Why The Downside To The Fed's "All In" Attempt To Spike Shadow Monetary Velocity Is A $4.5 Trillion Drop In GDP (And The "Upside" Is Hyperinflation)

It appears that the one topic pundits have the most problems grasping is the spread between the segregation of traditional and shadow monetary aggregates, overall economic deleveraging and aggregate monetary velocity, and how all that impacts GDP. A summary which confirms just how prevalent the confusion is, is this terrific post by the Calafia Beach Pundit, terrific not because it is even remotely correct (the post is so blatantly wrong - one wonders if Western Asset Management even expects its current and former asset managers to count beyond 2... M2 that is), but because it demonstrates how self-professed "pundits", whether of the beach variety or not, don't have the faintest grasp of more than merely trivial monetary topics.

The basis for the above-mentioned post's argument is that since M2 is growing (which it is for 16 weeks in a row now as we have been pointing out repeatedly), and since M2 velocity has performed a dead cat bounce off its 30 year lows following the complete collapse in M2 velocity after the bankruptcy of Lehman, that GDP has to grow. Period. This argument is so flawed and so one-sided, that its refutation and subsequent elaboration as to what reality truly is, is what this post was at first all about. Yet in refuting the simplistic conclusion of a mainstream pundit's myopic perspective, we uncover something far more troubling: namely that should the Fed fail in stoking consolidated aggregate monetary velocity very quickly, as the shadow liability collapse accelerates, US GDP has the potential to drop by up to $4.5 trillion over the next 3 years.

First, looking at M2, it is indeed the case that M2 has been growing. As the chart below shows, since the beginning of 2010, M2 has grown by $288.7 billion from $8485 to $8773 billion.

The problem, as Zero Hedge readers know all too well, is that M2 is merely a small subcomponent of all practical monetary aggregates, including those derived from the shadow credit system. As the beach pundit certainly should be aware, a far more important aggregate is M3, which the Fed has conveniently decided to eliminate, just so those of the permabullish persuasion can spin factless arguments using the far more easily manipulable M2 as a proxy for money demand. And looking beyond M2 is precisely where the entire argument falls flat on its face.

Since the bulk of credit and monetary growth over the past 30 years has occurred not at the observable M2 level, but at the level of shadow banking liabilities (from $620 billion in 1980 to $21.4 trillion at the peak in Q1 2008), and their monetary representation (be it M3, or our broader custom aggregation), a far more indicative view of GDP as a product of monetary aggregate velocity is that of GDP not to M2, but of GDP to M2 and Shadow Banking, which includes in addition to the generic M2 components such as M1 (currency, demand deposits), and retail money funds, savings deposits, and a variety of other deposits, also such shadow components as money market mutual funds, GSE capital, ABS issuers, repo money, open market paper, and agency and mortgage pools. The combination of all that is the most definitive and comprehensive representation of money demand available for the US economy.

The chart below shows just how much more of a factor the shadow economy has become of the past 30 years. While in 1980 the ratio of M2 to Shadow banking monetary aggregates was 135%, the resultant surge in shadow debt, and thus shadow money, as a result of 30 years of declining interest rates, led to a M2/Shadow ratio of under 50% in 2008 (black line in chart below).

A complete and valid representation of aggregate monetary velocity has to take all these excess components: anything else is an insult to the intelligence of one's, in this case, readers. Which is where a far more different picture than that presented by some pundit or another emerges.

Note that in the chart below, as credit has become easier to procure, and increasingly cheaper since the arrival of the Maestro, and as cheap credit-derived money flooded the system, the overall broad money velocity (M2 and Shadow Banking monetary equivalents) has collapsed, even as GDP has been growing. In other words, as more and more credit has gotten added to the system over the past three decades, such new credit has had a progressively smaller impact on true economic growth. And here is the key point that makes a mockery out of the abovementioned "analysis" - even as M2 has grown by under $300 billion, courtesy of QE 1 and QE Lite, shadow banking liabilities and appropriate aggregates have plunged by $2.1 trillion in just the first six months of 2010! Let's see: +$300 billion compared to -$2.1 trillion. Hmmm.

Let's recall that the prevailing theme of the ongoing depression is deleveraging: at the consumer and at the corporate level (courtesy of sovereign leveraging, and $13.7 trillion in federal debt compared to under $9 trillion three years ago, which makes the cost of deleveraging next to nothing), the current collapse in Shadow liabilities, and associated monetary aggregates will persist for a long, long time. Keep in mind the Fed has little control over this, and this is what most pundits (no matter how self-proclaimed) get teribly confused by. All that the Fed can do is hope to increase the velocity of the corresponding circulation of M2, and beyond, money.

Which is where things get really ugly.

Contrary to the beach pundit's conclusion that the growth in M2 most certainly portends a pick up in GDP, we present the completely opposite case: namely that the collapse of shadow credit, and the resultant elimination of shadow money, could result in a plunge in US GDP as high as $4.5 trillion over the next 3 years. And what most don't understand (but Blackhawk Ben most certainly does) is that what M2 does over this period is completely irrelevant as shadow deleveraing will be the far more dominant force vis-a-vis GDP.

And what the Fed is trying to do, more so than anything, is to return the M2+Shadow Banking velocity back to traditional levels, far higher from the current 58%. That the Fed has succeeded in raising it by 8% from its all time low 2 years ago, is purely a function of Quantitative Easing. The real question is whether QE2 will have the same success in stoking at least some consolidated velocity and its resultant GDP pick up.

As the chart below demonstrates very vividly, the upside-downside case for the Fed is blatantly obvious: either the Fed will succeed in spurring velocity to surge to over 80% over the next 3 years, in which case GDP will merely stay flat over the next three years due to the ongoing collapse in consolidated shadow liabilities, or it will fail. Should the latter case materialize, and should velocity be stuck in the current range in the upper 50 percentile, GDP will plunge by nealy 30%, or $4.5 trillion to $10.3 trillion by the end of 2013! Furthermore, if velocity once again begins to contract, which in the context of ZIRP is a distinctly possible outcome, the impact on GDP will be even more dire.

So now you know pretty much everything there is to know about the curve of economic growth over the next several years, and why the Fed is gambling virtually everything on succeeding in increasing money velocity with wave after wave of QE. Since Bernanke is unable to stop the deleveraging onslaught, and indeed via what will be an endless case of ZIRP (at least until the Fed is ended) is encouraging it, all he can do is to attempt to accelerate the velocity of money. Yet as many claim, where QE1 succeeded as it was a program to restore liquidity in a liquidity-strapped system, and thus managed to boost velocity marginally, the fatal flaw of QE2 is that it is the wrong prescription for the symptom ailing the economy. Namely, adding more liquidity to a system which no longer needs a liquidity injection but instead is in dire need of a fundamental restoration in the belief of the job creators (small and medium businesses) that the economy is if not sound, then at least without further threat of central planning interventions by the very same Fed which is now playing Doctor Nick to the US economy, and prescribing nothing less than a terminal poison to what is ailing the US.

The problem is that by adding virtually infinite liquidity to the system, the Fed has doomed a favorable systemic outcome from the very onset: at this point there are two real outcomes: either velocity dips again and GDP plunges by almost $5 trillion, or velocity explodes and hyperinflation arrives, resulting in a debasement of the dollar, and leading to a complete collapse in the system, as GDP becomes irrelevant (how many economists study the GDP over the many months of Weimar Republic hyperinflation?).

So the next time someone points out the growth in M2 and uses it as a flawed validation for a growth in GDP, inform them that until M2 annual growth is $4 trillion and at least offsets the annual deleveraging in the shadow system, and the resulting monetary extraction, that they should look for greater fools elsewhere.