The U.S. Economy: Why The Sky Isn't Falling

Revised Q3 GDP numbers for the U.S. indicate that the economy was 1.4% bigger (in nominal dollars) than the prior quarter and 4.2% bigger than it was on Sept 30, 2011. U.S. GDP has grown by about 4% per year from $13.9 trillion in mid-2009 to $15.8 trillion today. At the same time, the U.S. money supply has grown from $8.4 to $10.1 trillion. A 20% growth rate in the money supply compared to a 14% growth rate in nominal GDP poses a challenge.

Economists refer to how many times the same dollar gets spent each year as the ‘velocity of money’. In the U.S., a $15.8 trillion economy rests on a money base of $10.1 trillion. The chart below illustrates how significantly this ratio has changed.

Its current level, 1.57x, is the lowest in over 50 years. How significant is this? To put it into perspective, US economic activity would have to jump by 35% overnight to return velocity to the levels of the late 1990’s.

We know that the increase in the money supply over the last five years is a result of the bailouts that began under the Bush Administration (TARP etc.) and then continued with the Quantitative Easing programs of the Obama Administration.

There is a common “sky is falling” argument that the Fed’s money-printing is bad policy and erodes the value of the dollar. And this would be the case, if the U.S. Treasury were the only ones doing it.

But the U.S. is not alone in this. Most other major countries have conducted similar monetary policies and thus exchange rates have been relatively stable.

Most commodity prices including silver, oil and even the Goldman Sachs Commodity Index are essentially unchanged over the last two years. Gold stands out as one of the few commodity winners -- having appreciated in value by about 20% - slightly faster than the growth in the money supply over the same period.

So if all of this extra money is not devaluing the US dollar relative to its peers -- and is not creating commodity price inflation, where is this expansionary monetary policy having an effect?

Corporate profits represent a small share of GDP, but seem to be getting all of the benefits of the stimulus, having grown 25% over the past two years -- more than the growth in the money supply and the price of gold.

Perhaps surprisingly, owning companies has become one of the best hedges against an expansionary monetary policy, and the less regulated the industry, the better.

No doubt, stock prices have lagged earnings as many investors have chosen to lend money to governments to avoid stock price volatility rather than own profitable companies. As stock price volatility has subsided to its pre-financial crisis levels, we expect to see some of that money move back into stocks and push stock prices up in 2013.

This month, the financial press will be obsessed with politics -- not business. The fiscal cliff -- that looming combination of specific tax hikes, spending cuts and debt ceiling increases -- will be averted with different spending cuts, tax hikes and increasing the debt ceiling. We expect a deal. It will be unpopular with special interest groups and will thus allow each party to blame the other for its shortcomings.

The sky isn’t falling.