Monday, 30 October 2017

The Money Relation (as of Sep-17) - In Negative Territory For The First Time In Two Years

The money relation, a concept Mises explained (see Human Action) as the relationship between the demand for- and the supply of money, is a tremendously important concept in the theory of money.

In very simple terms and all else remaining the same, the purchasing power of money (the inverse of money prices) declines when the quantity of money increases and the demand for money to hold decreases. Conversely, the purchasing power increases when the quantity declines and the demand for money to hold increases. Both the quantity of money and the owners' propensity to hold on to them therefore combined determine the purchasing power of money.

An attempt to chart changes in the money relation is presented below; readings above zero represent some combination of the growth in the quantity of money outpacing the growth in the demand to hold money (here represented by the rate of saving). In other words, a reading above zero is representative of developments that exert downward pressure on the purchasing power of money and which as a result increase the prices of the goods, services, and assets money is exchanged for, including financial assets. With one exception (Aug-15) the money relation has been above zero since March 2015.

This has no doubt been a positive for stocks. But after peaking in October last year, the reading has declined steadily every month until the most recent reading (September) when it finally, after 24 months, now has dropped into negative territory. By itself, this is a negative for stocks, especially if it remains below zero and drops further.

What is especially concerning this time around is that the money relation is dropping despite a plunging saving rate that is now down some 31% year on year (y/y). In fact, the saving rate has dropped consistently every month on a y/y basis since December 2015, or 22 consecutive months. Based on data starting in 1973, this has only occurred once before: between October 1975 and September 1977 when it fell for 23 consecutive months.

The great difference compared to today however is that back then the saving rate dropped less and from a much higher level (from 13.0% to 10.7%) while this time it has dropped from an already slim rate (from 6.1% to 3.1%) and almost halved in the process. As spending cannot forever be paid for with declining rates of saving (and as real income is going nowhere), this is clearly a development that cannot last much longer. At the same time, bank lending growth is also plummeting. As this takes place at a time when, as judged by the stock market, things are great, there are few reasons to believe bank lending growth and hence money supply growth should pick up any time soon.

Alas, when the saving rate once again picks up, the money relation will more likely than not drop fast and well below zero. And that is when the purchasing power of money increases and financial crisis occur. We're not there yet, but things can change quickly and abruptly, like it last did in early 2008. By then the bear market was already firmly on its way though stocks were not nearly valued as highly as they are today on a range of metrics.

For more on the money relation, see this article:

The Money Relation - Yet To Signal An Economic Reaction, But...

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