January 9, 2010 – The total quantity of US dollars in circulation has declined over the past year. As of December 31, 2009, M3 is $14.193 trillion compared to $14.317 trillion one year ago, based on preliminary estimates prepared by shadowstats.com.
The nosedive in M3 annual growth rates from its peak of 17.4% in March 2008 seen in the following chart is…well, in a word, breathtaking.
The red line plots M3 based on Shadow Stats’ estimates, after the Federal Reserve stopped reporting M3 in February 2006, which was shortly before Ben Bernanke was appointed its chairman. There are five distinct periods on this chart, each of which is described by my label. These are as follows:
“1970’s Inflation” – the dollar inflation rate was double-digits in the 1970s because M3 grew at double-digit rates
“1980’s Disinflation” – Paul Volcker raised interest rates to bring inflation under control, which ushered in a decade of disinflation as M3 growth rates declined
“1990’s Reflation” – after his appointment in August 1987, Alan Greenspan followed Volcker’s disinflationary policies until M3 declined in early 1993; thereafter he opened the monetary spigot and reflated
“2000’s Flight from the Dollar” – even though M3 growth rates were declining, the demand for the dollar fell even more, evidenced by the dollar’s declining rate of exchange against other currencies during this period
“Bernanke Boom & Bust” – the rapid expansion of M3 led to 2008’s commodity bubble (the ‘boom’), and the subsequent contraction has led to the current ‘bust’
As Milton Friedman made clear: “Inflation is always and everywhere a monetary phenomenon.” If central banks create too much money, rising prices are a result. The other side of the coin is also true; deflation is always and everywhere a monetary phenomenon. Deflation arises when there is a drop in the quantity of money, which is what happened to the dollar over the past year. Basically, the purchasing power of money falls during inflation (e.g. 1970s) and increases during deflation (e.g. 1930s).
However, something here is amiss. The price of goods and service is rising, not falling. Even though M3 declined, the dollar is purchasing less than it did a year ago.
During the past year, the CRB Continuing Commodity Index rose 33.4%. The price of crude oil more than doubled from $39.75 to $79.36. Even the government’s CPI, which notoriously understates the true inflation rate, rose 2.7% for the eleven months through November 30, 2009. Clearly, the purchasing power of the dollar is being inflated away as is evident by these price increases. But how is inflation possible when M3 is declining?
I have been pondering this puzzle and here is how I see it. There are two possible answers.
1) Demand for the dollar is falling – A basic principle of Economics 101 is that price will fall if demand drops more rapidly than supply. This principle is also true for money, the ‘price’ of which is its purchasing power. So even though the quantity of M3 is less than it was one year ago, presumably the demand for dollars has fallen even more. The consequence is that the dollar today purchases less than it did last year. In other words, the price of goods and services is rising.
2) M3 is understated – It is possible that Shadow Stats is not capturing the total amount of dollars in circulation with its M3 estimates. One of the M3 components is eurodollars, which is notoriously difficult to estimate. I emailed John Williams, the proprietor of Shadow Stats, on this point, who acknowledged that there is little good reporting for eurodollars, but he also raised a related point. Given that the dollar is still the world’s primary reserve currency, the global stock of dollars has to be taken into account. Unfortunately, there is no reliable number for the total quantity of dollars outside the U.S.
It seems to me that both of the above alternatives are at work here. Consequently I continue to expect that there will be dollar hyperinflation caused by too much spending by the US government.
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