M3’s false signal and the Japan myth
Jul 21, 2009
Below is an excerpt from a commentary originally posted at www.speculative-investor.com on 19th July 2009.
M3 is sending a false signal, again
During April-June of last year we described the rapid growth in M3 money supply that was occurring at the time as a "major league false signal". We thought it was a false signal because it contrasted starkly with the performance of the monetary aggregate known as TMS (True Money Supply). Whereas TMS was suggesting that the rate of monetary inflation was relatively slow, and, therefore, that a deflation scare was a distinct possibility within the ensuing 12 months, M3 was pointing to an inflationary shock to the system.
M3 and TMS usually trend in the same direction, but on those occasions when they diverge in a big way -- as they did during 2006-2008 and also during the early 1990s -- we can safely assume that TMS is providing the more correct information about what's happening on the monetary inflation front. The reason is that M3 contains Money Market Funds (MMFs) and Time Deposits (TDs), neither of which are money*.
We are re-visiting this issue now because another big divergence between M3 and TMS is currently brewing, but whereas last year's divergence encompassed rapid M3 growth in parallel with slow TMS growth the latest divergence encompasses the opposite. Specifically, the chart at http://www.nowandfutures.com/key_stats.html shows that the year-over-year (YOY) M3 growth rate has plunged to around 4% and remains in a downward trend, while the chart displayed below shows that the YOY TMS growth rate is high and rising.
The main reason that M3 generated a patently false signal during 2007 and the first half of 2008 was the moon-shot in Institutional Money Market Funds that occurred in response to the developing financial crisis and economic downturn. The main reason it is now generating another false signal is that the amount of money invested in time deposits has fallen in response to the plunge in short-term interest rates (the total amount of money in time deposits tends to follow the short-term interest rate, with rising interest rates prompting increased demand for time deposits, etc.). In other words, changes in the NON-MONETARY components of M3 continue to paint a misleading picture.
It may be too soon for the current M3-TMS divergence to have practical investing implications in that the high rate of TMS growth of the past 9 months probably won't begin to affect prices until at least the first half of 2010. At this stage it is just something to keep in mind, especially when analysts begin citing the slowdown in the pace of M3 growth as evidence of deflation.
*MMFs are investments in interest-bearing securities. When someone invests in MMF units the investor's money is used by the MMF to purchase securities from a third party. Money is therefore transferred from the bank account of the MMF investor to the bank account of whoever sold the securities to the MMF. Similarly, the sale of MMF units involves the transfer of money from a third party purchaser of interest-bearing securities to the former owner of the MMF units. In other words, MMFs are intermediaries that transfer money between investors; they are not depositories of actual money. Including MMFs in the money supply would therefore count the same money twice.
A Time Deposit (TD) is a loan to a bank. In particular, when someone opens a TD they agree to let the bank have uninterrupted use of their money (they forego access to their money) for a pre-determined time in exchange for payment of a certain interest rate. In order to make a profit on this arrangement the bank will then lend the money to someone else in exchange for the payment of a higher rate of interest. Therefore, when money is put into a time deposit it doesn't drop out of the total money supply; rather, it gets shifted from one of the bank's customers to another. As is the case with MMFs, a monetary aggregate that counts time deposits in addition to savings and demand deposits will end up double-counting part of the money supply.
The Japan Inflation Myth
It is commonly believed that Japan's monetary authorities have created a huge amount of money over the past 18 years in an effort to elevate prices and stimulate the economy. The fact that the Yen has maintained its purchasing power and the Japanese economy has remained moribund is therefore considered in some quarters to be evidence that a high rate of money-supply growth won't lead to rising prices or meaningful economic growth in a post-bubble world.
Before getting to our main point it is worth noting that nobody with a good understanding of economics believes that creating money out of nothing can give the economy a sustainable boost. In fact, the opposite is true. Money is not wealth and it should be intuitively obvious to anyone with common sense that creating more pieces of paper money could only damage the economy over the long-term by distorting prices, re-distributing wealth and prompting additional mal-investment. In other words, if Japan's monetary authorities had created a huge amount of new money the end result would NOT be a strong economy.
This brings us to our main point, which is that Japan has experienced relatively SLOW money-supply growth since the 1990 bursting of its credit bubble. Specifically, the chart included herewith shows that Japan's year-over-year rate of M2 growth plunged from 12% to 2% in the immediate aftermath of its credit bubble and remained in a narrow range around 2% thereafter (note that we using M2 in this case because we don't have TMS data for Japan).
The idea that Japan attempted to inflate its way out of trouble is therefore wrong. Japan has experienced very little monetary inflation over the past 18 years, which explains why the Yen has done a reasonable job of maintaining its purchasing power and also why the Yen has strengthened against the US$ despite the ultra-low interest rates that have characterised Japan for as long as most of us can remember.
Rather than attempting to 'solve' its problems by promoting rapid monetary inflation, Japan's Government has relentlessly tried to generate sustainable growth via massive debt-financed spending on public works. This strategy has drained much-needed capital from the private sector and consumed it in non-productive ways, such as in the building of bridges to nowhere. As a consequence, what would probably have been a severe 2-3 year contraction has been transformed into a seemingly endless slump that is now into its 19th year.
Japan's sad story has unfolded as predicted by the theories of the great "Austrian" economists, but the even sadder thing is that the wrongheaded theories of John Keynes, upon which Japan's policy blunders have been based, are now more popular than ever. Policy-makers all over the world seem determined to mimic the mistakes made by their Japanese counterparts on the basis that, to paraphrase Joe Biden (the US Vice President), governments need to spend like crazy in order to avoid bankruptcy.
In conclusion, Japan's government has made mistakes that have prevented a sustained economic recovery from materialising, but the one mistake it hasn't made to date is to aggressively inflate the currency. Had monetary inflation been added to the mix then the Japanese people would have been forced to deal with rising living expenses along with everything else.
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