Global Macro Monitor produces informed opinion about markets and the global economy. This was originally published on January 20, 2011
“Inflation is Always and Everywhere a Monetary Phenomenon” – Milton Freidman
Monetarism as a theory, which states that the variation in the money supply has major influences on national output in the short run and the price level over longer periods, died during the 1980′s. Economists noticed that the monetary aggregates, GDP, and inflation were no longer stable in their relationship to one another. Milton Friedman was the father of Monetarism and Paul Volcker was one of the last great Monetarists.
The rapid advances in financial innovation and the rise of of the shadow banking system made the measurement and even the definition of money increasingly difficult. At one point, the Fed studied and even considered including equity mutual funds in one measure of money. During the height of the dot.com bubble some were even using stock options in start up tech companies as a medium of exchange — the purest form of money.
One of the basic tenets of monetarism is the concept of dishording. If people hold too much money, they dishord the excess balances and buy goods and services. We would add assets to that mix and think one of the problems today is that the excess money balances are disproportionately distributed throughout the global economy. The helicopter drop is resulting in collateral damage in higher prices for consumer necessities, such as food and transportation fuel.
The bulk of the excess cash, in our opinion, has been created and held by central banks in the form of foreign exchange reserves. In addition, the money created by the Federal Reserve is not being circulated throughout the wider economy because of the broken financial sector in the United States, which is the country’s main credit creation and money machine.
Thus, all this excess money is distributed among sovereign wealth funds, hedge funds, and money management firms, which sloshes around the world looking for a home. These managers are smart enough to know that much of the excess liquidity and reserves in the system is in the form of “high powered money“, which can be multiplied by a fractional reserve global credit system.
In other words, the global monetary punch bowl is heavily spiked by a monetary base which has gone parabolic in the past five years (see chart below) and when credit creation is finally added to the mix the result will be, and to some extent already is, a toxic brew of inflation.
We are already seeing this in the emerging markets and even in parts of Europe. The dishording and search for a “store of value” is becoming an obsession and driving everything from equities to onions. Throw in a supply shock or two to lather up the specs and the party really gets going. Take a look at the charts below.
Today’s Economist published a piece on the how the price of fine wine and crude oil move together. What the heck does crude oil and $5k bottles of Château Pétrus have in common? Some economists and academics can spin a story that maybe wine demand is driven by the OPEC countries or the emerging markets. Yada, yada, yada!
These are the same guys that told us the housing market was driven by fundamentals. A good fundamental story is a necessary condition for a bubble, with excess liquidity the sufficient condition. There’s just too much money chasing too few goods. Punto!
Ironically, unless wages and household wealth keeps pace, food and energy inflation is ultimately deflationary in other sectors and will depress economic growth as real wages fall. We think the Chinese government understands this and is rapidly increasing the minimum wage throughout the country, in effect, trying to monetize the food price inflation. This is why we believe China will have a more difficult problem containing their inflation and risks an inflationary spiral.
Inflating a stock market or housing bubble feels good for everyone x/shorts, can create temporary wealth and economic growth, and potentially increase the popularity of governments. A commodity bubble is a different story, however. Though gold is a benign store of value and actually should be encouraged by governments, in our opinion, higher food and energy prices are a potent political mix. Go no further than North Africa to see the results.
We bet many governments are hoping the commodity markets roll-over with the Shanghai as we wrote about on Tuesday. Just not the commodities they export. Stay tuned!