Recent survey news on the British economy has been satisfactory, even quite good, particularly given the continuing travails of the Eurozone. The purpose of the current note is to relate these developments to the latest monetary trends. The central point is that broad money growth has been consistent with the recovery, in that it has been running in the mid-single digits (at an annual rate) for several quarters. However, the monetary expansion has not been the result of banks’ increasing their loan portfolios. Instead it has been due to the Bank of England’s purchases of long-dated government bonds from non- banks (i.e., to ‘quantitative easing’, as it has become known). The Monetary Policy Committee of the Bank of England appears to be split on the wisdom of maintaining QE in coming months, with one supporter of continued QE (Sir Mervyn King, the governor) due to step down in a few weeks.
The main cause of the persisting weakness of credit growth is that the banks remain subject to official pressure to raise capital/asset ratios, to ‘tidy up their balance sheets’ and so on. The government and the Bank of England have pushed artificial schemes – such as Funding for Lending and the Help to Buy (i.e., to buy a home) initiative – without apparently understanding that the regulatory assault on the banks is to blame for their reluctance to expand their assets. At any rate, over the last year or so a moderate rate of money growth and very low interest rates have been associated with healthy rises in asset prices, and private-sector balance sheets (i.e., the balance sheets of households and companies) have improved dramatically compared with early 2009. As long as broad money growth remains positive and in the mid-single digits (at an annual rate), a steady recovery is to be expec The new Bank of England governor, Mark Carney, is something of an unknown quantity as regards money targeting, although he has expressed interest in ‘nominal GDP targeting’. (The subject of nominal GDP targeting is not discussed here.)
Regulatory blight on banking industry has checked recovery
The regulatory blight on banking systems continues in all the world’s so-called ‘advanced’ economies, which means for these purposes all nations that belong to the Bank for International Settlements. The growth of banks’ risk assets is constrained by official demands for more capital relative to assets, for more liquid and low-risk assets in asset totals, and for less reliance on supposedly unstable funding (i.e., wholesale/inter-bank funding). If nothing else were happening, the contraction of asset totals and the rise in the proportion of capital to total liabilities would result in falls in the quantity of money, broadly-defined, which would in turn imply falls in the equilibrium levels of national income and wealth. In some of the Eurozone’s Club Med countries, and even to some degree in France and Italy, these processes of money contraction are still very much at work, and macroeconomic outcomes are weak and disappointing. Indeed, for the Eurozone as a whole output is flat and unemployment is rising.
In virtually all the advanced economies the ratio of safe assets (i.e., cash and government securities) to banks’ total assets is rising. The importance of new credit extension to banks’ business activities has declined, despite constant laments in the media about the absence of new bank lending to such allegedly deserving causes as small business and first-time home buyers. Senior policy-makers seem not to understand the connection between the regulatory zeal ‘to tidy up bank balance sheets’ and the marked reluctance of banks to grow their businesses. In the UK this has led to obvious, indeed ludicrous policy inconsistencies. In the UK it is the same Chancellor of the Exchequer (George Osborne) who endorsed the regulatory excesses of the Vickers Report in 2011 and who announced the Help to Buy initiative to boost mortgage lending in the 2013 Budget. The left hand taketh away and the right hand giveth back, and the taking-away and giving-back occur at the same time and are blessed by the same government.
Importance of QE in maintaining positive growth of broad money
The situation is redeemed to some extent by the widespread adoption of so-called ‘quantitative easing’, which can be regarded as the deliberate creation of money by the state. (A multiplicity of definitions is possible, because the subject is intellectually a total mess.) Because the banks’ safe assets are growing as a result of QE, the quantity of money is in fact rising slightly – typically at annual rates in the low single digits – in most of the leading countries, including the UK. In association with virtually zero interest rates, low but positive money growth has been accompanied over the last year by asset price buoyancy, with rising stock markets, very low bond yields, and steady markets in residential and commercial property. While the global upturn is being led by the USA, macroeconomic conditions in the UK have been satisfactory and better growth is also being seen in Japan where aggressive monetary stimulus is currently intended by the new Abe government. It is only in the Eurozone, where QE operations are hampered by the multi-government, hydra-headed monster that is the single currency area, where monetary conditions remain persistently hostile to growth.
In the UK the M4x measure of money increased by 4.5% in the year to March, while the stock of M4x lending (i.e., bank lending to the non-bank private sector, excluding that to intermediate other financial corporations) fell by 0.1%. (The stock of M4 lending as a whole was down by 1.9%.) In other words, money growth has been positive only because other forces have offset the contractive effect of reductions in bank claims on the private sector. QE has undoubtedly been the dominant such force.
The chart above is useful in understanding the forces at work. After the Second World War most banks’ assets were dominated by claims on the government, reflecting the legacy of the war-financing effort. In subsequent decades the normal pattern was for banks to concentrate on expanding their claims on the private sector, which were more profitable than government securities. When banks increase their lending, they add identical sums to both sides of the balance sheet, loans on the assets side and deposits on the liabilities side. The deposits can then be spent an indefinitely large number of times and so are money. The emphasis on credit to the private sector continued until 2007 and 2008, when the closure of the global inter-bank market (in August 2007) and a drastic tightening of bank capital regulation (in October 2008) caused a radical re-appraisal of banks’ strategic priorities. From then until now banks have been under official pressure to shrink their risk assets relative to their capital. This has led to substantial declines in their loan portfolios, which – in the absence of some other influence – would have resulted in the cancellation of deposits and the destruction of money balances.
Fortunately, deliberate measures to expand the quantity of money were announced in the UK in March 2009. These measures, which have become known as QE, have led to the banks’ holding much increased amounts of cash and government securities. In the chart, which cuts out the awkward effect of the so-called ‘intermediate other financial institutions’ on both the M4 and M4 lending totals, this is illustrated in the relative positions of the lending and non-lending counterparts to the change in M4. Until mid-2008 the lending counterpart (the blue segment of the bars) was always positive, while the non-lending counterpart (the red segment) was negative most of the time. (The negative value of the non-lending counterpart was largely due to banks’ need to grow their capital to match the rising risk in the loan portfolios. Extra capital meant lower deposits in the liabilities side of the balance sheet.) By contrast, from early 2009 until the end of 2012 the blue segments of the bars were negative, indeed very negative in 2010 and early 2011, while the red segments became very positive, because of the effect of QE. Cumulatively, the values of lending from Q2 2009 to end 2012 were negative by £326b., equivalent to about 20% of M4x at Q2 2009. That is a measure of how necessary QE was to prevent an even worse recession than the one actually recorded.
Premature to worry about overheating
Although recovery is certainly under way in the UK, it is wholly inappropriate for commentators to start worrying about overheating in labour and product markets. In fact, the latest figures for consumer price inflation were better than expected and almost back down to the 2% official target. The news from the labour market varies from month to month, but some of the most recent numbers – which may be erratic – have indicated rising unemployment. (See the chart above.)
On policy decisions, the balance of arguments seems still to be against an increase in sterling interest rates. A salient feature is that the stock of bank lending has yet to resume the relentless upward growth that prevailed until 2008. Indeed, bank credit to the private sector is so weak that QE needs to be continued at a sufficiently high level to ensure that broad money growth (on the M4x measures) runs at an annual rate of between 3% and 5%. The case for higher interest rates in 2014 is likely to be more persuasive in 2014. But much depends on a realization in official quarters that overregulation of the banks is, almost everywhere in the advanced world, the dominant explanation for the sluggishness of money supply growth and, hence, the key factor holding back a stronger recovery.