Money Printing, Debt Funding, Massive Distortions

The massive monetary injections in the form of Government debt and excessively loose Central Bank policy have been inflating a wide range of assets over the last year. When the Government authorities choose to stimulate the economy they are able to do so at some entry point, but after the money enter the economy it has very little control (outside of outright force) where the money will end up. What the Government understands is that it does not want the money to simply stay in banks; they want people to spend it. This is their interventionist thinking: should money stay in the bank it means that it is not circulating and therefore economic stimulation is not having the effects desired. But at the same time, they do not want the economy to be overly stimulated because it will lead to inflationary pressures, which will thereby derail any economic success. So, it is a fine balancing act; an art more than a science.

That being said, over the last year (March 2020 to March 2021) the Government has injected into the economy somewhere in the neighborhood of $10 Trillion dollars! Yes, Trillions! This comes in the form of roughly $4.5 Trillion of new debt issued by the US Department of Treasury (and if we add the recently passed COVID bill by Congress costing about $1.9 Trillion, then the total would be $6.4), and the $3 Trillion of extra money printed by the Central Bank. Never in the history of the US, perhaps with the exceptions of the early days of the Republic, has so much debt and money printing happened. 

This massive amount of money is what is fueling the skyrocketing equity valuation. Simply take a look at the box below. The Year-over-Year changes in valuations are eye-popping. The Price-to-Earnings ratio in the major US equity markets tells you how much value the market has place for each dollar of earning. Taking the Dow Jones, for example, people now are willing to pay now about $33 for each $1 of earnings. Last year at this time people were only willing to pay about $18 for the same $1 of earnings. That translates to an 85% increase in valuation. The same dynamic is seen in the other major Indices. The outlier here is the Russell 2000 where Earnings are Zero, which anyone having a basic understanding of arithmetic can attest that any number divided by zero is inoperable – that is, it cannot be done. When you also look at the Dividend yields, you see a significant decline. That is not indicative of a healthy outlook. 

When will this irrationality end, no one knows. In fact, it can continue for a lot longer; but when the day you begin to hear a general chorus coming from the mainstream media that we have overcome and that all is well, that will be your warning sign that the bubble soon will pop. We are not there yet, but as each day pass the day of reckoning approaches. Given the gigantic mountain of money being created, which is causing significant distortions, the downside will be in equal proportion. 

Money Multiplier: A Warning Sign to the Stock Market

I have written about the exorbitant expansion of the FRB’s balance sheet. An equal important measure is how fast that money injection is multiplying in the economy. Putting it simply, when the FRB injects money in the economy it ends up creating additional money via the banking system. For example, assume the FRB injects $100 in the economy, and assume that banks are required to hold 10% on demand and lend the rest, that would translate in an additional $900 dollar created out of thin air ([100/0.1] – 100). In this example, the money multiplier would be 10%. In the real world there are other variables to consider, but broadly speaking, the example is indicative of how the money creation process works and the importance of taking into account the rate of multiplication. It goes without saying that the extra funds created would chase other goods, and what we would expect to see is prices rising somewhere in the economy. And this is what we have seen starting about May 2020. I have estimated the money multiplier as the ratio between M1 and the Monetary Base. 

The graph below shows you the time period from April 2018 to the present. What is obvious that the money multiplier was picking up speed during most of 2018, which fueled the stock market bull run prior to the government-induced shutdown of the economy. The economic shutdown had the obvious effect of decelerating the money multiplication process. But what becomes obvious is that the money multiplier has picked up speed in particular during the latter part of 2020. This has translated at present in record setting numbers in the equity market. It is critical to understand that the money multiplier metric is backward-looking, so we must make some sort of assumption about the future. What we know is that the money creation process is still continuing and that gives support to the continuing rise of the equity market in the very short term (which I define here in the next 2 months), all things being equal. However, as this rate continues to decline, it will be another sign that a correction in prices is soon coming.  

Money Multiplier

Data Source: FRB's H.6 Statistical Release