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4. The Growth of Money Supply

Amplified Market Cycles

S&P500 and Nasdaq correction

The cycles we have experienced over the last 30 years have been more amplified than one would usually expect. This phenomenon has given rise to periods of outstanding expansion which are followed by painful, exaggerated contractions. A recent example is the dramatic rise of the global stock markets during the 1990’s and subsequent catastrophic collapse when the bubble burst in March 2000. Between 1990 and 2000 the S&P500 rose from 350 to 1550 (a rise of 340%) before crashing 48%. The Nasdaq crashed a massive 77%.
The Catalyst for Change
In America in the 1960's and 70’s, significant overseas investment by U.S. corporations and the expanding expenditure on the Vietnam war resulted in millions of dollars leaving the United States. Its trading partners found themselves holding increasing amounts of U.S. dollars and as they exchanged their dollar holdings for gold with the U.S. Federal Reserve, a torrent of gold began to leave the U.S.

Unhappy with the rate of outflows, in 1971 the U.S. suspended the convertibility of dollars into gold and by 1973 the major trading countries had agreed to end the gold-based Bretton Woods agreement and to let their currencies float freely against one another.

The major currencies were no longer backed by gold, or any other store of value. There was now no correction mechanism in place to prevent economic excess.

“The most important thing about money is to maintain its stability….You have to choose between trusting the natural stability of gold and the honesty and intelligence of members of the government. With due respect for these gentlemen, I advise you, as long as the capitalist system lasts, to vote for gold. George Bernard Shaw.

“Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost.” Fed Governor Ben Bernanke.

“No nation in history has ever survived fiat money, money that did not have precious metal backing.” President Ronald Reagan.
A New Era – The Exponential Supply of Paper Money

Money Supply and FX Holdings

As the requirement to peg their currencies to gold was lifted, countries began creating un-backed paper money at an unprecedented rate.

Rather than pay for their purchases in gold, governments and corporations issued paper money (e.g. debt instruments such as bonds) to pay for their purchases. Since there is no limit to the production of paper money, the supply of money has increased at an exponential rate since the early 70’s.

To put this statement into perspective, consider that in the 3 years between 1969 and 1972 the reserve assets of the world’s nations, which are predominantly made up of foreign exchange currency holdings, increased more than during all previous centuries combined.
Exponential Credit Creation
The consequence of this exponential increase in money supply was, of course, an exponential increase in credit creation. As the massive influx of paper money entered banking systems around the world, banks were able to create credit with increasing ease. With easy access to funds, individuals and corporations have borrowed vast sums of money in order to finance their lifestyles and investment choices.

Taking the U.S. as an example, since 1973 the U.S. has racked up massive trade debts with its trading partners, with the cumulative deficit now standing at around US$9 trillion. This deficit would not have been possible under the previous gold standard agreements. In fact, so much gold would have left the U.S. as it paid for its purchases that credit would have evaporated, throwing the country into a deep depression.

The ability to borrow easily and to fund purchases and investments with paper money, has enabled economies around the world to expand at an unsustainable rate. These exaggerated booms are great while they last, but eventually the tide turns to expose years of excess and a lack of risk control. Steep, painful contractions result as the excesses of the boom are unwound, revealing the latest example in a series of amplified cycles which have occurred since the Bretton Woods agreement ended.

“There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.” Ludwig von Mises.
So historically economic equilibrium was maintained by pegging currencies to a store of value, commonly gold, which ensured monetary stability. Both separately and together countries experienced a cyclical pattern of economic expansion followed by economic contraction. The end of the Bretton Woods Agreement removed the requirement for money to be backed by gold and in doing so it removed the correction mechanism necessary to prevent economic excess.

Without the need to back money with gold, over the last 30 years paper money has been created at an unprecedented rate. Money has flooded into banking systems across the globe, and has been re-lent, further magnifying the supply of money. Banks are so awash with money that, in seeking to lend as much as possible, they have caused an exponential increase in the availability of credit (this is one of the reasons we see the proliferation of such things as 0% credit cards). The easy availability of credit led to a borrowing boom which has allowed economies to expand at an unsustainable rate and has pushed asset prices to stratospheric levels.

So, if we examine our original three questions:-

What is money supply? It is the amount of money in circulation at a given time.

How much money has been flowing into global banking systems recently? Truly vast amounts, led by the exponential increase in paper money following the end of the Bretton Woods agreement.

What effect has this had on property prices? The easy availability of money has allowed borrowers to borrow huge sums very easily. There is currently so much money chasing property that there has been nowhere for prices to go but up. The question now is “Where next?"

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