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USA: monetary base vs. quantity of money

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The current weekly note attachment – like the last one – is about the consequences of confusing ‘the monetary base’ and ‘the quantity of money’. This confusion has plagued commentary on both the Japanese and American economies in the last few years. (There has also quite a lot of nonsense in the UK from, for example, Liam Halligan in his Sunday Telegraph column.) In the note – which has recently appeared in Economic Affairs, a magazine published by the Institute of Economic Affairs – I recall the inflation warnings given by American monetarists in early 2009, as they bewailed the then surge in the USA’s monetary base as a result of the Federal Reserve’s asset purchases. These warnings – which were neither dated nor quantified – have so far proved silly. In fact, in the year to autumn 2013 the USA’s finished- goods producer prices index is likely to be unchanged or even to be down slightly. The failure of American monetary-base-focussed monetarism demonstrates, yet again, that the measure of money that matters in macroeconomic analysis is one that is broadly-defined to include all assets with fixed nominal value that can be used in transactions. In most countries the total of bank deposits is the best approximation to that measure of money, which has the further implication that public policy should be concerned to maintain growth of the banking system balance sheet at a low and stable rate. It should be a low rate to combat inflation, and at a steady rate to help in securing wider macroeconomic stability (i.e., stable growth of demand and output). Anyhow it is the quantity of money, not the monetary base by itself, that matters to macroeconomic outcomes.  

Japan: monetary base vs. quantity of money

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Japan’s ‘Abenomics’ is reported to have three arrows, - a ‘revolution’ in monetary policy with ‘the Bank of Japan injecting huge amounts of “money” (whatever that means) into the economy’ (or something of the sort), - a short-term fiscal stimulus accompanied by long-term action to bring the public finances under control, and - ‘a growth strategy’ (which means in practice shaking up such over-protected parts of the Japanese economy as farming and retailing). Commentary on the last two of the three arrows has often been sceptical. Initial ‘stimulus’ (i.e., a widening of the budget deficit) is not easily reconciled with ultimate fiscal consolidation (i.e., a narrowing of the budget deficit), while Abe’s Liberal Democratic Party has drawn much of its traditional support from groups that benefit from protection and restrictive practices. By contrast, most media reporting has suggested that the Bank of Japan has definitely changed course and that a major upheaval in monetary policy is under way. This note argues  that,  although  Japanese  monetary policy  has  indeed  shifted  in  an expansionary direction, the shift is far less radical than the rhetoric that has accompanied it. Japanese policy-makers and the greater part of the commentariat seem to believe that the monetary base by itself has great macroeconomic importance. This is a mistake. National income and wealth in nominal terms are a function of the quantity of money, which must be distinguished sharply from the base. Movements in the monetary base and the quantity of money may be related, but the relationship is not necessarily all that precise or reliable. It is the quantity of money, not the monetary base by itself, that matters to macroeconomic outcomes.  

How dependent is US money growth on QE?

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And what will happen if QE is tapered or stopped?

Quantitative easing’ is understood in this note as the purchase of assets from the non-bank private sector by the central bank. (Other definitions are available!)  The  central  bank  finances  these  purchases  by  issuing  cash reserves to the commercial banks, while the bank deposits of the non-bank private sector increase as it receives the proceeds of its asset sales. As bank deposits can be used to make payments, they are money. The effect of QE is therefore to cause an increase in the quantity of money, with bank balance sheets showing extra deposits on the liabilities side and extra cash reserves on the assets side. The change in banks’ cash assets measures, more or less, the effect of QE on the quantity of money. (I say ‘more or less’ because there are some technical caveats. They may become important, but they are not relevant to this note and are not further discussed.) The Federal Reserve’s ‘QE3’ operations are an example of this form of quantitative easing. The Fed has purchased mortgage-backed securities, mostly from non-banks (but also to some extent from banks, one of those ‘technical caveats’), and that has boosted banks’ cash reserves enormously and been a major positive influence on the quantity of money. QE is expected to be ‘tapered’ soon and ended at some point in the next few months. What effect will that have on the growth of the quantity of money in the USA? Will M3 – which has been rising slowly since 2011 – continue to increase? The analysis  in  this  note  suggests  that,  unless  banks  were  to  resume  the expansion of ‘bank credit’ in the usually understood sense (i.e., of claims on the private sector), the growth of US broad money would come to a complete halt with a cessation of QE. It is very important for International Monetary Research subscribers to realize that the Fed does not analyse the monetary situation by inspection of quantity-of-money data; its officials would have no interest in the conclusion I will now reach.  

Cost of the EU: The total cost: roughly 11% of national output

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It is now time to bring the strands of the analysis together. There is no single, exact number for the damage that EU membership does the UK, but vast damage has been done. Chapter 1 established that the direct fiscal cost of the UK’s EU membership is now 1¼% of gross domestic product each year; chapter 2 examined the damage of EU regulation in terms of employment and energy use, and in the international financial sector (i.e., ‘the City’), and also discussed small business closures because of substance and product authorisation regulations, and arrived at a number of between 5% and 6% of GDP each year at present, but growing over time; chapter 3 borrowed from work by the OECD and Minford to reach an estimate that resource misallocation due to the EU’s trade regime costs the UK over 3% of its GDP each year; chapter 4 argued that, because the UK labour market had been too open to immigration from Eastern Europe, over 100,000 UK-born people had been without jobs over a significant length of time, with a cost that may be difficult to quantify, but might be 3/8% of GDP for the relevant period; chapter 5 surveyed the costs of waste, fraud and corruption, and argued that the Common Fisheries Policy, the Common Agricultural Policy, environmental directives, and fraud and corruption in EU- or EU-related administration led to waste that in total might be 3/8% of GDP; and chapter 6 looked at actual and potential losses from ‘health tourism’, ‘benefit tourism’, fines from the European Court of Justice and ‘contingent liabilities’, which added another ¼% of GDP.  

The misgovernment of Europe

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Full economic and political integration of their continent – culminating in a federal  ‘United  States  of  Europe’  –  has  been  a  dream  of  many  European politicians and opinion-formers since the early 1950s. Much has changed in Europe over the last 60 years, reflecting the integrationist process under the European  Steel  and  Coal  Community  from  1952,  the  European  Economic Community  from  1957,  and  the  European  Union  from  1993.  Many  of  the changes have been for the better, including the achievement of industrial free trade  and  free,  non-discriminatory,  cross-border  payments  within  the  EU. However, the EU member nations have  been reluctant to hand over fiscal powers (i.e., the powers to tax, above all) to central EU institutions. The EU is quite unlike the United States of  America, which from its inception had a federal  government  with  fiscal  powers.  The  powers  were  used  largely  to finance military expenditure against the USA’s main enemy at the time, which was the United Kingdom of Great Britain! Because the EU institutions, particularly the European Commission, have been thwarted on the fiscal front, they have tried to make ‘European government’ a reality by expanding a body of European ‘law’. The Commission has therefore secured the passage into law  of  thousands  of  ‘directives’  and  ‘regulations’,  by  a  process  which  is massively interventionist, but also undemocratic. The result has been a heavy burden of regulation which has checked economic growth across the EU. The EU institutions are also inefficient and wasteful, partly because they are not subject to proper democratic scrutiny. The accompanying analysis is chapter 5 in the 2013 edition of my publication, How much does the European Union cost Britain?, for the UK Independence Party.  

Immigration and the UK labour market

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Heavy net immigration into the UK has occurred in the last 15 years, reflecting the impetus of mostly administrative changes at the start of the last Labour government in 1997. (No major announcement was made and no public debate was held on the desirability of this new development in British life.) A particularly important new trend was inaugurated about a decade ago. Following a decision by the then prime minister, Tony Blair, the UK would not impose any restrictions on the inward movement of workers from eight East European countries when they joined the European Union in May 2004. Since spring 2004 UK-born employment in the UK’s labour market has fallen, whereas foreign-born employment has increased by about 1.8 million. Roughly half of the 1.8 million come from the so-called ‘EUA8’ countries, i..e, the eight accession countries of May 2004. The mere recital of figures does not demonstrate a causal connection, but more detailed work (such as on regional employment patterns) does suggest that UK workers have lost jobs because of the influx of foreign workers. On 1sJanuary 2014 people from Bulgaria and Romania – which together have a population of about 30 million people – will be free to come to the UK, and to live and work here. The following note – which is chapter 4 of the 2013 edition of my study for the UK Independence Party on How much does the European Union cost Britain? – discusses these developments in more detail.  

Money trends in the main countries

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The rate of change in the quantity of money, broadly-defined, is the fundamental driver of the rate of change of both nominal national income and nominal  national  wealth.  Since  a  nation’s  wealth  includes  both  corporate equity and the main forms of real estate (residential, commercial, rural), money trends are basic to all investment decisions. Of course the patterns of money growth vary from country to country, depending on developments in the banking system and monetary policy. This note has a quick look at the USA, Japan and the Eurozone in early 2013. I hope to expand it next week. Anyhow, to summarize, in the first half of 2013 broad money growth ran, roughly, at  the  following annualised rates  in the  three areas, 4% to 5% in the USA,                                                                                                  - 3% to 4% in Japan, and little more than zero in the Eurozone. My verdict is that money growth rates like these are consistent with a reasonable continuing recovery in the world economy, but not with the kind of strong rebound that might be expected after the savage downturn of 2009 and the rather feeble upturn in 2010. The exception remains the Eurozone, where the reports of an improvement in recent months seem far from convincing.  

The costs of regulation

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From a constitutional standpoint, the European Union is a monstrosity. Powers have been ceded to EU institutions  that  place  them  above  the  member  nations  in  the  constitutional  hierarchy.  These institutions are, in effect, federal bodies that  constitute a ‘government’  for  the  EU as a  whole. Nevertheless, the member nations have retained trappings of statehood, and in particular continue to have their own military forces, their own legal systems and their own fiscal prerogatives. Critically, most taxes are raised and most public expenditure is administered at the national level. EEC expenditure was a mere 0.03% of member states’ aggregate gross domestic product in 1960, and had climbed to 0.53% of that figure in 1973 on the UK’s accession. The ratio has subsequently risen to slightly more than 1% of EU GDP, as we saw in the last chapter. But it is striking that Germany – the main sponsor of European integration – has over the last 20 years been one of the member states most opposed to additional spending in the union’s name. At the Edinburgh meeting of the European Council in 1992 Germany actively supported a spending ceiling of 1.27% of aggregate member nations’ GDP.1 On the face of it the EU has two layers of government, one at the national level and the other for the union as a whole. But the word ‘layer’ implies, falsely, that a clear and definitive understanding has been established on the proper relationship between the two. In fact, EU member states are in the dysfunctional situation of having two distinct governments, one in the national capital and the other in Brussels, with their relative powers and responsibilities largely unsettled. The EU bureaucracy has been unable to wrench the key fiscal prerogatives, the powers to tax and spend, from the member states. To compensate for this failure, it has tried to expand its influence by pressing for more European ‘laws’. The heart of the process is that the European Commission proposes new ‘directives’ and ‘regulations’ to the Council of Ministers. Successive treaties have weakened the power of individual  nations  to  block  new  EU  legislation  that  they  dislike.  Particularly  since  the  Single European  Act  of  1986 the  nation  states  have  become  increasingly feeble  in restraining the  EU juggernaut. Over the 55 years of its existence the European Commission has authored thousands of directives and regulations that have the force of law across the EU. At the last count the EU’s various legislative enactments – which are termed the acquis communitaire – covered over 120,000 pages. As far as the EU is concerned, the acquis is sacrosanct and must be adopted by all new member states without cavil. Directives and regulations are the main expression of EU authority, and nowadays infiltrate every nook and cranny of national life. In the words of Lord Denning over 20 years ago, ‘Our sovereignty has been taken away by the European Court of Justice…No longer is European law an incoming tide flowing up the estuaries of England. It is now like a tidal wave bringing down our sea walls and flowing inland over our fields and houses—to the dismay of all.’2  

Cost of the EU – The Direct Fiscal Cost

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Its membership of the European Union requires the UK government to make certain payments to EU institutions, and entitles it to a number of receipts. How much are these direct fiscal costs and benefits, and what is the net position? That may seem like a simple question which can be answered with a single number or set of numbers. Surely, when the government spends £100 million, it spends £100 million, and it does so without fuss or ambiguity. In fact, a range of complexities mean that no one  figure  for  many  EU  financial  concepts  is  exactly  ‘right’.  Like  love,  the  UK’s  financial contribution to the EU is a ‘many-splendored thing’. Again like love, it causes many squabbles.  

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