How Much Deflation Given Decline in M2 and Fed Money Printing?

 I read a piece over the weekend from www.contraryinvestor.com, (CI), which stated that a future decline in M2, in concert with other declining credit metrics, will cause the Fed to start printing money, and buying securities again, in the near future. This is so far out of the mainstream, and against prevailing “market consensus,” that I thought I’d investigate it a bit further.


The folks at CI cite a number of metrics by which credit is contracting. If you look at my blog dated, March 19th, I also outline a number of deflationary metrics, which ultimately should support more easing tactics by the Fed. This is consistent with the conclusions by CI, but I must admit that they are definately out there in terms of when to expect the Fed to have a change of heart. I have re-worked some of their points, to fit a view of the world a bit more consistent with my perspective. Here goes:


This week marks the end of the Fed’s MBS purchase program. All told, the Fed will have purchased $1.725 trillion of securities over the last 15 months. This has allowed the Fed to exit the three largest emergency lending programs (Commercial paper, foreign central banks currency swaps, and term financing) which were instituted in 2008. The money the Fed has printed through securities purchases has only replaced the money the Fed created in 2008, in response to thefinancial crisis. Over the last 15 months, the Fed’s securities holdings have increased about $1.55 trillion, with another $100 billion or so of agency MBS yet to settle. Since the beginning of the financial crisis, in August of 2007, the Fed’s balance sheet has risen from $900 billion to $2.35 trillion, for an increase of $1.45 trillion. Here is the important part: in the last 2 years, the increase in Money supply, as denoted by M2 (money market accounts, small time deposits, checking accounts and cash), has only risen by $775 billion.  In other words, despite the Fed putting almost $1.5 trillion of new money into the economy, the increase in money in the economy has only risen by half as much. We can easily conclude that in the financial crisis of the last 2 years, that some of the decline of money (net of the Fed’s printing experience) went to cover losses on financial assets. I thought about the possibility that some of the money growth could have been used to invest in real assets, and taken out of the realm of financial assets. While that sounds good, the fact of the matter is that over $10 trillion of net worth has been lost over the same time period, so if financial assets were spent on real assets, then they were thrown into a black hole, quite possibly never to be seen again. And even if someone takes money to buy real assets with, the person receiving the money would have shown an increase in their accounts, and reflected in money supply.


This brings me to the question as to what will happen now that the Fed’s MBS purchase program is over. The debate in the market place centers on if the Fed will sell their MBSs, and if so, then when the Fed might sell these securities, and when the Fed will raise short term interest rates. My best guess is that the Fed will not need to raise rates at all this year, and eventually, rising rates on the seemingly endless supply of treasuries will push longer term rates higher. On some level, the market will appear to be tightening for the Fed, taking them off the hook. Economic activity will remain subdued, and a continued weak housing market will keep CPI contained, giving the Fed the cover to maintain a ZIRP (zero interest rate policy) through 2010 in my opinion. 


The drop in consumer credit and other lending measures in our financial system will continue to weigh on the prospects for self-sustaining growth. To the extent that losses on real estate loans continue to ripple through our financial system, then it is likely that we will see pressure on M2 over the months ahead, especially since the Fed will be out of the money printing business. In turn, this will not be a positive sign for the economy. And this is one of the main reasons why the folks at CI think the Fed will start printing money through the purchase of securities in short order. I must admit, that is a brave stance to take in this environment, but is something which should be watched. With their permission (which I have yet to receive), I will share more details about their deflationary perspective going forward.


* A reader wrote in response to last Monday’s piece, in which I pointed out how dependent our economy is on the deficits the Federal government is running. I presented a graph which showed the GDP, less the amount of government spending. My conclusion is that without the government spending, the economy would really be sucking wind, because there is no other exogenous, or endogenous source of growth. At the end of the day, the US government will not be able to spend money at the $1.5 trillion deficit pace we are doing today. And when the US is forced to pull back on this reckless spending spree, the economy will collapse. I see this coming. In the blog from last Monday, I also mentioned that if you assume that government spending has a 2:1 multiplier effect on economic activity, then the impact of reducing our deficits will be disasterous when the market forces this upon us.


Here is the reader’s comment/question:


My biggest issue is with your “assumption” of a 2:1 multiplier for government spending.  Explain to me how MY tax dollar gets filtered through the government and then produces MORE than if I didn’t get taxed and SPENT the $1.00 myself??  


In fact, there is quite a bit of evidence that the so-called government “multiplier” is less than 1:1 (more like 0.6:1, meaning for every dollar of government spending – that is, YOUR money being re-allocated by the government – there is a corresponding 60 cents of economic activity.  It makes sense, doesn’t it?  I mean, just think of the corrupt bureaucrats! I really don’t think that I need to argue that hard that government spending is inherently “wasteful”, but it is intuitive.  Now, if we were a nation that actually SAVED money, you might be able to construct an argument; unfortunately, as we all know, America has a net savings rate at or near zero. With no savings, every tax dollar (i.e., dollar of government “spending”) is a dollar NOT spent by the private sector.


So what creates more growth, your dollars spent by you, or your dollars spent by the government? (end of readers comment/question)


Okay – this debate is as old as modern economics… “What is the multiplier effect of money spent by the government?” For starters, I am only concerned with the amount of money spent which represents deficit spending. We can debate whether revenue neutral spending (spending which is off-set by tax revenues) is best left for the private sector. (I would argue that spending is best left for the private sector except when it comes to defense, education law enforcement/ judicial system expenses, and likely a few others I am forgetting). What I am referencing in my discussion, last Monday, has to do with the spending for which there are no offsetting revenues. I am also assuming that the beauracracy of the government is already in existence and that on margin, you do not need to hire the staff which already exists. (This helps with the efficiency of converting new spending into putting actual money into the economy).


There are other debates as to how much money the government can borrow before other productive capital market borrowers get crowded out. From what I have read, economies perform poorly when government borrowing exceeds the GDP. We are rapidly approaching the day when that will be the case in the US. And if you add in state and local borrowings, then government debt is in excess of GDP.


Let’s look at the $1.5 T deficit the government is currently running. And for now, lets focus on the few hundred billion sent to states to help pay for teachers and public employees on the payroll. Now, obviously, some of the money spent on wages actually comes back to the government in the form of taxes (income, sales tax, etc). In reality, only a percentage of the money the government spends is spent on goods and services. What does get spent in the economy can then be recycled by those who received these proceeds, and in turn, the money which is recycled will have a similar slippage effect. Depending on the tax bracket of the recipient, as well as how the money is spent, will determing how much slippage there is. Those making the least will likely spend all of the money with sales tax being the largest aspect of slippage. Those making the most are likely to be taxed at over 50%, and are further likely to save a good portion of their marginal income, and hence the lowest multiplier effect. Here is a table to guide you in how much impact a dollar spent has on total economic activity:


For each $100 spent, if the multiplier is


80% (20% slippage) = $400 total increase in economic activity, ignoring the first $100

70% (30% slippage) = $233 

60% (40% slippage) = $150 

50% (50% slippage) = $100 


For those who want to try this at home, here is your formula for the impact of money spent in the economy:


Economic activity = Deficit Spending / (1 – slippage rate)


If the slippage rate is 20%, then total spending including the initial deficit of $100 will be $500. If you knock out the initial $100 of spending, then economic activity will increase by a 4:1 multiple. With a 40% slippage rate, which the reader suggests, there is still a 1.5 x multiplier effect.


Over the long haul, we will not be able to continue to run deficits as we do. I furthermore remain bearish on the US’s economic prospects because of the deflationary headwinds I see throughout the economy. I also agree with the reader in so much that I do not think the government is the most efficient spender of our resources. Obama does not want to preside over a depression, but he will be credited for creating an even worse situation when the US cannot borrow it’s way to economic prosperity.