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The Problem With Modern Monetary Theory

The Problem With Modern Monetary Theory

Modern monetary theory has been…

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During the quarter there were…

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A Dose Of Reality

An "unwelcome fall in inflation"
The statement issued by the Fed following last week's monetary policy meeting included this gem:

"...the Committee perceives that over the next few quarters the upside and downside risks to the attainment of sustainable growth are roughly equal. In contrast, over the same period, the probability of an unwelcome substantial fall in inflation, though minor, exceeds that of a pickup in inflation from its already low level."

When the Fed talks about inflation it doesn't mean inflation in the correct sense (an increase in the money supply), it is referring to rising prices for goods and services. Therefore, Greenspan and Co. appear to be worried about a substantial fall in prices. The question is, why? After all, computer prices fall substantially every year, yet no one complains about being able to buy better computers for less money and the computer industry hasn't collapsed. Why wouldn't it be good, rather than bad, if prices throughout the economy mimicked computer prices and fell every year?

As a result of on-going productivity improvements the natural long-term price trend for most goods is down. This trend is blatantly obvious in the computer industry because the gains in productivity over the past two decades have been spectacular, but it is also applicable in most other industries. The reason that prices actually spend most of their time rising, rather than falling, is because credit growth is typically a lot faster than productivity growth. Therefore, what the Fed is really worried about isn't falling prices, it is slower credit growth (high credit growth is what prevents prices from trending lower).

In our 23rd April commentary under the heading "War Cycles and Peace Cycles" we explained why slower credit growth could be such a huge problem. In a nutshell, under the current monetary system almost all new money comes into existence as the result of a loan. Every newly-created dollar therefore brings with it a liability in excess of one dollar due to the obligation to pay interest, and this, in turn, means that the total of all obligations to pay money will be greater than the total supply of money. Furthermore, the more money that is borrowed into existence the greater will be the gap between the total supply of money and the total of all obligations to pay money. Obviously, all attempts to keep the system afloat by facilitating faster credit growth will only provide momentary relief while creating an even bigger problem for the future. Momentary relief is, however, the overriding goal of current Federal Reserve policy.

Interestingly, after trending lower for much of the past 16 months the rate of credit growth has recently begun to move away from what the inflation merchants at the Fed would probably consider to be the danger zone. As evidence, note the definite up-tick in the year-over-year M2 growth rate illustrated on the below chart. Based on US Government and Federal Reserve actions and statements over the past two years, we suspect that a year-over-year M2 growth rate of 6% is now considered to be dangerously low. That is, the money supply must now expand at the rate of at least 6% per year to allow most existing debts to be serviced. The M2 growth rate had fallen to 6.4% in early January this year, but thanks to massive government borrowing to finance the war in Iraq and to the lowest interest rates in many decades, momentary relief has been accomplished.

The break of the downtrend isn't 'real', yet
We regularly include a chart of the S&P500 Index showing the downward-sloping channel in which this index has moved since the first quarter of 2000. We won't include the chart today, but will note that the latest rally has done something that none of the other bear market rallies has been able to do - break the S&P500 Index out of this channel. This upside breakout does not indicate to us that a substantial up-move is going to occur in the near future, but it does reinforce our view that a major decline is NOT on the cards as far as the next 1-2 months are concerned.

Interestingly, although the S&P500 Index in US dollar terms (the way it is typically reported) has broken out to the upside from its 3-year channel, the S&P500 in terms of hard money (gold) has NOT broken out. As the following chart shows, the S&P500/gold ratio appears to be 'rolling over' below its channel top. In fact, in terms of gold the S&P500 is below its 21st March peak.

We place greater importance on the chart of the S&P500/gold ratio than on the chart of the nominal S&P500 Index. We do this because the speculating herd pays far less attention to the S&P500/gold ratio than it does to the S&P500 Index.

The above comment warrants additional explanation. Millions of traders and investors look at charts these days and most of them can figure out where to place trend-lines and can recognise many of the chart patterns. As such, an obvious upside breakout will usually prompt the legion of chart-followers to buy while an obvious breakdown will prompt this crowd to sell. Therefore, if you were a large player with a lot of stock to distribute one of the ways to do so at the most attractive price would be to manufacture a breakout above obvious resistance. You could then distribute your stock into the buying frenzy created by the breakout. Similarly, if you wanted to buy a substantial position at the best possible price one way to do so would be to first manufacture a breakdown below obvious support.

Further to the above, it is very important to observe the behaviour of price following a breakout rather than just reacting to the breakout. Also, it is our opinion that a chart that is not followed by many market participants is less likely to be manipulated (is more likely to represent the true situation) than one that is followed by almost everyone.

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