No way out

I just viewed this disturbing graph at Mish, which he got, in turn, from the Telegraph.

Now I like Mish. I think he's wrong on inflation but he's pretty much right about everything else. Moreover he's a serial pessimist like myself.

Mish's opinions of what is going on are worth reading. In regards to the US Broad money supply in this graph, he says this:

I have been talking about this all year. The bottom line is that one has to look not only at what M3 is doing, but why it is doing it. Nearly everyone got this wrong.

M3, of course, is a measure of the total amount of money churning around an economy. Money is created by a central bank (in this case, the Fed) and then created by the commercial banks who take it in as deposits and lend it out and then take it in as deposits again. The process of money creation is known as fractional-reserve banking.

Like any commodity, the amount of money churning around an economy depends upon the forces of both supply and demand. Since commercial banks respond to economic conditions (by either lending money out or keeping it), the money supply is affected by the overall money demand.

What this graph shows us is that money growth in the US has slowed to a trickle - and has dropped drastically since May. Such a sharp drop is indicative of a major economic upheaval - in other words, a recession.

Yet, as Mish is quite happy to point out, such a process is naturally deflationary. There is always a relationship between the rate of inflation and the growth of the money supply. Any reduction in the money supply would therefore have a deflationary effect upon an economy. With this in mind, Mish is convinced that "inflationistas" like myself have got it completely wrong, and that we should be preparing ourselves for an onset of deflation.

But while this is true in theory - and by theory I mean learning the results of hundreds of observations throughout history that have more or less provided empirical instances of it working this way - why is inflation still running so high? Not only is headline inflation running at 5.7%, but the markets were rocked in the last 12 hours by a report showing that producer prices have rocketed upwards by 9.8% over the previous year - an increase not seen in decades.

So, on the one hand, we have a report showing that the money supply is undergoing a severe change, a change that has a deflationary effecy. But, on the other hand, we have consumer and producer price reports that clearly show dangerously high inflation. Moreover, both sets of data depend upon economic activity in the first half of 2008.

So what is going on? Is it the problem inflationary or deflationary?

Sadly, it is neither. When a series of economic shocks hit together as they are now, the effect upon economic growth will be profound.

In a previous post, I created this analogy to describe what is going on:

Imagine you own a house on a flood plain. One day, your house catches on fire. At exactly the same moment, a massive rainstorm hits upriver and causes a flood. You look at your burning house and think "Thank goodness, some water to put the fire out". But the flood is only one metre deep - enough to cause major damage to the bottom half of your house. Meanwhile the top half of your house burns away and no fire engine can get to you to put it out. So the top half of your house burns up while the bottom half rots away underwater.

The fact that the housing bubble is deflationary does not mean that inflation caused by high oil prices fixes it. After all, it is quite possible that house prices will fall greatly while everything else in an economy rises horribly. No, instead we have multiple shocks hitting the economy and no way of mitigating them. The property bubble popping may have flooded your house, but the high oil prices are burning up the roof.

Put another way, if an investment bubble pops at the same time as oil prices go through the roof, the result won't be a balancing out. Instead, you'll have a double shock to the economy while prices remain reasonably stable.

One thing is important to realise when understanding how inflation and deflation can be linked to money supply and money demand, and that is this: Even if the money supply contracts, supply may still exceed demand. In this scenario, both GDP and M3 are contracting, but inflation is rising because the demand for money is falling faster than the money supply.

This is, of course, a nightmare scenario because no policy tool is able to solve both problems at once. Monetary policy's ability to help the economy recover is rendered useless because any tightening of the money supply to reduce inflation will simply result in an even greater economic loss while an expansion of the money supply will result in dangerous levels of inflation. You can't win, in other words.

With this in mind, the only real solution is to wait until the market sorts itself out. Despite the deleterious effect that high interest rates would have upon contracting economies, the only thing central banks can and should do is control inflation. Keeping a lid on consumer and producer prices - even during a stagflationary recession - will not "cure" the problem but will help to limit medium-term economic damage. On the other hand, nations which have low levels of net public debt (ie not many of them) could probably afford to increase spending and run deficits to boost aggregate demand.

Unfortunately, this is what I believe is occurring now. This is why growth in M3 is dropping sharply while inflation is rising sharply. We're not undergoing one economic shock, but two or maybe even three at once - and while one shock results in deflation, another shock results in inflation. And while it is entirely possible that the inflationary and deflationary effects may cancel each other out, the effects of a double or triple shock will devastate economic growth.

No. There is nothing we can do except to learn from our mistakes. We can't solve the current crisis through monetary or fiscal intervention so we need to limit the damage while letting the market sort itself out over time (a painful period which may take years). In order to prevent this sort of event occurring again would probably require a combination of much stricter monetary policy (which would have prevented an investment bubble from forming) and foresight into understanding any supply limits for essential goods (such as the peaking of crude oil production).