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.

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With a flamboyant downgrade of the outlook for economic growth, jobs, and profits, Wednesday’s 280 point Dow plunge to launch the so-called June stock swoon is a warning shot across the bow.

The Dow tanked alongside a batch of dismal economic data. The ISM manufacturing index, ADP employment, Case-Shiller home prices, and consumer confidence are all pointing to 2 percent growth or less, rather than the kind of 5 percent growth we ought to be getting coming out of a deep recession.

The economy now looks like a Government Motors engine that’s stalling out. Or perhaps, with energy and food inflation, and housing deflation at the same time, the economy is acting like a pinball machine on permanent tilt.

There’s a key message here: Big-government stimulus never works.

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Despite the astonishing flood of more than a trillion dollars in new commercial-bank reserves that the Fed created in late 2008 and early 2009, when it undertook to rescue the big banks and other institutions from the consequences of their boom-time mistakes, Ben Bernanke has insisted that the Fed can and will contain this inflationary potential, and he has emphasized that inflation remains under control, indeed, that potential deflation presents the greater danger. He rests his case on the evidence of standard macroeconomic indexes.

Standard measures of the money stock, for example, have not increased greatly. The year-to-year change (ending in January 2011) in M2 was only 4.3 percent; the two-year change, only 6.4 percent. For MZM (money zero maturity), the corresponding rates of change were 2.6 percent and 4.4 percent, respectively. Thus, it would appear that by historical standards money has grown quite moderately in the past two years.

Bernanke and his supporting cast of monetary economists can also point to corroborating evidence that by historical standards the rate of inflation has been modest. The year-to-year change (ending in January 2011) in the all-items consumer price index (CPI) was only 1.7 percent; the two-year change, only 4.3 percent. The implicit price deflator for GDP, the broadest of all price indexes, reveals even less inflation. This index, which is computed on a quarterly basis, shows a one-year change of only 1.4 percent for the year ending in the fourth quarter of 2010, and a corresponding two-year change of only 1.8 percent.

(I have computed all of the figures mentioned in this article from basic data available at the website maintained by the Federal Reserve Bank of St. Louis.)

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Today on Coffee and Markets Francis Cianfrocca and I discuss the fiftieth anniversary of Eisenhower’s “military-industrial complex” warning, Defense spending and cuts, and the challenges of Fed policy on inflation.

We’re brought to you as always by Stephen Clouse and Associates. You can find our iTunes feed at CoffeeandMarkets.com. If you’d like to email us, you can do so at coffee[at]newledger.com. We hope you enjoy the show.

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The U.S. Federal Reserve was brutally criticized last week for initiating Quantitative Easing II (QE II) – a new $600 billion dollar scheme to inflate the money supply and stimulate the economy.  Was Fed Chairman Ben Bernanke’s already aware that the $600 billion dollar European Financial Stability Facility (EFSF) was about to be tapped out.

In May, the European Union gathered in a show of strength to halt the continental debt crisis with the “shock and awe” of a $145 billion cash rescue of Greece.  Predominately funded by Germany and France, the EFSF was trumpeted as guaranteeing a decade of fiscal solvency for the infamous PIIGS: Portugal, Ireland, Italy, Greece, and Spain.  Sovereign debt markets rallied and the media extolled the virtues of 450 Europeans banding together to prevent the debt crisis’ contagion.

Six months later European bond markets are once more in shambles, as interest rates paid by the PIIGS has again skyrocketed.  Ireland is the latest casualty in this game of dominos, after investors began the massive dumping of Irish bonds and pulling money out of Irish banks.

No longer is the tell tale sign of bank run evidenced by lines of desperate depositors waiting for the doors of the local bank to open.  In 2010 a click of a mouse key can move billions of dollars from one country to the next.  The graph below demonstrates why there are probably millions of mouse keys clicking all over Europe right now.

Although Ireland denies any intention to seek a Greek style bailout, teams of bankers from the European Union, European Central Bank and the International Monetary Fund arrived last night to discuss how to “stabilize” the Irish state-guaranteed banks.  If stabilize is the new code word for preventing immediate default, is “QE II” the new code word for the U.S. bailout?

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The great Bernanke QE2 debate continues to heat up. In the run-up to the G-20 meetings, China, Russia, Germany, and others are all coming out against the Federal Reserve’s quantitative-easing agenda. They don’t want hot-money excess dollars to flow into their higher-yielding currencies.

The assault against Bernanke’s easy money has reached such fever that President Obama felt it necessary to defend the $600 billion in new-money printing in a news conference in India.

Meanwhile, World Bank president Robert Zoellick has actually called for putting gold back into global money, in order to use it as an international reference point to measure market expectations over inflation or deflation. The former Treasury and State Department official wants a successor to Bretton Woods. To my way of thinking, Zoellick is dead-on right.

And then there’s Kevin Warsh’s opus op-ed in Monday’s Wall Street Journal. I have written about Warsh in the past, and his sound-thinking views. Taking a bit of a shot at Bernanke’s QE2, the Fed board member basically says: Look, you want better growth, reform the tax code and stop regulating. “The Federal Reserve is not a repair shop for broken fiscal, trade, or regulatory policies,” he writes.

But in the key part of his op-ed, Warsh calls for a strictly limited QE2, not an open-ended commitment. He describes it as “necessarily limited, circumscribed, and subject to regular review.” And he goes on to say that if the dollar decline and run-up of commodity prices continues, these inflation signals should stop QE2, regardless of the unemployment rate.

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The Federal Reserve announced “Quantitative Easing 2” (QE2) last week, a stimulus program whereby the Fed will print $600 billion of paper money to buy U.S. government bonds. Fed Chairman Ben Bernanke took the extraordinary step of trying to justify this action by writing an Op Ed in the Washington Post. The article claimed his goal is to drive down longer term interest rates and drive up stock prices, so that “a virtuous circle will support further economic expansion.” The concept is that if Americans felt richer because their 401Ks went up in value there would be a “wealth effect” encouraging the public to spend more money and businesses to increase capital investments. Unfortunately, this is like starting a barbeque with a flamethrower. You will surely create a fire, but it will probably burn down the neighborhood.

Back when Lehman Brothers filed for bankruptcy in the fall of 2007, the Fed panicked and “Quantitatively Eased” by slashing interest rates and purchasing $1.7 trillion of mostly dicey mortgage related bonds from the banks at full value. The price of food and other commodities were sent skyrocketing, oil climbed to an all-time record of $145 per barrel. Consumer price inflation rose by 5½% over the next year, but the higher costs of essentials hammered personal disposable income and consumers put the brakes on their discretionary spending. As the U.S. money supply leaped, hedge funds borrowed in depreciating U.S. dollars to invest in appreciating Asian currencies.

Instead of creating an economic boom, Chairman Bernanke actions caused the worst recession since the 1930s. As business profitability tanked due to lower sales and higher material costs; production was cut and workers laid-off. The rate of unemployment and underemployment soared on Main Street. When the bubble burst and the markets fell back “under their own weight” and a period of deflation began that is probably far from over.

Wall Street on the other hand, did quite nicely thanks to Ben and his buddies at the Fed.

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With no shock and awe and little pomp and circumstance, China has declared war on the world.  Having watched the Gulf Wars on CNN, Americans are accustomed to wars fought with jets, battleships, tanks and infantry.  We constantly are on the look out for foreign enemies on our soil and the vigilance of our citizens has thwarted numerous terrorist attacks.  Unfortunately, Americans are not accustomed to recognize international weapons of economic mass destruction.  In the modern world, exports, deflation and economic competiveness are weapons far more powerful than cruise missiles.

Naive to this new deadly threat, the US government has launched wave after wave of assaults on the competiveness of American business.  Healthcare and financial service “reform” is driving business operating costs higher and credit availability down.  The soon-to-expire tax cuts will result in the largest tax increase in American history.  It should not be surprising that China would use tactics akin to economic guerrilla warfare to attack when our nation is most vulnerable.

China’s supply of young workers entering the labor force is peaking this year and will decline by one third over the next dozen years due to decades of population control.  But big increases in rural farm productivity are pushing huge numbers of the young off the farms and into the factories on the coast.  With factory worker suicides rampant and labor striking over wage rates too low to buy food, China panicked last year and increased its money supply by a spectacular 40% to quell dissent.  Given the threat from a sinking economy creating a revolutionary environment at home, communist China chose to invade world markets by exporting almost 40% of its gross domestic product.

Statistics just released have obliterated any hope that a meaningful economic expansion is under way in Europe, Japan or the US.  Business confidence, factory orders, auto sales and consumer product purchases are plummeting.  Meanwhile, Chinese exports grew a blistering 22% rate for the second quarter of 2010.  With their exports equaling 5% of the world’s gross domestic product (GDP), China’s capture of another 1% of the world’s economy will force producers in other countries to cut employment by approximately 10 million jobs.

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In this week’s edition of Coffee and Markets, featuring The New Ledger’s Francis Cianfrocca, we’re talking about GM’s purchase of Americredit, changes in FHA policy, deflation, Ben Bernanke, Tim Geithner, and more. We’re brought to you as always by Andrew Breitbart’s BigGovernment.com and LibertyPundits.com.

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In this week’s edition of Coffee and Markets, featuring The New Ledger’s Francis Cianfrocca, we’re talking about Capitol Hill’s new financial regulations, the China revaluation that wasn’t, the spectre of deflation, and the poor gamesmanship of the Business Roundtable. We’re brought to you as always by Andrew Breitbart’s BigGovernment.com and LibertyPundits.com.

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Deflation is a concept many Americans have a tough time understanding.  They do understand the concept of Social Security.  As Federal budget deficits soaring, the public is being barraged by late night advertisements to buy gold as an inflationary hedge.  Unfortunately, the deflationary environment we are facing today is the biggest threat to the Social Security check Joe the Plumber is counting on for retirement.

The definition of deflation as a decrease in the general prices of goods and services may be simple, but a Google search for articles on deflation generates 3.5 million “hits”, versus a whopping 354 million “hits” for inflation.  This demonstrates that Americans are 100 to 1 more knowledgeable of inflation!

There have only been three bouts of deflation in the United States since its founding over 200 years ago. The first was the recession of 1836, when the currency in the United States contracted by about 30%.  The second was after 1865, when the Nation returned to a gold standard by retiring paper money printed during the Civil War.  The third period was the Great Depression, when prices and output fell by 25% from 1928 to 1933.  Very few Americans are familiar with the specifics of what happened during these periods, but they know it was a bad time for the “common man.”

Social Security was established during the Great Depression and continues to be the most important income stream for America’s seniors.  A large majority of the 16 million people over age 65 rely on Social Security for at least half of their income.  One-third of this group relies on Social Security for over 90% of their income.  Most retirees have come to rely on the annual cost-of-living increases in their check to make their life better.  In a deflationary environment we are facing today, few recipients are prepared for their check to actually shrink.

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Today the leading Austrian economic think tank, the Ludwig von Mises Institute held a conference at the University Club in Manhattan in which Marc Faber, famed contrarian investor and publisher of the “Gloom, Boom and Doom Report” gave his perspective on the financial crisis and his outlook for the future.

Below are his main points and entertaining quotes:

• Central banks will never tighten monetary policy again, merely print, print, print
• Bubbles used to be concentrated in 1 sector or region in the 19th century, but off of the gold standard this concentration has ended
• “The lifetime achievement of Greenspan and Bernanke is really that they created a bubble in everything…everywhere.”
• “Central banks love to see asset prices go up,” and their policy reflects their desperation to perpetuate this
• US housing bubble that Greenspan could not spot (even though he has recently spotted bubbles in Asia) stands in stark contrast to that of Hong Kong in 1997, where prices fell by 70%, yet none of the major developers went bankrupt; this was a result of a system not built on excessive debt like that of the US
• “You have to ask what they were smoking at the Federal Reserve,” during the housing bubble, as prices were increasing by 18% annually when interest rates started to steadily rise in 2004
• Over the last couple of years, when the gross increase in public debt has exceeded the gross decrease in private debt, markets have risen, whereas when private debt growth has outpaced public debt growth, markets have tanked
• The next 3-5 years will be highly volatile

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Panic has gripped stock markets worldwide over the Greek debt crisis and the threat of a debt-deflation contagion through banks in Europe (primarily) and the U.S. that own the bonds of Greece, Portugal, Spain, and so forth. If these bond asset prices collapse totally, lending facilities would be badly crimped for both the short and long term. And that, in turn, would damage prospects for economic recovery.

The Dow closed yesterday off nearly 350 points. Earlier in the day the Dow was down 850 points, though there is talk of computer glitches and technical problems that may have temporarily undermined trading. Either way, the market is getting creamed as a result of the Greek story.

The real winner? Gold. It’s up about $25, to $1,200. People want real money. They do not trust the debt-laden currencies of Europe and the United States. Or for that matter Japan. Gold is fast becoming, once again, a reserve currency of choice.

Meanwhile, the EU/IMF bailout package for Greece, which does include draconian budget cuts, contains a 2 percentage point increase in the VAT tax that is anti-growth. Steve Forbes correctly said Wednesday on CNBC that the Greeks should be slashing spending and should move to a flat tax, just like the countries in Eastern Europe. I gave him a Nobel Prize for that.

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What if a future President wants to go to war or ship more troops overseas to protect American interests, but can’t because China won’t let him? Could this actually happen? We’ll discuss the dangerous foreign policy ramifications of America’s current path on the latest edition of Coffee and Markets, a daily podcast from The New Ledger on politics, policy and the marketplace with Francis Cianfrocca, brought to you by BigGovernment.com.

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Related Links:

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