Friend or foe?

One critical piece of information that may tilt the balance at some point and help unleash a renewed wave of consumerism that may include the purchasing of anything from real estate to stocks, is the data referenced by MZM or money with ZERO maturity. A quick interpretation of MZM is that it shows the liquidity in the system that may come as a result of fear when market participants -induced by a “flight to safety” instinct- decide to become ever more liquid or when the level of money in the system increases as a result of credit expansion by banks (satisfying demand for loans) or money pumping by the Fed.

In any case, MZM is money that is at anyone’s disposal for consumption and spending with no redemption penalty. As such, there is a direct correlation between the growth rate of MZM, its effects in the economy and the rise and fall of the stock market. Bottoms in consumer sentiment and MZM growth usually coincide, stressing how important consumer sentiment is for the attainment of a healthy economy.

Lending without a lender: What is behind MZM and why it matters.

MZM includes all types of financial instruments that can be easily converted into money without penalty or risk of capital loss and seems to solve the problem of double counting money in the system, as specified by John B. Carlson and Benjamin D. Keen in 1996. It excludes all securities which are subject to the risk of capital loss, as well as time deposits which carry penalties for early withdrawal. MZM is money in the form of currency -notes and coins-, demand deposits, traveler’s checks, savings deposits, and money-market accounts. Fixed-term deposits, on the other hand, should not be accounted for as its issuer has knowingly relinquished ownership over the funds for a specific period of time, thus rendering the original money unavailable.

The way to think about demand deposits or money with zero maturity is as money backed 100% by the deposited cash. Because this cash cannot act as collateral, it doesn’t assist banks in the creation of fictitious credit. True expansion of money is only achieved when banks lend part of this deposited cash which comes back to the bank in the form of a new demand deposit but without the original backing of cash. What has taken place in this instance is the creation of credit by fictitious means. It is this expansion that, once unleashed, plants the seeds of future deflation… when “the music stops”. As the money created out of thin air is returned to the bank, the imaginary excess supply vanishes and there is a de-facto contraction of the money supply that was earlier expanded. Less money in the system means less money chasing the same amount of goods which results in the lowering of prices until a point of equilibrium is reached. If this point isn’t reached the system suffers under deflation.

It is easy to see now, how an increase in credit without the backing of cash increases money supply, while a fall in fictitious credit results in a contraction of money supply which is at the heart of a deflationary cycle. Extrapolating this idea, a reduction in bank lending reduces man-made created credit which diminishes the rate of growth of money supply, all of which has deflationary consequences.

This brief introduction to deflation is needed to understand the critical role money supply plays in economic activity and inflation/deflation expectations. Currently, we see MZM starting to grow again and although this could be interpreted as a consequence of the flight to safety phenomenon, it would still indicate that the system remains healthy in terms of credit expansion supporting the idea that there is enough money chasing the current inventory of goods and services, thus creating a floor for prices. But what about increases in money supply? Shouldn’t this be the goal as there will be more money to buy stuff? The best way to think about this is by understanding “cash” as shares of a corporation called USA, inc. When cash and cash equivalents expand, or when more shares are issued, each individual stock certificate becomes less valuable as the total value of USA, Inc. has to be divided among many more shares (or more of the cash that is now part of MZM). A practical consequence is that more money is going to be chasing the same output, therefore creating inflation.

As we can see, the rate of growth of the money supply is a balancing act. One that should be carefully tweaked as there is always the danger of crossing into extreme territory indicated either by severe deflation or very high inflation.
 

A complex problem

MZM appears to be growing again.

What could become worrisome is that piles of this cash remain stubbornly stuck in the MZM equation. This would mean effectively a buyer’s strike which could happen independently of the Fed pumping massive amounts of money. For as long as the money generated remains “available” sitting in accounts and not exchanged into other forms of assets, it has no economic consequences. And while this by itself may not depress the economy, it could still have psychological ramifications that could in turn recreate uncertainty and fear leading to a spiraling down as more and more purchasing decisions are withheld. This is the time when Mr. Bernanke must realize he cannot push corporations to invest, nor make banks lend their money if they don’t want to neither that he can force regular folks to borrow and spend like there has been no economic calamity in this country.

A refusal to spend reduces the rate at which money changes hands, which creates an expectation for prices to fall leading to a dangerous feedback loop for delaying buying. So it is critical that central bankers get it right the first time. It is crucial that the managing of these expectations is handled correctly. There are no second chances once inflation or deflation expectations get firmly entrenched in the mind of market agents and individuals, as it appears is the case in Japan. What we should not see year-over-year is a contraction in money supply as per MZM historic record: MZM took roughly 200 years to reach $908 billion in 1980, 6 years to double again from 1980 to 1986, 12 years to double again from 1986 to 1998, and 8 years to double again from 1998 to 2006. So there is no conclusive evidence that money supply grows exponentially neither that it is always growing.

The tug-of-war between bonds and stocks continues

Recently, as near as three months ago, government bonds have been hot. In the past, the US bond market has been an excellent indicator of money velocity and today’s slow pace could be attributed to a combination of low demand for loans as much as to banks tightening their lending standards. The run they had so far has pushed yields to record lows. One reading would be that money managers have been looking for refuge as a protection against deflation. However, the most interesting observation is that as bonds reached for their 2008 highs, stocks refused to break under the lows set in June. In fact, a few times, both bonds and stocks attempted rallies simultaneously. Obviously, this cannot go for long and a major question is which instrument is going to prevail. Morgan Stanley’s research stated that 5 out of 8 times stocks have been right in similar circumstances. And there is considerable evidence that this may be the case this time as well, if as I believe, consumers are only withholding purchasing decisions because of uncertainty. It is not, in my view, that money is lacking and goods abound. Money is there. It just seems to be under the mattress.

A change of heart

It is difficult to assess what kind of news, data, event or information will produce a change in sentiment. Most likely, it will be a realization that things are not that bad and that America continues to be a resilient nation that has the stamina to recreate itself. As a vignette of things to come, here is what First Trust Portfolio emailed today to some of its member base:

“The headline (seasonally-adjusted) number showed 473,000 new claims for unemployment payments.  This was down 31,000 from the week before, the largest weekly drop since February.  While this drop was a relief from recent increases in claims, the seasonally-adjusted level of claims is still relatively high. Digging deeper into the report we noticed that the non-seasonally adjusted data tells an even more optimistic story.  The actual number of claims – the raw data – fell to 380,935, the lowest level since Septmeber 2008, when the financial panic was just beginning.  This is a very encouraging sign.  It suggests that the underlying labor market is healthier than seasonally-adjusted data make it appear.  Moreover, given the pattern of seasonal adjustments, we expect a decline in “seasonally-adjusted” claims to under 400,000 by early October.”

Now, think for a minute… Claims under 400,000 by early October! Wouldn’t that be an astonishing piece of good news?

Related Posts:

• The real maginot line
• Want to bet against Warren?