Free money supply and growth
Part 1: M3 free money supply
The variation of the real GDP growth rate is inversely proportional to that of the free money supply which is the difference between the increase of M3, the money supply in current data and (less) the growth rate of the real GDP.
In fact the variations of this free money supply are important: as it increases, the real GDP growth decreases, and conversely.
The free money supply is a concept derived from the free cash-flow which is the total cash-flow less the part which will be in any case used to finance the renewal of the fixed assets (to maintain in state the outputs), the payment of the income taxes and of the dividends.
This free cash-flow is important for a company: it varies a lot according to the economic situation and to the (good or wrong) decisions of its managers.
M1 is the cash in billfolds and current accounts of the consumers, M2-M1 their savings and M3-M2 the whole of treasuries of companies.
The variations of these aggregates are thus found in those of the M3 free money supply.
Thus, in a normal situation, the real GDP growth is 3.5 percent and that of the free money supply is also 3.5 percent. The increase in M3 is at 7 percent in current prices. It integrates full inflation and a wealth effect.
As the variation of the free money supply accelerates (by exceeding 3.5 percent more and more), the real GDP growth slows down more and more under its optimal potential of 3.5 percent and conversely: as the variation of the free money supply decreases (while passing more and more under 3.5 percent), the real GDP growth increases more and more, over its optimal potential of 3.5 percent.
(Click here to enlarge the graph)
To start again the GDP growth (when it is below its optimal potential as in 2002-2003), the central bank have to decrease its target to reduce the free money supply. Indeed, in this case consumers save relatively less (by spending and investing more, which boosts demand), and free cash flows decrease (the companies increase their business investment, which boosts demand and supply) .
Conversely, to decrease a growth of a real GDP too strong, above its optimum potential as in 2006 and in 6 first months 2007 (thus inflationary and unsustainable in the long term), the central bank must raise its target to increase free money supply thanks to the increase of savings (on savings accounts in M2-M1, consumers anticipating an economic slowdown while increasing their precautionary savings by consuming relatively less and investing less, which reduces demand), and through the increase in cash flows (M3-M2 by investing less, which reduces supply and demand, and by increasing earnings in 2006 and in 6 first months 2007).
The central banks make move the markets in the wanted direction, by increasing or decreasing their basic rate according to circumstances, to vary the free money supply so that the real GDP growth is nearest possible to its optimal potential without inflation.
The ideal would be that the growth of the real GDP is stable at 3.5 percent, without variations, but such situation of balance is never durable. However, with the passing of years, the Fed succeeds in decreasing the range of the real GDP growth and of the free money supply which were sometimes important: it increased more than 10 percent in 2001 and it decreased in end 2003 beginning 2004, which corresponded to a recovery very (too much) strong of the real GDP thereafter because inflation set out again.
Contrary to the commonly widespread ideas, it is thus not by increasing the free money supply that a central bank can start again the economic activity, but on contrary by restricting it (by decreasing its basic rate) provided that there no were before monetary skids (as in Japan for example in 80s and now in euro zone).
Conversely a central bank slows down the GDP growth by increasing its basic rates, that increases the free money supply.
The evolution of the free money supply (in rise or fall) is important because the real GDP growth is it inversely proportional.
On the long term, the increase in the free money supply is higher than the real GDP growth of a half point at least, which is due to an wealth’s effect of the consumers and companies. Indeed, when the growth of the real GDP increases, their wealth increases, the consumers save more and the profits increase more.
The Fed does not publish any more since March 13, 2006 the data of M3, which prevents from well analyzing these problems.
However, this measurement does not present major disadvantages because the variations of the free money supply in M2-M1 are significant and the evolution of the cash-flows of the companies can be known by other reliable means.
Part 2: M2-M1 free money supply
The variation of the free money supply depends in fact (especially in the United States) on the variation on only one aggregate: M2-M1, i.e. of the savings of the consumers (on savings accounts) which must drop so that the real GDP increases. Indeed, by saving less, the consumers spend more: demand increases and supply answers it (so, the real GDP increases).
Conversely, the Fed has slowed the real GDP growth by maintaining its base rate at 5.25% in 2006 and during the 6 first months 2007, above its neutrality at 4% (or 4.25%), which led to an increase of consumers savings (i.e. an increase in the M2-M1 free money supply) by a relatively small increase in consumption. The Fed has sought to slow the real GDP growth as it was above its optimum potential, which is not tenable in the long term because this was inflationary.
The financial and monetary situation of the United States is generally sound: Americans have largely accrued predictable pension costs (in pension funds), the deficit of the State is contained in the standards, cash flows have never been higher, the indebtedness of companies is generally low.
The Fed waited until the core inflation return back in the acceptable area (an increase in the PCE: PILFE must be below 2%, preferably fluctuating between 1 and 1.5%) due to the slowdown in GDP growth .
Part 3: free money supply and behaviorism
To understand the relations between the free money supply and the GDP growth, it is necessary to understand with what actually correspond, concretely, the variations of the monetary aggregates.
As consumers fear that their situation is degraded in a near future, they spend relatively less and thus they increase their precautionary savings, which means that M2-M1 increases and that the real GDP growth slows down: savings and growth are inversely proportional.
Conversely, as they anticipate an improvement of their situation, they spend more by decreasing their savings: M2-M1 decreases and the growth of the real GDP increases. Finally, this law of free money supply is simple!
What is important is thus the reaction of the consumers, i.e. individuals, which is visible starting from the variation of the monetary aggregates.
The behavior of the consumers is thus determining: it explains this almost perfect correlation between the M2-M1 free money supply in current prices (not deflated) and the real GDP growth for 50 last years in the United States and the same results in the euro zone, in Thailand and everywhere else.
The reactions of Americans are very fast and very elastic. The Fed publishes Thursday evening the data of M1 and M2 which makes it possible to know with only 10 days of delay their behavior. Thus, it is possible to know almost in live the trend of the GDP and thus to correctly anticipate the markets, before the investors who do not know this law of free money supply... from where its interest because the speculation is then winning!
The FOMC members raised too late and too slowly their basic rate in 2004, leading to a too strong GDP growth in 2005 and 2006, above its optimum potential, and therefore inflationary. To bring down underlying inflation in the ideal range from 1 to 1.5%, the Fed was obliged to create a decline in growth and, ultimately a recession. However, as American economy is very strong, the decline is slow and weak, but certain. As stock markets badly anticipated this slower growth, there is a collapse.
This law of the free money supply is verified for more than 50 years in the United States, but a new paradigm is being set up.
On the one hand, the behavior of Americans is changing: now their level of wealth allows them to consume and save.
On the other hand, the optimal rate of GDP growth in the future will be lower than it was in the past because the participation rate tends to drop, inactive (retired) will be more numerous than in the past .
This new paradigm is beginning.
Part 4: M3 Free Money supply in euro zone
In the euro zone, the increase in the free money supply is too strong. Thus, GDP growth is below its optimal potential: M3 increased at 4.5% year-on-year in May 2004 and now at 12%!
(Click here to enlarge the graph)
The increase in the money supply come from sound money and unearned money because of the provisions for retirement are not accounted. So, there is monetary creation.
To boost real GDP growth, the monetary creation (which was far too high, especially in France and in the Club Med) have to stop.
To do so, it would have had to restrict the mass distribution of so-called social aid and grants, and force companies and the government to comply with the accounting rules which give an accurate picture of reality, by accounting retirement commitments in funds pension.
M3 free money supply in Thailand
(Click here to enlarge the graph)
I studied these monetary problems in collaboration with Fred Rabeman, technical analyst, whom I thank: http://www.maestrade.com/
Originally published on January 11, 2007 and on this blog on August 12, 2007 and reviewed on January 28, 2008.