30 November 2009Market Focus
The Dark Side of the Moon
In May, we showed that a rising public debt and a bigger Fed balance sheet weresubstituting for a collapse in private debt, lending, and leverage. We presented aframework for quantifying this and estimated that the huge expansion of the monetarybase and of public debt (public shadow money) had merely offset a sharp contraction of private shadow money.This broad conclusion remains true today: our measure of the US effective money stock,which includes bank deposits (M2) plus public and private shadow money, is up 6.8%since Q1 2007, just before the financial crisis began. For comparison, nominal GDP hasrisen 3.4% over the same period (Exhibits 1 & 2 below). All of this modest excess growthof money reflects the 3.7% growth in effective money since April.Restoring funding liquidity has allowed private shadow money to rebound by about $1trillion over the past six months. (Recall that it plunged some $3.6 trillion during the crisis.)Public shadow money is up just $150bn since April, after soaring $3 trillion in the crisis.Further credit healing should allow public shadow money growth to slow further, or evencontract as the private balance sheet begins to function again.
If we are correct, extreme opinions about both inflation and deflation are simply notsupported by the facts, and stem from not understanding how the modern financialsystem really works, and so looking at incomplete measures of money and credit.
The error involves too much focus on commercial bank assets and deposits, which nolonger dominate either credit flows or liquid, money like assets. Like the dark side of themoon, shadow money is hard to see. But just because we can’t always see it does notmean we should ignore it.No scientist would make such an elementary error as ignoring the gravitational pull of invisible things, and nor should participants in financial markets. Unfortunately, a greatdeal of bad analysis and potentially bad investment decisions are currently flowing frommaking exactly this kind of mistake.Understanding what is happening to shadow money and credit is therefore of profoundimportance to us all.
Exhibit 1: Total Effective Money Stock and Nominal GDP
Effective MoneyNominal GDPRatio of Effective Money to Nominal GDP
Source: Credit Suisse