Investments: One Chart Reveals All

If there is one chart you could show to convince the most diehard optimist that the world is headed for financial disaster, the one on this page should do it.The chart shows the growth rate of the U.S. money supply (M1, which includes currency and checking accounts) since 1976.

Of course, the money supply plays a major role in determining the economic and financial events of the future. It is one of the Commerce Department's leading economic indicators. In fact, as I pointed out in my December column, the dramatic shift in monetary policy in 1987 (toward tight money) was the underlying cause of the October stock market panic.

Several points are worth noting regarding the money supply chart.

First, Federal Reserve policy is getting more and more reckless. Despite the supposed popularity of the monetarist rule that the money supply be increased at a steady rate, the Fed has actually moved in the opposite direction, toward greater volatility. This has been especially apparent since 1979, when Paul Volcker came into office and announced, "We are going to end inflation and keep the markets guessing." He may not have ended inflation, but he sure kept the markets in turmoil. Every time the Fed has aimed to kill inflation in the '80s, it has backed off as soon as the economy starts teetering on the verge of a banking crisis and worldwide recession.

Second, the monetary authorities are becoming increasingly inflationary after each new threat of recession. Note how the monetary expansion rate reached new peaks after each recessionary threat—9 percent in 1979, 12 percent in 1981, 14 percent in 1983, and 18 percent in 1986. During the Reagan era, the Fed has panicked at least three times. In short, it is becoming more and more difficult for the central bank to control the economy.

Austrian economist F.A. Hayek suggested that this monetary acceleration would occur if the world went off a gold standard and adopted a fiat dollar scheme. He wrote about what I call "Hayek's Law" in Monetary Theory and the Trade Cycle in the early 1930s. Now, 50 years later, it's happening.

Essentially, Hayek argued that monetary authorities would expand fiat money at a progressive rate in order to avoid a recession at all costs. Obviously, in the long run, this can only result in runaway inflation. Fortunately, we have incurred enough recessions since we went off the gold standard in 1971 to prevent hyperinflation.

In another work in the 1930s, Prices and Production, Hayek also demonstrated that a fiat money-based economy will inevitably be punctuated by a boom-bust cycle. Thus, the American economy can never be "recession proof" and may not even be "depression proof" as a result of monetary fluctuations and an ever-looming banking panic.

Third, the overall trend is upward toward higher inflation. Each cycle brings higher rates of monetary expansion, while the troughs are never negative. The average growth rate of the money stock is rising. Politically, the government is losing its ability to stop the printing presses.

What does this all mean for the next few years?

In the short term, another recession is a distinct probability. In early 1987 the Fed made a drastic shift in policy from "fighting recession" to "fighting inflation," squeezing the growth of the money supply to its lowest level in years. Thus, we are headed for another brush with an economic debacle. Each time, we come closer to the brink of a banking panic or economic calamity.

The linchpin of economic stability is the banking system. Despite federal deposit insurance, most banks and savings institutions in the United States have gradually weakened over the years. Another stock market panic, here or abroad, could precipitate a run on the banks as liquidity-conscious individuals rush to get cold cash in their hands.

At some point, the Fed will panic, as it has done in the past, and will begin reinflating with a vengeance to keep the recession from turning into a full-scale depression. This reversal will probably result in an even higher rate of monetary inflation, perhaps to the 25 percent level.

Eventually, however, I believe the central banks of the world will be forced to abandon the international dollar standard and will adopt a multi-currency standard that will include gold as a stabilizing factor. The Group of Seven continues to hold top-level secret meetings in Europe to create a new world currency. If the new currency includes gold, which is highly probable, the principal benefactors will likely be the gold-mining companies.

What does the money supply chart suggest for investors? It means that short-term speculators will have ample opportunity to make a killing in the market as trends shift rapidly. For conservative investors, I would stress a strong cash position in top-quality money market instruments, low debt exposure, and a basic survival position in gold and silver coins. You should also consider having some funds overseas in a safe institution, such as a Swiss bank.

Financial advisor Mark Skousen is the editor of Forecasts & Strategies.