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M3's
False Signal & the Japan Myth
By
Steve Saville The
Speculative Investor
July
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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