As 2013 draws to a close, we continue to see a gradual broadening and strengthening of the U.S. economy’s recovery from the financial crisis and severe recession that began more than five years ago. Looking ahead, most analysts
expect further progress, with modest but solid growth in employment and spending for 2014. At least two leading indicators, however, point to the possibility that surprises may come on the upside, with acceleration in some variables that is considerably more rapid than the consensus forecasts now suggest.
The first positive signal comes from measures of the money supply. The graph below plots year-over-year growth in the Divisia M1 measure of money constructed by William Barnett and his associates at the Center for Financial Stability in New York City. In recent research, Michael Belongia and I have found this measure of the money supply to be tightly linked to future movements in output and prices. Indeed, the graph shows how marked slowdowns in money growth presaged each of the last three recessions: in 1990-91, 2001, and 2007-09.
Focusing on the most recent monetary statistics reminds us of what Milton Friedman often emphasized: that interest rates can be highly misleading as indicators of the stance of monetary policy. In particular, with the Federal Reserve’s interest rate target at or close to zero since late 2008, it has seemed to many observers that monetary policy has been fully accommodative throughout the recession and recovery so far. But, as the graph shows, this has not been the case: A sharp decline in money growth signals, instead, that monetary policy was allowed to become too tight in the first half of 2010, a costly error that almost surely accounts for at least some of the sluggish growth and slow inflation that we have seen in recent years.
Money growth has since recovered, however, and has now stabilized at a rate that is still quite robust by recent historical standards. Given the lags with which changes in the money supply affect the economy—another phenomenon about which Milton Friedman often wrote—these most recent data suggest that, for the first time in quite a while, monetary policy is lending its full support to a strengthening economy. Those who follow Friedman by tracking measures of the money supply will not be surprised to see the U.S. economy grow more rapidly in 2014.
The second positive signal comes from the stock market, where prices have risen sharply this year, with the S&P 500 up more than 25 percent since last January. It is striking how many commentators are quick to attribute any movement in asset prices to inflating and deflating bubbles and to the ebb and flow of the “irrational exuberance” that former Federal Reserve Chairman Alan Greenspan infamously identified. But while it is true that financial economists still struggle to explain the volatility of stock prices, it is also true that those prices remain anchored to the present value of the future dividends paid by U.S. corporations.
Thus, if bubbles regularly appear in stock prices, it should be possible for traders to consistently profit by selling stocks when their prices exceed the value of future dividends and to buy stocks when their prices fall below the value of future dividends. The work of many economists, including Eugene Fama, a winner of this year’s Nobel Prize in economics, shows that it is difficult if not impossible to make money in that way. Far more likely is that this year’s rise in stock prices reflects a fundamental and sizeable upward revision in the value of future corporate dividends. Similar to measures of money growth, therefore, stock prices signal much better times ahead. For an intriguing and complementary view, see Lars Christensen’s “There is No Bubble in the U.S. Stock Market.”
Of course, we will also need a little bit of luck to see this more optimistic scenario unfold. The Federal Reserve must stay on guard against a replay of 2010, when monetary policy was tightened too much, too soon. Our other representatives in Washington will have to resist the urge to inflict further damage on the economy, either to satisfy their own selfish ambitions or simply out of spite, because compromises naturally mean that people cannot get everything they want. And, most important, we have to hope that the world will see much less of the political and military turmoil that, regrettably, many have suffered from in recent years.
Luck plays but a small role in our overall story. Last weekend’s images from Kiev, of Ukrainians toppling a giant statue of Vladimir Lenin, serve as powerful reminders of what happens to leaders who consider themselves above the will of the people, who create vast intelligence networks to spy ruthlessly, even on their own citizens, and who insist on controlling outcomes in the most important sectors of the economy. Sooner or later, all such systems fail.
By sharp contrast, open democracies with free and fair markets deliver liberty and peace, economic opportunity and rising standards of living, consistently over the long run. Often before, America has been temporarily set back, but, every time, an extended period of renewal and growth has followed. History provides us with the best reason to be optimistic about the year ahead.
Peter Ireland is a professor of economics at Boston College and a member of the Shadow Open Market Committee.