Deflation in the US Money Supply

Growth in the US money supply is slowing. Does that mean deflation ahead...?

NOT INTERESTED in the relationship between broad money supply growth, the economy, and stock-market prices? asks Dan Denning of The Daily Reckoning Australia. You should be.

   Ambrose Evans-Pritchard reports in today's UK Telegraph that M3 in the United States (broad money supply) declined by $50 billion in July and is growing at just a 2% annualized pace. So what?

   Well, it takes new money to keep a credit bubble inflated...or to keep it from deflating. If the figures from the Fed can be trusted, and if they show that new money isn't forthcoming (or that it's forthgoing) then it may be a sign of even greater financial asset deflation in the months ahead.

   Translation: it's going to get a lot worse. What does that mean? It means if stocks are cheap, they're going to get even cheaper. It means if good resource projects are good value now, they'll be even better value as the market falls.

   Not that it's an easy thing to stomach. But let's remember what we're watching here. As investors de-lever and pay down debts, they sell assets to raise cash. It's a bull market in cash. And money that is used to pay down debt is money that is not spent on stocks or new cars or the things people spend money on when they aren't worried about debt.

   There are some market analysts, most notably Richard Russell at Dow Theory Letters, who believe the market is signaling full-fledged deflation ahead.

   Russell is the god father of financial commentary on the internet. He works as hard as anyone we know and has been through more up and down markets than nearly anyone alive. (By the way, we send our best wishes to Mr. Russell, who recently told his readers he's had a mini-stroke and will be cutting back his daily posts to once every other week. Get better soon...)

   Richard Russell's latest comment leaves us in a quandary. He cites the producer price figures released in the US on Tuesday. They show wholesale inflation rising at the fastest pace in 27 years. Yet Russell tells it's deflation he's worried about. Not inflation.

   "From what I see," Russell says, "the markets are telling us to prepare for hard times, and a global spate of the worst deflation to be seen in generations. This is why Gold has been sinking, this is why stocks have been falling big money, sophisticated money, is cashing out, raising cash, preparing for world deflation.

   "This is probably why Lowry's Selling Pressure stays at its high," says Russell. "Smart money is selling into the stock market, day after day. They're raising cash in preparation for the hard times when deflation is in the saddle. Deflation is ushering in the new strong dollar. Big money sees deflation and the lower rates that go with deflation.

   "Look, if you have five million dollars and you are only receiving 2% in interest on your money, that's only an income of hundred thousand dollars on your five million. Big money realizes that in a deflation you need a mountain of cash to keep up your lifestyle.

   "What I see is a coming world deflation, and I believe that's the message the markets are sending. What's the best stance in a deflationary situation? Lots of cash, and safe, solid, investments. Two areas that fit that requirement US Dollars and US Treasury paper.

   "What happens to stocks during deflationary times? They're sold to raise cash. What happens to business in deflationary times? It's crushed by ever-lower prices. What happens to the average citizen who's loaded with debt during deflationary times? They're battered unmercifully, as income buys less and less and as debt crushes them.

   "What happens to assets during deflationary times? They're worth less and less and their sale brings in fewer and fewer dollars. Isn't the price of Gold and oil already telling us that?"

   We have enormous respect for Richard Russell. However it seems to us that the monetary authorities will fight the broad money supply figures and debt deflation with money printing (or simply mailing checks to the American people). They've always done it in the past.

   And let's not forget, their product is paper money. They have an interest in preserving the system they've designed, even it means innovation of some sort...which we reckon is around the corner.

   The proper way to handle debts – if you are a believer in Fiat Money – is to pay them off with new money. Inflate them away. The US government wants to do this, but at a rate of inflation which does not spark panic among its creditors, who are up to their eyeballs in Dollar-denominated bonds and currency reserves.

   Ultimately, inflation and deflation both achieve the same result: they destroy value. But they go about it in different ways.

   As it is, we don't believe a real debt deflation is possible in a world with central banks. In a world without central banks? Different story.