The Evidence

Based on data from the Federal Reserve Bank of St. Louis, the supply of dollars (M2) in the economy has been shrinking lately.

With all the media chatter about interest rates and price inflation, the shrinkage in the money supply has received little, if any, press. This decline is a rare occurrence that deserves more attention.

Money Supply (M2) from St. Louis Fed

The Theory

The short version of the Austrian business cycle theory tells us that an expansion in the money supply tends to lead to an economic boom. The expansion of the money supply leads to a misallocation of resources (also referred to as malinvestments), which spreads through the economy and leads to price inflation. As these malinvestments become discovered, individual businesses begin to fail one after another until the economy falls into recession.

The first part of this theory has so far proven correct. Some economic indicators show the economy expanding while it also suffers from price inflation. More than likely we will see a bust, but when that will occur cannot be predicted.

The boom happens because the expanding money supply disrupts the price signals that are a normal part of a healthy market. Business people make rational decisions based on faulty price information. Increasing prices lead business people to believe shortages exist and they will increase production— a big mistake.

We are now faced with a new possibility. A declining money supply could lead to decreasing prices, which indicates to business people that an oversupply of goods and services exists. In this case, they might cut back production when they don’t need to—or should not.

The Conclusion

Over the last 70 years or more, the market has lived with a perpetual increase in the money supply. During that time, we have suffered numerous recessions when the growth of money simply slowed. We are now faced with a situation in which the growth of money has not only slowed but reversed course.

I make no suggestions or recommendations in this column, but I do want to point out a statistic that has not received enough attention. I suggest that people keep a closer eye on this critically important statistic.

Reference

I have included a link to an article from Goldman Sachs addressing the shrinkage in the money supply. While I don’t agree with much of what appears in this article, I think it merits reading as food for thought.

Goldman Sachs
Why the US money supply is shrinking for the first time in 74 years