Introduction to M2 and Recession
A reader doubted the possibility of a recession this year due to the continuous rise in M2, a measure of the total amount of money in circulation within an economy. This includes cash, checking accounts, savings accounts, and other liquid assets like money market funds. To understand the relationship between M2 and recessions, it’s essential to explore what M2 is and how it relates to economic downturns.
What is M2?
M2 money supply is a comprehensive measure of the money in circulation, including all the components that make up the economy’s liquid assets. Real M2 is inflation-adjusted in billions of 1982-84 seasonally-adjusted dollars. This distinction is crucial because recessions are defined in real terms, making real M2 a more relevant indicator for understanding economic trends.
Real M2 vs Recessions
Examining the historical data, it becomes apparent that M2 and real M2 nearly always rise. However, when focusing on real M2, which is adjusted for inflation, the picture becomes more nuanced. The relationship between real M2 and recessions is not as straightforward as one might assume. In fact, the data show that even on a percentage basis, it’s challenging to establish a consistent link between M2 changes and the onset of recessions.
Analyzing the Data
The charts illustrating M2 and real M2 percent change from year ago versus recessions do not reveal a clear-cut correlation. This lack of correlation suggests that M2 might not be the most reliable predictor of recessions. Instead, other economic indicators might offer more insight into impending economic downturns.
Understanding Deflation
If one defines inflation as an increase in the money supply, then logically, deflation should be the opposite—a decrease in the money supply. However, the experience between September 2021 and April 2024, where real M2 fell significantly due to the Fed’s Quantitative Tightening (QT) program, did not feel like deflation in the classical sense. This discrepancy highlights the complexity of defining and predicting economic phenomena based solely on money supply metrics.
Real M2 During the Great Recession
A particularly instructive period is the Great Recession. Despite a slow rise in M2 ahead of the recession and a rapid increase during it, the economy experienced one of its worst downturns since the Great Depression. This counterintuitive scenario can be attributed to debt deflation, where the value of credit on banks’ books was overstated, leading to a crisis of confidence and liquidity.
Debt Deflation: A Key Concept
Debt deflation, rather than fluctuations in M2, is a critical factor in understanding economic crises. The proposed definitions of inflation and deflation related to whether debt can be paid back offer a more nuanced view of economic health. However, the lack of transparent accounting practices, such as mark-to-market accounting, hinders the ability to apply these definitions in practice.
Conclusion
In conclusion, the relationship between M2 and recessions is more complex than a simple cause-and-effect model. The continuous rise in M2 does not necessarily preclude the occurrence of a recession. Instead, factors like debt deflation and the ability to service debt play more significant roles in determining economic outcomes. The Fed’s efforts to expand credit, even through quantitative tightening operations, and Congress’s actions contribute to the complexity of the issue. Ultimately, understanding how much credit expansion is required to grow real GDP and whether such debt can be sustainably managed is crucial for anticipating and mitigating the effects of future economic downturns.
