Is QE losing its effectiveness?

Posted by Tim Congdon in News Archive | 0 comments

What does companies’ monetary behaviour tell us?

QE is widely said to ‘have lost its effectiveness’. As I explained in my weekly e- mail note of 23rd November, QE is to be understood as ‘deliberate action by the state to increase the quantity of money’, while the claim that it is ineffective (or less  effective)  is  equivalent  to  the  claim  that  increases  in  the  quantity  of money have no effect (or a diminishing effect) on the equilibrium level of national  income’.  In  my  23rd   November  note  I  reviewed  the  relationship between changes in the aggregate quantity of money (as measured by M4x) and changes in the UK’s national income over the last 15 years. A key fact emerged, that the increases in both the quantity of money and of national income had been lower in the last five years than for many decades. The vital word is ‘both’. Money and national income have moved together, bang in line with basic theory. On this basis claims of QE’s ineffectiveness are bunkum.

This week’s exercise is somewhat different. All agents have a desired level of money holdings (relative to income and the attractiveness of money in comparison with non-money assets), and national income and wealth are at their equilibrium levels only when agents’ actual money holdings are equal to this desired level (i.e., in jargon, ‘when monetary equilibrium prevails’). But in the real world agents’ actual money holdings often differ from the desired levels, and transactions (indeed many rounds of transactions) are undertaken in order to move closer to equilibrium. The value  of  transactions  in bank settlement systems – which nowadays is typically 50 times gross domestic product – includes transactions in capital assets. The main kinds of agent involved in these transactions include households, companies and financial institutions. The focus here is on the monetary behaviour of companies. I show  that  the  ratio  of  money  holdings  to  bank  borrowings  of  British companies today is much the same today as it was 50 years ago, and that corporate monetary behaviour in the recent cycle has been much the same as in other cycles. To repeat, the notion of QE’s ineffectiveness is bunkum.

The monetary theory of national income determination: a brief statement

The 23rd November note included a few sentences on the monetary theory of national income determination. As explained there, agents are understood to have a demand to hold money balances, just as they have a demand for the services of other assets (such as those provided by the housing stock or transport equipment). A ‘money demand function’ can therefore be described, with the key explanatory variables being income and the so-called ‘own return on money’ (i.e., the attractiveness of money relative to other assets). Basic theory then says that, if the arguments in the money demand function other than income are assumed to take constant values, the standard money demand function has the property that money and agents’ desired level of income rise or fall equi-proportionally. It follows that – if, for example, the quantity of money is doubled – agents’ ‘equilibrium’ level of income (i.e., national income and expenditure in the aggregate) ought also to double. In other words, basic theory implies that policy measures directed to changing the quantity of money – such as QE, which is the deliberate creation of money by the state – are always effective. Further, the heart of the so-called ‘transmission mechanism’ of monetary policy lies in agents’ adjustments of expenditures and portfolios to monetary imbalances. A monetary imbalance (or ‘a monetary disequilibrium’) exists if actual ratios of money (to expenditures and portfolios) differ from the desired ratios.

In the 23rd  November note I mentioned that, although departures from equi-proportionality might appear to contradict the theory (and hence to support the notion of ‘ineffectiveness’), this was not necessarily so. Departures from equi-proportionality – which might be evidenced, for example, in change in ‘the velocity of circulation’ (the ratio of money to national expenditure or another transactions variable) – could be consistent with the underlying theory as long as they could be interpreted as due to

  1.  changes in the non-income arguments in the money demand function, and
  2.  the working-out of a period of monetary disequilibrium.

All  the  same,  analysts  are  reassured  if  they  find  data  which  fits  with  the  equi-proportionality

proposition, if, in other words, agents’ behaviour is characterized by

  1. marked underlying stability in a key financial or monetary ratio (i.e., a ratio analogous to the velocity of circulation) over a very long period, and
  2. clear evidence that deviations from the ‘normal’ level of a ratio are associated with macroeconomic developments attributable to agents’ endeavours to return to that normal level.

I will now present evidence that, in a key respect relevant to the so-called ‘transmission mechanism’ of monetary policy, the UK corporate sector has for over almost 50 years behaved with remarkable stability. Further, the turmoil of the Great Recession has not disturbed that stability. My conclusions are that the basic theory is correct, changes in the quantity of money do not alter agents’ desired ratio of money to other variables, and that action by the state to alter the quantity of money (upwards or downwards) remains an extremely powerful means of influencing macroeconomic outcomes.

UK companies and their money holdings: data from 1963

The UK’s monetary data in its modern from began in 1963, following a recommendation in the 1959 Radcliffe Report. The data are not only for the aggregate quantity of money, but also for the money holdings of particular sectors of the economy. We are therefore fortunate to have data on the money holdings of companies (as well as that of households and non-bank financial institutions) going back almost 50 years. As already noted, the standard money demand function includes in its arguments both income and the own return on money. In this context companies are rather unusual, since they have no income in their own right. (They belong to shareholders.) It makes no sense to view their demand to hold money as related to ‘income’ or ‘wealth’, as in the traditional formulations.

Indeed, shareholders seem to create companies – nowadays almost all with limited liability – at least partly as a means of shifting risk. Whereas the great majority of householders have both positive net assets (i.e., gross assets above debt) and positive net claims on the banking system (i.e., bank deposits in excess of bank borrowings), most companies incur liabilities to their banks in excess of their bank deposits (i.e., their money holdings). They operate in effect almost continuously on a negative net ‘money balance’. (By definition, no companies have positive net assets. Shareholders may and of course  usually  do  have  positive  equity  in  companies,  but  that  equity  belongs  to  them,  not  the companies.)UK companies' liquidity ratio from 1963 to today

However, just as most non-corporate agents’ demand to hold money is finite, so companies cannot let their negative money balances become too negative. If the balances become too negative, they may become unable to meet debts as they fall due and hence are deemed insolvent. (They can suffer this fate even if they are intrinsically good businesses, with strong future cash flows in prospect.) It follows that many companies operate with an understanding of the ‘right’ ratio between their money holdings and their bank borrowings. The borrowings are often on a medium- or long-term basis, secured against certain assets, while the money is held in an account that can be used immediately to make payments. What do the data – which, to repeat, go back to 1963 – show about the ratio between UK companies’ money holdings and their bank borrowings?

The chart above demonstrates the most important point, the marked long-run stability of the UK corporate sector’s ‘liquidity ratio’ (as the ratio of money holdings to bank borrowings) might be called. The ratio today is more or less the same as it was in the mid-1960s. This stability is the more remarkable, when the actual levels of the two variables – rather than the ratio between them – are reviewed. At the start of the data series, in the third quarter of 1963, UK companies held M4 balances of just under £2.4b. and had bank borrowings of a bit less than £3.5b., with a ratio between them of 68.6%. Money balances were ample relative to bank debt by later standards and 1963 was in fact a boom year for the economy, implying that companies had excessive money holdings with the 68.6% value of the liquidity ratio. In the four quarters of 1965 the average value of the ratio was 55.6%, practically the same as the 55.2% ratio that has been the value over the 48 years covered by the chart. The last quarter in the chart is Q4 2011, when UK companies held M4 balances of £247.6b., against bank borrowings of £442.3b., with an implied liquidity ratio of 56.0%. In short, companies’ liquidity ratio at the end of last year was virtually the same as it had been in 1965, 46 years earlier. Meanwhile from the very start of the data series until Q4 2011, companies’ money holdings had climbed 104 times and their bank borrowings 127 times, but the ratio between them had changed by less than 20%. (The chart does not include the final values for the first three quarters of 2012. They in fact show a healthy rise in the ratio to above-normal levels, which is a positive sign for the level of demand in the UK economy in coming quarters.)UK companies' money holdings and bank borrowings from 1963 to tod

At any rate, we observe an astonishing stability in the monetary behaviour of the corporate sector of the British economy. The ratio of companies’ money to their bank borrowings has changed in this period of almost 50 years, but these changes have been trivial relative to the changes in the variables in which the ratio has been expressed. In a chart representing the levels of these variables, the y axis has to be in logarithmic terms, and yet the parallelism of the movements in money and bank debt is plain.

Has  the  corporate  liquidity  ratio  affected  companies’ behaviour in the way expected by economic theory?

When companies are ‘short of cash’, they tend to retrench. Each company individually can rebuild its money balances by selling an asset (a subsidiary, a piece of land, an office building), but – if the asset is sold to another company – the total amount of money held by companies in the aggregate is unchanged. It follows that, if all companies are short of cash, transactions in order to rebuild every company’s money holdings fail in that purpose. Instead asset values fall, and that makes people and companies feel poorer, and they cut back on their expenditure. Conversely, if companies are ‘rolling in cash’, the same story applies, but in reverse. Each company individually can lower its money balances by purchasing an asset, but – if the asset is bought from another company – the corporate sector’s money holdings are unchanged. So transactions in order to disembarrass companies of their excess  money  get  nowhere.  Instead  asset  values  rise,  agents  feel  richer  and  they  boost  their expenditure.

But how are observing economists to know whether, at a particular time, companies are ‘short of’ or ‘rolling in’ cash? Obviously, the deficient and excess holdings of money have to be relative to some norm. A valuable merit of the corporate liquidity ratio calculated above is that it provides us with a measure of the norm as well as a series of values which at times deviate from the norm. If the statistical record shows that companies retrench when the liquidity ratio is beneath average and ‘splash out’ when it is above average, this provides support for a monetary theory of corporate behaviour and, at a further remove, for a monetary theory of national income determination. More formally, we need to regress the change in real domestic expenditure on the corporate liquidity ratio and to check whether the level of the ratio has a significant effect on the change in expenditure. This exercise is shown graphically in the chart on the next page, while an ordinary-least-squares regression between the two variables gives the following result for the 1963 – 2011 period,

Change in domestic expenditure (in real terms), % p.a. = -14.67 + 0.312 Value of the corporate liquidity ratio, %

The equation was a r2 of 0.35, while the t statistic on the regression coefficient is over 10, indicating that companies’ balance-sheet strength – as measured by the corporate liquidity ratio – has a statistically significant effect on expenditure. (The value of the r2 would undoubtedly rise if a more complex lag structure were estimated.) Inspection of the chart agrees with the identification of a worthwhile relationship between these two variables. The liquidity ratio was particularly low in 1966, 1969, late 1974, early 1980, late 1990 and late 2008, and in every case the economy was already in a recession or above to enter one; it was notably high in 1972 and 1973, and again between 1986 and 1989, on these occasions coinciding with buoyant economic conditions.

It needs to be recognised that many other variables affect the strength of demand over the short run, with – for example – the effects of world demand and the inventory cycle largely separate from the balance-sheet influence running from money holdings. Nevertheless, the robustness of the relationship over the medium terms is impressive. Companies’ money holdings are the numerator in the liquidity ratio and they affect demand in just the way that basic theory would predict.Corporate liquidity and demand in the British economy, 1963 - 2011

Did the Great Recession break the relationship

The relationship between the corporate liquidity ratio and demand would be breaking down if the residuals from the estimated best-fitting equation were larger in the last few years than before and showing signs of particularly clear increases in the last few quarters. The chart at the top of the next page plots the residuals from the best-fitting equation.

Assessment of this chart is to some extent in the eye of the beholder. It is true that in the Great Recession the best-fitting equation between the liquidity ratio and expenditure deteriorated in one sense. The equation produced values for demand that were appreciably higher than the outturn (i.e., implying a negative residual) and indeed did so to a degree not seen at any other point in the 48 years in the current exercise. (Quite large negative residuals were also recorded in the 1970s.) However, the residuals in the very latest quarters are not moving relentlessly in one direction, while the last few residuals have taken values lower than those which have been seen on many occasions in the past. My conclusion is that the behavioural  relationship  continues to  work.  To recall, that  relationship is between companies’ liquidity ratio (which incorporates their money holdings as the numerator) and changes in total domestic expenditure in real terms. This is very much a relationship relevant to the testing of the effectiveness of QE, since QE is intended to boost the aggregate quantity of money, and company money holdings are part of aggregate money.Is the relationship between coporate liquidity and expenditure breaking down

Conclusion: QE remains effective

The relationship between corporate money holdings and expenditure is one element in the larger relationship  between  money  and  nominal  GDP.  That  relationship  is  robust,  surviving  without difficulty through a series of cyclical fluctuations in the UK economy over almost five decades. This reinforces the conclusion in the 23rd  November note. As stated there, the facts of the relationship between money and nominal GDP since 1997 are consistent with the standard monetary theory of national income determination. The theory implies that a medium-term relationship holds between the rates of change of money and nominal GDP, and that the equilibrium level of nominal national income is a function of the quantity of money. A necessary consequence is that – if the state engineers deliberately large changes in the rate of money growth (as it undoubtedly can do) – it is taking powerful actions to affect macroeconomic outcomes. To repeat, claims that ‘QE has become ineffective’ are contrary to evidence and at variance with a large body of well-established theory.




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