You think the global economy is brightening? Beware: the big hit is yet to come BoomsandBustsCentralBanksTheFedMonetaryPolicyUSEconomy
Relief is spreading among economic analysts and stock market experts. Energy prices are decreasing noticeably. The energy supply this winter seems secure; in Europe, government support for consumers and producers is available if needed. China is turning away from its zero-covid policy, and production is ramping up again.
The enormous rise in goods prices, i.e., the high inflation, is a consequence of central banks' monetary policy. In the course of the politically dictated lockdowns, central banks have increased the money supply enormously. For example, the US Federal Reserve has expanded the M2 money stock by around 40 percent since the end of 2019, and the European Central Bank has increased the M3 money supply by 25 percent.
However, if the real money supply continues to shrink as sharply as it is currently, the signs point to at least an economic slowdown and, more likely, a recession. When the real money supply in the economy shrinks, those holding cash become poorer. They can now no longer purchase the quantities of goods they previously bought and need to adjust their spending: stop buying more expensive goods, or continue buying more expensive goods while forgoing other things.
The contraction of output and employment, in turn, exerts downward pressure on rising goods prices, establishing a new relation between the outstanding money stock and goods prices in accordance with peoples' preferences. Once this adjustment has run its course and the nominal money stock remains unchanged, goods price inflation dies out. The economy ends up with a higher level of goods prices when compared with the situation before the nominal money supply had been increased.
A recession will likely put highly indebted economies under severe stress. Many debtors will no longer be able to service their debts. Loan defaults increase. As a result, banks become reluctant to grant new loans and demand repayment of expiring loans. Investor confidence in debt-ridden economies and financial markets is dwindling. The result would be a fulminant credit crisis, at least at the scale of the one in 2008/9.
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