Banks Are Lending And Money is Abundant Again

Monitoring the money supply can be a useful tool in understanding "the big picture" of what is going on in the economy. Towards the end of the summer/early fall of 2008, we saw money supply indicators, like MZM, contract. This was the result of deleveraging; in our debt-based economy, in which all money originates out of debt, paying off debts reduces the money supply -- while the issuance of debts increases money supply. Thus, the combination of deleveraging (paying off debts) with a decrease in bank loans resulted in the money supply contracting, the dollar strengthening, and asset prices falling -- all characteristics of deflation.

These trends seem to be reversing. The chart below tracks MZM; note the recent spike upwards.

Likewise, the TED spread -- an indication of fear and risk in the market, and whether or not banks are lending -- has been declining. A lower TED spread means less fear and more lending. The increase in money supply makes sense with a lower TED spread. Both run contrary to reports from much of the media that banks are still unwilling to lend.

The chart below illustrates the TED spread; note it has declined significantly from its peak in October, when the psychology of fear was at its peak.

In terms of financial markets, we've seen the dollar weaken of late, while gold has been rising. This is consistent with the behavior of MZM and the TED spread.

Disclosure: Long gold.

A Beginner's Guide to Understanding Currency Valuation

The market value of asset is largely a reflection of supply and demand for that asset. And thus, if we are looking to assess the value of a currency, we should try to gauge the supply of and demand for that particular currency.

Understanding Supply

To understand money supply, it is crucial to note that in under current monetary policy, money is created out of debt. This happens in two ways:

1. Money is created when governments need to borrow, and central banks then print money and buy treasury bonds
2. The money supply is then expanded again when banks loan money; banks are allowed to loan out 10X the money they have in deposits, and thus expand the money supply when they loan.

Because money comes out of debt, we can extrapolate two further points:

1. If there is no more debt -- meaning if lenders are not willing to lend and borrowers are not willing to take on more debt -- the money supply will have difficulty expanding.
2. Paying off debts results in decreasing the money supply. Ironically, if all debts were repaid, there would be no money.

There are a number of ways to calculate the money supply; see our previous post on this subject. The Mises Institute also offers a free tool to let you compare various money supply indicators.

Understanding Demand

The following can help you gauge demand for a currency:

• Trade flows
• Capital flows
• Reserve currency status -- do other central banks hold the currency in question as part of their reserves? Are they changing their reserves?
• Commodity prices -- If commodity prices are rising, the currency is likely weakening

Gauging how supply and demand is changing can help you develop a longer-term outlook on how currency prices will fare.

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Milton Friedman, John Keynes, and Other Foes of Sound Money

Given that debates on how to fix the financial crisis have become the conversation du jour, now seems like an appropriate time to re-visit various monetary theories to see what works. So here goes:

Keynesian. John Maynard Keynes is the father of contemporary macroeconomics. I would consider this to be a rather negative claim, given that Keynesian policies are at the heart of our current crisis. According to Keynes, deficit spending is not a problem, and the government should use it when necessary to stimulate the economy. Traditional Keynesian economists are not concerned with price inflation, because they argue that prices will not rise above aggregate demand (i.e. prices will not rise above what people are willing to pay for them). Stagflation is precisely the term for the scenario in which prices begin to rise beyond aggregate demand; witness Zimbabwe, and to a lesser extent, the United States in the late '70s and in 2007.

Regrettably, we still see Keynesian solutions being offered to Keynesian problems. US President-elect Barack Obama has stated that deficit spending should not be feared, and needs to be embraced in the short-term to boost the economy.

Friedmanites. Milton Friedman is not too different from Keynes; the only real difference the most significant difference is that Friedman advocates legislative bodies like Congress regulate the money supply via an agreed upon formula, rather than an independent central bank unbound by formulas. The assumption implicit in this school of economics, though, is that a proper formula can be devised, and that a political body can manage it appropriately without the threat of overwhelming corruption.

Supply-siders. Led by Arthur Laffer and Charles Kadlec, supply-siders argue for watching commodity prices, and then tinkering with the money supply to keep commodity prices stable. In a way, this is similar to the policies championed by Paul Volcker, Federal Reserve chairman during the late '70s. Gold prices were rising dramatically, and Volcker raised interest rates to effectively contract the money supply, strengthen the US dollar, and bring gold prices back down.

Austrians. The Austrian school of economics calls for commodity-backed money. This means that government's job is simply to ensure that each currency certificate can be redeemed for a specific commodity -- typically a precious metal like gold or silver -- and that it is government's role to define the terms of convertibility. The money supply is thus determined by the availability of a commodity. Should the market need to expand the money supply, demand for commodity production will grow. Thus the money supply is regulated by market forces.

What Type of Monetary Policy Can We Expect -- And How to Trade It

I am a strong proponent of the Austrian school of economics, and believe it will result in the most sound monetary system, upon which free market capitalism can best survive and flourish. Though the Fed is pushing interest rates to zero, should the US dollar give back the gains it made in 2008 and should the US government have difficulty finding buyers of its debt at such low rates in a globally weak economy, the result may be the need to raise interest rates sharply, thus bringing about a return to supply-side ideas and Volcker's policies in the '70s (we talked about this previously in our article on bond prices). This would be a bearish argument for gold -- just as we saw gold fall in price after Volcker's Fed raised rates.

Ultimately, though, I think Keynesianism is still the dominant ideology. The ideal result of this would be prolonged deflation, as seen in Japan, though as I've stated before, my larger concern is that this will result in sharp currency devaluation, as seen in Argentina.

Trade accordingly!