Has QE lost its bite? Do large-scale asset purchases by the state no longer boost the economy? Contrary to the impression given by today’s media, this is an ancient question in economics. It flared up in the 1930s and now seems to be doing so again. (I refer to the 1930s, because it was the disagreement between Keynes and Ralph Hawtrey, in effect the UK government’s top economic adviser and exponent of the so-called ‘Treasury view’, that provoked Keynes to write The General Theory. Hawtrey claimed that large-scale asset purchases by the state [i.e., QE] could boost an economy with no need to unbalance the budget; Keynes denied this, and urged increased government expenditure and budget deficits.) A good statement of a common argument was made by Jeremy Warner, the influential commentator on The Daily Telegraph, in a piece on 19th September. Although a supporter of the ‘initial bout’ of QE in early 2009, he suggested that ‘now QE seems to have hit the law of diminishing returns; it appears pretty much ineffective in getting the economy going again’. QE is to be understood as ‘deliberate action by the state (the government or the central bank or the two acting in concert) to increase the quantity of money’. In other words, the claim that QE is subject to ‘diminishing returns’, and is therefore ‘ineffective’, is tantamount to the claim that increases in the quantity of money have a diminished (or even little or no) relationship with nominal national income. This claim is false. It has indeed been thoroughly refuted by the events of the Great Recession. The Great Recession is readily interpreted within the standard framework of monetary economics, in which the demand to hold money is a stable function of a small number of variables, including income, and changes in the quantity of money alter the equilibrium level of national income. The note below sets out some relevant evidence from UK experience in the last few years.
Since 2009 Greece has been a barometer of the Eurozone’s continued viability. The rake’s progress of the four years to early 2009 had been remarkable. It had run current account deficits (relative to GDP) of 7.6% in 2005, 11.4% in 2006, 14.6% in 2007 and 14.9% in 2008 or, over the four years combined, of about 50% of GDP. The big external creditors included international banks, particularly European banks, which had acquired large holdings of Greek government debt and made loans to Greek banks. The extra debt could be serviced in the long run only if Greece reduced its current account deficit substantially. A devaluation against the currencies of its main trading partners was therefore sensible, in order to motivate the necessary switch of production towards exports. Unfortunately, as a member of the Eurozone single currency area Greece could not devalue. It could leave the Eurozone, but that would shatter the geopolitical dreams of the Eurozone’s architects in Germany and France. For them the single currency area was a permanent structure which foreshadowed ever-increasing economic and political integration in the European Union. As devaluation within the Eurozone was impossible, the focus of the policy drive to improve Greece’s financial position was on the budget deficit. The Eurozone sovereign debt crisis escalated in early 2010. Since then negotiations have been held between international bodies (usually “the troika” of the European Commission, the European Central Bank and the International Monetary Fund) and the Greek authorities, about targets for the reduction of budget deficits and public debt. The Greeks have repeatedly missed the targets. Fiscal austerity and the implosion of the banking system have been associated with a drop in real GDP of almost a quarter in five years. The GDP decline has further pushed up the debt/GDP ratio. This note examines the latest developments. Although the budget deficit numbers have been better in 2012 than in 2011, the macroeconomic trauma is so severe and unrelenting that Greece must leave the single currency area as soon as possible.
Fears are being expressed that in 2013 the American economy will plunge over a so-called fiscal cliff. On unchanged policies the budget deficit (cyclically- adjusted) is due to fall sharply. Keynesian textbook orthodoxy says that a large decline of that sort represents a marked tightening of fiscal policy which will ‘withdraw spending power from the economy’, and so reduce demand, output and employment. But will it? The thinking behind modern fiscal policy were first developed in Keynes’ 1936 General Theory, particularly in its chapter 10, and his 1939 essay How to Pay for the War. The ideas were attractive in theory, not least because they accorded the government a large role in ‘managing the economy’. That appealed, and continues to appeal, to ‘the socialists in all parties’. (The phrase ‘socialists in all parties’ comes from Friedrich Hayek, The Road to Serfdom.) But does Keynesian thinking on fiscal policy work in practice? In the last few years the International Monetary Fund has published a database which includes numbers for both the output gap and the cyclically-adjusted (or ‘structural’) budget balance for all its important member nations. Analysts can therefore check the evidence on the relationship between changes in the structural budget balance and growth relative to trend. The Keynesian worldview would be confirmed if above-trend growth were associated with (or ‘caused by’) increases in the structural budget deficit. In my 2011 book Money in a Free Society I looked at the US evidence and established, at least to my own satisfaction, that the data up to 2008 flatly contradicted Keynesianism. In today’s note I extend the analysis to 2012 and also allow for some changes to old data. My conclusion in Money in a Free Society is not only confirmed, but reinforced. Naïve fiscalist Keynesianism does not work in the USA. The further implication is that the fiscal cliff does not mean that the American economy will suffer from another recession, or even demand weakness, in 2013.
Official statistics say that UK output has still not recovered its previous peak in the first quarter of 2008, but that employment has risen to an all-time high. By implication, recent productivity performance has been appalling. Indeed, it seems to have been worse in the five years to end-2012 than in any comparable peacetime period since the start of the Industrial Revolution. In a presentation I gave earlier this year at Investec I argued that one reason – but only one – for the weakness of productivity was that the composition of the labour force had changed during the Great Recession. (See the 21st May weekly e-mail on ‘UK productivity check’.) The opening of the UK’s borders to East European workers in 2004, as eight former Soviet bloc countries joined the EU, was followed by heavy immigration from these relatively poor countries. The immigration was mostly from people of working age and seeking employment. I suggested that, because on average the immigrant workers had lower pay than their UK-born counterparts, they were on average less productive. It followed that – if their share of employment increased – productivity would fall. This suggestion has often been met very critically, not least because it seemed to imply that the East European migrant workers were in some sense unsatisfactory. I meant nothing of the sort and have no personal animus towards East Europeans whatsoever. However, it must be possible to make statements about the pay and productivity levels of groups of workers, while a 2010 ONS paper confirmed that East European employment has been particularly ‘at the bottom end’ of the labour market in terms of pay and productivity. (See footnote 6 below.)
Is any expansion of the central bank’s balance sheet inflationary? And does ‘quantitative easing’ (whatever that is)* amount to ‘the last refuge of declining economic empires and banana republics’? The ‘last refuge’ phrase comes from a Sunday Telegraph column by Liam Halligan on 2nd January last year, in which he attacked both ‘QE’ as a concept and my own views on inflation. I had to respond to the attack which, although polite enough, was directed at me personally. The sequel was a request from me (in two International Monetary Research weekly e-mails, of 6th January and 17th January 2011) to Halligan to quantify his views on inflation and to hold a public debate on the matters at issue. Obviously, these matters were and remain vital to investment decisions, as well as public policy. Halligan declined the invitation to a public debate. I then offered him a wager (with up to £100,000 at stake) on inflation prospects. Halligan’s article of 2nd January 2011 forecast a big rise in inflation because of QE, which began in March 2009. I said the wager should therefore be about the question, ‘will the average annual inflation rate in the two years from March 2011 be 3% or more higher than in the previous two years?’. He would win if inflation were to accelerate by more than 3% a year; I would win if inflation came in lower. We now have inflation data for 18 months of the two-year period. The purpose of the current weekly e-mail is to see how inflation has in fact behaved. To repeat, these matters are vital to investment decisions and public policy. Halligan makes claims to have been particularly prescient about inflation. Let us check whether he has been right or wrong about QE and inflation.
* ’QE’ is ambiguous. Standard practice in the USA and Japan is to define QE as the expansion of the monetary base by central bank purchases of assets from the banks; standard practice in the UK is to define QE as the expansion of the quantity of money by central bank purchases of assets from non- banks.
The UK has had a deficit on the current account of its balance of payments in every year since 1984. On average in the 28 years to 2011 the deficit was 1.8% of GDP, implying that – cumulatively – the UK’s net ‘indebtedness’ to the rest of the world climbed by something of the order of a half to 75% of GDP. Logically, the UK should have been by the early 21st century a heavy net payer of investment income to the rest of the world. In other words, it should have had a deficit on international investment income. But that has not been the position at all. In fact, the UK has achieved a surplus on this account in most recent years. Somehow or other, the UK’s external payments have performed a miracle, a miracle that has been very much to our advantage as a nation and particularly to our ability to consume a rising volume of imported goods. Unhappily, the very latest numbers – for the second quarter of 2012 and published at the end of last month – suggest that the miracle may be coming to an end. The UK had a deficit on international investment income for the first time since 1999. This may be a flash in the pan or it may be the beginning of a trend. At any rate, the adverse developments on the investment income account will make it more difficult to restore overall balance on the current account. By implication, the UK will need in the next few years to grow its exports of goods and services faster than its imports. Although consumer spending has been in retreat during the Great Recession, it would be unwise to expect a meaningful recovery in the next few years.
A recurrent theme of media commentary and punditry in recent years is that ‘extra bank lending’ (in some sense, usually left vague) is a condition of wider macroeconomic recovery. This contention tends to be the prelude to another round of bank-bashing, with politicians and others blaming banks’ actual or alleged reluctance to lend as the reason for the sluggishness of demand, high unemployment and so on. The whole approach depends on the existence of a relationship between bank lending to the private sector and aggregate expenditure (or perhaps some subset of aggregate expenditure with an assumed powerful influence over the total). The claim that there is a relationship of this sort has no place in standard monetary theory, but has become fashionable in the last 20 years or so largely because of papers written by academics from the leading universities on the USA’s East Coast (Harvard, Princeton, Columbia, New York University and so on). Arguably, the current chairman of the Federal Reserve, Ben Bernanke, is the principal exponent of ‘creditism’, the set of ideas that pivots on the lending-expenditure relationship. The current weekly e-mail note is the first of a series that will criticize ‘creditism’. (In my opinion they will demolish it, but others must decide for themselves.) My focus here will be on the UK in the period of the Great Recession, but I believe the arguments to have wider validity. At any rate, I will show both that no relationship holds between bank lending to the private sector and nominal GDP in the UK in recent years, and that there are good reasons why a relationship between the two variables is not necessarily to be expected. (I do not deny that, in the normal course of events, new bank lending creates new bank deposits, which are money, and that a relationship holds between the quantity of money and nominal GDP. But it is the quantity of money as such, not bank lending, that is doing the vital work in the determination of nominal GDP.)
Housing market developments are critical to the macroeconomic outlook. Although the level of housing investment is small relative to national output in most countries, it is very volatile and changes in housing investment can significantly affect the economy’s cyclical course. Perhaps more important, wealth in the form of housing equity is a large part of all wealth, often equal to 40% or more of total personal wealth. Housing inflation or deflation affects consumption, because of the resulting ‘wealth effects’. Finally, mortgage credit is also typically 40% or more of the banking system’s assets, and the rate of growth of mortgage credit therefore impacts on the rates of growth of bank assets and banks’ deposit liabilities (i.e., the quantity of money). Signs of a recovery in the US housing market are of great importance to the macroeconomic prospect in 2013. They matter partly because of the ‘wealth effects’ for consumption and the implications for housing investment, as mentioned above. But they also matter because of the likely strengthening of bank balance sheets, as delinquent loans are reinstated and mortgage credit starts to expand again. The latest Federal Reserve data on delinquency rates on US banks’ assets, for the second quarter of 2012, show only a glacial rate of improvement in asset quality. In fact, the delinquency rate for banks’ residential real estate loans rose in Q2, even as delinquency rates for most categories of bank loan fell. But the news of house price increases has come more definitely in recent months (i.e., Q3). In September last year I sent out a bullish weekly e-mail on the American banking system, against the consensus at that time. I would like to repeat the general message in this weekly e-mail and to warn that, if US broad money starts to grow at 5% plus in 2013 (as seems plausible), the Fed would be very unwise to leave its funds rate at zero. Also in 2013 there will be a widening contrast between a reviving USA on the one hand, and seemingly chronic macroeconomic malaises in both the Eurozone and Japan.
Draghi’s commitment to do ‘whatever it takes’ to preserve the Eurozone undoubtedly has the support of the European political elite, particularly the German political elite. However, every balance sheet has two sides. If ‘doing whatever it takes’ implies that the ECB’s balance sheet is to expand, a further consequence is that its creditors (i.e., for the most part banks keeping cash reserves with it) are more exposed to its failure. As the following note (which is based on my next column in Standpoint) explains, the ECB’s dominant creditors nowadays are German banks, which keep over €750b. cash reserves with the Bundesbank. (See the chart on p. 2 below.) If the banks that borrow from the ECB (which nowadays are predominantly from the PIIGS [Portugal, Italy, Ireland, Greece and Spain] cannot repay their loans, and if the ECB’s modest capital of about €10 billion is exhausted by other losses, Germany’s banks are theoretically liable to a maximum loss of the full €750b. or so. I say ‘theoretically’, because Eurozone governments would be expected to recapitalize the ECB and to prevent such losses. In this disastrous situation they would of course - well, presumably – carry out the recapitalization. But the cost of the recapitalization would add to nations’ budget deficits and public debts. Further, the German constitutional court has just given its legal endorsement to the €150b. German commitment to the European Stability Mechanism. If the PIIGS’ banks and governments cannot repay in full their debts to the ECB and the ESM, the losses fall back on Germany. We are of course talking about losses that could reach €200b., €300b. or more. The following note (see chart on p. 3) also shows that the pattern of PIIGS’ borrowing from the ECB has changed. Whereas in 2009 the ECB was lending mostly to banks in Ireland, Greece and Portugal, in the last 18 months its new loans have been mostly – indeed almost exclusively – to Spain and Italy.
Some clients have been puzzled by my suggestion last week that the Greek government could go bust, and that Greece could still remain in the Eurozone and keep the euro as its currency. Actually, a government bankruptcy is much easier to reconcile with Greece retaining the euro than a banking system bankruptcy. In this week’s note I look at the consequences of a generalized banking system insolvency for Greece’s position in the Eurozone. I accept that – if Greece’s banks cannot meet their obligations in inter-bank settlement – the temptation to bring back the drachma may be overwhelming. (Professor John Whittaker of Lancaster University Business School has pointed out that – if Greek banks no longer have a positive balance in their cash reserve with the ECB – they cannot cover a deficiency in cash flows arising from customer instructions. Whittaker’s observation is compelling if depositors withdraw cash from Greek banks in ‘a run’. Indeed, I discussed that possibility in a weekly e-mail of 26th February 2010, with the key passage an appendix at the end of this note.) However, it must be remembered that Greece continues to receive large amounts of money – for farming and regional development – from the European Union. It seems to me that Greece will try to keep the euro even when both its government and banks are ‘bust’. I am not saying it will succeed in keeping the euro. I don’t know and I am pretty sure the key policy- makers are just as uncertain as I am. If Greece does keep the euro, there is a high possibility that Greek banks will be unable to repay deposits in full, perhaps for an extended period.