Rubbish – far too much rubbish – continues to be written about ‘quantitative easing’. As I have noted before, views on this set of open market operations vary wildly between so-called ‘experts’. On the one hand, Liam Halligan in his Sunday Telegraph column has compared QE to ‘money printing in banana republics’ and said it would lead to hyperinflation. On that basis, QE must be very powerful. On the other hand, Martin Wolf of the Financial Times has on occasion denied that changes in the quantity of money due to QE can matter to anything, since – in Wolf’s view – changes in the quantity of money always do not matter to anything. On that basis, QE is impotent. Two further muddled and misguided contributions have recently appeared in the Financial Times, a piece on 9th July by John Kay (‘Quantitative easing and the curious case of the leaky bucket’) and another by Jonathan Davis on 15th July (‘The art and artifice of Fed-watching’.) Mr. Davis said that assessing the effects of ending QE ‘is ultimately a matter of subjective judgment, not a simple binary decision that can be derived from objective analysis of data’. As I said in a letter to the Financial Times of 22nd July (see the end of the accompanying note), this is plain wrong. As long as one accepts the standard account of the monetary determination of national income, the relationship between QE and nominal national income is very straightforward in its essentials. (I don’t dispute the complexity of some of the adjustment processes involved, but – as I have been writing about them for over 35 years – I don’t doubt that they exist.) The relationship is discussed in the following note. To summarize, without QE the quantity of money in the UK today would be about 25% lower than it actually is, and so – more or less – would be the equilibrium levels of national income and wealth in nominal terms. QE prevented the Great Recession becoming a second Great Depression. QE was therefore both desirable and necessary.
Press reports have suggested that the International Monetary Fund has become unhappy with the Greek government’s austerity measures, since it felt not enough was being done to maintain fiscal solvency. Anyhow the latest tranche of money has been credited to the Greek government and life goes on, although Greece’s international creditors are watching the budget numbers month by month. The following note recognises that the Greek government is not far from achieving a ‘primary budget balance’ (i.e., non-interest public expenditure is only slightly above tax revenues). In that sense, much has been done to restore the creditworthiness of the Greek state. However, the cost has been calamitous, with falls of about a quarter in real terms in both national output and government expenditure. Even worse, it is not clear that the big austerity drive so far will be sufficient. Two points have to be emphasized. First, output has fallen so heavily from the peak (i.e., in 2007), and is still falling at such a rate, that a budget surplus would be needed to stop the debt/to/GDP ratio from rising further. There is no sign of that. Despite the defaults to private sector creditors, IMF data show the debt-to-GDP ratio now at about 175%. Second, the drop in output has of course a large cyclical element and, sooner or later, a cyclical recovery must surely happen. However, a deeper problem is now emerging, that international investors are shunning Greece and the trend level of output may be going down. To halt the rise in the debt-to-GDP ratio, Greece therefore needs an overall budget surplus over a series of years and not just a primary surplus in an emergency period Again, there is no prospect of that in any relevant planning horizon.
The Eurozone resembles a vast dyke which is full of holes and liable to disintegrate at any moment. This note concentrates on Portugal, where the recent resignation of the very able finance minister, Vitor Gaspar, was a huge disappointment. (It must be said that the Eurozone’s holes in Greece, Spain, Italy and France also remain large and conspicuous, despite international officialdom’s attempts to patch them.) Portugal’s problems arise partly because the economy’s trend rate of growth is now very low, perhaps even zero or negative. Gross domestic product per head is lower than ten years ago. With inflation almost zero, nominal GDP is at best flat. As a result, any deficit leads to an increase in the ratio of public debt to GDP. A May 2011 bailout negotiation with the ‘troika’ extended €78b. of loan and other financing, to help the Portuguese government and banking system. It must be acknowledged that Portugal has tried hard, with Gaspar at the finance ministry, to meet the conditions attached to the bailout plan. The cyclically-adjusted budget deficit fell from 9.0% in 2010 to 4.0% in 2012. Nevertheless, the debt-to-GDP ratio has kept on rising and is now over 120%, the kind of figure that was associated with the Greek dégringolade in 2012. (A fair verdict is that a debt-to-GDP ratio of 120% is sustainable when the nominal interest rate on the debt is 5% or less, but – once the interest rate goes into double digits – the debt interest burden runs amok like a Frankenstein monster.) The Portuguese people are apparently weary with austerity, and it has to be said that – without a resumption of growth and particularly of asset price appreciation, which would help banking solvency – the danger has to be that further deficit-reduction measures would not restore fiscal sustainability or national solvency. Holders of Portuguese banks’ bond liabilities and depositors with Portugal’s banks, you have been warned! PEXIT (Portuguese exit from the Eurozone) is – almost certainly – a better option than staying in.
More on the structural flaws of the EurozoneThe following note is in response to the call for evidence on ‘”Genuine Economic and Monetary Union” and its implications for the UK’ from the House of Lords’ European Union Committee, made on 24th April 2013. The main points of the note are
- banks’ risks of future loss, and hence their need for capital to protect depositors, depend heavily on future movements in asset prices, since these asset price movements determine the value of loan collateral,
- ii. a single set of capital rules (such as the Basle III rules now being imposed on advanced country banking systems) cannot be appropriate for all countries at all times, and undermines the flexibility of national regulators to deal with specifically national problems,
- banks’ loan losses in the Eurozone periphery nations are so large that depositors can be repaid in full only by capital injections from the state which affect these nations’ credit rating,
- the interaction between banks’ solvency problems and their host nations’ sovereign default risk has created a vicious downward spiral of fiscal and monetary retrenchment, and losses of output and employment, and
- this downward spiral is much worse than in a traditional monetary jurisdiction because governments in a multi-government monetary union such as the Eurozone cannot borrow from the central bank
Four years ago, at the worst point in the Great Recession, several leading American economic gurus said that the Fed’s easy monetary policy risked higher inflation which might imperil the recovery. In some of the early commentaries from International Monetary Research (in the spring and summer of 2009), I argued that these gurus – who included the revered Alan Greenspan and Martin Feldstein, a prominent adviser to President Reagan – were seeing ‘ghosts’. Also at that time Liam Halligan of Prosperity Capital Management used his column in The Sunday Telegraph to attack ‘quantitative easing’ (i.e., the large-scale creation of money by the state) as aggressive ‘money printing’ which would lead to a sharp rise in inflation. In a letter to the Financial Times published on 19th June, I showed that the inflation jeremiahs had been wrong. The last five complete years (i.e., the five years to 2012) saw the lowest increases in nominal GDP in all the G7 economies since the deflationary 1930s. The jeremiahs of 2009 made a serious analytical mistake. They thought that inflation was caused by excessive growth of the monetary base, not of the quantity of money broadly-defined to include all bank deposits. In future economic commentators should pay more attention to the quantity of money as such and de-emphasize the monetary base by itself.
Recent survey news on the British economy has been satisfactory, even quite good, particularly given the continuing travails of the Eurozone. The purpose of the current note is to relate these developments to the latest monetary trends. The central point is that broad money growth has been consistent with the recovery, in that it has been running in the mid-single digits (at an annual rate) for several quarters. However, the monetary expansion has not been the result of banks’ increasing their loan portfolios. Instead it has been due to the Bank of England’s purchases of long-dated government bonds from non- banks (i.e., to ‘quantitative easing’, as it has become known). The Monetary Policy Committee of the Bank of England appears to be split on the wisdom of maintaining QE in coming months, with one supporter of continued QE (Sir Mervyn King, the governor) due to step down in a few weeks. The main cause of the persisting weakness of credit growth is that the banks remain subject to official pressure to raise capital/asset ratios, to ‘tidy up their balance sheets’ and so on. The government and the Bank of England have pushed artificial schemes – such as Funding for Lending and the Help to Buy (i.e., to buy a home) initiative – without apparently understanding that the regulatory assault on the banks is to blame for their reluctance to expand their assets. At any rate, over the last year or so a moderate rate of money growth and very low interest rates have been associated with healthy rises in asset prices, and private-sector balance sheets (i.e., the balance sheets of households and companies) have improved dramatically compared with early 2009. As long as broad money growth remains positive and in the mid-single digits (at an annual rate), a steady recovery is to be expec The new Bank of England governor, Mark Carney, is something of an unknown quantity as regards money targeting, although he has expressed interest in ‘nominal GDP targeting’. (The subject of nominal GDP targeting is not discussed here.)
The following note considers whether the aggressive monetary easing now apparently under way in Japan will prove effective in boosting the economy. The Bank of Japan has indicated that it will double the monetary base by the end of 2014. But the important monetary aggregate for the macroeconomic prospect is the quantity of money, broadly-defined. The analysis in the note shows that earlier surges in the monetary base and M1 over the last 18 years have not led to lasting improvements in demand and output, and they have not been enough to deliver meaningfully positive inflation.
A longer version of the following noteconcerning QE2 will probably be published by one of the Thatcherite/free-market think-tanks in the next few months. It should be seen as a continuation of the argument in commentaries I wrote in the second half of the Thatcher government, when – in my view – many of the gains of the first six years (i.e., from 1979 to 1985) were frittered away in a foolish boom-bust cycle and other policy mistakes. Famously, Lady Thatcher was not for turning. Both of the excellent biographies that appeared shortly after her death drum the message home. The first volume of the official biography by Charles Moore, which ends the narrative at a well-chosen ‘half-time’ in 1982, carries the subtitle ‘Not for Turning’. The biography by Robin Harris, who had helped to prepare Thatcher’s own memoirs, covers her full career. His book is actually called Not For Turning. But is that the right characterisation? The argument here will be that the no-turning-back mantra overlooks some inconvenient monetary statistics. The control of inflation was basic to the Thatcher agenda at the start of her administration in 1979. The unfortunate truth is that the Thatcher government committed a massive U-turn in anti-inflation policy and, within a few years, the U-turn had disastrous consequences. Of course Thatcher herself is not the same thing as the Thatcher government, and the allocation of blame between her and her colleagues may be complex. All the same, as will soon emerge, the data have a clear message. In a key area of public policy a major priority in her original programme was abandoned and forgotten while she was in power. (Let me emphasize for clarity that I have a great admiration for Thatcher’s courage and abilities, and have always been a strong supporter of her overall project. This piece is written more in sorrow and regret than in anger and resentment.)
A critical question for financial markets over the next two to three years is the timing of a return to historically normal short-term interest rates, i.e., interest rates which are in the low or middle single digits instead of being close to zero. Although views on the Eurozone are far from unanimous, a case can be made that the macroeconomic plight of its periphery is intensifying. The next significant upward move in euro interest rates is therefore still distant. Conditions are very different in the USA, where a cyclical recovery is clear and definite, even if it is not impressive by the standards of past upturns. Given the relationship between the quantity of money and national income, a rise in the quantity of money is a precondition for a more meaningful and robust recovery. The quantity of money, broadly-defined to include all bank deposits and money-like assets, has been rising in the USA since late 2010. Indeed, in recent quarters its annual growth rate has been in the 2% - 5% vicinity, which has been consistent with progress on output and employment. The banking system in the USA – like its counterparts in Europe and Japan – still has to grapple with the Basle III burden of regulations from the Bank for International Settlements, Even so it has been expanding its risky non-cash assets at about 4% a year. A significant proportion of the money expansion since late 2010 reflects so-called ‘quantitative easing’ operations conducted by the Federal Reserve. The purpose of this note is to identify the effect of such operations on the money growth recorded in the last year or so. (It is similar in approach to earlier weekly e-mails on 19th November 2010 and 22nd June 2011, which endorsed the QE packages then being implemented.) The main conclusion is that the American recovery ‘has legs’ and would be maintained even if QE were halted. Short-term dollar rates may need to rise in 2014.
The UK’s poor productivity performance in the Great Recession and its aftermath: how is it to be explained?
The supply-side performance of the UK economy deteriorated in the Great Recession of 2008 and 2009, and has remained unimpressive in the hesitant recovery that has followed it. In the year to the third quarter 2007, which saw the run on Northern Rock and so heralded the financial strains of the Great Recession, national output was booming. As measured by gross value added in real terms, it rose by 4.7 per cent. From then until the third quarter of 2012 the average value of the annual change in national output was negative at minus 0.2 per cent. In other words, at the time of writing (April 2013) output remains below its level five years ago, an outcome so weak that it has no precedent in the period of modern quarterly national accounts that began in 1955. However, employment has been surprisingly resilient in the Great Recession and has recently reached a new all-time peak. As the change in output can be viewed as the sum of the change in employment and the change in output per person employed (or ‘productivity’), it is clear that the central disappointment of these years has been the stagnation of productivity. The accompanying table below shows that in the five years to autumn 2012 productivity typically fell by 0.4 per cent a year, whereas in the preceding 45 years it rose on average by about 2 ½ per cent a year. The question to be discussed here is ‘why?’.