Monetary Stuff

By: Steve Saville | Mon, May 26, 2008
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Below is an extract from a commentary originally posted at on 22nd May, 2008.

Cash on the Sidelines

An argument that regularly gets put forward in support of a bullish stock market outlook is that there is a lot of "cash on sidelines", the implication being that there is a lot of money waiting to move into the stock market.

This is a really silly argument because all the cash within the economy is always on the sidelines. To be more specific, apart from a small physical "float" (in wallets, in cash registers, under mattresses), all the money in the economy stays within the banking system at all times. It never goes anywhere -- it just gets shuffled around between accounts. By way of further explanation, here are some hypothetical examples:

1. When Johnny buys shares from Freddy, money gets transferred from Johnny's account to Freddy's account. In other words, Johnny's decision to buy shares doesn't put money into the stock market, it puts money into Freddy's bank account.

2. When Johnny invests money in a bond fund and the bond fund uses this money to purchase bonds from XYZ Corporation, money gets transferred from Johnny's account to the account of the bond fund and then to the account of XYZ Corporation. No money actually goes into the bond market.

3. When Johnny pays tax, money gets transferred from his bank account to the government's bank account.

4. When XYZ Corporation sells Asset-Backed Commercial Paper (ABCP) to a hedge fund and invests the proceeds of the sale in a Money Market Fund (MMF), money is initially transferred from the bank account of the hedge fund to the bank account of XYZ Corporation. The money then gets transferred to the account of the MMF, and, lastly, to the account(s) of the seller(s) of the securities purchased by the MMF.

As long as the supply of money continues to increase then so will the amount of "cash on the sidelines", regardless of what happens to the stock market or any other market. Moreover, note that large increases in the amount of so-called "cash on the sidelines" did not prevent the US stock market from losing half its value during 1973-1974 and during 2000-2002.


Adam Hamilton has posted a good article about inflation at We agree with the bulk of this article and are in total agreement with the article's primary message -- that rising prices are not inflation. For the purpose of this discussion we will, however, zoom in on the few parts of the afore-linked article that we disagree with.

The first point we'll make is that MZM (Money of Zero Maturity), the money supply measure cited in the article, is currently generating a false signal. Over the past 10 years it usually hasn't mattered, from a practical standpoint, which monetary aggregate an analyst used to determine the inflation (money supply growth) rate, because M2, M3, MZM, TMS (True Money Supply) and AMS (the "Austrian Money Supply" preferred by Frank Shostak) were all behaving roughly the same way. The only thing of real consequence was that the analyst understood that inflation equals money-supply growth. However, over the past two years there have been huge divergences between different monetary aggregates, meaning that widely varying conclusions could be drawn depending on which money-supply measure was used. These divergences prompted us to delve much more deeply into the methodology of money supply measurement.

We don't want to go back over the ground we've covered in earlier commentaries, but suffice to say that MZM, like M3, has been boosted in a big way over the past 18 months by spectacular growth in institutional Money Market Funds (MMFs). This is an important consideration because the rapid growth in institutional MMFs does not have anything to do with increasing money supply. It is, instead, largely due to a general shift away from riskier income-producing investments such as asset-backed paper. For instance, if institutions, as a group, sell $100B of asset-backed paper and re-invest the proceeds in MMFs (as per Example 4 in our "Cash on the Sidelines" discussion), no additional money will actually be created but both M3 and MZM will increase by $100B.

Currently, the supply of US dollars is growing MUCH more slowly than suggested by MZM.

The other aspects of the article that we'll address are in the concluding paragraphs. In particular, we take issue with:

"...the commodities price increases we have seen lately are not all inflation. A large portion, the majority in most cases, is due simply to global imbalances in production and consumption growth. Inflation is purely a monetary phenomenon, it has nothing to do with supply and demand in individual commodities."

Nobody can ever know how much of a price rise is due to inflation and how much is due to other factors. That's one of the beauties of inflation from the perspective of central bankers and other policymakers. Moreover, if inflation did nothing other than bring about a reduction in the purchasing power of money then it wouldn't be anywhere near as big a problem as it actually is. The main problem with inflation is that it distorts the price signals upon which businesses rely, thus causing the misdirection of resources on a grand scale and the "imbalances in production and consumption growth" mentioned in the above excerpt. Inflation is purely a monetary phenomenon, but it leads to major imbalances within the real economy. That's why inflation-fueled booms are ALWAYS followed by painful busts.

It is also worth noting at this point that the large increases in commodity demand emanating from countries such as China and India have a lot to do with inflation. For some strange reason, even people who have a decent understanding of inflation often jump to the conclusion that higher prices must be real -- that is, not fueled by inflation -- if they result from increasing emerging-market demand, as if the "emerging economies" haven't experienced explosive money-supply growth over the past several years.

Finally, we couldn't disagree more with the comment in the article's last paragraph that "investors wrongly attribute too much to inflation today". Based on what we've observed and also on the results of opinion polls and the performances of various financial markets, we doubt that even one person in one hundred would say that growth in the money supply was a major contributor to the big rise in commodity prices. As far as we can tell, most people attribute the large increases in commodity prices to NON-monetary factors such as strong growth in China, price gouging by greedy corporations, OPEC, the Iraq War, government stupidity, and the weather (including "Global Warming" and natural disasters). Some of these non-monetary factors are significant, but our assertion is that few people appreciate the key role being played by the systematic debasement of all national currencies.

The almost total lack of understanding of the monetary problems underlying much of what is happening in the financial world is why gold is relatively cheap. But people will eventually catch on, so it is also why gold is destined to become much more expensive.

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Steve Saville

Author: Steve Saville

Steve Saville
Hong Kong

Steve Saville

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