"By allowing persistent declines in the money supply and in the price level, the Federal Reserve of the late 1920s and 1930s greatly destabilized the U.S. economy and the economies of many other nations as well.
- Federal Reserve Governor, Ben Bernanke, 2004

Ben Bernanke, Nobel Prize winner Milton Friedman, and most other economists out there agree that the reason the Great Depression was so deep and destructive was that the Federal Reserve failed to keep the money supply from shrinking. I'm a little more skeptical, but I agree that it would be impossible for an economy to grow without a growing supply of money in a debt-based monetary system.
That's why this news article should be extremely distressing.

The stock of money fell from $14.2 trillion to $13.9 trillion in the three months to April, amounting to an annual rate of contraction of 9.6pc. The assets of insitutional money market funds fell at a 37pc rate, the sharpest drop ever.
"It’s frightening," said Professor Tim Congdon from International Monetary Research. "The plunge in M3 has no precedent since the Great Depression. The dominant reason for this is that regulators across the world are pressing banks to raise capital asset ratios and to shrink their risk assets. This is why the US is not recovering properly," he said.

As our political and financial leaders are using every tool at their disposal to jump-start the economy, there are fewer and fewer dollars in circulation. That's not a prescription for a growing economy. It's a prescription for economic disaster.

David Rosenberg from Gluskin Sheff said the White House appears to have reversed course just weeks after Mr Obama vowed to rein in a budget deficit of $1.5 trillion (9.4pc of GDP) this year and set up a commission to target cuts. "You truly cannot make this stuff up. The US governnment is freaked out about the prospect of a double-dip," he said...
Mr Congdon said the Obama policy risks repeating the strategic errors of Japan, which pushed debt to dangerously high levels with one fiscal boost after another during its Lost Decade, instead of resorting to full-blown "Friedmanite" monetary stimulus.
"Fiscal policy does not work. The US has just tried the biggest fiscal experiment in history and it has failed. What matters is the quantity of money and in extremis that can be increased easily by quantititave easing. If the Fed doesn’t act, a double-dip recession is a virtual certainty," he said.

America's M3 isn't the only indicator of trouble ahead. Europe's M3 is giving the exact same warning signals, right along with Europe bank lending.

Along with the money supply we are seeing a dramatic drawback in liquidity. The commercial paper market is cutting back. This is happening at the same time that the Libor is rising.

Those economic geeks out there might remember that the M3, commercial paper, and the Libor were the early indicators of the current recession. They flashed warning signs before most economists even acknowledged we were entering a recession.
Another coincidence indicator to watch is global forex reserves.

The key driver of the global credit bubble of the past decade was growing economic imbalances. This can be measured by the building up of massive currency reserves in surplus countries such as China and Japan. It is the foundation of Bretton Woods II - a now busted and defunct global monetary system.
Bretton Woods II failed when the Great American Consumer's credit card got maxed out. This is reflected in China's trade numbers.

So what should you do with this news? Well, hedge fund manager Hugh Hendry has interesting advice.

"I would recommend you panic."
"Banks today are refusing to lend to each other. Bank share prices are collapsing. We have no ability to gauge the credit-worthiness of the banking system."

Of course, being a hedge fund manager, Hendry might be "talking his book", but he does have a few good points.

The reason why the credit-worthiness of banking systems are in question is the same reason why liquidity is drying up, and is the same reason why the M3 is shrinking, and is the same reason why we entered the Great Recession in the first place - the collapsing housing market.

T2 Partners has a great presentation of the condition of the housing market. I would like to share just a couple of the slides.

The current troubles in the real estate market are not because the federal government hasn't taken unprecedented efforts to keep the housing bubble from deflating. The entire multi-trillion dollar mortgage market has been nationalized, and yet even that has failed to keep home prices from sliding. This has left the big mortgage providers swimming in debt.

Foreclosures are still near record highs, despite the best government efforts to stall and delay the foreclosure process. The government's mortgage modification programs have been accused of doing more harm than good.

“I don’t think there’s any way for Treasury to tweak their plan, or to cajole, pressure or entice servicers to do more to address the crisis,” said Mark Zandi, chief economist at Moody’s Economy.com. “For some folks, it is doing more harm than good, because ultimately, at the end of the day, they are going back into the foreclosure morass.”

All the government has managed to accomplish is to create this massive overhang of properties that must one day be foreclosed on and brought to market.

The number of people living in homes for months on end, and have absolutely no hope of ever paying again, without having been foreclosed on is simply staggering.

In the end the banks are going to have to write off all these losses in their mortgage holdings. To cover these losses, to avoid going bankrupt, the banks have to build up cash reserves. That means cutting back on loans, both business and consumer.

The recovery cheerleaders like to talk about recent numbers and charts, but they don't spend much time talking about the fundamentals of the economy. The fundamentals start with the amount of money and credit in the system.
It's possible to get a temporary bounce in the economy based on massive government stimulus and intervention, but you can't get a sustained recovery under any circumstances without an expanding money and credit supply. Unless that changes, we are going into a double-dip.