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M3 Inflation and Ireland: Deflation Sets In

My thought bubble on M3 Inflation is going to be developed further as time goes on. The basic premise is that the annual growth rate of money supply (M3) minus the amount money can earn in a year (short term interest rates) will approximate a ‘true’ measure of inflation/deflation. This type of measure is needed because the standard measure of inflation currently used by government statistical agencies around the world is hopelessly flawed.

Having constructed an M3 inflation measure for Australia over the last several decades the picture is one that if put to the average joe on the street would much more accord with how they ‘feel’ inflation in their everyday lives. The measure for Australia shows much higher levels of inflation over the last decade and also several short periods of deflation in the two decades before that.

This is still only a thought bubble with no peer review as yet, I am an academic economist with an honours degree, a PhD and some publications in econimics, but currently non-practising. I can come up with these ideas free from the constraints many non-orthodox economists must deal with on a day to day basis.

So the thought bubble will be expanded to Ireland. Basically the same methodology, annual growth in M3 minus short term bank interbank interest rates (90 days). With the monetary unification of the European Union the classic measures of M3 for each member country became obsolete overnight. However, Ireland has constructed it’s own measure of M3. The measure is known as the Irish contribution to the equivalent euro-area aggregate M3.

The Iriish Central Bank put a great deal of thought into how a new measure for M3 could be constructed given the financial implication of the Maastricht treaty. The following document is one example, http://www.centralbank.ie/data/QrtBullFiles/2003%2003%20Money%20Supply%20in%20Ireland.pdf.

So let us cut to the chase and have a look at M3 Inflation in Ireland. The following graph clearly show that with my measure of M3 Inflation, Ireland lurched into a sever period of deflation in 2008 and has slowly been clawing back ever since. The deflation rate plunged to levels of 15% .

Source: Data compiled from http://www.centralbank.ie/frame_main.asp?pg=sta_late.asp&nv=sta_nav.asp

So what is the story for Australia? As this blog has explained in earlier posts, the deflation episode for Australia is yet to happen. For comparisons sake I constructed a graph of each countries M3 Inflation over the same period from 2004. The good news for Australia from this graph is that the inflationary period does not seem to be anywhere near as severe as what happened in Ireland. One would assume that the resulting deflation may not be as severe as well. To repeat the often quoted copout line, only time will tell.

Source: Data compiled from http://www.centralbank.ie/frame_main.asp?pg=sta_late.asp&nv=sta_nav.asp and http://www.rba.gov.au/statistics/tables/index.html

“They Deal in Real Things”

”The Chinese want a gateway into Europe,” said Deputy Prime Minister Theodoros Pangalos. ”They are not like these Wall Street —–, pushing financial investments on paper. The Chinese deal in real things, in merchandise. And they will help the real economy in Greece.”

http://www.theage.com.au/world/china-forges-a-new-silk-road-to-the-west-20100704-zvrz.html

… and there just in one simple statement is the essence of economics.

Dealing in real things.

You can only grow when you create things that are real.

By real, it means something that has a true value.

Not a hedge or a swap.

Something real.

A good or a service.

Economics is very simple. If you transform a good or service using your enginuity someone else will be prepared to pay for its provision if is offers ‘value’.

Even with credit, if a consumer or investor thinks they will get a return over time at least equal to their outlay a transaction will be made.

When the economy becomes over-run with financial ’services’ that are nothing more than moving money to make money, then nothing productive is being created and those that suffer are the consumers of these ’services’ particularly when they are based on credit.

Paying another person’s money that they never had for something that does not exist is a recipe for disaster.

That sentence summarises the last 30 years of economic activity in the world.

Net Foreign Debt Wagging the Money Supply Dog

M3 Money Supply and Net Foreign Debt - Australia

Source: RBA Statistics

The graph above fairly clearly indicates that Net Foreign Debt (NFD) is a leading indicator for changes in M3 money supply. It looks like there is around a six month lag (give or take) between NFD moving and then M3 following suit.

The majority of foreign debt generated by Australia is not a result of business investing in productive capital but rather the major Australian banks servicing the demand for mortgage debt fuelled by the Australian housing bubble. We can see this influence clearly through this graph.

If you notice at the end of 2006 NFD begins trending downwards after a spike upwards, it was not until the end of 2007 that M3 followed suit. Both measures were trending downwards quite dramatically until in the middle of 2009 when there was a massive turnaround in NFD. From falling by $13.7B in the second quarter of 2009 NFD proceeded to increase by $37.7B in the third quarter, that is a $51.4B turnaround. A further $30.8B poured into Australia in the final quarter of 2009.In total over $68B was pumped into the Australian economy from foreign sources in just a six month period.

What would cause this you might ask?

The culprit was the First Home Owners Grant (FHOG) which was increased substantially in this period. With the help of high Loan to Valuation Ratios (LVR) this grant had the effect of enabling borrowers to add over $100,000 to the amount a bank was willing to lend. Little wonder then that the Aussie housing bubble was further inflated. House prices in large cities such as Melbourne rose at rates upwards of 20% per annum.

So again, after a big jump in NFD we see a big jump in M3. The FHOG had kicked the deflation can down the road by 6-12 months.

The FHOG was returned to ‘normal’ levels at the beginning of 2010 and already we have seen NFD drop back into negative territory. Where NFD goes, M3 follows.

I expect there to be one more quarter of positive M3 numbers before the deflation genie begins to peek out of the lamp again.

Or will the lamp be kicked down the road again?

Moving Money to Make Money

In the third year of my economics degree one of the classes was International Finance. This particular class opened up my mind to a world I previously knew nothing about. We were introduced to a whole array of financial instruments and procedures that to me represented little more than moving money to make money, which was anathema to my trusted philosophy of no such thing as a free lunch. How could there be people out there whose whole career is dedicated to moving money around in order to make more money? How can arbitrage be a way of life? In fact I loathed the course content so much this subject resulted in my lowest grade throughout all my academic life. It was not that I did not understand the subject matter, my mind rebelled against it.

This was back in the early 1990s. In terms of finance, this is almost prehistoric. The array of financial instruments have grown ever more exponentially complex since then. However, the same basic principle underlies many of them, moving money to make money. As Bill Bonner points out on his excellent piece from the Daily Reckoning, finance as an industry has exploded in recent decades.

According to Alan Newman, daily trading volume has ballooned more than 25 times since the 1970s. The financial industry has gone from a minor activity representing only 3% of GDP in the ’70s, to a substantial 7.5% of GDP today…and its single major source of profits.

This financial dervish produced plenty of dust but less and less forward motion. Net private investment in the US hit a high in 1978 at about 8% of GDP. It has been declining ever since, recently hitting zero. After WWII, wages and real GDP increased steadily. But without investment in new plants and equipment, hourly wage gains stopped in the 1970s, while real GDP gains declined. People kept up appearances by borrowing heavily. But that only caused another problem.

The private sector is now solving the problem of too much debt by cutting back. Consumer credit is falling. Commercial and industrial loans are falling. The money supply, as measured by M3, is deflating at the fastest rate since the Great Depression – more than 9% annually. And prices – as measured by the US core CPI – are going up at the slowest paces since 1966.

http://www.dailyreckoning.com.au/honohan-meet-havenstein/2010/06/07/

So why should this matter? After all it is just another industry? I’m old fashioned in some ways, growth comes from production, making or servicing something, improving things, making a table, writing a book, changing a tyre. The financial industry in many developed countries has grown at the expense of other industries, crowding them out, rather than supporting them. When you make money by moving money it can seem like magic, but there is no free lunch the magic is not driven by the engenuity of financiers, it is driven by the availability of credit. One thing about credit is, it needs to be paid back, eventually.

There is no free lunch, eventually.

Most of the developed world has been engorging on the biggest free lunch of all time for the last couple of decades. The time has come where the bill finally needs to be paid. Free lunches are addictive though, and like any addict they will ask for more food in order to delay the starvation, but this just adds to the bill. The bill needs to be paid, the only two things that will change from this point forward are how long it will take to pay off and whether it will be enlarged even further before it begins to be paid off.

The sensible option is accept that we have a problem and work to pay off the bill and starve over a shorter time period.

That is not what is happening.

M3 Inflation and the Gold Price

In a recent post an alternative proxy of inflation was created which was very basic in concept. Basically the idea was that the annual growth in money supply minus short term interest rates would represent the general level of inflation and deflation in an economy. The argument is that the annual growth rate in money supply represents how much each year your individual units of currency are being devalued by inflation, however with those units of currency anyone can derive income from interest rates. Therefore to get a good proxy for inflation/deflation, the level of devaluation (M3 growth rate) must be adjusted for the common level of revaluation (short term interest rates). When the two measures are combined using Australian data the following results are found for the last several decades.

Source: RBA statistics

This chart suggests that Australia has in fact experienced several periods of deflation in recent decades, before the early 80’s recession, before the 87 stock market crash and during the early 90’s recession, with several little bouts of deflation during the 1970s. What the chart actually suggests is that dips into deflation are infact common and what is actually uncommon is the last 15 years of nearly constant and rising inflation (which is currently nearing an end). All things being equal if a period of short bouts of inflation and short bouts of deflation are followed by a long series of inflation then one would expect a long period of deflation to follow. Something that time will no doubt reveal one way or another.

But back to gold, charts from the predecessor of this post were shown on a forum called talkfinance in this thread. One keen observer noted the chart from the Real Inflation and Real Deflation post which revealed the accumulation of M3 Inflation over time, the graph showed a rapid acceleration in the 1970s, then a slow deflation over nearly 20 years followed by another long accelration from the 90’s to today. The comment was made that this chart closely followed the pattern of the nominal price of gold over the same period. The data was examined and this did indeed turn out to be correct as the following chart demonstrates.

Source: RBA statistics and http://www.wrenresearch.com.au/downloads/

It just so happens that the gold price does track the same basic pattern over the last 40 years since the gold price was unshackled in 1971. If we assume the blue line is cumulative inflation then an argument can be made that the price of gold does indeed track closely to inflation. In fact after a quick calculation the price of gold and our representation of cumulative inflation show an 80% positive correlation. That’s not brilliant, but it is also pretty good, when you think of all the different factors that impact independantly upon the gold price and this M3 inspired measure of inflation then an 80% correlation is very good.

There have been a lot of articles written on both sides of the gold and inflation debate, this one is novel amongst them all as far as I know. Hopefully this branch of my research will get further developed as more information and thinking time is available. Comments from both gold bugs and non gold bugs would be most appreciated.

Deflation Case Study: Latvia

This case study really should have been one of the first covered because the deflation dynamics at play in Latvia have been more pronounced than just about any other country in the world. This case study will confirm many of the patterns we have seen in previous case studies. Namely a fall in the value of housing, followed by a fall in M3, followed by a fall in credit and CPI. This seems to be the pattern so far of a classic deflationary episode. Much more thought needs to be put into the whys and wherefors of what is causing this pattern as it might have some significant implications in economics if formulated properly. At this stage however, we are just dealing with blog posts, the vision is still cloudy but over time things will clear up and a clearer vision of what exactly is happening will emerge. Meanwhile enjoy the ride.

If we look at the classic deflation indicators graph (below) the same pattern rears its head, housing then M3 then credit then CPI.

Source: http://www.csb.gov.lv/csp/content/?lng=en&cat=355, http://www.bank.lv/eng/main/all/statistics/bank_mon_stat/bmsq42006/, http://www.arcoreal.lv/index.php?page=60&lang=en

The housing collapse in Latvia is especially pronounced. From 2005 to 2007 prices almost tripled and then proceeded to fall back below 2005 levels by mid 2009. One of the reasons for the change being so severe may be that the Latvian government actually intervened in the housing market in order to quell rampant speculation. Measures such as reducing credit availability, increasing land and mortgage registry fees, secure certification of legal income for buyers and additional taxes on speculative real estate transactions all pushed the marker to deeper lows than experienced in other economies where a housing bubble burst.

If we look at some of the longer term trends of the deflation indicators we see that from 2000 to 2007 credit growth grew at incredible rates of between 40% to 60% every year. Classic bubble behaviour, this type of exponential growth is not sustainable in any type of organic or economic system without a pulback.

Source: http://www.bank.lv/eng/main/all/statistics/bank_mon_stat/bmsq42006/

Money supply showed similarly ridiculous annual rates of growth between 30% and 40% for several years before succumbing to the gravity of economic common sense.

Source: http://www.bank.lv/eng/main/all/statistics/bank_mon_stat/bmsq42006/

Make no mistake, a template is forming about what governments and central bankers should be watching out for to stop credit driven housing mania which leads to debt deflation episodes. It is not rocket science. Hopefully some simple rules can be developed to help the agencies that can make a difference stop the cause rather than try to sure the illness.

Because, really there is no cure to the illness with respect to debt deflation. Whatever debts that have been built up on nothing but hot air have to be paid one way or another.

One of the classic saying in economics is ‘There is no such thing as a free lunch”.

It is a very prescient saying and one I adhere to, but it can be more accurate. The saying should be:

“There is no such thing as a free lunch, eventually.”

Because when a credit/housing mania happens, some people do actually get the free lunch that no-one is supposed to get. However for the economy as a whole this is not what happens, the free lunch is eventually paid for one way or another, and while those that got the free lunch along the way may have been better off even they have to pay eventually through the macroeconomic effects of what happens when the free lunch is paid back.

Real Inflation and Real Deflation

One of the more annoying aspects of economics is the importance placed on the CPI figures and how infuencial they are not only on the economics profession, but on life in general. So many aspects of our lives are effected by this number, HECS debts, pensions and any number of other parts of our lives where a number produced by the Australian Bureau of Statistics (ABS) determines how much we get and how much we pay in everyday life. For an excellent critique of the Australian CPI figures please read this post.

It is an ever changing and arbitrary measure of one organisations opinion on what a typical snapshot of prices are for a typical Australian. As products become more sophisticated and pricing methods more and more complex, the ABS is expected to keep up with the complexities of the market. In my opinion this is a pipe dream. As each year passes the CPI figures become more and more irrelevant. Business is too clever by half these days and they have many ways of increasing prices without actually increasing prices.

The CPI is an old fashioned and out of date concept.

The worrying thing though is the importance placed upon it by the business, economic and political communities.

I do not agree with the vast majority of the theories of the Austrian school of economics. Far too Laissez-Faire for my liking. There is however one aspect of their thinking that I do agree with, up to a point. The Austrians theorise that inflation is represented purely and simply via the change in money supply. Money supply goes up, there are more dollars, this devalues the existing stock of dollars, effectively an inflationary impact.

I happen to think this is a much more accurate representation of inflation than the CPI figures all countries rely upon. However, I would add one more qualification. If the money supply is rising 10% a year this does not mean a 10% inflation rate. My simple reasoning is that if short term interest rates are 6% over the year then in theory the money stock could have earnt itself that 6%, therefore making the real inflation (M3 growth – Short term interest rates) 10% -6% = 4%.

I fully realise this is not a perfect measure of inflation, there in all likelihood is no perfect measure.

This measure is a much more realistic representation of what is actually happening in an economy and how the average person is ‘feeling’ inflation in an economy than CPI.

So we should begin by having a look at how this particular measure of inflation has behaved in Australia historically.

For the purposes of this study I will be using the M3 figure as a measure of the money supply and the monthly average 90 day bank bill rate as the measure of short term interest rates.

The chart below shows the annualised growth rate of M3 and the monthly average of 90 day bank bills from the period 1970 to 2010 for Australia. What quickly becomes apparent from the chart is that these two measure historically tracked each other in the sense that they would diverge only for two or three years at the most before reversing anf diverging in the opposite direction. A constant dance of correction, suggesting each measure attempts to balance the other one out. This was true up until the turn of the milleneum when the 90 bank bill rate has been below the M3 growth rate for an unprecedented 9 years in a row. If not for the very brief period of parity during the dotcom bust in 2001 the unbroken run would have stretched for an incredible fifteen years in a row. Essentially that means fifteen years in a row of inflation after a period where inflation and deflation were working to balance each other out. Notice the spikes in the 1970s, in this period inflation did manifest itself in the CPI. However, in the 2000s the CPI has never shown the rate of inflation indicated by this chart. The explanation for this is that the inflation of the 2000s has primarily been asset price inflation, mostly in asset classes that are not represented adequately in the CPI figures.

Data sources from: http://www.rba.gov.au/statistics/tables/index.html

If the difference is taken from the growth in M3 and the 90 day bank bill figures the resulting number is a new measure of inflation for the country. The chart below shows clearly that inflation has been on the rise for 15 years. Before that there were short sharp bouts of inflation followed by short sharp bouts of deflation. As the chart demonstrates into 2010 the inflation rate is dramatically falling. In my opinion what will happen is that the country will now enter an extended period of deflation to counteract the previous extended period of inflation.

Date Source: http://www.rba.gov.au/statistics/tables/index.html

In this final chart I simply show the accumulation of the difference between M3 and 90 bank bills (inflation). What this chart reveals is the build up of inflation in the 1970s and then an extraordinary period of stability over 20 years from 1978 to 1998 where the inflation rate was in balance. The of course the rise of inflation again in the 2000s. Interesting that the rise in the 2000s and the 1970s are very similar.

Source Data: http://www.rba.gov.au/statistics/tables/index.html

It is my argument that the data represented above is a true representation of inflation in Australia. Just ask yourself, how have you personally felt the cost of living over the last 10 years? Do you think the cost of living has only marginally risen in that time or do you think it has been accelerating, eating into the value of each dollar you earn? The hope is that the economics profession looks outside the square and maybe investigates ideas that challenge the orthodoxy.

India and China: A Short Comparison

I’ve been fortunate enough to visit both China and India within the last two years and have the opportunity to see the lay of the land in two important cities simply by walking the streets for days on end. When I visit a new city I like to really explore it on foot, not following any maps, just walking around and seeing how the city ticks.

My experience in Beijing was amazing, I walked extensively around the circle from the embassy area to the central city. During my wanderings I ventured into some impressive new buildings. To my amazement several of these complexes had dozens of shops, upmarket, even by western standards, each was manned by dutiful employees. I walked through several of these types of malls and I was the only person in there apart from the staff. Apart from the creepiness of the surroundings, my economics background was ringing alarm bells.

How could this happen? In my mind ths could only mean a property bubble, this was back two years ago though. I have no idea what has happened since, but going by media reports the property market has heated up rather than slow down.

I sometimes wonder what happened to these buildings and all the shops and their expensive stock and their employees. Surely simple business basics must mean they are all boarded up now?

Then recently I visited India and the wonderful city of Kolkata. I stayed in the most prestigious and expensive part of the city. It was a pleasant stay in a simple guest house. Over many days I walked to all corners of this southern part of the city. In the whole area there was only one western style mall and it was buzzing. People everywhere, shopping, eating, watching movies and enjoying themselves.

No empty buildings, no idle staff or depreciating stock.

It could be said that this was an example of underdevelopment, the place seemed to be splitting at the seams wanting to be more consumerist.

I’m not sure what caused the difference between the two experiences. But one thing is for sure, I am much more confidant about the medium term future of India’s economy over China’s from my brief experience.

Australia: On the Precipice

The popular opinion if one is to believe the mainstream media and various talking heads is that Australia has missed the worst of the GFC and the future looks bright as Australia gravitates back towards ‘normal’ growth levels. The unseen opinion is that Australia is on the precipice of a debt deflation period, which will mean a protracted bout of reduced consumption and higher unemployment as the country works to pay down debt.

Australia is unusual in the respect that it is one of the few housing bubbles in the western world that is yet to pop. The increase in the First Home Owners Grant (FHOG) in October of 2008 provided a massive boost to the housing industry which was showing signs of buckling. With the FHOG tripling from 7k to 21k for new home builders the extra 14k for a deposit would allow someone to borrow an extra 140k given a Loan to Value Ratio (LVR) of 90%. Obviously this increased the scope for credit and gave home buyers much more flexibility in terms of their offer price for houses. In terms of policy there would be few that could offer so much bang for the buck, as a result of credit creation a dollar of government money was causing an effect of many multiples on the economy. It is no surprise that 2009 was one of the best years on record in terms of house price increase.

The following graph clearly illustrates that owner occupied housing credit growth was slowing rapidly from the start of 2007 and that reduction quickly stopped upon the introduction of the FHOG at the end of 2008 which quickly sent credit growth back to 10% per annum. The grant finished at the end of 2009, this graph has figures up to the end of 2009. It will be interesting to see what happens from here but my guess is that the trend will begin again and credit growth will approach zero before turning negative over the next year or two. The recent move by Westpac to reduce the LVR to 87% is a worrying sign that banks will now begin to severely limit the amount they are prepared to loan to those seeking to buy homes. The reduction of LVR from 95% to 87% effectively halves the amount someone can borrow given a designated deposit. This will have a depressive effect on house prices if it spreads to the other big banks.

Annuallised Change of Owner Occupied Housing Credit

From: http://www.rba.gov.au/statistics/tables/xls/d02hist.xls

Why do I anticipate the shrinkage of housing credit? My argument throughout this article is that Australia has reached peak credit and sits on the precipice ready to reduce debt. This will come at a big price because Australia has become dependent on a good proportion of its consumption expenditure being financed by increased credit. When credit begins to be paid down rather than increased then all consumption driven by credit is wiped out.

So has credit really peaked? The ratio of debt to disposable income has been rising dramatically since the early 1990s. However, it seems to have reached its peak at just under 160%, this most likely indicates that Australians have reached their limit where the debt is too overwhelming.

Ratio of Debt to Disposable Income - Australia

From: http://www.rba.gov.au/statistics/tables/xls/b21hist.xls

If total credit in the economy is examined it can be observed from the following graph that after a rapid climb the level of credit has plateued, mainly at this stage due to a decrease in the amount of business credit in the economy.

From: http://www.rba.gov.au/statistics/tables/xls/d02hist.xls

Indeed, the whole credit market has changed dramatically in Australia in recent decades. Business lending used to dominate the scene with a 60% share at the beginning of the 1990s it now represents less than 40% of the credit market. This share has been eroded by household credit, both investor and owner occupied which together have grown from a 25% share in 1990 to a 50% share now. This is clearly a massive structural change. We have gone from an economy which uses most of its credit to attempt to create, manufacture and provide services to an economy which uses most of its credit to buy and sell houses.

From: http://www.rba.gov.au/statistics/tables/xls/d02hist.xls

If the total credit figures are given as an annualised growth rate things become a little clearer. If you observe the following graph it shows clearly a big fall in the growth rate of total credit during the last recession in the early 1990s, it can clearly be seen that a similar event is happening now. Please let me divert for a second though, if it is good enough for important economic statistics such as GDP and CPI to be represented by annualised growth figure why do the ABS fail to represent other statistics in the same way?

Annualised Growth in Total Credit - Australia

From: http://www.rba.gov.au/statistics/tables/xls/d02hist.xls

Business Credit in Crisis

Business credit in Australia is now undergoing a firestorm. It is over 10% down off its peak in November 2008. Many reports indicate that credit for business loans has dried up substantially from banks. This does not represent as big a problem for big business because they have the ability to raise capital through shareholders. For small business though this is a much bigger problem as they do not have that option.

Tougher lending standards have been implemented by banks towards business loans over the last two years. In 2009 commercial property sales decreased by a staggering 30% as REITS abandoned the market. The average capital value of industrial properties has fallen 25% from peaks of two years ago. There is bad news everywhere.

This is the worst drop in business credit in recorded history. As the following graph demonstrates, annualised growth in business credit has fallen off a cliff into unprecedented levels.

Annualised Change in Business Credit - Australia

http://www.rba.gov.au/statistics/tables/xls/d02hist.xls

Coinciding almost perfectly with the drop in business credit has been a significant drop in the Producer Price Index (PPI) which is a cost index of all the inputs needed to run a business. In other words, many of the items paid for by business credit to produce items and provide services make up the PPI. The lack of credit and the consequent effects on business demand have had a deflationary effect on the PPI. After about a 6-9 month lag the big reduction in business credit has fed into the PPI figures. As the following graph shows this movement is once again unprecedented.

From: http://www.rba.gov.au/statistics/tables/xls/g03hist.xls

Deflation is Upon Us: Over the Cliff We Go

Every argument needs a kicker and I have left it till last. The classic sign of deflation is not as many people think, negative CPI numbers. The CPI is a very much imperfect measure of prices in an economy. Products and services change so quickly that the CPI measure becomes more irrelevant with every passing year.

There is one thing you can measure with certainty though. That is the amount of money in the economy. The broad measure of money M3 is a widely recognised measure for economists, but for Joe on the street it means very little. In very simple terms it is the total amount of money available in an economy at a certain point in time.

While I am no monetarist I still think M3 is a powerful indicator of deflation if it decreases.

What we have basically had over the last decade is large growth in M3 with very little inflation. In the old days if M3 was growing rapidly it would be accompanied by inflation. Recently we have seen very strong growth in M3 with no inflationary effect. So what made up the difference? Something for further study. One thing is for sure though, when M3 goes backwards the economy goes backwards.

So before we go on lets look at M3 over the years in aggregate. Nothing really stands out except the precipituous growth in the last decade. There is a little blip downwards there at the end, but it looks harmless enough, right?

From: http://www.rba.gov.au/statistics/tables/xls/d03hist.xls

If we once again annualise the growth rates what is really happening can be revealed. Well so what you say, looks like a recession may be the worst thing that might happen, after all look at what happened in the early 1990s recession. There were falls in M3 over this time, in fact over 1991 to 1993 there were eight monthly occurences of falls in M3, all were individual except for two which were concurrent in October and and November of 1991.

The big deal is that at the moment we have had four months in a row of a decrease in M3. In the records going back to 1965, this has never happened before. It is unprecedented.

An outlier?

One would hope so.

My bet though is that it is the start of a new trend. One that will see the M3 do something it will not have done on living memory. Decrease, year on year.

If the current trend continues then annualised M3 growth will be in negative territory by April. Just to be safe I am going to call negative annualised growth for M3 before July 2010.

From: http://www.rba.gov.au/statistics/tables/xls/d03hist.xls

If you think there is nothing to worry about consider the following article. This was just before the massive impact of the GFC and the still ongoing incredible effects on the United States economy.

From: http://globaleconomicanalysis.blogspot.com/2008/08/m3-contraction-future-is-now.html

If you still think M3 doesn’t matter check out the graph from shadowstats detailing their estimate for M3 over time.

Everything went pear-shaped in the United States precisely after M3 started to decrease. Is Australia at the precipice, ready to fall. Only time will tell of course, but given factors such as our massive debt, housing bubble, collapsing business credit and unprecedented fall in M3 already I think the time is now. Australia, you are standing in it.

Deflation Case Study: Spain

Things are going so bad economically in Spain that the national pastime has changed from bullfighting to bearfighting. Now that I have that terrible joke out of the way, what are the prospects for deflation in Spain? It had been characterised, like quite a few other advanced economies, with rapidly rising credit and asset prices. The bubble in asset values popped with the downturn in housing. Now Spain has the lot, very high external debt, unemployment at 17% and rising, large current account deficits and a shaky and nervous banking system. We’ll have a look at some of the same deflation indicators we have examined for previous case studies to see what is happening.

First we look at house prices and the national statistics provided by the Spanish central bank reveal that the housing bubble popped roughly at the start of 2008 and since then prices have fallen around 10%. I expect further price falls in this asset class as deflation takes hold in Spain.

Spain HPI

After averaging about 3% for years the CPI has recently dropped into the negative zone. I repeat this is not the be all and end all of deflation signs. CPI is just one flawed indicator that gives us a bit of a clue as to what is happening.

CPI Annual Change

The growth in total credit has been very rapid, not unusual though amongst economies currently in the grips of deflation. ‘Peak credit’ seems to have been reached in recent months, expect the amount of credit to drop over time as deleveraging slowly strangles the economy.

Total Credit

PPI is also interesting to look at in terms of deflation, as usual it is rapidly falling into negative territory.

PPI Index

Unfortunately I could not find a time series for M3 for Spain (if anyone can point me in the right direction I would appreciate it. It would have been interesting to see what the money supply is doing. As with the Ireland case study I indexed several variables onto the same graph to see how each is changing in orders of magnitude and how the deflationary effects are happening over time to each indicator.

Deflation Indicators Spain

As soon as I saw this graph it reminded me of something, so I had a look at the Ireland data and was amazed. I decided to put the Spanish and Irish data together and this is what it reveals.

Deflation Indicators Spain and Ireland

The correlation between each variable is quite stunning, housing has increased at the same order of magnitude, credit has changed in the same order of magnitude and also CPI. The remarkable thing is that not only are the order of magnitude changes the same but the ordering of the changes in direction are the same. First housing goes down, then followed some months later by CPI and credit. I have been staring at this graph for quite a while trying to figure out what it might mean. It might mean nothing, I certainly have not come up with anything yet. It will be interesting to see how many if any of the future case study subjects conform to these graphs.

The correlation coefficients between the same variables for each country are all over 96%. There is no reason to believe in any sort of causality but the similarities are quite stunning. Maybe this data will provide some food for thought and maybe sow the seeds for something new in economics.

Data Source:

http://www.bde.es/estadis/estadise.htm

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Spain the Hole in Europe’s Balance Sheet

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