There is a sense of relief among economists and stock market specialists due to decreasing energy prices and a secure energy supply for the winter. With government support available in Europe and China’s return to production after shifting from a zero-covid policy, the high cost of goods remains a significant worry. Despite some interest rate increases from central banks aimed at preventing currency devaluation, it is still too early to say goodbye to economic crisis and recession concerns.
The Underlying Impact of Real Money Supply Contraction
There is a significant global economic trend that is equivalent to a storm but goes unnoticed by numerous experts and investors, and that is the contraction of the real money supply. The real money supply refers to the actual buying power of money. For instance, if you have ten dollars and one apple costs one dollar, you can purchase ten apples. If the apple price goes up to two dollars, your ten dollars will only buy five apples, illustrating how the real money supply is affected by the interaction between the nominal money supply and the prices of goods.
The actual buying power of money, represented by the real money supply, is impacted by both the amount of money in circulation (the nominal money supply) and the cost of goods. Currently, the decline in nominal money supply combined with the rise in goods prices is causing a decrease in the real money supply. The annual growth rate of the real money supply in the OECD, as shown in the chart from 1981 to October 2022, has decreased by 7.3% year over year, a historical occurrence without a clear explanation.
Real money stock in the OECD, annual changes in per cent; Source: Refinitiv – calculations Degussa.
Central Banks’ Role in the Economic Turbulence
The significant increase in goods prices, or high inflation, is a result of the monetary policy set by central banks. During the lockdowns imposed for political reasons, central banks greatly increased the money supply. For instance, the M2 money stock of the US Federal Reserve increased by around 40% since the end of 2019, and the M3 money supply of the European Central Bank rose by 25%. As the increase in the supply of goods has not kept up, there is now an overabundance of money, which is contributing to cost-push factors such as the impact of green policies, lockdowns, and the conflict in Ukraine, leading to steep inflation in goods prices.
The Potential Risks of an Impending Recession
At the same time, however, the growth of the nominal money supply has decreased significantly again. In the US, it declined by 1.3% YoY in December 2022, and in the Eurozone, it dropped to 4.1%. The cause of this drop is a decrease in loan demand; fewer loans are being provided by commercial banks, and therefore, the creation of new money through bank lending is decreasing. Additionally, central banks are no longer purchasing government bonds, contributing to the reduction of new money entering the economy.
It may seem counterintuitive, but the high inflation in goods prices is actually reducing the excess money supply, and with the recent significant decrease in the growth of money supply, the pressure for future inflation to decrease is growing.
However, if the real money supply continues to shrink as much as it currently is, it signals an economic slowdown and possibly a recession. When the real money supply in the economy decreases, those who hold cash become less wealthy as they are unable to purchase as many goods as they previously could. They must adjust their spending, either by not purchasing more expensive items or by purchasing more expensive items while giving up something else, causing a decline in overall demand.
The idea that high goods price inflation is reducing the money supply overhang, despite seeming paradoxical, is a well-known theory known as the “real balance effect.” This theory, proposed by economist Don Patinkin, suggests that the economy can recover from a crisis without government intervention if there is a decrease in goods prices. This increase in the purchasing power of market players leads to an increase in demand for goods and helps the economy recover.
In the current scenario, the initial increase in the money supply fuelled consumption and production; however, as goods prices continued to rise and monetary expansion slowed down, the real money stock declined significantly, leading to a decrease in economic activity and the possibility of a recession.
The decline in output and employment then puts pressure on the rising prices of goods, establishing a new relationship between the existing money supply and goods prices that align with people’s preferences. Once this adjustment is complete and the nominal money supply stays the same, the inflation in goods prices subsides. The result is that the economy ends up with higher prices for goods in comparison to the situation before the increase in the nominal money supply.
Central banks, however, are considering raising interest rates further, as they are concerned that doing nothing about the current high inflation could erode people’s trust in paper currencies that aren’t backed by anything. This could lead to higher inflation expectations among market participants, which is already happening, and create an even bigger inflation crisis in the future. Additionally, monetary policy decisions made by central bank councils are usually based on the current inflation rate, with little to no consideration given to the development of the real money supply.
Therefore, central banks, whether intentionally or unintentionally, are causing a stabilising recession—a contraction in the economy—to break the wave of inflation. At first glance, their plan might work. If demand for goods decreases, companies can only reduce their inventory by lowering prices. The ability to pass on costs and speculate on future price increases decreases. Wage demands fail to materialise, and most importantly, credit and money supply growth slows down during a recession, reducing future inflationary pressure. However, at second glance, this is a very risky approach in the current monetary environment.
Challenges Ahead for Debt-Ridden Economies
A potential recession would put heavy pressure on economies that are heavily in debt. Many debtors will struggle to pay their debts, leading to a rise in loan defaults. This will make banks hesitant to issue new loans, and they may demand repayment of existing loans. Investor confidence in these debt-ridden economies and financial markets will decrease. This could lead to a severe credit crisis similar to the one seen in 2008/09. Investors may fear that they won’t receive their interest or principal payments, causing credit markets to freeze and putting the unbacked monetary system at risk of collapse.
The consequences of a recession would be severe, and central banks may come under political pressure to lower interest rates and provide more credit and money to keep the economy afloat. In an effort to avoid a crisis, governments and the public may see increasing the money supply as the lesser of two evils. In some cases, even a high inflation policy may be seen as an acceptable solution. History has seen similar cases where unbacked paper money systems have been handled in this manner, such as during the 2008/09 global financial crisis and the 2020/21 crisis following the politically mandated lockdowns.
Central banks have previously addressed crises by lowering interest rates and expanding the money supply, as seen in 2008/09 and 2020/21. This has led to inflation, either in the form of asset price inflation (in early 2009) or consumer goods price inflation (towards the end of 2021). It is possible that history will repeat itself if central banks continue to manipulate market interest rates and increase the amount of money created out of thin air.
If central banks are not restrained, their actions of causing economic booms and busts through interest rate manipulation and expanding the money supply will eventually result in an unprecedented level of inflation. The declining real money stock in the world economy may be a sign of a new round of easy monetary policy and high inflation, potentially even leading to hyperinflation down the road.
Concluding Thoughts on the Evolving Economic Landscape
In conclusion, the current global economic trend is a complex and dynamic situation. Decreasing energy prices and a secure energy supply provide some relief to economists and stock market specialists, but the high cost of goods remains a significant concern. The contraction of the real money supply, caused by the decline in the nominal money supply combined with the rise in goods prices, signals a potential economic slowdown and a possible recession. This is a well-known theory known as the “real balance effect.” Central banks are considering raising interest rates further to curb inflation, but this could lead to a stabilising recession and put heavy pressure on economies that are heavily in debt. The situation requires careful consideration and monitoring of various factors, including the nominal money supply, goods prices, inflation, and loan defaults, to prevent any negative impact on the economy.