Comments on UK monetary policy and its global context

Posted by Tim Congdon in Article Archive | 0 comments

The following note – or rather set of notelets – is heavily based on my latest submission to the Shadow Monetary Policy Committee, a body set up by the Institute of Economic Affairs in July 1997. In my comments on the UK, I argue that recent monetary trends argue for the validity of the monetary theory of national income determination. Hence, they do not justify alarmism about the inflation outlook, although it is true that the supply-side performance of the UK economy has been poor in recent years. This has been a key reason that low growth of national output in nominal terms has been accompanied by disappointing inflation numbers.

I also discuss output growth trends at the world level, to see whether similar concerns about supply-side performance apply more generally. The results came as a bit of a surprise. Of course it is well-known that growth was strong in the global boom of 2004 – 07. In fact, the global boom of 2004 – 07 was the most powerful since that of the early 1970s, which also had to be aborted as rising commodity prices were accompanied by a more general inflation problem. 2009 was the first year since the Second World War in which world output fell. However, the last decade has in fact been an outstanding one for growth. Despite the 2009 dip, the ten years to 2012 saw an average annual growth rate of output of 3.8%. That is a fantastic rate of growth by any past standards. (A 3.8% annual rise in real incomes would imply an almost 14-fold rise in a lifetime of 70 years.)

‘Money still matters’: money trends in the Great Recession and after

The last five years have been the most difficult for the British economy since at least the 1970s and perhaps since the Second World War.  The disappointments on both output and inflation have been severe, and were more or less completely unexpected in 2007. (So much for the notion that agents’ expectations determine macroeconomic outcomes, despite all the pretensions of the ‘rational expectations’ school and its New Keynesian associates like Michael Woodford.) It is therefore worth emphasizing that the data of the period are again consistent with the monetary theory of national income determination. A salient fact is that in the five years from mid-2007 to the third quarter of 2012 (i.e., the period of crisis and recession, and I am taking it that we are still in that period, which may be wrong) the growth rates of M4x (a compound annual rate of increase of 2.4%) and nominal GDP  (2.1%)  have  been  extremely close.  Despite  the  turmoil  of  events  and the  vagaries of  the commentariat in discussing them, the latest five-year period has seen both the lowest rate of increase in the quantity of money and the lowest rate of increase in nominal GDP since the 1950s. Moreover, as the following chart shows, in the most pronounced period of downturn (i.e., from autumn 2007 to mid-2009), the parallelism of the changes in money and nominal GDP is striking. Also money had a short lead over nominal GDP, just as Milton Friedman would have envisaged. The Great Recession in the UK, like the Great Depression in the USA, is to be interpreted – above all – as a monetary phenomenon. (Admittedly, the quarter-by-quarter parallelism breaks down from late 2009, although I would insist that the medium-term similarity of the rates of change remains.)Money and nominal GDP in the UK in the last major downturn

I emphasize the continuing validity of the monetary theory of national income determination not just in order to restate an essential truth in economics, but also to criticize two of the commentariat’s latest fads. The first fashion is to claim that ‘the effectiveness of “quantitative easing” is subject to diminishing returns’. On this line of thinking, the Bank of England – like similarly-challenged (or supposedly-challenged)  central  banks  –  will  have  to  find  some  new  method  of  conducting expansionary monetary policy. (‘Quantitative easing’ is of course the conduct of expansionary open market operations by the central bank and/or the government in order to increase the quantity of money.) The ‘diminishing returns’ claim has been made, for example, by Professor Charles Goodhart of the London School of Economics and Jeremy Warner of The Daily Telegraph. It is bunkum. The state can always create money balances, simply by making larger payments to the non-bank private sector than the non-bank private sector is making to it, while the effect of a 1% (or 5% or 50%) increase in the quantity of money is to raise – roughly speaking – the equilibrium level of national income also by 1% (or 5% or 50%). (Yes, I know that the phrase ‘roughly speaking’ raises lots of questions. I also know that the kind of people who make a fuss about these questions routinely underestimate, or even overlook entirely, the force of the central proposition being advanced.)

So inflation alarmism looks misplaced

Secondly, at various points in the last few years concern has been expressed about the risk of high and rising future inflation. Inflation has indeed been disappointingly high in the immediate sequel to the Great Recession, as was earlier noticed, and the official inflation target has been exceeded by more than 1% (of the price index) for much of the five years since 2007. However, to characterize the UK as in the grip of a runaway inflationary process, like that in the 1970s, would be absurd. Also as earlier noticed, the increase in nominal GDP since 2007 has been lower than in any other quinquennium for 60 years, if not longer. The setbacks on inflation should be seen as the consequence of

  1. the big 2008 devaluation (which had a lagged effect on inflation, as the relative price of tradeables and non-tradeables reverts over several quarters to its long-run equilibrium, as well as the immediate and more well-known effect due to the rise in the sterling price of imported goods) and
  2. the economy’s  poor  supply-side  performance  (i.,  because  the  short-term  trade-off between growth and inflation has been much worse recently than in the 25 years to 2007, because of such influences as the depletion of North Sea oil and gas, the over-expansion of public expenditure, the rising burden of regulations, and so on).

(I would in turn explain the 2008 devaluation as partly attributable to unduly high broad money growth in the 2004 – 07 period, although I accept that causality is difficult to establish.)

The point here is that alarmism about inflation is justified only if the trend rate of money growth is changing. The latest data do in fact show an upturn in the growth rate of M4x. In the six months to September M4x rose at an annualized rate of 6.1%. Given that the low return on money balances is compatible with a fall in the ratio of money to income/expenditure, that rate of money growth ought to be consistent with – say – at least a 5% increase in nominal GDP. However, it does not seem to me that inflation is ‘out of control’ or anywhere near ‘out of control’. The recent upward blip in money growth can be ascribed to the resumption of QE operations, for which the argument was (in my view) far less than clear-cut than in early 2009. The QE operations should be paused, at least for a few months until there is greater visibility in the money growth outlook. One possibility should be welcomed, that the UK banking system is now able – at last – to resume steady growth ‘under its own steam’. (By that I mean that banks can respond to their customers’ credit needs by expanding their balance sheets, in the way that was seen as normal before the regulatory excesses of the Great Recession. To reiterate, the QE operations should be paused because they are working to raise money growth and so to strengthen demand, when it is not obvious that official efforts to boost money growth are still needed. The case for pausing has nothing to do with the alleged ineffectiveness of QE operations.)

GDP data subject to large revisions: mid-year ‘recession’ talk overdone

Before I close, I want to make a couple of rather miscellaneous comments. The first is that the numerous media stories about ‘the UK slipping back into recession’, which appeared in the middle of 2012, were misleading. Admittedly, they were based on official statistics (of GDP, retail sales and so on), but the UK’s GDP statistics are not reliable in short-run macro analysis. Far better in understanding the latest trends are business survey information and employment numbers, and these have indicated an economy growing at about its trend rate (or even perhaps a little above it) in recent quarters. The trend growth rate is maybe only 1% – 1½% a year, but in that context growth of a mere 1½%  –  2%  is  above-trend  and  we  should  be  grateful  for  it!  It  cannot  be  overlooked  that unemployment has been falling throughout 2012. To illustrate the unreliability of the official GDP figures, I would like to contrast the view contained in the late-2008 GDP data (to be exact, in the October 2008 issue of the Office for National Statistics’ publication Economic & Labour Market Review) about the six years to 2007 to the view in the latest exactly comparable data. The variable under consideration in the accompanying table is the annual growth rate of GDP at market prices, in both current-price volume terms, on a quarterly basis. This is one of the most bread-and-butter concepts in macroeconomic discussion, with the latest official number all too often viewed as gospel.Officialdom's changing views of 'the truth'

The table shows that, on average, the original estimates underestimated growth in nominal terms by just under 0.2% a year and in real terms by over 0.4% a year. Can we be confident that similar errors do not affect the data from the end of 2007? If 0.44% were added to the annual growth rates in GDP for every quarter in the last three years, the ‘recovery’ would look appreciably more like a ‘normal’ cyclical recovery than the official figures – as they currently stand – suggest. Concern about the sluggishness of the recovery, and anxiety about ‘the need for the government “to do something”’, would also be articulated less often.

Do UK companies face a hostile world economic environment?

The second of the miscellaneous comments relates to the world economy and, hence, to the international environment for British exports and for British companies with a high ratio of foreign to domestic earnings. Too much attention in this country is paid to the Eurozone and in fact to Europe as a whole. Sure enough, the various dysfunctional features of the single currency area are now glaringly on display. They have caused a major economic and social disaster in our neighbours, and seem likely to continue to do so for a few years yet to come. Members of the European Union also have to cope with the damage to enterprise being done by the over-regulatory and burdensome acquis communautaire. That is bad news for us and will hold back our own economy to a degree. However, the Eurozone now accounts for only a sixth of world output and its share is falling rapidly. If the rest of the world economy (i.e., the nations that – without us and the Eurozone – constitute over 80% of world output, with their share rising over time)  is considered, the underlying forces making for economic growth remain very powerful.The world economy in the last 30 years

The chart above is of the world economy’s growth rate since 1980, using the International Monetary Fund’s data. Four points deserve emphasis. The first is that the global boom of 2004 – 07 was the biggest since that of the early 1970s. This is clear from inspection of the area in the chart above the average line in those years, which occupies a larger space than the other booms (or ‘mini-booms’) of the period, such as the Reagan boom of the mid-1980s and the boom of 1998 -99. The scale of the mid-noughties’ boom may come as a surprise from a European perspective, because those years did not have a big-boom feel in most of the EU member states. But, to repeat, the EU is a declining economic power and has ceased to be representative of the world as a whole. (And, of course, big booms were under way in, for example, Ireland and Greece in the mid-noughties, and these now look like hubris before nemesis.) Given the world economy’s gluttony in the boom of the mid-noughties, it is hardly surprising that some indigestion has followed. The indigestion took the form of housing market collapses in the USA and several European nations, but the dominant problem was that by 2008  sharp  rises  in  commodity  prices  contributed  to  a  widespread  upsurge  in  inflation.  The commodity price rises reflected emerging long-run scarcities, particularly of ‘hard commodities’ and energy resources, including oil. (At a deeper level the inflation was caused by excessive growth in the quantity  of  money,  while  the  commodity  price  gains  should  be  seen  as  a  relative  price  shift determined by the world economy’s underlying supply-side characteristics.)

The second is that, although the Great Recession has been a major setback and will leave its scars on the economies of several nations for many years, it would be premature to suggest that the trend rate of world economic growth is decelerating. The table below shows the average rate of world output growth in recent decades. Yes, the last decade did see in 2009 the first year since the Second World War with an actual fall in world output. Nevertheless, the average rate of growth of world output in the decade to 2012 was 3.8%, well above that in the decades of the 1980s and 1990s. Numerous authorities  have  interpreted  the  Great  Recession  as  a  sign  of  the  inadequacies  of  free-market capitalism, but – if the growth numbers are taken as an arbiter of the performance of economic systems – free-market capitalism has been doing fine.World economic growth in recent decades

Thirdly, the commodity-price gains of the 2004 – 08 period, and the persistence of rather high commodity prices subsequently, argue that growth is hitting a fundamental constraint, namely the inability of the earth (which is of course finite) to produce ever-rising amounts of certain substances that have been basic to economic progress since the Industrial Revolution. At the bottom of the table I have shown what would happen to world output over periods of a few decades if an annual growth rate of 3½% continued. After 20 years world output would climb by 1.8 times and after 50 years by almost 4½ times. Despite the shale gas and shale oil revolutions, there is a widely-held view that the world could not produce three or four times the present level of hydrocarbons for any length of time before depleting all the resources that are worth extracting, at current prices and with current technologies. Of course, technologies will change, but the persistence of high commodity prices in the Great Recession hints that the relative price of commodities is now on a long-run, cross-cyclical upward trend.

Finally, the UK’s ‘income from overseas’ has become a hugely important source of international credits in the last few decades. Practically all of it comes back to the UK via companies, although ultimately being very important to UK personal incomes, living standards and consumption. The growth of ‘income from overseas’ will depend on wider trends in the world economy, including cyclical fluctuations around the 3% – 3 ½% annual average which still seems a plausible trend figure over the next decade or two. The behaviour of UK companies’ international income will matter enormously to the investment records of UK savings institutions and individuals, perhaps even more than it has in the past. (See the weekly e-mail of 19th  October on ‘End of UK external payments miracle’, for further discussion of the UK’s international investment income position.)

Conclusion: the need for low and stable growth of the quantity of money

The purpose of the last section was to argue that, whatever the stresses and strains of the last few years, and whatever the economic challenges faced at home in the UK and its European neighbours, the medium-term world economic outlook remains very favourable for British companies. What about the more immediate prospect over the next few quarters? Chinese monetary policy is being eased, as the tightening of 2010 and 2011 has successfully curbed inflation. Meanwhile the USA seems likely to enjoy in 2013 and 2014 a relatively standard cyclical recovery. Its banking system has absorbed most of the losses of the sub-prime mortgage debacle and is now well-capitalized by past standards. The hullabaloo about the USA’s ‘fiscal cliff’ is reminiscent of that which attended the UK’s 1981 Budget, with the silly letter of protest from 364 economists. It is entirely misplaced, as the return to a positive rate of broad money growth in the last few quarter and virtually zero short-term interest rates imply a rather good year for US economic activity in 2013.

As far as the UK’s monetary policy dials are concerned, my view is that there is no hurry to move to a higher level of short-term interest rates for the present, although I find it possible I will be advocating a rise in interest rates in 2013. The overriding objective should be stable growth of the quantity of money at a low non-inflationary rate. As mentioned above, with broad money growth quite strong in recent months, QE should now be paused. However, the pausing of QE does not mean that debt management policy is unimportant or that it has ceased to be effective as an instrument of macroeconomic policy. The ‘monetary authorities’ (i.e., the Bank of England, the Treasury and the Debt Management Office as a Treasury agency) need at all times to coordinate the management of the public debt, so that the state’s transactions in public debt help in maintaining a low and stable rate of money growth.

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