Thursday, 15 August 2013

How Increases in Money Supply Fuels Financial Markets

Back in June, Tomas Salamanca wrote an interesting article published on the Ludwig von Mises Institute of Canada titled We Learned an Important Monetary Lesson this Week. In the article the author points out how Bernanke "tapering talk" impacted financial markets when it was first mentioned.

Of greater interest, I thought, was his explanations on how increases in money supply finds it way to the financial markets:
Put another way, in evaluating the Fed’s policies, it cannot be assumed that additions to the money stock merely affect the consumer goods sector.
Indeed, it ought to be no surprise that increases in the money supply make themselves felt in the financial markets. That is, after all, where the newly created money first enters the economy. Usually, the central bank adds money by purchasing bonds from commercial and investment banks in what are known as open market operations. Until the various iterations of quantitative easing came along, this was done with a view to fixing a benchmark interest rate at some targeted level. In the U.S., this benchmark is the Fed funds rate. All that distinguishes quantitative easing from this more traditional approach is that the purchase of bonds occurs with the specific aim of increasing the money supply by some desired amount. Whether through interest rate or money supply targeting, however, the additional funds land in the accounts of private financial institutions who can then turn around and do any number of things with it. One of these is to buy stocks and bonds.
Eventually, the new money does find its way into the real economy. A company may take advantage of the higher stock prices caused by the injection of liquidity to issue new stock, investing the proceeds in equipment and machinery. A government might exploit the lower yields on its bonds to borrow more, using the money to build roads and bridges. Or, perhaps, the government expands unemployment insurance payments, the recipients of which spend the money on consumer goods. So too, of course, sellers of bonds and stocks may decide to cash the proceeds out of their brokerage accounts and buy a car or remodel their house. Yet as the experience with quantitative easing over the last four years makes clear, once the money is put into the financial markets, it can remain stuck there for quite awhile, relentlessly driving up asset prices.
How is that possible?  The most compelling explanation was given by Fritz Machlup in his 1931 book, subsequently updated in 1940, entitled The Stock Market, Credit, and Capital Formation. Though Machlup, originally a student of Ludwig von Mises in Vienna, would sadly drift away from the Austrian school of economics towards a more orthodox position in the discipline, that book must still form the foundation of any attempt to construct a full-fledged  Austrian theory of finance. In the book, Machlup points out that, during monetary easing campaigns run by the central bank, money is liable to get dammed up in the stock market in a speculative chain of transactions.
First, the monetary stimulus causes stock prices to trend higher. This, in turn, generates expectations of future gains such that sellers of shares continually reinvest their trading profits in other stocks. Thus, A buys shares from B, who then buys from C, who then buys from D, and so on.  As long as the money keeps coming in from the central bank, this sequence can persist, especially if the investment and consumption opportunities in the real economy are not perceived to be as promising as the chances of racking up returns in the markets.
One might think that market participants would immediately discount the central bank’s monetary policy. As such, stock prices would go up all at once, rather than doing so in a protracted trend during which investor enthusiasm is allowed to build and launch equities to dizzying heights. But Machlup observes that the central bank’s actions cannot be fully discounted because no one can know for sure when exactly it will stop easing.  Given this uncertainty, investors and traders are better off playing on a continuation of the bull market until it becomes evident that the central bank is about to turn off the monetary spigot . One does not want to leave the central bank orchestrated party too soon.