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 Forecasting America's Destiny ... and the World's


Generational Dynamics Web Log for 24-Aug-2008
Money supply contracts dramatically, as credit markets continue to seize up.

Web Log - August, 2008

Money supply contracts dramatically, as credit markets continue to seize up.

Former IMF chief: Worst of global financial crisis is yet to come.

I'm grateful to several web site readers this week who sent me references to different articles and blog entries all saying the same thing: That the amount of money in the world has been contracting sharply in the last few months.

There have been three closely related stories in the past week:

UK housing price index from mortgage lender Halifax <font face=Arial size=-2>(Source: Telegraph)</font>
UK housing price index from mortgage lender Halifax (Source: Telegraph)

These three news stories are all related to the same thing: That the global financial system is in a deflationary spiral, and there is less money in the world each day than there was the day before. One web site reader put it this way: "Seems like deflation is right around the corner despite persistent hysteria about inflation among the general population."

Related Articles

Deflation vs Inflation
The spectre of deflation forces a historic change in economic theory: Economists are shocked that the fight against inflation is over.... (8-Nov-2008)
What's coming next: Understanding the deflationary spiral: Why are the dollar and the yen getting stronger, while the euro is getting weaker?... (27-Oct-2008)
Roubini: The situation is "sheer panic," as hundreds of hedge funds are going bust: Policy makers may need to close markets for one or two weeks.... (24-Oct-2008)
There's never before been a day like this on Wall Street.: Possible exception: One of the days just before or after the 1929 crash.... (11-Oct-2008)
Ben Bernanke's Great Historic Experiment is at the brink: Desperation sets in as credit markets continue to seize up.... (25-Sep-2008)
Government promises to buy bad debt to end the credit crisis: Stock markets stage huge comeback as giddy investors pile in.... (19-Sep-2008)
Web site readers express sadness, anxiety and anger: It's beginning to sink in.... (18-Sep-2008)
Another stunning and historic bailout: Fannie Mae and Freddie Mac: Giddy investors are popping the champagne corks.... (9-Sep-2008)
Long-term negative market trends asserting themselves strongly: Stock and commodities prices plummet as worldwide foreclosures and recessions worsen.... (5-Sep-2008)
Money supply contracts dramatically, as credit markets continue to seize up.: Former IMF chief: Worst of global financial crisis is yet to come.... (24-Aug-2008)
As commodities plummet worldwide, the meaning is unclear.: We speculate on some possibilities.... (11-Aug-2008)
Alan Greenspan calls this a "once in a century" liquidity crisis.: Says that the "big surprise" is the "impressive" American economy... (3-Aug-2008)
More questions from readers on finance and investing: Anxious readers wonder what's going on, what to do next.... (18-Jul-2008)
Pundits and analysts are baffled by the market's performance: They have some interesting fantasies, as well.... (10-Jul-2008)
Questions from readers on finance and investing: On fraud, the FDIC, China, and other subjects.... (23-Jun-2008)
Royal Bank of Scotland issues global stock crash alert: "A very nasty period is soon to be upon us - be prepared,"... (18-Jun-2008)
Ben Bernanke is still the "Man without Agony": What was he thinking?... (11-Jun-2008)
A clearer explanation of credit default swaps.: How credit default swaps (CDSs) present a systemic risk to the global financial system... (4-Jun-2008)
WSJ's page one story on Bernanke's Princeton "Bubble Laboratory" is almost incoherent: So is Thursday's speech on bubbles by Fed Governor Frederic S. Mishkin.... (18-May-2008)
Brilliant Nobel Prize winners in Economics blame credit bubble on "the news": Meanwhile, the deflationary spiral is in progress, but hyperinflation is not.... (27-Apr-08)
Investment bank UBS is now "writing down" clients' auction rate securities: From individual investors to tech firms, people are losing their money.... (29-Mar-08)
Both consumer and commercial credit is disappearing as deflationary spiral accelerates: Wall Street markets plummet 3% on Tuesday, as service sector contracts sharply.... (6-Feb-08)
Will hyper-inflation make the dollar worthless (like the Weimar republic)?: I've gotten this question several times this week from web site readers,... (21-Dec-07)
Questions and answers about the "credit crunch": What's going on, and what you can do about it.... (6-Dec-07)
Understanding deflation: Why there's less money in the world today than a month ago.: As the markets continue to fall, the Fed is increasingly in a big bind.... (10-Sep-07)
Bernanke's historic experiment takes center stage: An assessment of where we are and where we're going.... (27-Aug-07)
Ben Bernanke's Great Historic Experiment: Bernanke doesn't believe that bubbles exist. His Fed policy will now test his core beliefs.... (18-Aug-07)
Japan's real estate crash may finally end after 16 years: To see where America is going, look what happened in Japan.... (20-Feb-07)
This week's financial data points to trend back toward deflation.: Several inflationary indicators are down for June... (17-Jul-04)

For those who wish to understand this better, please refer to the accompanying list of "related articles." A good place to start is "Understanding deflation: Why there's less money in the world today than a month ago."

The collapse of M3 since February is one of the most dramatic pieces of evidence yet of the deflationary spiral.

There's also plenty of anecdotal evidence about the worsening credit squeeze. I recently spoke to an accountant who told me that American Express has frozen the long-time accounts of three of her clients. American Express is cutting off credit to its own customers.

M3 has become somewhat controversial, since the Federal Reserve announced in 2005 that it was discontinuing the computation and reporting of M3. This has led to a number of conspiracy theories that the Fed was hiding information from the public for dire reasons, even though several private firms are now making their own M3 computations available to the public. See for a current chart.

I look at the M3 question a little differently than most.

When I was studying economics in the 1970s, I learned that M1, M2 and M3 meant the following:

"M1 = Money that can be spent immediately. Includes cash, checking accounts, and NOW accounts.

M2 = M1 + assets invested for the short term. These assets include money-market accounts and money-market mutual funds.

M3 = M2 + big deposits. Big deposits include institutional money-market funds and agreements among banks."

These definitions made sense in the 1970s when I was studying them, as did concepts like the velocity of money. But when you're in a credit bubble, as has been the case since 2002, they make no sense at all.

For example, money in money market funds is counted in M2 and M3. What about money in other kinds of funds that are "just as good" as money market funds -- like funds backed by auction rate securities or CDOs? What about funds backed by credit default swaps (CDSs) or other credit derivatives?

Back in the 70s, when I was learning this stuff, there were clear boundaries between different kinds of money. There were few credit cards around, and most credit was clearly defined.

Today, there's no way in practice to distinguish between money and credit. Money "created" by credit can be spent in exactly the same way as printed money. If a bank has money provided by the Fed's discount window, and another bank has money provided by depositors, then it's money either way, and can be loaned to borrowers to spend.

Money created by the alchemy of CDOs or credit derivatives is still money. You can't buy groceries with a CDO security, but you can use the security as collateral for a loan of money that you can use to buy groceries. And with $700 trillion in credit derivatives in the world, there's no longer any real meaning to M3.

And so I don't view the Fed's discontinuance of publishing M3 figures as a major international conspiracy to fool the public. I view it as acquiescing to the obvious -- that M3 has no real meaning in a credit bubble. Once the credit bubble has dissipated over the next few years, then measuring M3 will make sense again, and the Fed will probably start doing it again.

A web site reader asks the following about the recent news about the collapse of M3:

"This plays well into your thesis I suspect. I don't doubt that history repeats itself but what is interesting to me is how it is playing out right now. As a test of the robustness of your theory, what is the next thing to happen when the gov't bails out freddie/fannie (which seems inevitable)? At some point I figure the dollar value deflates (even more) as the balance of financial power shifts elsewhere and the central bank has to raise interest rates just to pay its enormous debt."

If I could reliably predict the "next thing to happen," I wouldn't tell you guys -- I'd just use the information to become millionaire.

The best list of "next things to happen" was provided by Nouriel Roubini's "12 steps to financial disaster" in the current financial crisis. I summarized Roubini's 12 steps in an article last April. However, Roubini doesn't always get it right. He didn't get the housing bubble until 2006, even though it was obvious (and was discussed on this web site) in 2004. By 2005, Alan Greenspan was mentioning it, but Roubini and other mainstream economists ignored it.

This web site uses generational theory to make predictions based on long-term trends. I was telling people in 2002 that we would be entering a new 1930s-style Great Depression, and at that time I didn't know what a "collateralized debt obligation" or an "auction rate security" was. All I knew was that the stock market was overpriced by a factor of over 200%, and that generational theory showed we were overdue for a major stock market crisis.

(For an explanation of why the stock market is overpriced, see "How to compute the 'real value' of the stock market." For an explanation of why the credit bubble didn't create massive inflation, see the discussion of the "crusty old bureacracy theory" in "Greenspan to increase interest aggressively.")

What we're seeing today is that the the world financial system is now careening toward the fulfillment of the predictions made in 2002. This had to happen. It could not be either caused nor prevented by Alan Greenspan, George Bush, or anyone else. It was caused by a lethal combination of incompetent Boomers and nihilistic Gen-Xers: The Gen-Xers created the financial instruments necessary for the fraudulent activities leading to the credit bubble, and Boomers who were supposed to be managing the Gen-Xers instead encouraged the fraudulent activities so that they could all make money.

I've estimated that the probability of a major financial crisis (generational stock market panic and crash) in any given week from now on is about 3%. The probability of a crisis some time in the next 52 weeks is 75%, according to this estimate. (24-Aug-2008) Permanent Link
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