For the First Time in the Modern Era, the Money Supply Is Contracting. This Is Not at All Bullish.

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For the first time in the modern era, the U.S. money supply is contracting.

You can see it in the chart below, which shows the monthly year-on-year percentage change in M2 (a broad-based money supply measure) dating back to January 1960. Prior to last month, M2 growth had never gone negative in the history of the data series. But in December, it did.

Like Shoes for a Teenager

Under normal circumstances, an expanding money supply goes hand-in-hand with economic growth.

As an economy grows, the total volume of economic activity increases. That means more transactions, more bank loans, more workers in the labor pool, more capital in savings and retirement accounts, more public expenditure on fiscal programs, and so on. This pick-up of economic activity translates to an expansion.

Then, too, it’s not as if the authorities have direct control. Only a single-digit percentage of the money supply in circulation can be traced directly to central bank actions.

The vast majority of money supply expansion comes from credit expansion as a function of monetary velocity — the pace at which banks are willing to lend and consumers and businesses are willing to borrow and spend.

When banks are lending more because businesses are hungry for expansion capital, and consumers are borrowing and spending more because they are feeling flush, you get more dollars in the system. This is true because money is rapidly circulating out of banks in the form of loans, and then back into banks in the form of savings deposits, and then back out into the economy again via spending against those deposits.

This is why, for a growing economy, the money supply should expand over time. Think of it like shoes for a teenager. As a boy goes from 12 years old to 16 years old, his shoe size will get bigger — a lot bigger. The same thing happens with an economy.

Tractorcades and Behavioral Economics

Some will argue that, in theory, you don’t need an expanding money supply to facilitate economic growth. But that view is flawed on several fronts.

First of all, as explained above, most of the expansion or contraction in the money supply — government spending aside — is organic, meaning it comes from bottom-up lending and spending activity. In a system with no central bank authority, this would be even more true.

Second of all, America already has experience with liquidity shortages born of a money supply that is expanding too slowly or not at all — and history shows them to be incredibly painful.

American farmers did a lot of protesting — a fair bit of it violent — in the years between 1870 and 1980. Many of those protests can be traced back to perpetual currency shortages — a lack of money and credit in the system — which translated to a lack of loan availability and all-too-frequent farmer bankruptcies.

• Imagine you are a wheat farmer in the late 19th or early 20th century who just brought in a large harvest. The problem is that lots of other farmers did too, which means the market price for wheat has temporarily plummeted due to a glut.
• Thanks to low wheat prices, you don’t have enough income to cover the mortgage on your farm. This is a temporary situation, and you have plenty of viable long-term assets to borrow against — in the form of the farm itself and the earning potential for future harvests. But no bank will give you a loan beyond your original mortgage because there isn’t enough currency in circulation, which means you are forced to go bankrupt.
• Thanks to low wheat prices, you don’t have enough income to cover the mortgage on your farm. This is a temporary situation, and you have plenty of viable long-term assets to borrow against — in the form of the farm itself and the earning potential for future harvests. But no bank will give you a loan beyond your original mortgage because there isn’t enough currency in circulation, which means you are forced to go bankrupt.
• This scenario played out so frequently in the 19th and 20th centuries, farmer protests in Washington, D.C., became a recurring theme over the decades. The last big one, dubbed “Tractorcade,” took place as recently as 1979, when 3,000 farmers drove their tractors to Washington, D.C., to protest against foreclosures.

When money is too tight, liquidity shortages become a regular occurrence.

That is what happens when a business (any type of business) has assets worth lending against, but there are no loans to be had and no capital available for business expansion.

A growing economy needs a growing money supply to keep this from happening, not unlike how the aforementioned 12-year-old becoming a teenager needs ever-larger shoe sizes. If a 16-year-old tried to make do with his 12-year-old shoe size, his feet would hurt and eventually it wouldn’t work at all.

On top of that, a routine expansion of the money supply is necessary to keep prices stable, or otherwise rising in a gentle and predictable manner.

This dovetails with human behavior in terms of wage expectations. If an economy grows while the money supply does not, wage levels have to fall, and people understandably hate that.

It’s easy to give an employee a raise and justifiable to keep an employee’s pay the same, but almost no employer says, “Guess what, we’re reducing your pay this year by 10% to account for deflationary trends.”

At any rate, those factors help explain why, in normal times, an expanding economy and a reasonably expanding money supply go hand in hand. But when government spending enters the picture, things can look radically different.

Spot the Fiscal Stimulus

Referring back to the M2 chart above, you can see a crazy spike circa 2020 where money supply growth temporarily expanded by more than 25% year-on-year.

That was the impact of fiscal spending in the wake of the March meltdown and Covid lockdowns, when trillions of dollars in stimulus were pumped directly into the U.S. economy (with a fair chunk of it sent directly to households).

When the money supply is expanded by a huge amount in that manner, which typically only happens as a result of runaway government spending, things can get wild, which is exactly what happened in 2021 and 2022.

The monster expansion of the money supply, brought about by trillions in fiscal stimulus, at first ignited the unprecedented stock market boom conditions experienced in 2021 (along with the biggest mania environments of all time in terms of meme stocks and crypto). It then fed directly into the runaway inflation prints that caused the Federal Reserve to unleash one of the most aggressive rate-hiking campaigns in history in 2022 to try to bring inflation down.

Contraction Ain’t Bullish

All of the above points to where we are now — and general conditions are not at all bullish.

• We are witnessing the first ever recorded contraction of the U.S. money supply because the Federal Reserve worked overtime in 2022 to kill off inflation, and the way you kill inflation is by raising interest rates and reducing the availability of credit.
• An unprecedented contraction of M2 demonstrates the degree to which liquidity is disappearing from the marketplace. As the money supply shrinks, there will be fewer loans to be had, reduced credit availability, and lower volumes of lending and spending on the part of consumers and businesses. The M2 contraction is evidence this is already happening.
• At the same time, the Federal Reserve is not done hiking interest rates. Even if they drop down to a 0.25% pace, nobody knows how high they will go. And Europe is on a tightening path, too, with Japan likely to go that way soon.

As we write this note, the bulls are enjoying a rally in speculative risk assets. One of the most speculative bellwethers of them all, the ARK Innovation ETF (ARKK), is up more than 18% from its Dec. 30 close.

And yet, the Federal Reserve isn’t done. Neither is the European Central Bank. And Japan will soon enough be tightening, too. Consumers are still burning through a one-time bonanza of stimulus cash that will eventually be spent down, perhaps by this summer, and the U.S. money supply is contracting for the first time in the history of the data with yield curves still deeply inverted.

General conditions say more pain is coming.