The last few weeks have seen a lifting of the storm clouds that troubled financial markets in January. Critically, monetary policy is being further eased in China and the Eurozone. In China the monetary authorities have sharply raised banks’ credit allocation limits, just as they did in 2009. Meanwhile in the Eurozone the quantity of “quantitative easing” (if you will excuse the expression) has increased by a third, from €60b. a month to €80b. Meanwhile on the other side of the Atlantic the recent pace of broad money growth in the USA has been disappointing. But very low inflation makes it unlikely that the Federal Reserve will touch Fed funds rate again until June. All things considered, banking systems are in reasonable shape and the latest trends in money growth are at worst neutral for this year’s global macroeconomic prospect.
Fears that monetary policy-makers are “running out of ammo” are bunkum. The last few years have seen a clear association between low growth of money and low growth of nominal gross domestic product, confirming the validity of the long-established quantity-theory-of-money propositions on the link between money and national income. As the state can always create new money by borrowing from the banking system and using the proceeds to buy something from the non-bank private sector, monetary policy can never run out of ammo. The world economy will not suffer a recession in 2016, and it would require grotesque policy errors for one to happen in 2017 or 2018. The rebound in the oil price has cheered equity markets, as the better oil price is being viewed as a pointer to demand conditions more generally. But the ultimate determinant of the change in nominal GDP is the quantity of money. Central banks should pay more attention to the money numbers than they do to the movement of one commodity, even if the commodity is as important to the world economy as oil.
Money trends in early 2016 in the main countries/jurisdictions
What are the latest money growth trends in the main countries? And what is the message for global economic activity over the next year or so, and for inflation/deflation over the medium term thereafter? The table below summarizes the key numbers. For detail, it is recommended that the reader looks at the individual country comments below. Beneath the table I make an overall assessment, and later make some comments on recent banking and monetary developments in the Eurozone.
My main comment here is much as in February. As I said there, financial markets were spooked in the opening weeks of 2016 by talk of an imminent and/or probable recession. But two points had to be emphasised,
- no one in central bank or regulatory officialdom, or in top political positions, in the main countries wants a recession in 2016 or even, frankly, a slowdown in growth from the rather meagre levels of the last four/five years, and,
- with inflation at close to zero, and a widespread view that the latest bout of weak commodity prices signals outright deflation, policy-makers have ample scope to pursue expansionary monetary policies.
The concern that policy-makers might “run out of ammo” was baloney. The running-out-of-ammo argument rested on the idea that monetary policy is described – adequately and completely – by “the rate of interest”, where the phrase “the rate of interest” means the money market rate set by the central bank. In the most extreme form of this kind of statement, no attention at all was paid to the quantity of money. But it is a simple matter to assemble evidence which shows that the change in nominal national income and expenditure is much better correlated with the change in the quantity of money than with any interest rate concept. Further, the creation of money by the state is child’s play. All that is necessary is for,
- the government, or an agency of the state such as the central bank or a public sector institution, to borrow from the banking system, and
- to use the loan proceeds to purchase something – anything – from the non-bank private sector.
It should be obvious that, by these means, the state expands the quantity of bank deposits held by non-bank private-sector agents, i.e., the quantity of money, broadly-defined. In other words, policy-makers have the ability to raise nominal national income by any extent they wish, if they adopt sufficiently expansionary monetary policies. The processes at work are so straightforward, and the mechanics of the operations can be so shockingly brazen, that many nations – including Germany and some Latin American republics – have monetary constitutions that try to deter money creation of this kind. For instance, while Germany still had the deutschemark as its national currency, the government was forbidden from borrowing on overdraft from the Bundesbank. However, the constitutional prohibition of money creation by the state is also risky.
The quantity of money expands when banks extend new credit to any agent, whether the agent is private sector, public sector or foreign. In the historical long run the main type of bank credit has been lending to the private sector. Indeed, in the 40 years to 2008 this type of credit was so dominant that, as a share of total assets, banks’ claims on the government (or the public sector as a whole) collapsed. Unfortunately, officialdom reacted to the banking problems of 2007 and early 2008 by radical changes in bank regulations. In theory these changes were to make the banks safer, but in practice the result was also to cause banks to shrink holdings of risk assets of all kinds (securities, loans to the private sector). When banks’ assets shrink, the deposit liabilities that constitute most of the quantity of money must also go down. So the tightening of regulations, particularly the demands for more bank capital, caused a crash in both new bank lending and the rate of broad money growth, and the further consequence was the Great Recession of 2009.
It is in circumstances of this sort that the prohibition on state money creation is so dangerous. When the quantity of money is falling, or any rate liable to fall unless a counter-force is put in place, the monetary authorities need to be free to create new money balances. Let us now look more specifically at the Eurozone. The squeeze on new bank credit to the private sector has continued almost until now, and in 2012, 2013 and 2014 the stock of bank lending to the private sector actually fell. But actions by the ECB and the 15 or so Eurozone governments have in this period contributed to positive money growth. “Quantitative easing” from January last year made the policy of state money creation more formal and deliberate, and it has in fact meant that the positive effect of state action on money growth was higher in the 12 months to January 2016 (at almost €350b.) than in any previous 12-month period. Further, broad money growth in the year to January 2016 was 5.0%. This is a more or less ideal figure for a monetary jurisdiction with a low trend growth rate of output (at most 1 ½% a year), if the authorities in that jurisdiction want to take it out of semi-recession conditions.
In my view it is not at all clear that the ECB needed to do anything more. Draghi’s announcement on 10th March, with its addition of €20b. a month to the earlier €60b.-a-month dosage, may eventually be deemed overkill. Monetary policy is characterized by long and variable lags, and it will take another year or two before the full impact on macroeconomic outcomes is evident. (Eurozone stock markets had a good 2014, as they anticipated the QE announcement, and 2015 did indeed see reasonable demand and output growth in most Eurozone member states.)