The money supply is like one of those long balloons that skilled people can twist into entertaining shapes. Once you blow a certain amount of air into the balloon, it is going to show up somewhere. You can squeeze down on one part of the balloon, but it just bulges out somewhere else.
That is one lesson this week’s declines in stock market prices may drive home.
Many economists have argued that if the money supply grows faster than production of real goods and services over the long run, the price of such goods and services has to go up. Economist Milton Friedman has been forceful and articulate in expressing this truism, though many others before and after him have made the same argument.
The numbers are pretty straightforward. From the first quarter of 2001, when the Federal Reserve first began to cut interest rates, to the first quarter of 2004, real output of goods and services grew 8.4 percent. That works out to an annual rate of 2.7 percent. The M2 money supply (referring to the amount of currency in circulation plus the amount in checking and readily available savings accounts) grew 6.8 percent per year for total growth of just under 22 percent in three years.
That difference between 8 percent total output growth and 22 percent M2 growth means that money was sloshing around the economy and had to pop out somewhere.
It didn’t pop out in the form of higher prices for consumer goods, despite current angst about gasoline and meat prices. Over the same period, the Consumer Price Index grew by 5.8 percent, which translates into an annual rate of 1.9 percent per year.
So, where did the extra money that the Fed pumped into the economy go? It is becoming increasingly clear that it went into the prices of stocks, bonds and houses. Prices of all three rose sharply as excessive liquidity found a home. Now that the Fed finally is constricting the money supply, prices of the first two are falling. Only time will tell what will happen to home prices.
Some observers talk of an “echo boom” in stock markets. By this they mean an unsustainable upswing in share prices caused by Federal Reserve attempts to shield the overall economy from a recession resulting from the collapse of the 1990s financial market bubble.
With the Dow well above 10,000 in the past year and the Nasdaq sharply up from its 2002 trough, it seemed that stock markets had regained some of the magic of the mid-1990s. Skeptics pointed out that stock price increases were excessive relative to corporate earnings and to the lackluster state of national output and income.
The Dow, for example, rose 47 percent between its low and early 2004. The Nasdaq rose 93 percent and the S&P 500 nearly 51 percent. The extent of such increases was not justified by higher earnings or expected earnings, but rather by excessive demand engendered by excessive money.
We now face a situation where employment, total national output and business profits all are rising, but stock prices are melting away like a May snowfall in North Dakota. Excessive stock price growth in response to easy money means that stock price shrinkage may be dramatic when a central bank such as the Fed decides it is time to sop up some of the liquidity it spilled so readily only months ago.
The real economy — work, raw materials and physical output — is related to the financial economy — stocks, bonds and options — but the linkage is not as immediate as many people think. It is entirely possible for the real economy of employment and output to continue to grow even as stock and bond prices decline, just as such prices rose in the last two years as the real economy remained in the doldrums.
It is rare, however, to come off a really roaring binge without feeling some hangover.
The liquidity injected to keep U.S. interest rates low in the past three years did not just flow into stock and bond markets. Low rates also motivated speculators to borrow in the United States to invest at higher interest rates in other countries.
As long as the dollar kept getting weaker against the euro, U.S. dollars invested in that currency yielded larger sums of dollars when the money was brought back home again. Borrowing in the United States for investment overseas seemed a sure thing.
Now higher rates in the United States are squeezing any existing interest rate differentials and are strengthening the dollar. This sends speculators a double signal to bail out while they can. The interest rate differential between the United States and other countries is narrowing and the dollar is moving against those hanging on to overseas money.
As large amounts of such speculative short-term foreign investment are liquidated, the dollar is likely to strengthen even more than it has in recent weeks. That is not good news for manufacturers who export or who compete with imports. It is not a welcome development for Minnesota farmers either.
© 2004 Edward Lotterman
Chanarambie Consulting, Inc.