How has QE2 affected US money growth trends?

Posted by Tim Congdon in News Archive | 0 comments

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.)

  1. The rationale for monetarism

Why do Thatcher’s acolytes make all this fuss about turning and not-turning? The answer is to be found in the awkward and unhappy Conservative government of 1970 to 1974, under the premiership of Edward Heath. In the 1960s and 1970s Britain suffered from ever-rising inflation, which was widely seen as public enemy number one. Two types of policy response were proposed. They were very different in substance and almost antithetical in their underlying political-philosophical premises, while the debate between them was bitter and polarized. The first was for the state to interfere in the setting of individual prices and wages by means of ‘prices and incomes policy’. This had been the approach for much of the 1960s, with the Labour government of 1964 to 1970 ensuring that the policy had statutory backing.

The second antidote to inflation was control of the money supply, in the belief that – to recall Milton Friedman’s  much-quoted  line  –  ‘inflation  is  always  and  everywhere  a  monetary  phenomenon’. Whereas price and incomes policies encroached on the freedom of individuals and their businesses, monetary control of inflation allowed supply and demand to work unimpeded by the state. Monetary control of inflation therefore fitted comfortably in a wider agenda of freedom. In its opening stages the Heath government was interpreted as having a programme to curb the state’s role in the economy, as one of its earliest acts was to scrap the preceding government’s prices and incomes policy.

However, by the summer of 1972 Heath was alarmed by the simultaneous persistence of both high unemployment and high inflation. He decided to re-introduce a statutory prices and incomes policy. By passing legislation for ‘a Counter-Inflation Programme’ in October 1972, and by negotiating with trade union leaders over its terms, Heath had rejected the free-market approach. It was a radical policy U-turn. Further, in early 1973 Heath and his ministers, notably his Chancellor of the Exchequer, Anthony Barber, dismissed warnings from several commentators that money supply growth was too high. These commentators – who included Professor Alan Walters – thought that excessive money supply growth would result in rising inflation, no matter the rigour of the prices and incomes policy.

The sequel to the U-turn was a disaster. The economy boomed in late 1972 and early 1973, but boom turned to bust in late 1973. The Counter-Inflation Programme was smashed by the coalminer’s strike in 1974 and Heath’s government narrowly lost the first of two general elections that year. Inflation accelerated, with the peak annual increase in the retail price index coming in August 1975 at almost 27 per cent. This was similar to the peak rate of growth of the M3, the broadly-defined money measure which was then the principal aggregate mentioned in public debate. The highest annual growth rate of M3 had been recorded in the final quarters of 1973 at over 28 per cent. The similarity of the changes in the price level and the quantity of money was striking, and seemed to give empirical support to the monetary explanation of inflation. The failure of the U-turn had a bracing effect on thinking in the Conservative Party. In February 1975 Thatcher, who had mentioned the virtues of money supply control in a 1968 speech to the Conservative Political Centre, replaced Heath as party leader.  In  the  late  1970s  the  Conservatives  in  opposition  committed  themselves  to  a  so-called ‘monetarist’ programme. They would combat inflation not by an administered prices and incomes policy with its blatant interference in the free market, but by reducing the rate of money supply growth. Ideally, this reduction in money growth would be engineered in a wider context of economic liberalization. Unlike Heath, they would not be deflected from this course. The repudiation of the ‘U-turn’ was therefore fundamental to Thatcher’s understanding of her task when the Conservatives were elected to government in 1979. Thatcher would stick to monetary restraint, come hell or high water, and indeed come Arthur Scargill or Mick McGahey. (Arthur Scargill and Mick McGahey were two Communist leaders of the National Union of Mineworkers, and were openly committed to the overthrow of the free-market capitalist system.)

130502 Table1

2. The abandonment of the monetarist agenda

Unfortunately, she inherited an economy in which inflationary expectations were deeply entrenched and recent growth rates of the money supply had been disturbingly high. Interest rates were raised steeply to discourage the extension of bank credit and the creation of new money balances. In 1980 a medium-term financial strategy was announced, with commitments to lower both the budget deficit and the rate of money supply growth. Money supply growth was to be curbed gradually, until it was consistent with price stability (or at any rate modest inflation), and then kept there.

But that is not what happened. Sure enough, between 1979 and 1985 steps were taken in a reasonably systematic and organized way to reduce the rate of money supply growth. Monetary restraint was largely responsible for the severe recession of 1980 and early 1981, and even after the recession ended the monetarist road to sound money encountered several unexpected roadblocks, diversions and cul- de-sacs. Nevertheless, by the mid-1980s the programme was working. Britain had curbed inflation in line with the original thinking, and had done so while also ending exchange controls and liberalizing the financial sector. Meanwhile the annual growth rate of the broadly-defined quantity of money had fallen to about 10 per cent, well beneath the typical figure in the 1970s.

130502 Table2 QE2

If it ain’t broke, don’t fix it. But in late 1985 Nigel Lawson, the Chancellor of the Exchequer and one of Thatcher’s closest colleagues, decided to end the broad money target and the accompanying machinery of monetary control. With banks still responding to the newly-deregulated environment, over the next four years they expanded their assets rapidly in order to increase profits. Fast growth of profit-earning assets on one side of their balance sheets meant similarly fast growth of their deposit liabilities, which are the main constituent of broad money. The rates of money growth seen in the Lawson boom of 1986 – 89 were not quite as high as in the Heath-Barber boom of the early 1970s, but they were plainly a marked acceleration from the early 1980s. (See the chart above.)

The sequel to the Lawson boom was not quite as ghastly as that to the Heath-Barber boom, but it was still appalling. Whereas inflation had been brought down to 5 per cent a year in the mid-1980s, in 1990 it again exceeded 10 per cent. When Thatcher became prime minister in May 1979, the latest increase in the retail price index (for the year to April) was 10.1 per cent; when she was removed by office in November 1990, the latest increase in the retail price index (for the year to October) was 10.9 per cent. The figure for the year to November 1990 was better, at 9.7 per cent, but it cannot be escaped that double-digit inflation was again experienced after a decade in which Thatcher had been prime minister continuously. Another gruesome recession was needed to wring inflation expectations out of the economy, and that recession was to be accompanied by sharp falls in house prices and thousands of small business bankruptcies.

Inflation was therefore higher when Thatcher left No. 10 Downing Street than when she entered it. Perhaps even worse, at the time of her resignation base rate was 14 per cent, implying a phase of high interest rates that was about to devastate many British businesses and to alienate millions of Conservative voters. Further, the main cause of these disappointments was a sharp acceleration in the rate of money supply growth, even though an acceleration of this sort was supposed to have been made unthinkable by the monetarist principles espoused by top Conservatives in the late 1970s and early 1980s, and by explicit commitments in the medium-term financial strategy of 1980.

The evidence of the money supply numbers is clear-cut. Instead of money supply growth falling steadily and stabilizing at a moderate rate, money supply growth went down rather erratically and then surged upwards. M3 rose by just over 13 per cent in the year to the end of 1985, but by almost 23 per cent in the year to the end of 1987. (The numbers are less extreme on the M4 money measure, which became the dominant one after the Bank of England stopped publishing M3 figures in the early 1990s. M4 is the aggregate displayed in the chart at the end.) To summarize, a shocking U-turn in monetary policy took place in the mid-1980s, with results that were every bit as disastrous as those that had followed Heath’s U-turn in October 1972.

3. The U-turn on monetary control and after

Given all the sound and fury about ‘no turning back’, what had gone wrong? In her memoirs Thatcher discussed the many debates on monetary policy during her premiership and even mentioned the difficulties in monetary control that led to the dropping of M3 as the government’s monetary pilot. One sentence noted that ‘[s]ome analysts – notably the perceptive Tim Congdon – would argue that the rise in £M3 now and later did cause later problems.’ But she then endorsed the views of her advisory group, who had come to regard broad money as misleading or irrelevant, and preferred the M0 money measure. She concluded the key paragraph as follows, ‘Certainly, I do not believe that monetary policy in 1985 – or 1986 – was the main cause of the problems we were later to face.’

That begs an obvious question. If high money growth was not the cause of ‘the problems’ – meaning of course the problems due to rising inflation – that ‘we were later to face’, what was the cause of those problems? Bluntly, none of Thatcher’s subsequent remarks in her chapter on these matters (chapter XXIV ‘Floaters and fixers’ in the second volume of her memoirs, on The Downing Street Years) provide a meaningful or worthwhile analysis. The rise in inflation in the late 1980s is not explained in monetary terms or, indeed, in any organized theoretical terms whatsoever. Instead most of chapter XXIV of The Downing Street Years is concerned with a personnel problem, her growing tensions with Nigel Lawson. At the end of the Thatcher premiership Lawson (and practically all the official machine in the Treasury and the Foreign Office) favoured entry into the European exchange rate mechanism as an effective system of inflation control, whereas she (supported by her personal economic adviser, Alan Walters) opposed it.

The central puzzle about monetary policy in the Thatcher premiership is indeed the role of Nigel Lawson. It is clear from his memoirs, The View from No. 11, that Lawson grew disillusioned with broad money targeting at an early stage, probably in 1980 and certainly by 1982 or 1983. It is even plausible that his aversion to money targeting was a constant throughout the period, because he had in the late 1970s advocated ERM membership in articles in The Financial Weekly. On 15 June 1981 he wrote a long note to Geoffrey Howe, arguing that ‘we should take advantage of our forthcoming presidency [of the European Union] to join the European Monetary System’. From that time on he and Howe worked together to push EMS/ERM membership. They did not care in 1985 or 1986 about the possible inflationary effects of abandoning control of the quantity of money, because – quite simply – they had at that point ceased to believe in a monetary theory of inflation. (And one has to wonder if they had in fact ever believed in or understood that theory.)

At any rate, in late 1985 the Thatcher government committed a U-turn in macroeconomic policy every bit as drastic as Heath’s in autumn 1972. The later results of both U-turns were increases in the rate of money supply growth, a boom and rising inflation, which had to be countered by high interest rates, a bust  and  a  bad  recession.  Thatcher  herself  became  deeply  suspicious  of  Lawson’s  attitude  and conduct. She was right. Although the lady may not have wanted to turn, her Chancellor of the Exchequer was intent on policy gymnastics, and embarked on a conspicuous and foolish pirouette. Macroeconomic policy in the Thatcher premiership was spoiled by bad errors of judgement and avoidable  mistakes.  The  Lawson  boom  and  the  subsequent  bust  wrecked  the  Conservatives’ reputation for economic management for a generation; the boom-bust cycle also validated, once again, the monetary theory of inflation and the case for a monetarist programme of inflation restraint.

In one sense Lawson triumphed. Britain did join the ERM in October 1990, just as he had been planning for several years. But the fixed-exchange-rate regime meant that interest rates were inappropriate for the UK’s own economy. Sterling was kicked out of the ERM in September 1992, partly because of a speculative attack orchestrated by the celebrated hedge-fund manager, George Soros. Ironically, the British banking system and its customers took such a battering in the recession associated with two years of ERM membership that for much of the 1990s banks were reluctant, or even unable, to expand their balance sheets quickly. (As today, they did not have enough capital to take on new risk assets.) Broad money growth was therefore lower and more stable than in the 1980s. (See the chart below.) Macroeconomic outcomes for the 15 years of the so-called ‘Great Moderation’ were remarkably good. But the benign numbers came after Thatcher’s downfall and owed little, if anything, to her policy thinking. In the Great Moderation low and fairly stable money growth was accompanied by low inflation and steady output  expansion, just  as the monetarists  would  have expected. But the achievement was as much due to serendipity as to official deliberation and forethought, and cannot be credited to Thatcher or the leading ministers in her government.


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