What do we mean by "money supply"?

I understand inflation is tied to the money supply, and that the value of the dollar is tied to the demand for the dollar, but does the demand for the dollar (value) relate to inflation, or the gov't debt, or both? Also, is it too early to begin investing in other gov't securities whose currency is stronger than ours?

So, historically, what is the (numerical) relationship (and its correlative strength) between M0 and CPI: x% change in M0 => y% change in CPI? And, what is the lag period and the length of time the effect is sustained?

I notice the October CPI-U is the lowest since April. Can we assume the QE1 effect has max'd out?

This is a much better way of looking at the money supply BASE than the link provided:
http://research.stlouisfed.org/fred2/series/BASE
This is even more revealing:
http://research.stlouisfed.org/fred2/series/AMBSL
As the authors have said repeatedly: INFLATION IS COMING, not an if but just a when now. Because there is so little lending going on with the extra money in the system, the effects of all this growth in the money supply is slowed but not stopped. China grew their money supply tremendously but immediately lent it out, causing the high inflation that we see already. Our time will come.

The money printing was intended to counteract debt deflation so we wouldn't have the same situation we had in the great depression. It worked as expected, but the fiscal problem is still there.

There are many ways to get inflation, it's not purely a monetary phenomenon. The dollar bubble crashing will be felt as inflationary. Since global oil usage is maxed out, any decrease in oil supply increases the price, and since oil affects the price of everything that can cause inflation.

To get a second opinion on all of this, check out the 2010 book by Eric Janszen. He had a chapter "Americas Bubble Economy" and his work is well worth reading in its own right.

The authors are too nice to shoot down a post so I will, heh. Eric Jansen wrote a book called "The Postcatastrophe Economy: Rebuilding America and Avoiding the Next Bubble" according to Amazon. "America's Bubble Economy" was written by the Aftershock authors. Do your homework. As for other books about our current fiscal crisis, there are plenty and I have read most of them. Only Aftershock has it pegged.I have read it 3 times, cover to cover (4 if you count the 1st edition) to REFUTE the damn thing and I simply have not been able to do so. They have an amazing track record of prediction, more that any other book I have found by far.
As for inflation, so, so wrong. Milton Friedman (hopefully the reader has heard of him) said "Inflation is always and everywhere a monetary problem" which the authors have quoted in Aftershock. The oil example is just plain supply and demand, nothing to do with inflation.

An interesting article in the WSJ talked about how to have inflation and NOT have it immediately affect the rate for sovereign debt bonds. United Kingdom has a $9.8 trillion dollar debt, third highest in the world after EU ($16 trillion) and US ($14.8 trillion). Their inflation rate is over 5% but their long term bond rate is around 2.58% for 10 year. Why? Simple, "changing investor psychology" (part of quote for an asset bubble in Aftershock). It is flight to safety from the turmoil going on in Europe. How long this lasts is anyone's guess. Eventually, the inflation rate will drive up the price of their debt. Right now, owning UK debt is actually PAYING the UK 2.5% interest to buy their bonds!

The AS authors and Eric Janszen are at least 90% in agreement. EJ guest wrote the chapter on Gold in ABE and has an ABE award in AS. Ignore EJ's contributions at your own risk.

Janszen goes into more depth and detail in his book, but it's a year older, so there was a bit more hope that the course might be altered. He's still predicting a long malaise just as in AS, but he spends a good portion of the book looking at what we can do to climb out of that.

If you want to define inflation as a purely monetary phenomenon, then that's a tautology. Since I'm sure Milton Friedman was not that thick, that means that he was wrong. Oil scarcity will cause cost-push inflation in the price of goods, because the global economy is energy constrained. That is NOT a monetary phenomenon. MF was brilliant, but not a god.

Inflation rate in the US is commonly measured by the Consumer Price Index by the US Bureau of Labor Statistics. The most used table is the "core" CPI which excludes the more volatile energy and food prices while the "headline" CPI includes them.
http://www.bls.gov/cpi/cpiqa.htm
There are many websites (such as shadowstats.com) that dismisses the CPI as being manipulated by the government. MIT took up the challenge with their Billion Price Project:
http://bpp.mit.edu/usa/
which clearly shows that the published CPI is very close to the actual inflation rate.
Inflation Wikipedia:
http://en.wikipedia.org/wiki/Inflation

I don't think the inputs to CPI are manipulated, though I think the formula itself is manipulative. Anyway, what is your point? I know what inflation is. Do you think I'm saying inflation isn't coming? I'm not. I'm just saying that when the cost of many goods start going up, it's not just inflation (in the classic Friedman sense) that is working on them. You really should read Janszen's book and website in addition to this one.

Please explain what are the currency and credit dirivatives that show up on us national debt clock. They are over $762 quadrillion now and climbing very fast.

I love the US Debt clock!:
http://www.usdebtclock.org/
I thought Keith was making up the Quadrillion number but wasn& 39;t. Credit Default Swap is a kind of insurance policy against catastrophic losses usually on sovereign, corporate, or financial debts. They are supposed to be a "good" thing as it is a way of protecting against a failure to pay or bankruptcy. However,CDSs have many negative features, including non-regulated,no transparency (private), no need to own the underlying debt, no need to have collateral to back the CDS, and generally is highly linked to speculation. Bear Sterns bankruptcy is credited by some to the speculation by CDS linked to them.
Right now, CDS are running strong hedging against European sovereign debt. Is that a good thing to help protect banks or is it just a speculative way of making huge sums of money by indirectly pushing to the brink of default?
http://en.wikipedia.org/wiki/Credit_default_swap

I apologize. Eric Janszen was indeed co-author of "America's Bubble Economy" along with David Wiedemer, Robert Wiedemer, and Cindy Spitzer. Mr. Janszen has also written his own book "The Postcatastrophe Economy: Rebuilding America and Avoiding the Next Bubble" available on Amazon.

Mike,
After correcting for variables (such as GNP growth), the correlation between MB (rather than M0) and inflation would be close to 90 percent. Traditionally the lag period would be about 27 months, but it could take longer due to the very unusual circumstances and steps taken to delay the effect. (It's literally never happened before that a wealthy, stable country of this size has devalued the currency like the US has.) And inflation would last until the money supply and price levels reach equilibrium (i.e. if the monetary base is tripled, the currency would be devalued by roughly three times). Far from seeing the end of inflation, we likely won't begin to see it rise to significant levels until late 2012 or 2013. Inflation generally starts slowly, but then can snowball very quickly.

Bert,
In the long run, demand for the dollar comes from its scarcity, which is directly linked to the money supply. Public debt is related in the sense that investors will flee from US bonds when they fear a devalued dollar, which will only make the situation worse.

Short term foreign bonds should be fine for now, but there's still plenty of volatility and inflation in foreign currencies ahead, especially as central banks respond to trouble. If terms are short enough, certain bonds in foreign currencies may be able to "beat" inflation when they mature, but this requires active management. We'll probably be approaching a dollar bubble burst in the next 18 months to 2 years. Proceed with caution.

David,
It's important to distinguish between real price increases and inflation. By the same token, shrinking asset values is not the same thing as deflation. (They sometimes go together, as they did during the Depression, but these are different times.) Far from heading toward a deflationary spiral, the dollar was already being artificially propped up by export economies like China and Japan before 2008. Any fears of deflation don't begin to support the volume of expansion of the monetary base we've seen in QE1 and QE2.

Could you please explain the Fed's Operation Twist effect on the stock market? If you look at a chart of the S&P, it appears the latest stock market bull run coincides with the start of Operation Twist. How does this happen when no new money is actually printed?

Is there a good reference for countries who have experienced large inflation or hyperinflation and the increase in monetary supply leading up to that?

Do you hear any rumors or evidence that China's economic situation is far worse than has been reported and that they in desperation are making plans to form a partnership with Russia and other countries to break their dependency on the US dollar?

Chris, I haven't read it, but try: "This Time It's Different" by Reinhart (2009). It covers 66 countries across 5 continents and 8 centuries to show that, in fact it's never different. It's 512 pages from Princeton University press... probably not an easy read but the data should be there.

Bert, http://www.todayonline.com/World/EDC111227-0000046/Beijing,-Tokyo-move-to-bypass-US-dollar

Davidst,
I Did read the tome of "This time it is different", heh. Absolutely exhaustive and meticulous research of crash and recoveries going back 600 years. And the sum total of their research is that we should have been well out of our "crash" of 2008 by now (its a 4 year "cycle"). Lots of info about the book on Amazon reviews.
books about China are numerous as Amazon will attest. I read two that opened my eyes about China, "Poorly made in China" about how risky dealing with Chinese companies really is, and another book that I cannot remember the title that clearly laid out who is in charge in China, and no it is NOT the country's leaders but a group of about 1000 anonymous local leaders that actually select the pretty much puppet national leaders (all connected by red telephones, heh).

Fascinating. I have wondered how exactly China is led. It's nominally communist, but that can mean anything really.

Sounds like "this time is different" has the data but reaches the wrong conclusion. I took the title to mean: Despite All Signs Pointing to a Crash, This Time There Won't be One! So it's actually an optimistic book attempting to explain that we will simply crawl right back out of this mess on a cyclical basis? Definitely the wrong conclusion then. We have a fundamental resource problem (an approaching decline in oil production) that is behind everything and will prevent the usual cyclical recovery.

Heather,
Operation Twist is an unlikely explanation for market behaviors, as it's basically just a manipulation of interest rates. The market does show signs of manipulation, though we can't always be sure what is going on behind closed doors. At any rate, any link in the timeline with Operation Twist would appear to be a coincidence.

Bert,
China's economy is almost certainly doing worse than reported, which we can gather by looking at the very closely related economy of Hong Kong, which is nearly in recession, as well as those of export economies like Canada and Australia.

There's no doubt China would like to end its dependence on the dollar, but there's not much it can do about that in the immediate future, since a strong dollar has been propping up the Chinese economy for so long.

What a great blog...

Anyway, when the Fed buys bonds, reserves are added to the banking system. However, don't the added reserves in excess of required reserves drive the funds rate to zero, since reserve requirements do not change until the following accounting period? Doesn't this force the Fed to sell bonds, i.e., drain the excess reserves just added, to maintain the funds rate above zero?

It seems that the Fed has no control over the quantity of money, but controls only the price. Can you please clarify if you believe that it is the Fed that increased the MB or it is other market participants (like the Treasury)?

By the way, Martenson makes a good point that population is growing faster every year (exponentially). So, by the time the dollar is supposed to burst, what if the surge in population growth BY THEN will be large enough to spur enough new demand (even if barely) for the dollar? After all, it's all about supply and demand. Maybe that's what the FED is "banking" on...

Nick B. It sounds like the Fed is counting on investors in the future buying up all the junk that they took off the market.

After watching Chris M's Crash Course several times over and with the growing population combined with the possibility of peak oil in the next 20 years, I almost think the "Aftershock" will actually save us from the horrors of massive resource depletion.

The "Aftershock" will basically make every nation on earth a welfare state that we can over come eventually.

Peak oil and the depletion many other resources will pretty much send us all back to the 19th century.

It almost seems like the so called "Aftershock" (popping of the dollar and Govt debt bubble) will be necessary.

As the book mentions "Say goodbye to the age of excess".

Personally I couldn't be more pleased to see the age of excess go away. Excess in all of it's forms.

Hi Nick,
An expansionary money supply does drive the interest rate near zero, which is essentially what we have. But the Fed only keeps excess reserves from being lent out by paying interest on them at 0.25 percent, the high end of the target interest rate range.

The Fed controls the money supply and influences interest rates through open market operations conducted by the New York branch, in which traders buy bonds on the market, putting the money into the federal funds accounts of banks (which in turn credit the deposit accounts of the sellers, their clients). Before the Fed makes a purchase, the money is not in circulation, so this directly increases the monetary base.

Even the most liberal projections for population growth wouldn't begin to offset the tripling of the monetary base since 2008, let alone the future quantitative easing we think is inevitable.

Thank you for your responses, Aftershock Team (and others too).

Can you address Mish Shedlock's argument that our economy is primarily credit-based, that M2 is the largest portion of all the money, and that for this reason we are headed for deflation rather than inflation (due to debt/credit contraction). (This argument is presented in Mish's interview on CapitalAccount at www.youtube.com/capitalaccount#p/u/9/s1EBQfIjYns at 11:10) ?

Or take the MMT camp, who challenge the basic premises on which arguments in the Aftershock are based on. For instance, government does not tax to get money to spend, but to create demand for its currency (the MMT argument goes).

From this, it follows that the federal gov can eliminate all fed debt simply by crediting the bank accounts of T-securities owners. For example, the “debt” to China could be eliminated by crediting China’s checking account at the Federal Reserve Bank. The U.S. government can credit any U.S. bank account, any time.

Under this paradigm, "contrary to popular myth, there is no post-gold standard relationship between federal debt and inflation" (see chart under no. 8 here: rodgermmitchell.wordpress.com/2009/09/07/introduction/). Also, U.S. depressions tend to come on the heels of federal surpluses.

And so on... Intuitively, I side with the position expressed in the Aftershock. But I can& 39;t bring myself to articulate a rationale for refuting the MMT perspective or the deflation camp...

Nick,
Take a look at our answer to Bud in "Is Gold Still Golden?" from January 30. We discuss the effects of credit and deleveraging.

http://www.aftershockeconomy.com/blog/Is-Gold-Still-Golden.htm

To clarify, the Federal Reserve acts as a bank to the banks of the US. The banks have reserve accounts with the Fed, private individuals do not. Also, as a partially privatized entity, the Fed is separate from the Treasury and the rest of the federal government. So it's not quite as simple as the Fed paying off government debt by crediting accounts.

Though money printing is often used to address national debt, it's money printing itself, not debt, that leads to inflation. While a growing money supply is necessary for a growing economy, inflation becomes a problem when the money supply grows significantly faster than the economy. Currency is a commodity like anything else: when supply outpaces demand, the value goes down.

Chris,
You may be interested in When Money Dies by Adam Fergusson, which deals with hyperinflation in Weimar Germany.

http://www.amazon.com/When-Money-Dies-Devaluation-Hyperinflation/dp/1586489941/ref=sr_1_1?ie=UTF8&qid=1328058954&sr=8-1

From what I've been reading the Chinese are
trying to buy as much gold as they can. Do you think they are going to back there paper currency with gold, and if so wouldn't we lose our reserve currency status?

Hi Tom,
It's hard to know exactly what the Chinese are doing, but it does appear likely that they are buying gold. However, they have no incentive to back their currency with gold, which would give them less manipulative power over it.

Because of the size and global reach of the US economy, the dollar will still be used as a go-between for many countries to do business with each other. However, certainly a devalued dollar will mean many countries will not want to own them.

I just finished reading chapter 9. In it you have given 4 elements that need to be included before a working numerical simulation model will succeed. It seems to me that you have a very good grasp of what needs to be done and all the main stream economists are in denial, so... maybe it's time for your team to step up to the plate, get a few grants in place and do what all the psuedo-economists couldn't. Please...

We're working on it, Rob. Thanks for the push.

The monetary base has increased substantially. However, the money supply has not. That is driven mostly by 1) much of QE went to foreign banks and to a greater extent 2) the Fed is paying for excess reserves.

My question is why would the Fed continue to pay for excess reserves knowing that it inhibits lending? Add to that, if/when the economy starts producing why can't the Fed simply sell back the bonds and reduce the monetary base? This would have no impact on supply (since it was never released) and therefore no impact on interest rates?

My guess is that QE was more about bank insolvency than it was ever intended as a stimulus. Just another way to bailout banks that continue to have toxic asssets on their book.

The conspiracist part of me thinks it was a solution to potential failed treasury auctions as a last-ditch safety net. Which is why the interest rate on excess reserves.

The Fed didn't intend for this to be lent. Which is the basis for the first question and why perhaps there isn't a fear of inflation?

BTW, just ordered the second edition and plan to purchase the subscription here.

Hi Ben,
It's not that the money supply hasn't increased along with the monetary base — those funds don't just go to the banks as reserves; they also go into the deposit accounts of bank clients as cash, and thus into the economy. It's just that the money multiplier hasn't taken effect because of the enormous amount of excess reserves, which is the purpose of paying interest on those reserves.

Pulling the money back out of the economy is the idea, but the problem is that there's never a good time to do so. Certainly the Fed can't do that while the economy is still recovering. And even if we were to see a major recovery, not only would a contraction of the money supply jeopardize those gains, but it would also involve selling $1 to $2 trillion dollars worth of US bonds, sending yields skyrocketing and making an already precarious debt situation much worse.

Thanks for ordering the book. Hope you enjoy our services.

I have read a lot of books on this financial crisis, Roubini, Harry Dent, A Gary Shilling, Peter Schiff.
I think we are in the age of deleveraging, people and companies are deleveraging very quickly. Possibly quicker than goverments can lever up. I believe that private debt is collapsing faster than government Debt is increasing. This would lead to deflation. Ie less money in the system. I don't buy the Fed balance sheet as indication of money. M3 is much better measure. Won't the bond market reject higher debts of the US much like Greece once it becomes clear the US won't be able to pay back. Thus money printing stops?? Rates would shoot up, crush the economy, drive down value of everything. Money supply collapses.
Is the US dollar not the least ugly in this currency beauty contest?
Good book, really enjoyed, not sure about whether deflation due to deleveraging or inflation. Both are bad.

Deleveraging can slow inflation but it does not shrink the money supply. Once money is created as debt, it is in the economy regardless of what happens to the debt. (It goes wherever the debtor spends it.)

Money printing will stop when it becomes unsustainable, but by the time that happens the damage will have already been done. Values will go down, but that is not the same thing as deflation. Deflation comes from a contraction of the money supply, not a decrease in demand for goods and services.

Canada only has 5 year mortgages,thus I am paying off my debt feverishly. As I pay off that money (debt) the amount of money in the system shrinks. Banks create money through fractional reserves. The Government has given banks that power. This is my belief on what I have read from a lot of books.
So won't the paying off of debt and not creating new debt collapse the money supply?? This would be deflationary.
Boomers are aging and realizing they haven't saved enough, they are paying down debt and trying to save. No new lines of credit, tighter lending standards, frugal is the in thing. It all seems very deflationary. Wages are dropping, taxes increasing. The only ones adding to debt and spending appears to be the governments.
Please explain why paying down debt does not decrease the money supply. Thank you so much for the reply. This is truly a scary and vasinating time.

Harry S,

The well-advertised deleveraging of American consumers may be much less real than widely claimed. You might be interested in the well-supported position in the recent blog article at this link:

http://www.theburningplatform.com/?p=30405

Whether you agree or not, there is plenty of food for thought.

Harry,
Under normal circumstances you'd be right, except that deleveraging doesn't so much decrease the money supply as slow its increase. The big wild card in this case, though, is money printing. The Fed has already tripled the monetary base since 2008, and there are strong indications that it is nowhere near finished with the printing press. The more dollars in circulation, the less valuable they become. Hence inflation.

Also remember, asset values can fall for lack of demand, which is not the same thing as deflation.

Steve B. Thx so much for the link. I had read that 70% of the debt reduction was due to defaulting on mortgages not actual debt reduction. This very clearly makes the lack of debt reduction shocking!! This would tend to indicate we haven't seen anything yet. Once rates go up and the economy really slow, the financial crisis will be truly unbelievable.
As inflation sets in, business won't be able to pass on price increases, sales are likely to fall as consumer spending will have to slow due to debt and lack of jobs or money.
It is hard to imagine how much longer the central banks can kick this can down the road.
Aftershock team, thx for the clarification. I think there is no limit to the extent to which the central bankers will print money to avoid price collapses.

Thanks for the reply. I still am confused as to why the Fed would implement a stimulus (QE) but limit its affects through interest on ER. Why not just cut the QE in half but allow it all to be placed into the economy by eliminating ER interest?

More importantly, any comments on the proposed sanitized bond purchasing being mulled over by the Fed? I understand the premise of contracting money supply through short-term repo for every dollar printed and spent on long-term bonds. But 1) doesn’t that increase short-term rates and 2) doesn’t the interest make its way into the money supply?

Obviously, the amount of interest isn’t the same as the full amount of long-term bond purchases but at a minimum it would increase the money supply a little based upon interest alone wouldn’t it? Or is this simply a way for the Fed to try and monetize the Federal debt with no real impact on inflation? What other inflationary and/or interest rate risk does this action have?

Ben,
By implementing QE and encouraging banks to keep excess reserves, the Fed theoretically has the option of pulling that money back out of circulation once the economy gets going again by selling bonds through those financial institutions. The problem, of course, is that there's never really a good time to do this, as it would jeopardize any gains, and would require a massive sell-off of government bonds.

Your assumptions about sanitized bond purchases are basically correct. We'll see if it actually happens in earnest. The problem is that whatever might be done to limit the inflationary effect would also end up limiting the stimulus effect. The Fed is looking for consequence-free stimulus. It doesn't work that way.

Aftershock Team, in your book you say that printing money will certainly lead to inflation. However you acknowledge that a lot of money has gone to "money heaven". A lot more money has gone to heaven than has been created. Thus, the newly printed money only makes up for a drop in the bucket of what we had when we didn't have inflation (except maybe house price inflation). I do not know why you believe inflation has to happen. You say we are in new territory. This is not your grandma's depression. This is not a normal expansion (or contraction). Nothing is normal about this. It is a manipulated economy. The manipulations are working. And lastly, doesn't US military supremacy count for something?

Hi Carolyn,

We address the relationship between "money heaven" and inflation in a comment on the "Is Gold Still Golden?" blog post on March 21 if you want to take a look. You're right that manipulation is working for now, but the more the tools are used the less effective they become, and just end up creating problems down the road. If that weren't the case, every government would print massive amounts of money with no consequence.

Not sure exactly what you mean by military supremacy counting for something. The military has to be supported fiscally like every other part of the government, and that becomes more and more of a problem when the US eventually has trouble finding lenders and can't rely on the Fed.

Aftershock Team, I just read your book. Job well done.
I believe I have what you seek, a theory/framework that explains, predicts, and measures this mess. It starts with "no individual, government, or information source is perfect".
I have worked on this since 1987, am not an economist nor lunatic. But I don't do blogs.
If you are interested in discussing, please contact me direct on my e-mail. And yes, the M-6 money supply (I know...I had to make it up)analysis supports your predictions.

Hi everyone, we're moving discussions over to our dedicated forum at theaftershockforum.com. We'll be closing down the comments section of the blog very soon. You can continue the discussion for this blog article at: http://theaftershockforum.com/index.php?topic=22.0