Wednesday, February 7, 2007

Global Money Supply

A post by a reader started me re-thinking about the global money supply. See the first comment to my post of February 1, 2007, titled, "When is a Breakout Confirmed?" He referred to an article by the famous bond investor, Bill Gross (see and look for the Featured Market Commentary for February, 2007). For background, I've read many books about the early development of the modern financial system, money & credit instruments in the 19th century, and financial panics. I also vividly remember Fischer Black in a business school class at MIT when monetarism becoming widely accepted, as saying, "What's your definition of the money supply?" to challenge us. I've been noodling over the Bill Gross article, as it had excited my "little grey cells" and finally after being energized by this AM's workout I can articulate my thoughts for this post.

Before World War I, the global money supply was firmly tied to gold and silver. Temporary large deviations in regions (such as in the US during its Civil War) were either soon reversed or led to excess money & credit creation & financial panics. The Panic of 1819 occurred after years of money and credit growth from land speculation in the US west after specie payments were suspended in 1814 due to the War of 1812. In that example, money came to be created by state banks (banks printed their own banknotes then - I have one in my money collection) based on loans on land. When the US government refused to accept state bank notes for discharge of debts, the credit system collapsed.

Roll forward. The US trade deficit floods the world with US dollars and many / most of the dollars are reinvested in US Treasury securities by the world's central banks. These US Treasury securities are the foreign reserves for those central banks and are a primary monetary base for their own currencies. Few have significant gold assets and some are buying Euro-denominated bonds of European countries. [aside - confidence in the Euro took a hit when the proposed European constitution was defeated, so obviously it's no substitute.] So the global money supply is principally based on US debt and the growth in the world's monetary base is tied to the US trade deficit.

Bill Gross was wondering what would happen "when" this spigot of cash was turned off. I have to agree with him there. Although I disagree with many points in his article, I think he's right that a reversal or cessation in the US trade deficit could have enormous negative repercussions on the global economy & monetary system. More later re my ideas on the "when"; this post is long enough.

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