Introduction

Steve Hanke, a distinguished professor of Applied Economics and Founder and Co-director of the Institute for Applied Economics, Global Health, and the Study of Business Enterprise at the Johns Hopkins University, recognized by Focus Economics as the world’s third most influential economist and co-author of the recently released book Making Money Work: How to Rewrite the Rules of our Financial System, shared his expertise on monetary policy, trade wars, and currency reform.

The Primacy of Money Supply in Monetary Policy

Hanke emphasizes that monetary policy hinges on the money supply, not interest rates, as the primary driver of economic trends. He critiques the Federal Reserve’s current approach, particularly its focus on interest rates, and highlights the sluggish growth of the U.S. money supply (M2), which is currently expanding at a year-over-year rate of 4.5%, well below his recommended “golden growth rate” of 6.3% to achieve a 2% inflation target.

Policy Recommendations for the Federal Reserve

To avert a potential recession, Hanke proposes two key adjustments:

1. Halt Quantitative Tightening: The Fed has been reducing its balance sheet through quantitative tightening, which contracts the money supply. Ceasing this practice would allow for looser monetary conditions, encouraging economic growth.
2. Eliminate the Supplementary Liquidity Ratio: Introduced post-2008, this regulation requires banks to hold reserves against U.S. government bonds as if they were high-risk assets. Hanke argues this is an outdated and overly restrictive measure that hampers bank lending, which accounts for approximately 80% of broad money (M2) in the U.S. Removing it would stimulate lending and boost money supply growth.

The Quantity Theory of Money

Hanke’s analysis is grounded in the quantity theory of money, a cornerstone of his book Making Money Work. This theory posits that changes in the money supply significantly influence asset markets, economic activity, and inflation. He cites the Fed’s rapid money supply expansion during the COVID-19 pandemic—peaking at 18% year-over-year—as a driver of subsequent asset price surges, economic growth, and inflation, which hit 9.1% in 2022, closely aligning with his and co-author John Greenwood’s predictions.

The Importance of Monetary Neutrality

Hanke also advocates for monetary neutrality, where policy changes should not disproportionately affect specific sectors or income groups. He points to the non-neutral effects of the Fed’s 2020 money supply surge, which disproportionately benefited asset owners—primarily the wealthy—exacerbating income inequality. U.S. billionaires’ wealth as a percentage of GDP rose from 14.1% in January 2020 to 21.7% today, illustrating this disparity.

Bank Regulations and Their Role

Bank regulations play a critical role in monetary policy, as commercial banks produce roughly 80% of the broad money supply. Hanke stresses that overly stringent regulations, like the supplementary liquidity ratio, constrain lending and hinder economic growth. Policymakers must consider these regulations’ impact on money creation to ensure a stable and predictable monetary environment.

Trade Policy and the Risks of Tariffs

Hanke, a self-described classical liberal and free-market economist, is a staunch advocate for free trade. He warns that the U.S.’s current trade policies are steering the economy toward a “trade war doom loop.” With the average effective tariff rate at 18%—comparable to the 1933 Smoot-Hawley tariffs, which deepened the Great Depression—Hanke argues that these policies are misguided.

Misconceptions About Trade Deficits

Hanke challenges the notion that trade deficits are inherently harmful or caused by foreign manipulation. Instead, he attributes them to domestic overspending, where consumption, investment, and government expenditure exceed GDP. This gap is filled by a trade deficit, a basic identity in national income accounting. Reducing tariffs and other trade barriers, he argues, would mitigate economic uncertainty and prevent escalation with major trading partners like China.

Economic Implications

Hanke predicts that persistent trade barriers and slow money supply growth (currently at 4.5%) could push the U.S. economy toward a recession. He notes that the money supply has been contracting for over two years, a trend that historically precedes economic downturns.

Indicators for Investors

When it comes to critical indicators for investors to monitor, Hanke downplays the importance of short-term data points, which he views as symptoms of past money supply changes rather than causes. Instead, he urges investors to focus on the money supply’s historical trends, as these are the “engine” driving economic outcomes. Additionally, he highlights “regime uncertainty”—a term describing widespread changes in economic rules, as seen during the 1930s New Deal era or Yugoslavia’s transition in the early 1990s—as a significant risk. The current “Trump regime uncertainty,” driven by shifting trade and economic policies, could deter investment and exacerbate economic slowdown.

Hanke also warns of a speculative bubble in the U.S. stock market, suggesting that investors are underestimating these risks. He recommends caution and a long-term perspective, focusing on the underlying monetary and policy drivers rather than reacting to daily data fluctuations.

Gold’s Resurgence and Central Bank Strategies

Hanke notes that gold is outperforming stocks by a factor of four, driven by central banks’ increased gold purchases and a shift to domestic sourcing. This trend is fueled by:

1. Trade Wars and Dollar Weaponization: The U.S.’s use of sanctions and asset freezes (e.g., Russia’s assets in Europe) has prompted countries, particularly in the BRICS bloc, to diversify away from U.S. dollar assets. China and Russia are among the largest buyers of gold.
2. Domestic Economic Challenges: In China, a burst real estate bubble and economic struggles post-COVID have driven private citizens to invest heavily in gold, distrusting the yuan.

Investment Positioning

Hanke advises investors to consider precious metals as a hedge against economic uncertainty and currency devaluation. Given the bull market in gold and the risks of a stock market bubble, allocating a portion of portfolios to gold could provide stability amidst potential equity market volatility.

Austrian Economics and Currency Reform

As a proponent of Austrian economics, Hanke advocates for principles like the quantity theory of money to guide central banks away from policy missteps. He critiques the International Monetary Fund (IMF) for fostering a “doom loop” of debt and recidivism in countries like Argentina, the IMF’s largest debtor. Despite President Javier Milei’s campaign promises to dollarize Argentina’s economy, Hanke notes that Argentina has instead accrued an additional $10 billion in IMF debt, bringing its total to $57 billion. Capital flight, equivalent to 68% of accumulated debt since 1995, remains a persistent issue.

Currency Reform Solutions

Hanke proposes two robust solutions for stabilizing economies plagued by currency depreciation and inflation, drawing on his experience as an advisor in countries like Montenegro, Bulgaria, and Bosnia:

1. Currency Boards: These institutions issue local currency at a fixed exchange rate with an anchor currency (e.g., the euro), backed by 100% reserves. Hanke’s implementation of a currency board in Bulgaria in 1997 reduced hyperinflation from 242% per month to single digits within 30 days. He recommends this approach for countries like Ethiopia, which faces 50% inflation.
2. Dollarization: By adopting a stable foreign currency, such as the U.S. dollar or euro, countries can eliminate currency risk and restore confidence. Hanke’s work in Montenegro in 1999, where the German mark (later the euro) was made legal tender, exemplifies this strategy.

Both approaches aim to restore trust in the currency, curb capital flight, and attract foreign investment by ensuring monetary stability.

Conclusion

Steve Hanke’s insights underscore the critical role of money supply in driving economic outcomes, the dangers of protectionist trade policies, and the need for robust currency reforms in struggling economies. Investors should remain vigilant about monetary trends and regime uncertainty, considering gold as a safe haven amidst potential economic turbulence. By grounding policy in the quantity theory of money and Austrian economic principles, Hanke offers a roadmap for navigating the complex economic challenges of 2025.

Here is a link on the interview with professor Steve Hanke Recessions, Monetary Policy and Currency Reforms – Steve Hanke

Disclaimer: This article is not a recommendation to buy or sell any shares, products, or services. Always conduct your own due diligence and consult with a financial advisor.