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Chinese Premier Wen Jiabao has missed the point. Those who say that loose monetary policy in the US will lead to inflation miss it too.

Right now, the US economy is facing its severest test in decades, if not longer. The media and the blogosphere are full of predictions of doom. And they have got it completely wrong. It is dangerous, and this is why.

According to research from Roubini Economics published last month, the reason why the Depression of the 1930s was so bad that it had Great put it front of it was that the government pandered to the demands of the media, markets and electorate, who called for common-sense policies.

Common-sense said that times of austerity required cutbacks. Savings rates shot up. The pressure grew on the US government to make savings. The US money supply contracted, and as a result the Depression just got deeper.

Today we are told that rock bottom interest rates and quantitative easing will lead to a burst of inflation comparable to that seen in Zimbabwe.

Others apply economics that not even Mickey Mouse could stoop so low as to use, and say the pound has fallen faster than the Zimbabwean dollar.

Well, yes, it has over a short period of time. But imagine you have two people, one person jumped off a cliff and hit the bottom, and therefore stops falling. Some time later another person stumbles over a twig. For a split second our stumbler is falling while the person who stepped off a cliff isn’t. So what. It’s obvious. You can read nothing into this. But this scenario is analogous to the comparison between the likes of the UK and Zimbabwe.

Then there’s the fiat money conspiracy. The day we left the gold standard and moved to paper money backed by nothing, is the day we entered an inevitable period of self destruct, say the conspiracy theorists.

And then Premier Wen accuses the US of protectionism, because he says that by creating all these extra dollars the Fed is effectively pushing down on the dollar.

All those who say quantitative easing is a form of protectionism, really do need to read some economics books.

For one thing, Ben Bernanke made his name as an academic, saying the real reason why the Great Depression lasted so long was that the US money supply contracted.

Current monetary policy has nothing to do with protectionism, there is no conspiracy. All Mr Bernanke is trying to do is avoid another Great Depression. China should be grateful, because if the US falls back into 1930s style malaise, the crash in international trade which will follow will have a catastrophic effect on China’s exports and then on growth and unemployment.

As you know, when we measure the money supply there are lots of different measures we can use. There’s your base levels, M1 and M2, which include such things as notes, coins and bank deposits at the Fed. But to cover the whole gamut you need to include others such as credit. In the US, the M3 measure was meant to cover this. Alas, the Fed does not publish data on M3 any more, but Capital Economics has been producing its own estimate. And it reckons that the US M3 has actually been falling quarter on quarter for seven months in a row. And annually, it has had M3 contracting for three months in a row.

The snag is that there is a relationship between M1 and M2 and M3. The precise form of this relationship is determined by borrowing. Capital Economics explained: “The problem is that the money multipliers have collapsed as banks have not boosted lending on the back of the huge amounts of excess reserves held at the Fed.”

The contraction in the US money supply is very dangerous. And could yet lead to deflation.

Of course, if US borrowing returns to pre credit crunch levels, then given that US M1 has shot up over the last year, inflation becomes a risk. But right now, there is little chance of this happening, and this not likely to change for a very long time.

The thing that the fiat money brigade people forget is that innovation is pushing potential capacity, as is globalisation; and to meet this potential, more demand is required. In a static world that sees no innovation, or rising capacity, the gold standard is fine. But if we were to return to the gold standard in today’s times, as the fiat money conspiracy theorists say we should, the result would be depression, followed by a lurch back to the Stone Age.

For an article explaining the relationship between borrowing and the money supply see If banks are printing so much money, why is the money supply contracting?