What is a financial bubble?
We had a lot of these in the 1990s and no one really came up with a definition of what a bubble was.
Here’s a picture for you that might indicate that a Blister, or blisters, have formed in the past two years or so.
In early 2020, in response to the spread of the Covid-19 pandemic, the Federal Reserve began “pumping” money into the banking system to protect the economy lest economic conditions collapse.
Here is the picture of the Fed’s securities portfolio.
Huge amounts of money flowed into the financial markets.
More traditional firms have been inundated with funds.
Less traditional firms have been inundated with funds.
Newer money managers thrived with the money glut. For example, the Special Purpose Acquisition Companies (SPAC) or “blank check” companies thrived.
Innovative ideas flourished. Take the rise of bitcoin for example.
The stock market also appeared!
During this time, money flowed everywhere.
And what did you get? The bubble in the money supply M2.
The M2 money supplies
In 2018, the money supply M2 rose by 3.7 percent from December to December.
In 2019, the money supply M2 increased by 6.7 percent.
These are not extraordinary numbers, but typical of the entire period of economic recovery since the end of the Great Recession in 2009.
But then the pandemic hit the scene.
From December 2019 to December 2020, the money supply M2 increased by 24.8 percent.
Never in history has the US M2 money supply increased by this amount!
Then, the next year, from December 2020 to December 2021, M2 increased by 12.4 percent.
Still a historically high number.
So the United States experienced two years of massive excess money growth.
The US economy was spared a severe recession…or worse…but what was the economy going to do with all that cash lying around?
Well, as mentioned earlier, the financial sector of the economy exploded. Funds were floating around everywhere.
But even after ten years of economic expansion with no significant sign of inflation…inflation appeared.
And as you can see from the second chart above, the Federal Reserve has now moved into a more hawkish mode.
The Fed’s securities portfolio started contracting after mid-March 2022 and according to the first chart shown above, M2 money supply started contracting in April 2022.
The peak month for M2 was March 2022.
By October 2022, the annual growth rate of the money supply M2 fell to 1.3 percent.
As things are going, it would not be surprising if the annual growth rate of the M2 money supply turns negative soon.
Where has the money gone?
To support the discussion above, most of the money generated by the Federal Reserve went into the financial circuit of the economy and not into real spending, such as investing in real capital.
How can I say that?
Well, the velocity of circulation of the M2 money supply went down, and then stayed at a very low level.
Note that the velocity of M2 money had been declining since 1997. This decline was related to the changes taking place in the investment world at the time.
Because of the Fed’s policy, which was based on stimulating a low rate of inflation in order to achieve a lower level of unemployment, investors saw that they could make more money by investing in assets such as commodities, houses or stocks than they could with less risk investments in physical capital, such as plant and equipment.
Asset prices rose and rose and rose while consumer price inflation remained moderate.
So the speed had dropped regularly.
But in 2020, as the Fed pumped a lot of money into the financial system, velocity plummeted.
The stimulus money went into financial assets rather than physical assets.
So, the economic growth over the past few years hasn’t been great while all those funds created have gone into assets like “blank check companies” and Bitcoin and FTX cryptocurrency exchanges.
Note that FTX was founded in 2019.
FTX, led by Sam Bankman-Fried, took advantage of all the money and boomed. Quite a story based not only on the cryptocurrency “bubble” but also on the “bubble” created by the Fed.
The other side of the story
Now we need to move on to the next phase of the story, the period of Federal Reserve tightening.
The Federal Reserve is shrinking its asset portfolio.
As can be seen in the charts above, this action leads to a decrease in the M2 money supply.
Money is pulled out of the system.
What can happen?
Well, since its peak on November 9, 2021, Bitcoin has fallen from around $67,500 to around $16,500.
The S&P 500 stock index has fallen from its peak on Jan. 3, 2022, a drop from just under 4,800 to 4,000, and has hit a low near 3,600.
And BTX filed for bankruptcy a week ago.
This is the other side of the “bubble” story.
The question, of course, is where do we go from here?
What if the M2 growth rate becomes negative?
Inflation will fall.
The economy will go into recession.
And we’re going to have some bad times trying to settle things down after the bubble bursts.
The question is, do we have the tools and the right people to control the financial markets and the economy?
Keep an eye on what happens to the M2 money supply.