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Every economist is familiar with Milton Friedman’s dictum that inflation is always and everywhere a result of an expansion of the money supply. For many economists, the Friedman argument was borne out during the pandemic when central banks responded with an enormous surge in the money supply growth, aided and abetted by an explosion in public spending.  

But what about the reverse conditions? Does a contraction in the money supply mean deflation or, at least, disinflation?

Money supply is measured in several ways with the most influential measure being M2---- which includes currency in circulation, savings accounts, money market funds, and certificates of deposits. A growing economy requires credit expansion to foster economic activity. The important measure is monetary supply velocity, better understood as the willingness of commercial banks to accommodate borrowers. Lending means more transactions, more workers hired, and more capital investment. Money should be rapidly circulating in the form of bank loans and then returned to the banks in the form of savings deposits which, in turn, lent out to spur economic growth.

Throughout the advanced economies, the money supply is shrinking, at rates not seen in decades. US money supply is declining at an annual rate of 4% which will continue to weaken economic growth, soften asset values, and, importantly, moderate the rate of inflation. Canadian money supply has also been on a steady downward path, approaching zero growth for M2, but negative for more narrow measures of money supply.
 

 US Money Supply Growth

Canadian Monetary Aggregates Growth Declines

 Lacey Hunt clearly states the problem when writing about the prospects for the US economy, to wit:

“Negative money growth, increasing fiscal deficit, rising real interest rates, and central banking guidance of higher short-term interest rates are creating a classic ‘credit crunch.’ ....... { Changes in the } money supply lead to bank credit. .... the latest 12-, 24- and 36-month rates of change in real bank credit are all negative, respectively, -2.3%, -0.7%, and -0.5%. Historically, real bank credit has increased at an average of 3.4% per year. As the second quarter ended, the contraction in bank credit showed the markings of an old-fashioned credit crunch” (Credit crunch).

Put differently, it is just a matter of time before the economy gives way to the negative effects of declining bank credit.

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