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Money, Money Everywhere

Even as the global economy slows to a halt, liquidity is surging worldwide. In the U.S., repeated interest rate cuts by the Federal Reserve mean that M3 (the broadest indicator of money supply, including bank deposits and money-market mutual funds) rose by almost 14%, year-on-year, to the end of October. That's the fastest rate of growth in more than 20 years. In the euro zone, M3 grew by almost 8%, quicker than at any time since 1993. There has even been an M3 uptick recently in Japan, where money supply had been shrinking for four years. "There's plenty of money just about everywhere," says Mary Davis, an economist at Credit Suisse First Boston in London. "We've never seen liquidity increasing so fast right around the world."

Nevertheless, most economists now believe that the liquidity overhang is not likely to have much impact on inflation. Classical theory teaches that a rapid increase in the supply of money should quickly feed through to higher prices. But that isn't happening this time. Japan is worried about deflation, not inflation. In the U.S., inflation is heading down as unemployment rises. And forecasters now predict that inflation will plunge in the euro zone, from 2.4% in October to 1% by the end of 2002. "We don't see any reason to worry about inflation for at least a year," says Carlo Monticelli, co-head of European economics at Deutsche Bank. "Even then, we don't think it will be a problem in the medium term."

One reason is that industrial production and business and consumer confidence continue to tumble in most countries. Unemployment is climbing. And competition from low-wage developing countries will help keep prices under control.

To be sure, economists say there is a clear link between surging M3 and the recovery of equity prices in October and November. Moreover, the massive increase in liquidity has helped the financial markets withstand the Enron Corp. bankruptcy and the turmoil in the Middle East. But they say this doesn't mark the start of an asset price boom or an upswing in retail prices. Everyone knows that financial stress can help break up a marriage. But a new study from the National Bureau of Economic Research Inc. shows that some financial problems are more likely than others to lead to divorce.

In particular, the authors of the study, Kerwin Kofi Charles of University of Michigan and Melvin Stephens Jr. of Carnegie Mellon University, find that being fired from a job significantly raises the probability of getting divorced. Married men who are fired have an 18% higher chance of being divorced within the next three years, while women have a 13% higher chance.

But someone losing his or her job because of disability doesn't mean a significantly increased probability of seeing the marriage break up. Similarly, a plant closing that affects a group of people doesn't raise the odds of divorce.

By way of explanation, Charles and Stephens suggest that the character traits that cause a person to be laid off could also make him or her a bad mate. "For example, if a wife can conclude that a husband lost his job because of his repeated irresponsibility or bad temper," they write, "she should conclude both that he is likely to face employment troubles in the future and that he may not be a good person with whom to raise children."

By contrast, a plant closing or a sudden disability is viewed as bad luck rather than a deserved punishment for a bad personality. These events are less likely to spark a divorce even though, in the case of disability, the income loss to the couple is generally greater. The events of September 11 shook foreign investors' faith in the U.S. as a safe haven for their money. Even before the attacks, money flows into the country had been slowing (chart). And after the direct hit on the nation's financial capital, some economists feared that foreign investors would go rushing for the door. Indeed, initial data show that in September, foreign portfolios shed $9.5 billion worth of U.S. stocks and about $2 billion worth of U.S. Treasury securities.

But foreign investment in the U.S. has been more resilient than was expected. While foreign investors dumped stocks in September, they increased their total U.S. investment portfolios by $7 billion by purchasing corporate bonds and debt issued by government-sponsored lenders such as Fannie Mae (FNM) and Freddie Mac (FRE).

Numbers to be released later this month will likely show that capital inflows rebounded in October, says Joseph P. Quinlan, a senior global economist at Morgan Stanley Dean Witter & Co. "The market is expecting a quick resolution to Afghanistan and is looking at the U.S. economy to be the first to emerge from global recession," he says.

History suggests that in times of conflict, capital inflows recover quickly once it is clear the U.S. is winning the war. For example, says Quinlan, in the two months after Iraq's invasion of Kuwait in August, 1990, foreign investment in U.S. debt and equities fell by $6.6 billion. But foreign investors responded to the successful American counterattack in January, 1991, by buying up large amounts of U.S. government debt.

So, unless the war against terror takes a sudden turn for the worse, there may be a quick recovery in foreign investment. Indeed, with Japan in the midst of an economic crisis and the European Central Bank's interest-rate cuts lagging the Fed's, U.S. equities are likely to be the best game in town for many months.

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