The Deflationary M2 Explosion

Larry Kudlow
The Deflationary M2 Explosion

Amidst the financial flight-wave to safety, with stocks plunging, gold soaring, and Treasury bond rates collapsing -- and all the European banking fears which go with that -- there’s an important sub-theme developing: An almost-forgotten monetary indicator, M2, which is mostly cash, demand-deposit checking accounts, savings deposits, and retail money-market funds, has been soaring.

According to the St. Louis Fed, M2 is up 24.2 percent at an annual rate over the past two months. Almost out of the blue, that comes to a near $500 billion increase. In rough terms, the M2 explosion breaks down to $165 billion in demand deposits and $335 billion in savings deposits.

What’s going on here? There’s a flight to government-guaranteed accounts. Some people believe Europeans are withdrawing from their own banking system and parking their money in the U.S. banking system, guaranteed by Uncle Sam. Kelly Evans reports in her Wall Street Journal column of a $30 billion outflow from equity mutual funds that has probably gone into cash.

This is a very disconcerting development. Normally, big M2 growth would signal a faster economy, and maybe even higher inflation. But as economist Michael Darda points out, the velocity, or turnover, of money seems to be plunging.

“The recent pickup in broad money in the U.S. looks like a dash for risk-free cash assets,” writes Darda. He also notes that widening corporate-credit risk spreads and shrinking government-bond rates signal a recession risk, not a coming boom.

So contrary to monetarist theory, the M2 explosion seems more closely related to a deflation/recession risk. Economist-blogger Scott Grannis writes, “The recent growth of M2 surpasses even the explosive safe-haven demand for money that accompanied 9/11 and the financial crisis of late 2008. Something big is going on, and it can only be the financial panic that is sweeping Europe as money flees a banking system that is loaded to the gills with PIIGS debt.”

Grannis concludes, “In short, it looks like there is a run on the European banks and the U.S. banking system is the safe-haven of choice.”

On the other hand, all may not be lost -- at least from the standpoint of the American economy.

Economist Conrad DeQuadros, who acknowledges the precautionary demand for high cash balances in the current financial uncertainty, believes that the economic data do not yet signal recession. DeQuadros points out that jobless claims, hours worked, retail sales, and industrial production are all picking up. He also notes that profits are still rising, even though their growth is slowing. And C&I business loans have grown at an 8 percent annual rate over the past three months.

I would just add to all this: The biggest problem for the plunging stock market is coming out of Europe. Fears over the safety and solvency of European government debt and banks are haunting the stock market. I still don’t believe it’s 2008. But yes, like everyone else, I’m worried.

That said, we are awash with liquidity everywhere. U.S. banks and companies have more cash than they know what to do with. The problem is they are immobilized by fiscal policy run amok. We desperately need a regulatory rollback and flat-tax reform to boost asset prices and to get banks to loan, companies to invest, and America back to work.