S&P 500 and the Monetary Tsunami

It has been said that Lenin, the ruthless communist dictator of the Soviet Union, once claimed that if you want to crash a capitalist economy, you destroy its banking system. Whether or not that quote is actually attributable to him is for others to determine; the point, though, is frighteningly accurate. As I explained in my article Credit, Risk and Capitalism, the recent, violently fast monetary expansion is now threatening an essential part of the fabric in a capitalist economy: the tie between price and risk on financial markets.

Our banking system exists to master the price-risk relationship. Once these two variables are separated, the essence of free-market capitalism withers away.

Today we can report more numbers that reinforce the impression that our very economic system is in jeopardy. Before we proceed to examine how the active ingredient of this destructive process – the tsunami of a monetary expansion – affects the stock market, it is worth noting that the Federal Reserve is not the real culprit here. They have printed an inordinate amount of money because Congress wanted extreme “stimulus” spending in response to the Covid-19 economic shutdown, without having to pay the political price in the form of higher taxes.

With that said, let us take another angle to the monetary explosion. Figure 1 reports the velocity of money in the U.S. economy, a variable that tells us what the balance is between money supply and money demand. The velocity is calculated as current-price GDP (representing money demand) divided by money supply (defined as M1):

Figure 1: Velocity, M1 and GDP; Quarterly data at annual rates

Sources of raw data: Federal Reserve (M1); Bureau of Economic Analysis (GDP)

The velocity of money has virtually imploded in 2020, illustrating with chilling clarity how the increase in money supply has saturated the economy with liquidity for which there was neither need nor demand.*

Where, then, did the money go? We have been told that it was to cover much-needed stimulus spending, which in turn was needed to plug a big private-sector income hole caused by the Covid-19 shutdown. There is no doubt that many Americans suffered as a result of the shutdown, and as I have explained elsewhere it was the duty of Congress to compensate the private sector for the artificial, government-created disruption in economic activity. However, that compensation vastly exceeded private-sector losses, which in turn means that government has seriously over-sized its stimulus outlays. As a result, the Federal Reserve printed lots of money for which there was no intrinsic demand.

Where, then, did the money go? Figure 2 gives us a hint. It reports quarterly numbers for year-to-year changes in S&P 500 trade value (defined as trade volume times close index) and year-to-year changes in M2 money supply. Note how the two take off as rockets in the first and second quarters of this year:

Figure 2: S&P 500 Index (left vertical axis); M2 Money Supply (right)

Sources of raw data: Yahoo Finance (S&P 500); Federal Reserve (M2)

Here is a highlight of the past six quarters, with changes to the S&P 500 index in the left column:

In other words, a good part of the newly minted money supply has come to finance equity investments. While the economy went into a severe downturn – artificial but still – the stock market apparently thought it was the right point in time to drastically raise the value of that same economy. The close index was about ten percent higher in May, June and July this year than last year, with trade volumes exceeding previous-year figures by 38-85 percent.

The rally has subsided somewhat in recent months, but both close index and trade volumes still exceed 2019 numbers. In short: the stock market is in love with 2020, and a good part of the reason is that the Fed’s money printing presses are working overtime.

Which brings us to the dire problem embedded in these numbers. Since there is no macroeconomic value to motivate this stock-market rally, its sustainability is entirely dependent on the Fed’s decisions going forward. We know already that the central bank has no plans on turning off the money faucet, but for a host of reasons this monetary fueling of equity prices is entirely unsustainable. It will collapse by the weight of its own over-inflated might.

Unless, of course, the money printing first causes hyperinflation in the economy. Which, again, is now a possibility – not probability but possibility – we have to consider.

There is only one way to kill this monetary inflation vortex: drastic reductions in government spending. Will that happen? We’ll see.

*) The terms “need” and “demand” are used deliberately. The difference is too intricate to cover in a blog article, but will be explained upon demand.

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