This weekly e-mail – which follows the same lines as that sent out on 24th January 2011 – reviews money growth trends in the leading “advanced countries” (i.e., those that belong to the Organization of Economic Cooperation and Development) in order to draw conclusions about 2012’s macroeconomic prospect. The analysis a year ago was cautious to the point of being pessimistic. It argued that banks would continue to restrict bank balance sheet growth, in response to regulatory pressure from – for example – the Basle III rules, and the resulting very low broad money growth would constrain demand and output. That prognosis has been reasonably accurate.
The current exercise is more sanguine. Sure enough, the regulatory attack on the banks is still very much in effect. However, money growth appears to be reviving in the USA despite that attack, while the inflation outlook is much better than in 2011. Moreover, everywhere in the advanced countries short- term interest rates are very low or even at zero. The verdict for this year might be “relaxed to the point of being optimistic”.
The main worry remains the dysfunctional character of the strange multi- government monetary union that is the Eurozone. In 2011 the large and widening divergences between Eurozone governments’ bond yields partly reflected banks’ difficulties in borrowing from the international inter-bank market and hence their inability to retain all their assets (i.e., including the supposedly very safe government bonds). In his first major policy decision Mario Draghi, the ECB’s third president, dealt with this problem by extending cheap three-year loans to Eurozone banks. When push comes to shove, even the ECB realized that action had to be taken to mitigate the recession risks that arose from the banking system’s problems.
The current global pattern of money and banking
Every few months it is important to bring together in one place data on different countries’ money trends. The current cycle – like all those before it – confirms the centrality to macroeconomic instability of bank balance sheet patterns and, hence, changes in the quantity of money. I provided “a global money round-up” in my weekly e-mail of 24th January, 2011, and the current e-mail is on much the same lines.
My emphasis last year was on the adverse impact of the Basle III regulations on the growth of bank balance sheets, since banks were – and still are – being required much higher capital relative to the risks in their loan portfolios than has traditionally been the case. In my view, the inevitable consequence of the misguided regulatory push was that – in the absence of some countervailing force – banks would stop growing and the quantity of money would stagnate. By implication, 2011 would prove a disappointing year for world economic activity. To quote from last year’s exercise, “The uncritical endorsement of Basle III governments, commentators and so on in recent weeks suggests that nothing has been learned. The key panjandrums in the leading central banks, finance ministries and regulatory agencies do not see the connections
- between their efforts ‘to make banks safe’ and the sluggishness of broad money, and then
- between the sluggishness of broad money and the disappointing employment outcomes.
The message has therefore to be that the implementation of Basle III implies that 2011 will be another mediocre year, in terms of demand, output and employment, for the BIS member countries.” That has proved a pretty good prognosis, although I did not emphasize enough that the intensification of the Eurozone sovereign debt crisis would reinforce the general malaise of demand weakness.
Another problem a year ago was that the main economies were clearly being hit by unfavourable trends in commodity prices, including energy prices. These trends were then aggravated by the “Arab spring”, which led to the ending of Libyan oil production for some months. Happily, the outlook for inflation today is markedly better. Oil prices remain elevated, partly on fears that supplies through the Straits of Hormuz will be disrupted. However, natural gas prices have fallen back in recent quarters and, increasingly, it is the price of gas rather than of oil that matters to macroeconomic conditions. In this note I argue that the combination of positive money growth – even if at a low rate – and falling inflation signal a better macroeconomic prospect for 2012. In the USA banks seem once again to be adding to their loan portfolios, so that a self-sustaining cycle of credit generation, monetary acceleration, asset price revival and so on can be envisaged; in the Eurozone the massive loan facilities that Draghi has mobilized for the banks have eased the sovereign debt crisis and also hint that key policy-makers will “print” rather than preside over another deep recession; the UK has suffered from a particularly harsh attack on the banking system, but the Bank of England seems more trigger-happy on “quantitative easing” than any other central bank. (I am not sure what to say about the Bank of Japan.)
I am particularly positive on the USA. The Federal Reserve publishes data on banks’ loan write-off rates (i.e., the %age of the total loan portfolio that has been written off as unrecoverable). The level of loan write-offs remains very high, but the rate of decline in the write-off rate at present is much better than at the same stage in the early 1990s. With Fed funds rate at zero, borrowers are finding their debts manageable. I would not be surprised if Fed funds rate edges up somewhat in the second half of 2012, perhaps to the 1% – 2% area.
One of the most important – and most difficult – debates in monetary economics arises over the various measures of money. Friedman argued that sharp changes in the rate of money growth tend to precede movements in output with quite a short lag (of six or nine months, or so), whereas the impact on inflation takes more time, and is subject to “long and variable lags”. But which aggregate is most useful and reliable in generalizations of the kind that Friedman was making? And which aggregate therefore should be the focus for analysts who are trying to comment on and predict macroeconomic trends? Some economists favour so-called “narrow money” (i.e., notes and coin in the hands of the public, plus sight deposits [or “current accounts”, in the UK context]) and in the last 30 years or so it has even become fashionable in some circles to see the monetary base by itself (i.e., the liabilities of the central bank) as the key money aggregate.
On the other hand, others emphasize that “broad money” (i.e., narrow money, plus time deposits [“deposit accounts” in the UK] and wholesale balances), partly on the grounds that time deposits and wholesale money are vital to agents’ portfolio decisions. I discussed this “battle of the aggregates” in essays 16 and 17 of my recent Money in a Free Society, and I have covered the topic in much other work over the years. My strong preference is for a broadly-defined money measure in macroeconomic analysis and forecasting. It is worth saying here that – although Friedman’s allegiances to the various aggregates were far from constant – his favourite tended to be the broad measure, M2, which includes time deposits. (Indeed, in their celebrated work A Monetary History of the USA, 1867 – 1960 Friedman and Anna Schwartz said explicitly that they found an aggregate inclusive of time deposits worked better than one without such deposits.)
The two charts on US money trends illustrate the importance of this debate. The M2 measure had a wild surge in late 2008 and early 2009, seemingly implying a buoyant 2009! In fact, the surge in M2 was largely the result of shifts of balances between money holdings in M3, but not in M2. Such “money transfers” have no necessary significance for expenditure, as I explained on pp. 354 – 60 of Money in a Free Society. Indeed, M2 gave little warning of either the boom in 2006 and 2007, or the slump in 2008 and 2009. By contrast, annual M3 growth climbed to the mid-teens in 2007 and mid-2008, and then crashed. Recent experience justifies an analytical focus on M3.
The latest M3 numbers have a satisfactory message for the macroeconomic outlook. Because of regulatory pressures banks were still shrinking risk assets in early 2011. “QE2” was necessary to prevent this shrinkage causing a reduction in broad money, and it did have the desired effect. Further, it must be emphasized that short-term interest rates are virtually zero, which is of course very helpful for growth of demand and output. Signs are starting to emerge that US banks are expanding their loan portfolios again, as well as purchasing asset-backed securities. Leading indicator indices for the US economy are fine at present, with a definite point upwards. If a zero Fed funds rate is held throughout 2012, there is a good chance that the second half of 2012 will enjoy above-trend growth. The current cycle has confirmed the centrality of the banking system and money growth to the behaviour of key economic agents. A heartening current trend is that write-off rates on banks’ loans are falling sharply. A common feature of most recoveries is that loan write-offs become loan-write-backs, as asset prices return to earlier levels. Will American banks and their regulators continue to view as strictly necessary the elevated capital/asset ratios mandated by the Basle III rules? Probably not. But the relaxation of the capital rules might eventually be followed by too fast growth of bank balance sheets and rising inflation. Bond investors, please note.
Last year was the most testing so far for the European single currency. Although the euro has now been in existence for over a decade, the attempt to provide a single money for a large number of sovereign governments remains a remarkable experiment. Fears of the exit of one or more of the member states caused different governments’ bond yields to diverge dramatically. Banks might have been expected to purchase short-dated high-yield government bonds on a speculative basis, but until the closing weeks of the year they suffered from severe strains in funding their assets. The answer came with the decision by the newly-appointed president of the ECB, Mario Draghi, to extend apparently unlimited three-year lending facilities (at a mere 1% interest cost) to Eurozone banks. Between 21st October 2011 and 23rd December 2012 the ECB’s lending to the Eurozone banks soared by almost 300b. euros, from 585.2b. euros to 879.1b. euros. There had been a precedent for this in October/November 2008 when, in the context of the severe financial uncertainties at that time, equally large and generous facilities (known as “the non-standard measures”) were offered to Eurozone banks. These were withdrawn in 2010, apparently because the then ECB chief economist (Jurgen Stark) was worried about their potential inflationary consequences. Forecasts of improving inflation in 2012 seem to have led to a rethink and Draghi has, in effect, restored the non-standard measures. Although further expansion of ECB lending to commercial banks may prove controversial (not least because these low-cost funds have major effects on bank competitiveness), the message must be that – one way or another – the Eurozone authorities will “print money” rather than allow another recession.
2011 was a difficult year for Japan, not just because its export industries struggled with an over- valued yen, but also because of the Tohoku earthquake in March, and the subsequent Fukushima nuclear disaster. The Bank of Japan made emergency liquidity facilities available to Japan’s banks after the earthquake, but – from a wider monetary standpoint – both the earthquake and the nuclear disaster were non-events. Broad money growth in Japan has been negligible for over a decade and it remained negligible in 2011. With Japan participating fully in the Basle III exercise, continued semi- stagnation of bank balance sheets and broad money seems likely in 2012.
As I explained a year ago, “The population is age-ing and many households are repaying mortgage debt. As banks’ assets shrink, so too must their deposit liabilities.” Banks might expand by increasing their claims on government, but – again as I explained a year ago – the Japanese authorities appear not to understand that the argument for “quantitative easing” is an argument for the expansion of a broadly-defined money measure (not the monetary base), to be sought by the more astute management of public debt. An upturn in broad money growth might nevertheless occur if heavy foreign exchange intervention to prevent (or even reverse) the yen’s appreciation were not sterilized by offsetting domestic open market operations. The Bank of Japan has been intervening by selling yen at an exchange rate of about 77 to the dollar, but it does not borrow the yen (i.e., the yen that it sells) from the banks, which would result in the desired expansionary monetary effect.
In 2011 UK banks continued to shrink their risk assets, dominated by loans to the private sector, as they responded to the regulatory pressures from the Basle III rules and anticipated the gold-plating of these rules in the Vickers Commission report. (UK officialdom – led by Mervyn King at the Bank of England – believes that it is in the national interest for banks to have extremely high capital/asset ratios both by past standards. Weirdly, King also wants banks to expand their lending to the private sector.) In the 12 months to November 2011 UK banks’ lending to genuine non-banks (i.e., excluding the awkward category “intermediate other financial corporations”) dropped by almost £15b. Although the massive capital-raising of 2009 and 2010 appears to be over, the quantity of money – as measured by the M4x aggregate – stagnated for most of 2011. (Note that – when a bank issues new equity or bond capital – money is usually destroyed, because the investor pays for the equities or bonds by using the balance in his deposit. The deposit falls and the quantity of money in the economy drops.)
Disappointingly high inflation discouraged the Bank of England from embarking on stimulatory monetary policy actions until early October, when another round of “quantitative easing” (of £75b.) was announced. The positive impact of these asset purchases on M4 growth was clear in the October and November money supply data, and over the last three months the annualised rate of M4x growth has been positive at almost 5%. Inflation will fall in 2012, while policy-makers seem determined to sustain positive money growth with QE operations. The UK macroeconomic outlook is satisfactory, with demand growth likely to run at about a trend rate of 2% a year quarter by quarter.
The overall verdict is that 2012 should be a better year for the world economy than 2011. Caveats have to be expressed about China and India (which do not belong to the OECD, and therefore have not had their money trends reviewed here), the possibility that the trend rate of output growth has been damaged (especially in the UK, with its large international financial sector) by the attack on the banks, and the longer-term ramifications of the latest shifts in global energy supply and demand. But discussion of these topics would take us too far from the immediate issues raised by this note.Tags: Bank of England, Central bank, Economic growth, European Central Bank, Federal funds rate, Federal Reserve System, Great Recession, Janet Yellen, Mark Carney, United States