Equity Strategist Ewen Stewart makes the case that the national debt will within 5 years be over £150,000 per family of 4 with debt repayments of twice the present defence budget, up from £31 billion in 2008/9 to £70 billion in 2013/14. He explains the root causes of our difficulties and indicates a route to recovery.
It’s all over. What a fuss about nothing. The economy will soon be growing again and, look, the FTSE100 is up almost 50% since the March low. Even house prices, according to the Halifax, have risen 6 months in a row. The doom mongers were wrong. Central Banks and Keynesian public spending programmes, together with QE, have worked. Brown indeed has saved the world!
Well that would be one interpretation and a very short sighted one too, for this recovery shows all the hallmarks of a drug addict who claims to be going straight injecting a further mighty dose of the substance that has caused such decay in the first place to prolong the party.
The problem is that the underlying fault lines in the UK economy remain and, thanks to the Government’s response, are even more pronounced.
The underlying problem is, in my view, an addiction to debt, a banking system which is over-leveraged, and now government finances that are out of control. This country that has been living considerably beyond its means for a very long time. Artificial efforts to prop this up, through printing money or inappropriately low interest rates, at best are a short term delaying tactic and at worst risk stoking a loss of confidence and ultimately inflation.
It is my central conjecture that much of the economic growth over the last decade was less the result of genuine private wealth creation but more the result of a number of unique factors which were both unsustainable in their nature and damaging to long term growth. If this view is correct the scale of the over-leverage and the action required to alleviate the problem become even more pronounced.
Toby Baxendale explains that, contrary to some mainstream analysis, monetary policy caused the boom, the bust and the savings glut.
Martin Wolf - Global Imbalances
Distinguished commentator and economist Martin Wolf of the FT holds that the savings glut was the source of the excess liquidity that caused the current crisis in which we all find ourselves.
Wolf’s views are expressed crisply in this PowerPoint presentation. In summary, he tells how the Mercantilist approach of the emerging nations after the Asian crisis of the 90s led to a policy of setting exchange rates to encourage exports and limit imports, supported by the stockpiling of foreign currency (a majority in USD) to fund the whole program. The imbalances can be seen as either a “savings glut” or a “money glut.”
I believe from reading Wolf’s articles in the FT that the suggestion is that the savings glut nations not only have policies of fixing exchange rates to encourage exports over imports but also that the people in those nations have a much greater propensity to save than their Western counterparts. It is argued that this demand for money, certainly in USD, causes the Federal Reserve to embark on an expansionist policy.
From page 15 of Wolf’s presentation:
My own view is that the savings glut caused the money glut, by driving the Federal Reserve to pursue expansionary monetary policies, which then led to the reserve accumulations in the creditor countries
But it is also possible to view the Federal Reserve as the causal agent: the money glut causes the savings glut
Either way, the reserve accumulations and fixed exchange rates played a big role in the story
I interpret Wolf’s remarks to mean that when the massive accumulated USD reserves in the emerging nations were partially spent, a surge in liquidity arrived back at the shores of the USA, causing a housing bubble, subprime lending, less than secure CDO’s etc and the bust we now observe.
Wolf is in good company. It would seem that Federal Reserve Chairman Ben Bernanke has endorsed this view in at least the following two recent speeches.
The world is suffering through the worst financial crisis since the 1930s, a crisis that has precipitated a sharp downturn in the global economy. Its fundamental causes remain in dispute. In my view, however, it is impossible to understand this crisis without reference to the global imbalances in trade and capital flows that began in the latter half of the 1990s. In the simplest terms, these imbalances reflected a chronic lack of saving relative to investment in the United States and some other industrial countries, combined with an extraordinary increase in saving relative to investment in many emerging market nations. The increase in excess saving in the emerging world resulted in turn from factors such as rapid economic growth in high-saving East Asian economies accompanied, outside of China, by reduced investment rates; large buildups in foreign exchange reserves in a number of emerging markets; and substantial increases in revenues received by exporters of oil and other commodities. Like water seeking its level, saving flowed from where it was abundant to where it was deficient, with the result that the United States and some other advanced countries experienced large capital inflows for more than a decade, even as real long-term interest rates remained low.
Importantly, in our global financial system, saving need not be generated in the country in which it is put to work but can come from foreign as well as domestic sources. In the past 10 to 15 years, the United States and some other industrial countries have been the recipients of a great deal of foreign saving. Much of this foreign saving came from fast-growing emerging market countries in Asia and other places where consumption has lagged behind rising incomes, as well as from oil-exporting nations that could not profitably invest all their revenue at home and thus looked abroad for investment opportunities. Indeed, the net inflow of foreign saving to the United States, which was about 1-1/2 percent of our national output in 1995, reached about 6 percent of national output in 2006, an amount equal to about $825 billion in today’s Dollars.
Saving inflows from abroad can be beneficial if the country that receives those inflows invests them well. Unfortunately, that was not always the case in the United States and some other countries. Financial institutions reacted to the surplus of available funds by competing aggressively for borrowers, and, in the years leading up to the crisis, credit to both households and businesses became relatively cheap and easy to obtain.
The Error
I submit that these two great economists have made a grave error. The government of the USA has legal tender laws that allow only it, ultimately, to create USD via its sanctioned agent, the US Federal Reserve. As it is in charge of the stock of Dollars and the fractional-reserve banking system, it is (counterfeiting aside) the sole source of all issuances.
As I have pointed out in other articles on this site, we use money to exchage our goods and services that we make/provide for sale for other goods and services. Money is the final good for which all other goods and services exchange. Dollars in the USA are the final good you use to exchange your goods for goods offered by other people. A price of a good exchanged for another good is the amount of money paid for that good.
If the pool of money is getting larger, there will be more Dollars to exchange for goods and services. If the quantity of goods and services offered for sale and the number of Dollars in circulation are growing at the same rate, it is possible to argue, if you are prepared to set aside the problems of relative prices, that the “general price level” will be unaffected. However, any economist would argue that if the supply of money increases faster than the supply of goods and services, prices will rise: like any other good, money is devalued by creating more of it.
Therefore, the cause of the crisis can be found only at the door of the monetary authority that created the money in the first place – i.e. the Federal Reserve and other deficit-nation central banks – and not with the saving glut nations. All they have done is seek to exchange some of their goods and services for some of the goods and services of the USA, expressing a time preference along the way. This transfer of ownership does not in itself “bid up prices” to create an “asset price boom”: it is the creation of new money which devalues it.
If new Dollars are locked away for a time and only return to their original economy in an abrupt fashion, they could well seem to be the cause of a sudden asset price bubble, but the prior cause can only be the creation and supply of the wherewithal to do this in the first place.
A Note on Mercantilism
Wolf mentions in his PowerPoint presentation quite rightly that the modern trade regime we have is “in short, a mercantilist hybrid”. Many of the Classical Economist and Political Philosophers such as Hume, Locke, Smith and in later times David Ricardo, point out in various writings that the bullion (gold and silver) that was invariably money was not wealth as such but that the goods they exchanged against were. So, create more money with no associated increase in productivity and the prices of things will rise. Consequently, the Mercantalist goal of having exports higher than imports and thus more bullion at home would just mean that prices would rise at home and cause a flow of that specie to move away from home. Therefore, if in the analogy you substitute US Dollars for bullion, our saving glut nations will get nowhere fast pursuing this policy.
Gold represented claims on already produced wealth. Thus it makes perfect sense that the more wealthy (industrially-devloped, capitalistic etc) countries had more gold historically. As we do not have a link to gold anymore, the USD acts in its capacity as the World Reserve Currency, like gold of old. Using this analogy, the gold producer / gold miner writ large is the Fed and other Central Banks. Dollars will flow away from the mine in exchange for goods and services and this causes a transfer of ownership of goods and services from people in the USA to people in the saving glut nations but can have nothing to do with asset price bubbles as the money was printed by the Fed and no one else. To argue that the savings glut itself has caused the asset price boom is seemingly to endorse the Mercantalist doctrine that was so clearly discredited many moons ago.
Some other reflections on this concept of a “Savings Glut” disturb me and lead me to question whether it is really a meaningful concept at all.
These saving glut nations still seem to have massive gluts but if spending the glut caused the bubble, you would expect the glut to have fallen as well; seemingly, it has not.
If nations save to create a glut, they must indeed refrain from consumption on domestic goods to boost the supply of export goods. This means cheap goods arrive on the shores of the deficit nations. Can this cause a boom across the economy? I think not.
The deficit nations are largely well-developed. As a 40-year-old entrepreneur with a mature business and a happy family, all well rooted in Hertforsdhire, I often say to my wife, “If I was 18 again, I would be straight out to China to exploit some of those massive developmental opportunities. The whole economy seems to be like Manchester was in the Victorian times.” So why do savings there, which should attract a greater rate of return there, not stay there?
In summary, the Fed has more than doubled its money supply since the mid 90’s as have other leading deficit nations. The savings glut and the boom and bust is only attributable to the lax money creation programs of irresponsbile central bankers around the world. They have a poor understanding of economic history and they make an intellectual mistake in misunderstanding what those Classical thinkers knew: money is not wealth.
By kind permission of Sean Corrigan, we make available the September edition of his Resource Ruminations “Superhighway to Serfdom”:
“The danger of modern liberty is that, absorbed in the enjoyment of our private independence, and in the pursuit of our particular interests, we should surrender our right to share in political power too easily. The holders of authority are only too anxious to encourage us to do so. They are so ready to spare us all sort of troubles, except those of obeying and paying! They will say to us: what, in the end, is the aim of your efforts, the motive of your labours, the object of all your hopes? Is it not happiness? Well, leave this happiness to us and we shall give it to you. No, Sirs, we must not leave it to them. No matter how touching such a tender commitment may be, let us ask the authorities to keep within their limits. Let them confine themselves to being just. We shall assume the responsibility of being happy for ourselves”
Benjamin Constant, ‘The Liberty of Ancients Compared with that of Moderns’, 1816
…
Imagine, if you will, that we stand today at a cross-roads and that we see to our right a minor road which branches away to climb rapidly upward in an ultra- (even a hyper-) inflationary surge to ruin. On our left, we find a trackway which twists downward, descending rapidly into a Slough of Despond after threading its way past the rusting ironwork, boarded windows, and unfinished building work of a renewed financial crisis and after jolting its users horribly about in the ruts and potholes of further, poor political decision-making as they motor to their doom.
In all likelihood, however, our state-employed bus driver will avoid these two offshoots and will rather stick steadfastly to the busy highway along which we are currently speeding, a broad Road of Good Intentions along whose dreary verges we see an army of labourers sweating over the construction of an ever more ramshackle confusion of governmental props, buttresses, and scaffolding as they try manfully to shore up the crumbling Babel of bad debt and faltering businesses to be found there, at least beyond the next election date.
The Cobden Centre’s Chairman, Toby Baxendale, explores Gordon Brown’s total responsibility for the meltdown of the UK economy.
It is said that the USA Sub Prime mortgage market – i.e. mortgages sold to people who had less chance of repaying the debt than the lender would normally lend to — is the cause of the Recession. How did the lenders get this money to lend to the less than creditworthy borrower?
From 1996 – 2007 in the USA, there was a spectacular increase in the money supply and thus credit grew from $5 trillion to $10 trillion, a frightening double increase in circulating money, if you take the M3 measure.
It is said by our Prime Minister that the bursting of this American bubble and the loss of confidence in the capital markets across the world is nothing to do with the UK Government’s policies, indeed “its not my fault .”
Like a school boy caught doing something wrong the Prime Minister says “its nothing to do with me, it was him, him and him”, i.e. anyone but himself. How can what happens in the USA cause anything to happen in the UK?
If you think about it, in the USA, you have a currency that is called the Dollar that is legal tender. In the UK you have something called the Pound Sterling that is legal tender.
Now for any dollar-based dodgy mortgage security, denominated in dollars, to be sold to a UK financial institution, such as one of our formally Great Banks, the bank must sell Sterling and buy dollars to pay for the security.
Under our Chancellor from 1997 – 2007 and now Prime Minister during this period, we have seen the money supply grow from £700 billion to £2 trillion if you take M4 as the leading indicator: such a massive increase in the circulating credit in the economy is un heard of in all our history!
Only armed with excess Sterling — newly minted money — can a bank consider buying sub-prime mortgages.
These schemes would never have been considered in normal markets as you place your loans, as a banker, in the strongest, most secure deals first and you avoid placing your clients’ money at risk if your clients’ money is scarce. If it is plentiful and you have run out of conventionally sound investments, you then look at the more risky investments.
Only the then Chancellor and now Prime Minister could have allowed such excesses to develop. He and he alone is the person who could have not printed the money and not allowed the excess credit creation.
The Smoking Gun is in his hand.
The destruction he and he alone has caused effects the lives on untold millions of people around our country as we now have:
Short-time working hours,
Layoffs, redundancies,
Mass unemployment and invalidity,
Large-scale reduction in the values of retirement pensions: people having to work longer to stay still,
A collective 30% pay cut verses other workers in the World, for a full 60 million of us as our currency has shrunk in value against most of the World’s other currencies.
More importantly, lets pause a minute and consider this number: £800 billion…….. It is the National Debt for next year that David Cameron will inherit when he is PM. It is more than the collective debts off all the governments collectively rolled together since William the Conqueror!
Madoff got life for blowing away peoples savings. His Ponzi scheme was the largest yet know in history.
Nothing compares with the scale of destruction that Gordon Brown has caused: that lays firmly at his feet and no one else’s.
We have listened to his delusional mumbo jumbo for long enough. If he had any Grace he would resign. I fear he will not go quietly.
I have an image in my mind of the lovely Sarah Brown dragging him from Downing Street with Gordon muttering 5, 6 or 7 new initiatives to combat this, that or the other ailment that He has caused.
She tells him “it’s over Gordon, do not worry, I have booked us a long needed holiday in a nice holiday home in Libya with our new friends!”
Let us then hope the new Administration will not repeat the mistakes of the current one.
Hopes for a flurry of company takeovers and growing belief in the strength of economic recovery on Wednesday propelled the FTSE 100 index through the 5,000 level for the first time in almost a year.
The stock market has enjoyed its best month in more than six years, boosting the savings of millions of investors and bringing hope that the worst of the recession may be over.
The FTSE 100 index of leading shares climbed 8.5 per cent in July, adding £134 billion to the value of the stock market, its best monthly performance since the fall of Baghdad during the second Gulf war in April, 2003.
The rise in share prices followed a series of strong profit figures from Britain’s biggest companies, with many proving to investors that they are coping well in the recession by cutting costs.
However, according to Austrian-School theorist Jesus Huerta de Soto1:
[U]ninterrupted stock market growth never indicates favorable economic conditions. Quite the contrary: all such growth provides the most unmistakable sign of credit expansion unbacked by real savings, expansion which feeds an artificial boom that will invariably culminate in a severe stock market crisis.
In other words, and most unfortunately, the present stock market conditions are an illusion produced by quantitative easing that will not last. And:
The crash will take place as soon as economic agents begin to doubt the continuance of the expansionary process, observe a slowdown or halt in credit expansion and in short, become convinced that a crisis and recession will appear in the near future. At that point the fate of the stock market is sealed.
De Soto, “Money Bank Credit and Economic Cycles”, p462 [↩]
In the 1 September 2009 edition of Material Evidence, Sean Corrigan explains why the stock market is rising and why the appearance of prosperity will not last.
Corrigan, Material Evidence
… the CRB equal‐weight index has put in a six‐month burst only topped in half a century in the run‐up to 2008’s peak and during the severe dislocation of the first oil shock, while the DJ Industrials ‐ lagging by a couple of months – have just registered their best half year since 1933 itself.
Without stopping to rehearse the entire thesis (laid out most recently in the last two editions of Tangible Ideas, viz., ‘Lord Timon’s Purse’ – oriented towards money and credit ‐ and ‘Goodbye to All That’ – which dealt with their real‐side impact), this ‘bullishness’ may have imparted the impression that we have something of a schizophrenic mindset since, in all other respects, our outlook has been jaundiced, to say the least. To the contrary, the two are not at all incompatible, but, rather, interrelated, since what we have all along said would drive a rapid rebound in asset prices would be continued central bank laxity, supercharged by the monetization of soaring government deficits and magnified by the market’s utter misunderstanding of the nature of the ‘recovery’ this has engendered as the liquidity crisis of ‘Snowball Earth’ has partially thawed to a still glacial Little Ice Age of misallocated capital and sorely impaired balance sheets.
Thus we continue to try to look past the breathlessly‐reported headline ‘numbers’ (which, presumably, is somewhat fundamental to the very business of analysis) with the aim of trying to ascertain whether any genuine and abiding improvement of private business is in train or whether all we are seeing is the overspill of state‐led, monetary‐fiscal orgiastics which are therefore doomed to end in another debacle at some indeterminate – but hardly indefinitely postponable ‐ point in the future.
Update
See also:
Hopes for a flurry of company takeovers and growing belief in the strength of economic recovery on Wednesday propelled the FTSE 100 index through the 5,000 level for the first time in almost a year.
…
Graham Secker, equity strategist at Morgan Stanley, said that equities, helped by the improving economic outlook and continued support from the world’s central banks, were enjoying a “sweet spot” that would sustain the rally for now.
“Growth is picking up and the stimulus taps are still full on. That is a pretty good environment for stocks,” he said.
Responding to an article in The Times, Steven Baker indicates the origins of our views on the economic situation and its causes, of our prospects and of the best route to sustainable prosperity.
For the Times, Jim O’Neill, Chief Economist at Goldman Sachs, writes:
Based on the evidence I have seen this month, it looks as though the world moved out of recession in the second quarter. When we see the evidence for this, in the third-quarter data, it is likely that many areas will have returned to close to trend growth.
He goes on to explain the emotional and subjective criticism he has received in response to previous articles, the evidence and his optimistic outlook for the world economy, concluding:
Since March, close to the time that developed stock markets bottomed, our GLI has shown a vigorous bounce and, indeed, for the past two months the monthly increases have been the sharpest we can find. The chart of the monthly changes, as you can see, looks pretty much like a V, not a W. Right now, it suggests a much stronger bounce in the world in the next six months than consensus and, along with other data, is why in our latest forecasts we predict that world GDP will recover by 4 per cent in 2010. This will include the UK because, despite all its challenges, it is an economy small and open enough to be greatly influenced by the rest of the world.
Mr O’Neil is a senior economist and Goldman Sachs makes a great deal of money. So why do we disagree?
There are three important schools of economic thought: Keynesian, Monetarist and Austrian1. We follow the Austrian School. In contrast to the others, it has a robust capital theory and an understanding of the interest rate as the price which coordinates the economy across time. Unfortunately, Mr O’Neill’s economic thinking causes him to look at the immediate empirical evidence and make pronouncements which, while superficially justified, lack a deep theoretical understanding of the situation, that is, the distortions in the capital structure of production.
Of course, this is not to assert that money cannot be made by bankers in the short term under the present system. The question is whether that system of thinking can explain our predicament and the best route out.
By kind permission of Sean Corrigan, we reproduce his report Tangible Ideas – Goodbye to All That, in which he explains the end of an economic era.
Consider German revenues:
German Revenues
The sheer violence of this reversal of fortune – something akin to the sudden, mortal swoop of a melted‐wax Icarus after long hours of patiently spiralling heavenward on the thermals rising off the Cretan coast ‐ has perplexed everyone from Her Britannic Majesty and her hapless First Minister to the fallen idols of investment practice, like Bill Miller and Bruce Bent – yet while its pattern may be a complex tangle of circumstances, there are, in truth, only a few basic threads in the weave, all of them very familiar to those with an Austrian perspective on the case: fiat money, gross government interference with markets, and the avid, rent‐grubbing irresponsibility it fosters in everyone involved from the most prominent financial flesheater to the most pathetic, Forgotten Man structured‐product stuffee.
And malinvestment arising from the system of money:
Malinvestment Defined
The reason [the nature of modern money] has been so pernicious is that it has circumvented the very business of reserve management and so has turned what should be the semi‐automatic self‐equilibration of the classical specie‐flow mechanism into a positive feedback of ever wider current account gaps, ever more profound misallocation of capital, ever more inflation ‐ albeit one masked in terms of finished good prices, as we have already seen, by the supply side impact of shifting production to where labour is cheap and the local politburo is happy to connive with its buddies in the state‐owned enterprises to provide near‐costless finance, inexpensive land, export tax incentives, and even subsidised utilities to a producer who is therefore relatively indifferent to the price he has to pay for his commodity inputs (remember those relative price trends we discussed earlier).
In a fair system, based on a proper, hard currency, the country running a deficit settles up by losing the bullion on which its circulation is based: domestic credit then contracts, prices fall, activity shifts to import substitution, and competitiveness is hence restored – an adjustment quickened by the fact that equal and opposite changes are taking place in the surplus country. ‘The monetary sin of the West’, however (to employ another Rueffism), is that while the surplus country today uses its excess foreign exchange receipts to expand the stock of high-powered money at home and so triggers its own production‐lengthening cycle, it simultaneously loans those same receipts straight back to their creators, preserving their credit pyramid in turn and thus encouraging them to continue their gross overconsumption.
Adding to the dangers, the deficit nation central bank sees the low‐price imports and artificially stabilized exchange‐rate as helping achieve its monophthalmic goal of suppressing ‘inflation’ which – being typically mainstream in its analysis – it imagines to consist only of rises in its favourite (usually pared) consumer price index. It is thus perilously predisposed to running far too loose at the same time as its foreign counterpart is relaxing, all despite the obvious warning sign which the trade deficit itself constitutes, namely, that demand has already outstripped the potential for domestic output to meet it.
Inevitably, in the over‐financed, speculative milieu in which we live, the excess credit thus called into existence soon spills over into asset markets (whose inordinate rise does not at all figure in the wholly naïve policy settings being followed) and so begins that unstable spiral of financial convection which sees notional net worth increasing and effortlessly generating the fresh collateral which will form the basis for yet more asset price‐boosting loans in the next iteration. Tempted by the capacity to engineer illusory and prematurely capitalised ‘profits’ in such a conducive current, the ever more hubristic bankers – by now not so much on Cristal Roederer as on crystal meth (metaphorically speaking, of course) – soon allow their hired‐in, mathematical idiot savants to ferret out highly explosive ways to cheat shareholders and regulators of due disclosure and so arrange to heap a Pelion of non‐linearity upon an Ossa of over‐leverage and undercapitalization.
And on the role of credit in the crisis:
Perhaps the quickest and cleanest way to show this was indeed the case is to look at the behaviour of the BIS series for member‐country banking balance sheets over the relevant periods. Indeed, if we consider that inflation – i.e. excess money creation – is, these days, primarily an increase in (demand) liabilities at banks, it is instructive to look at the explosion in their size (here, strictly speaking, we have performed our calculations on the other side of the balance sheet for convenience, but the difference is not significant).
BIS Bank Asset Inflation
In the 3 ½ years to the March 2008 quarterly peak of $40 trillion, total banking claims grew virulently at a ~22% compound annual rate, achieving the fastest nominal doubling in a three‐decade data series. Though it took a while for consumer prices to respond, if you wanted inflation (properly defined), you certainly had it in spades going into the Crash!
And, concluding:
The market may have to suffer a nasty bout of disillusion before it reconciles itself to the fact that the halcyon days are long gone and that the clock is everywhere ticking toward a reckoning with the government debt market.
Entering the Greatest Depression in History by Andrew Gavin Marshall
While there is much talk of a recovery on the horizon, commentators are forgetting some crucial aspects of the financial crisis. The crisis is not simply composed of one bubble, the housing real estate bubble, which has already burst. The crisis has many bubbles, all of which dwarf the housing bubble burst of 2008. Indicators show that the next possible burst is the commercial real estate bubble. However, the main event on the horizon is the “bailout bubble” and the general world debt bubble, which will plunge the world into a Great Depression the likes of which have never before been seen.
The FTSE 100 Share Index has been riding high since it fell to a low of 3,512 on March 2, and continues to flirt with the 4,700 barrier. With the economic data being still so poor and underlying company results being very weak, why would this be so?
In the UK, we have seen, in the space of a year, the Bank of England Balance Sheet climb by 158%. This is in large part due to the £175 billion QE (Quantitive Easing – crudely speaking, printing money (Zimbabwe style) out of thin air) program. This is where in short, one arm of the government (the Bank of England) buys existing outstanding securities such as Treasury Bonds, that the other side of the Government, has issued to various creditors of the government with freshly minted cash, created out of thin air. This new money needs to ultimately be banked somewhere in the banking system. At the bottom of the banking system upon which all reserves of the banks sit, we have the Bank of England itself. Hence its balance sheet rises.
What happens to this new money?
If more money exists today than yesterday then all other things being equal, we can deduce that there is a surplus of money in relation to money demanded. What happens to this surplus? The only way to get shot of a surplus of money is to spend it. This spending increase prices of the goods and services that it is being spent on. One of the most liquid places for you to spend this surplus is to put it in near liquid assets such as highly traded shares. As excess liquidity builds up all over the world, over and above money demanded, we see various stock exchanges rising. In a separate article, our colleague Sean Corrigan points out that the huge increase in M1 in China has set the Shanghai Composite reaching for the top of Mount Everest!
What is Money Demanded?
Money is the medium of exchange. It is the most marketable of all commodities that facilitates the exchange of one person’s goods and services for the other person’s goods and services.
Since the economy has slowed, it must follow that there is less production of goods and services to exchange for money. This has the effect of suppressing the prices of those goods and services.
Conversely when the economy is booming and more production is facilitating more demand for money to exchange for more of those goods and services, you would expect to see prices rising.
If we have a given demand for goods and services, even if it is a suppressed demand, such as it is in the economy of today (in Recession / Depression) and there is a sudden increase in the supply of money, such as has happened with the stunning 158% rise in the Bank of England’s Balance Sheet, certain people’s monetary liquidity has dramatically risen. To start the process of eliminating this surplus liquidity, it would seem that money has moved into near liquid markets such as the various stock exchanges of the industrialized world when the practice of massive money pumping has taken place.
Does a stock exchange index reflect the value of the companies that make it up?
The monetary value of something is what the next person is prepared to pay for it. The stocks in the FTSE are no different. There as been a 30% increase in the value of the FTSE100 over the last 5 months, is this because underlying corporate earning have substantially, no, astronomically recovered? No, it is more to do with the fact that there is excess liquidity in the system created by the Government to provide the illusion of wealth. This is a dangerous policy to continue for the reasons mentioned here.
I would also suggest to any investor that they should watch the size of the Bank of England’s Balance Sheet as a key determinate in liquidity in the most liquid of markets such as the stock exchange. When the Bank starts to reverse its asset purchase program, this liquidity effect will start to unravel and put downward pressure on the Stocks. The only thing that will stop this unraveling is genuinely more production taking place, more efficiently with the given factors of production, by entrepreneurs in real business doing real things. This will create real demand for the service of money and real exchange for real goods and services that people want. We need to hope that the productivity gains that this recession is foisting on the private sector outpace the decline in liquidity that must happen when the Bank starts to reverse its process of QE.
