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The M2 myth: money is not in scarce supply





With the CPI having fallen a bit in April, and the equity market behaving as if a double-dip recession is in the cards, fingers are pointing to the very slow growth in M2 and warning of deflation and other dire consequences. Pundits can be mistaken, of course, so it's always best to do some homework. As of today's release, M2 growth, on an annualized basis, is 0.6% for the past 3 months, 0.5% for the past six months, 1.5% for the past year, and 5.1% for the past two years. The reason for the slow growth in the past year is that growth in the prior year was exceptionally fast, as should be clear from the first chart above.

For the past 15 years, M2 growth has averaged about 6% per year. Over the past two years it has only grown 5% on average, but it is still above what looks to be its long-term trend. For purposes of comparison, I note that since 1995 nominal GDP growth has averaged about 5% per year, and real GDP growth has been about 2.5% per year. Inflation has averaged about 2.5% as well, and has been relatively stable around that level. All of these are fairly unremarkable numbers, and about as stable, on average, as you could hope to see.

From these facts I conclude that there is no basis for the widespread concerns about the economy being starved for money, about deleveraging leading to a Japanese-style slump, or about deflation. As I've maintained all along, the strong growth in M2 in late 2008 was driven by a surge in money demand (and a big drop in money velocity), while the slow growth in the past year has been a sort of pay-back, with money demand declining and money velocity picking up.

On a final note, I see that the 3-month annualized growth rate of M2 has increased from a low of -1.4% four weeks ago, to 0.6% today. This, in the context of the level of M2 approaching its long-term trend, seems perfectly reasonable. The behavior of M2 going forward will tell the tale of whether we have too much money, or not enough. It will also be important to watch M2 velocity, since it has a long way to go to "pay back" its decline over the past year or so. If M2 velocity keeps rising and M2 growth also picks up, even modestly—which would not surprise me at all—we would have the essential ingredients for some monetary inflation.

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