JOHN WILLIAMS’ SHADOW GOVERNMENT STATISTICS

A L E R T

March 9, 2009

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Broad Money Supply Growth Slows in February,
Suggesting Intensifying Systemic-Solvency Issues

Fed Likely to Monetize Treasury Debt

Other Than Crisis-Driven Dollar Demand,
U.S. Dollar Fundamentals Are Sharply Negative and Deteriorating

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The worst elements to date of the systemic-solvency and economic crises may be about to unfold. Such is suggested not only by the accelerating economic freefall, but also by a sharp slowing in broad money growth. The latter element suggests an intensifying crisis in the U.S. financial system that could lead to a rapid and near-term monetization of U.S. Treasury debt by the Federal Reserve. Despite any near-term market volatility and systemic instabilities, the long-range outlook for much higher U.S. inflation and a much weaker U.S. dollar remains in place.

Based on slightly more than three weeks (out of four) of reported data, the Shadow Government Statistics Ongoing M3 Measure for February 2009 suggests annual broad money growth slowed to roughly 9.9%, from 12.0% in January, with the seasonally-adjusted month-to-month change effectively flat, if not slightly negative. Slowing in February’s annual growth rates of the narrower M1 and M2 measures also appears likely, with M1 growth slowing to about 13.4% (from 15.1% in January) and M2 growth slowing to 9.7% (from 10.5% in January).   Monthly change in M1 was roughly a 1.3% contraction (same as in January), with monthly M2 growth slowing to an estimated 0.3% (versus 1.1% in January)

Where periods of slowing annual M3 growth in the last 18 months have marked transitions into consistently deeper phases of the systemic-solvency crisis, the current slowing of annual growth may reflect the onset of a fourth and even more-severe leg of the financial system’s disorders. 

Annual growth in the SGS-M3 measure had risen fairly sharply and regularly from 4.6% in May 2005, to over 12.7% in May 2007. The increase in annual growth stalled around that level into July. In August, the Fed announced the existence of the systemic solvency/liquidity crisis, against which the U.S. central bank would provide liquidity, as needed, and M3 growth resumed. 

In December 2007, the pace of annual M3 growth slowed again, and the Fed’s liquidity provision evolved into the Term Auction Facility (TAF), the first of numerous vehicles whereby the Fed would become the absorber of bad assets held by commercial banks and other institutions, and become the effective systemic lender of last resort. In response to the easing of bad-asset pressures on troubled banks, banking lending resumed some semblance of normalcy, although at a still-slowing pace, and annual growth in the broad money supply — as measured by the SGS-Alternate M3 Measure — soared to an historic high of 17.2% in February 2008. Such broke the prior peak growth rate of 16.4% in June 1971, two months before President Nixon closed the gold window and imposed wage and price controls.

As the systemic solvency crisis intensified sharply into its second phase, broad money supply growth began to slow, again. As the Fed announced the March 2008 bailout of Bear Stearns, plunge-protection teams on a global scale appeared to go to work selling gold and buying dollars (as suggested by leaks out of the Bank of Japan), where gold was at an all-time high, and the greenback was setting new lows against a number of currencies. 

The Fed needed a stable dollar, and the drop in the gold price not only reflected and reinforced new dollar strength, but it also hit those investors who had been so bold as to use gold to hedge their wealth against the rapidly escalating malfeasance of the central banks. As the systemic crisis widened and deepened sharply, forced liquidations of various dollar-denominated positions, and ongoing needs to liquidate dollar indebtedness created a temporary dollar demand that still fuels some the strength seen in the dollar today.

The second phase of the systemic bailout did not go well, and broad money growth continued to slow at an accelerating pace as the third phase of the crisis broke open in September 2008, when Fannie Mae, Freddie Mac and AIG were seized/bailed out, but Lehman Brothers was allowed to fail. The Lehman failure triggered on run on the system, which, in turn, panicked the U.S. central bank and U.S. Treasury. As an emergency systemic bailout package was put together by the government, the Fed began flooding the system anew with liquidity, moving for the first time in the crisis to spike the monetary base (currency plus bank reserves). Where the monetary base is the Fed’s traditional tool for affecting money supply, annual growth rose from roughly 2% to over 100%, with a 20-fold increase in bank reserves.

As such began to seep into the system, annual growth in broad money bottomed at 9.9% in November and rose to 12.0% in January, before the current slowing.

Nationalization and Monetization?   As the system tumbles into the fourth phase of the systemic turmoil, the bottom lines for the Treasury and the Fed remain the same as when the crises first surfaced: maintaining a functioning depository system and avoiding consumer price deflation, at any cost.

The depository system has remained reasonably stable following the extended government guarantees that followed the Lehman crisis. Nonetheless, there are few large depositors that happily would sit by and watch their depository bank go under. With continued and mounting evidence of solvency issues with some large banks, and with the Obama Administration touting the need for another $700 billion bank-bailout package, the Treasury is under increasing pressure for further nationalization of major financial institutions. Market pressures ultimately are fair bet to force the enhanced nationalization route. 

The Fed is looking to debase (create inflation in) the U.S. dollar as a cure for possible deflation. Such an approach was outlined by Federal Reserve Chairman Bernanke back in 2002, when he was a Federal Reserve governor. So far, the Fed has been following the course he prescribed back then. Some critics of the Fed’s approach cite the example of Japan’s failed efforts to stimulate its economy for over a decade, but as noted by Mr. Bernanke back in 2002, Japan was not actively seeking to debase the yen.

If a central bank wants to debase its currency, it can find a way to do so. If the recent, extreme expansion of the monetary base does result in a significant growth surge in broad money supply and the attendant inflation risks, there is a more direct option open to the Fed: monetization of new federal debt. 

As the Treasury issues new debt tied to expanded funding needs from the Obama stimulus package and faltering tax revenues, the Fed can buy same directly, monetizing the new issuance. The cash then would flow directly to the bank accounts of those receiving the government’s checks, without an offsetting drain of cash on the system that otherwise would be lending the same money to the government. Such action might give the money supply a more direct boost than has been seen with banks parking their excess reserves with the Fed, where they can earn some interest without lending the funds into the normal flow of commerce.

Whatever looms, both the Treasury and the Fed will keep doing whatever they have to do in order to preserve the depository system and to debase the dollar. The cost of systemic salvation ultimately remains much higher U.S. inflation and a much weaker U.S. dollar.

Fundamentals Weigh Against the U.S. Dollar. A number of subscribers have been asking why the dollar is so strong. The strength seen in the broad dollar measures in the year since the Bear Stearns crisis has involved several factors, none of which normally should survive long-term. Beyond the systemic liquidity demand for dollars and the early (and likely ongoing intermittent) central bank interventions, there has been some flight to safety (quality) in the U.S. dollar and U.S. Treasuries, as well has a broad market hype that circumstances are much better in the United States than elsewhere.

The liquidity distortions eventually will run their course. The flight-to-safety concept already is beginning to lose its credence, as the rest of the world closely views the collapse of U.S. fiscal discipline that had and has engulfed both the Bush and Obama administrations. As the freefall in U.S. economic activity and the intensified systemic solvency crisis continue to batter U.S. business activity, and consumer and investor confidence, it should be increasingly clear to the global markets that the United States is ground zero for these crises. The greatest impact will be seen in the U.S., irrespective of collateral damages in the rest of the world. Perceptions to the contrary are due largely to some governments and central banks being more open or honest about their problems than are the U.S. government and the Federal Reserve.

The traditional, underlying dollar fundamentals continue to be bleak and are deteriorating. Eventually, the U.S. dollar faces a broad, major sell-off, which also will have significant impact on accelerating the pace of consumer inflation.

The following paragraphs (in italics) are from the last newsletter, and are repeated here for the benefit of those who may have missed them. There has been no change in outlook:

Those touting the U.S. dollar and U.S. Treasuries as bastions of safety in an increasingly insolvent world severely overestimate relative U.S. economic and systemic stability. Quite to the contrary, the world’s largest economy is tumbling into the deepest post-World War II downturn, with no end in sight. Further, the world’s largest financial system likely is largely insolvent, and may not be salvageable shy of significant nationalization of key firms. The solutions offered to these crises just add significant further unfunded liabilities to total U.S. government obligations that were at $65 trillion pre-crises. At more than four times U.S. GDP, and at a level greater that total global GDP, that debt means the U.S. government faces eventual insolvency, which most likely will be covered by the currency printing presses. The resulting hyperinflation will lead to a full debasement of the U.S. dollar and an overhaul of the global currency system.

Central bankers have a pretty good sense of what lies ahead for the U.S. currency, and no one can be particularly happy with heavy holdings of the greenback. Luo Ping, a director-general of the China Banking Regulatory Commission was cited by the Financial Times (FT.com, "China to stick with US bonds," February 11, 2009) as bemoaning the lack of options as to holding dollars and U.S. Treasuries:

"We hate you guys [United States]. Once you start issuing $1 trillion-$2 trillion … we know the dollar is going to depreciate, so we hate you guys but there is nothing much we can do."

I would not bet against the Chinese central bank finding other options. In a related area, any demand on the U.S. to issue its debt denominated in something other than dollars would place severe strains on the U.S. dollar as well as on the United States‘ sovereign credit rating.

General background note: The long-term outlook for the dollar remains for a massive sell-off, with flight from the dollar eventually evolving into a flight to safety outside the dollar. The U.S. dollar’s portfolio of underlying fundamentals generally could not be much worse. Relative to major trading partners, the U.S. economy is much weaker; interest rates are lower; inflation has been and will be higher; fiscal and monetary conditions are worse in the extreme; relative trade-balance conditions are horrendous; and relative political/systemic concerns are high, although the Obama Administration likely will enjoy some grace period with markets [the grace period seems to have ended].

Inflation Remains The Long-Term Problem. The second most common question I get from subscribers is as to the ongoing outlook for inflation. Thanks primarily to the short-term impact of sharp declines in oil and related gasoline prices in the second half of 2008, annual inflation in consumer prices (as measured by the CPI-U for January) effectively was zero. Such would be in the 3% to 8% range based on earlier reporting methodologies.  Although both oil and gasoline prices rose in January, oil fell in February, while gasoline prices continued to rise. Both oil and gasoline seem headed for fair gains in March, as global political tensions mount anew. Any heavy dollar selling also would tend to intensify upside price pressures on oil and other U.S. dollar-denominated commodities. Such factors can have significant but usually short-lived impact on reported consumer inflation.

The long-term problem for inflation is in strong growth in the broad money supply. Even with the current slowing of annual growth to around 9.9%, such is inflationary, particularly where monetary velocity (money growth turnover relative to nominal GDP) likely is neutral at present. Beyond the intensifying systemic solvency crisis, however, another factor may be at work.

The slowing in nominal (not adjusted for inflation) annual growth reported in the fourth quarter GDP, and in the quarterly contraction reported for that period, may be accelerating and dragging on M3 growth in the first-quarter, with lowered loan demand. Where money supply times velocity equals GDP, by definition, and GDP is composed of inflation and inflation-adjusted growth. It is possible to have rising inflationary pressures with inflation-adjusted GDP contracting versus a growing money supply, which appears to be happening. 

Eventually, as discussed earlier, the Fed should succeed in boosting broad money growth significantly. That, and an eventual dollar sell-off, still should have inflation at unusually high levels by year-end. If dollar has turned to an outright dollar panic by then, the groundwork would be in place for the onset of a hyperinflation. More will follow in the upcoming newsletter.

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