Historically, business expansions have been fueled by three
factors: monetary liquidity, internal cash flows and credit.
The key driver has been monetary liquidity. Expand it and the
economy follows suit. Contract it and a recession will
eventually occur.
Economic expansion over 1995-2000 was different. The basic
money supply M-1 was flat over this period, yet the economy
flourished, funded by cash flow and short term credit. Note
though that it took only a mild liquidity squeeze in 2000
to tip it over.
I bring this up because M-1 is not growing fast enough to
sustain economic expansion. This means that business must
rely on cash flow and credit to keep it going, as must the
consumer.
In my view, it is riskier when an economic expansion is
reliant on cash flow and borrowing alone. It does not
have the sure footedness it has when money is flowing
in and through the system adequately. My problem is that
I cannot quantify it. I can only say the resiliency of
the expansion is now being undermined to some degree.
How did this new wrinkle come about? It results from
the Fed's decision in 1992 to eliminate or minimize
reserve requirements on a host of large and "jumbo"
deposits to liquify a financial system stressed out by
the S&L and commercial real estate debacles. Regrettably,
I think, the Fed never re-imposed those requirements,
giving the banks a much freer hand to fund loan demand.
In giving talks to investment managers over 1995-2000,
I introduced these thoughts and issues. What I thought
was an interesting insight was met by shrugs. And it
paid not to worry for the longest time, right up to
the moment when the Fed tapped ever so lightly on the
brakes.
Now one piece of good news is that the adjusted monetary
base which leads the direction of M-1, has finally
started to creep up a little after a dead flat six
month period. We'll see.
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