Lacy Hunt by Kate Welling was featured in John Mauldin's Outside the Box yesterday. The chart of US velocity of Money from 1900 is particularly instructive. Here is a section:
Debt and Economic Activity — Conventional View

Beginning with Irving Fisher (1933) and A. G. Hart (1938), there is literature on the macroeconomic role of inside debt. Hyman Minsky (1977) and Charles Kindleberger (1978) have in several places argued for the inherent instability of the financial system, but in doing so have had to depart from the assumption of rational economic behavior. Footnote: I do not deny the possible importance of irrationality in economic life: however, it seems that the best research strategy is to push the rationality postulate as far as it will go.

Ben S. Bernanke (2000). Essays on the Great Depression, pages 42-43.

Vs. New View

The U.S. economic recovery has been weak. A microeconomic analysis of U.S. counties shows that this weakness is closely related to elevated levels of household debt accumulated during the housing boom. The evidence is more consistent with the view that problems related to household balance sheets and house prices are the primary culprits of the weak economic recovery. King (1994) provides a detailed discussion of how differences in the marginal propensity to consume between borrowing and lending households can generate an aggregate downturn in an economy with high household leverage. This idea goes back to at least Irving Fisher's debt deflation hypothesis (1933).

Federal Reserve Bank of San Francisco Economic Letter January 2011. Atif Mian University of California Berkeley, Haas School of Business and Amir Sufi , University of Chicago Booth School of Business.

Debt is a two-edged sword. Used wisely and in moderation, it clearly improves welfare. But, when it is used imprudently and in excess, the result can be a disaster. For individual households and firms, overborrowing leads to bankruptcy and financial ruin. For a country, too much debt impairs the government's ability to deliver essential services to its citizens. Debt turns cancerous when it reaches 80-100% of GDP for governments, 90% for corporations and 85% for households.

The Real Effects for Debt by Stephen G. Cecchetti , M. S. Mohanty and Fabrizio Zampolli . September, 2011. Bank for International Settlements, page 1.

Eoin Treacy's view My comments on money supply and the velocity of money from October 7th are now available in the public archive for subscribers and pre-subscribers to peruse at their leisure. At the time the majority of investors were concerned with the threat of a global economic slowdown. Central banks were equally worried, particularly by deteriorating velocity of money indicators, and responded with a massive increase in money supply. This helped drive the impressive rebound in risk assets over the last four months.

Velocity of Money, reported with a one quarter lag) had not improved by the end of December. The Federal Reserve's policy over the last three decades has been to respond to crises after the fact. Nothing has occurred to suggest that they will do anything different in future. This chart of M2 multiplied by the Velocity of M2 (nominal & log scale) gives us an indication of the Fed's strategy. From at least 1978, they have tailored money supply growth to compensate for variability in the Velocity of Money. Their ability to manage this relationship broke down in 2008 and they have been playing catch up since. Given the response to date, the Fed can be expected to continue to increase the supply of money until this multiple is back on a steady uptrend.

There are obvious risks with this approach not least that commodity price inflation is fomented by the constant increase in money supply. Perhaps the most important point is that while money creation is a local phenomenon, its effects are global. Increasing the quantity of money, keeping short-term interest rates low and lowering the criteria for access to capital, acts as a tailwind for risk assets. Following an impressive rally over the last four months, some of the best performing assets have developed short-term overbought conditions and the risk of a reversion towards the mean, represented by the 200-day moving average, has increased. However as long as central banks tilt their policy toward accommodation, the cyclical bull market for most stock markets is likely to remain intact.

Back to top