The victory for the Leave campaign in the UK’s referendum on EU membership has dominated financial news since 23rd June. It is of course a major event, not least because numerous forecasts of a mini-recession in the UK are now to be tested. The evidence so far is mixed, with the latest survey from the Confederation of British Industry (published a few days before 23rd June) reporting a rise in the balance of companies planning to expand output in the next three months. Elsewhere the main features are, first, in the developed countries continued growth of broad money at the almost ideal annual rate of 4%, and, second, in China and India signs of a slowdown in broad money growth. The slowdown in both China and India has come about suddenly, and may soon disappear from the data and not prove meaningful. On the other hand, the slowdown could last a few months, perhaps even more. Once a money slowdown/acceleration persists for six months or longer, it starts to matter to the cyclical prospect. My overall assessment is – despite the Brexit shenanigans – the global monetary background remains consistent with steady growth in world demand and output in late 2016 and into 2017. Far too much fuss is being made about Brexit. The UK’s share of world output (when output is measured on a so-called “purchasing power parity” basis) is modest, less than 2½ per cent. The credit downgrades faced by British banks have created possible funding strain for them, recalling the crisis of late 2008. The problem needs to be countered by the provision of long-term refinancing facilities from the Bank of England, just as Draghi handled a similar challenge in the Eurozone in December 2011
Brexit-lite and Brexit properPost-Brexit discussion suffers from a serious vacuum. Although the British people have voted by a narrow margin to leave the European Union, the next prime minister has not been appointed, and no one knows exactly how he/she and his/her team will organize the negotiations. Two main options (both with many potential variants) are emerging,
- Brexit-lite (“the Norwegian/Swiss option, plus or minus”. The government gives priority to maintaining access to the EU’s Single Market, although seeking (like Norway and Switzerland) to restore parliamentary sovereignty and judiicial supremacy (i.e., that the highest court in the UK is its own Supreme Court, not the European Court of Justice in Luxembourg). Control over new regulations would be with the UK Parliament, but EU regulation would have to be respected in much of the economy and not just on exports to the EU. The UK would pay some money (“danegeld”) to the EU. Given the politics of the situation, the UK would want significant concessions on “freedom of movement”, so that it did indeed control its borders, but something like “freedom of movement for workers only” night be devised.
- Brexit proper. The government says that access to the Single Market is not essential, as the UK can trade satisfactorily with the EU under World Trade Organization rules. It says this, even if UK exports would be subject to the “common external tariff”. Of course the UK restores parliamentary sovereignty and judicial supremacy. It also oversees all new business regulation, although exports to the EU must anyhow comply with EU regulation. The UK pays no money to the EU and recovers full control of its borders.
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.
The UK economy is clearly recovering and now achieving above-trend growth. Survey evidence is clear-cut, with the Confederation of British Industry’s monthly survey (of manufacturing, mostly) showing the highest balance of companies expecting to raise output since the mid-1990s. Past experience is that above-trend growth can be maintained for several quarters without provoking more inflation, as long as the revival is taking place from a depressed condition in which the level of output started well beneath trend. (The September 2013 CBI balance on price-raising intentions was in fact very low.) Money growth is satisfactory, but not particularly high. M4x (i.e., broad money excluding balances held by intermediate ‘other financial corporations’ or quasi-banks) was 4.5% higher in July 2013 than a year earlier, but the annualized growth rate in the three months to July was only 3.3%. Reasonably strong growth rates of demand can be reconciled with these rates of money growth, which are modest by long-run standards, largely because interest rates are more or less at zero, and people and companies are finding ways of economizing on their holdings of unattractive non-interest-bearing money. (In other words, the desired ratio of money to expenditure may be falling.) The argument for ending ‘quantitative easing’ (not in effect since the July meeting of the Monetary Policy Committee anyway) and/or raising interest rates has more cogency than at any time in the last five years. However, analysis of data from the Bank of England shows that over the last year money growth would have been negligible in the absence of QE.
The following note is work-in-progress. It is part of an attempt to bring to an end the great mass of confusions that have cluttered discussion of ‘quantitative easing’ in the UK’s monetary policy debate and indeed the monetary policy debates of many nations, in the last few years. Work on the note will resume next week…and perhaps in the following weeks.
David Cameron has promised, or at any rate indicated, that a newly-elected Conservative government would in 2017 hold an In/Out referendum on EU membership. As the Conservatives are generally regarded as unlikely to win the general election in 2015, Cameron’s promise may not amount to much. Nevertheless, the debate on the UK’s relationship with the EU will be intense at least until the general election and probably for some years thereafter. The purpose of this week’s e-mail note is to describe key features of the international scene, particularly those relating to Europe’s role in the world, as background to the debate. The main point is simple, that the EU’s share in world output and population is falling sharply, and the importance of the EU to the UK’s international trade and finance will decline. The focus is on two dates, 2017 for obvious reasons and 2059. 2059 is chosen because it is 42 years from 2017, while 2017 is 42 years from 1975, the last time that the British public was consulted in a referendum on EU membership. By 2017 British politicians would have taken 42 years to refresh the original mandate for UK involvement in ‘the European construction’. The most neutral assumption is therefore that – if that mandate were renewed in 2017 – they would take another 42 years to seek to refresh it again. (This note expands the argument on an article in the February 2013 issue of Standpoint.)
Draghi’s commitment to do ‘whatever it takes’ to preserve the Eurozone undoubtedly has the support of the European political elite, particularly the German political elite. However, every balance sheet has two sides. If ‘doing whatever it takes’ implies that the ECB’s balance sheet is to expand, a further consequence is that its creditors (i.e., for the most part banks keeping cash reserves with it) are more exposed to its failure. As the following note (which is based on my next column in Standpoint) explains, the ECB’s dominant creditors nowadays are German banks, which keep over €750b. cash reserves with the Bundesbank. (See the chart on p. 2 below.) If the banks that borrow from the ECB (which nowadays are predominantly from the PIIGS [Portugal, Italy, Ireland, Greece and Spain] cannot repay their loans, and if the ECB’s modest capital of about €10 billion is exhausted by other losses, Germany’s banks are theoretically liable to a maximum loss of the full €750b. or so. I say ‘theoretically’, because Eurozone governments would be expected to recapitalize the ECB and to prevent such losses. In this disastrous situation they would of course - well, presumably – carry out the recapitalization. But the cost of the recapitalization would add to nations’ budget deficits and public debts. Further, the German constitutional court has just given its legal endorsement to the €150b. German commitment to the European Stability Mechanism. If the PIIGS’ banks and governments cannot repay in full their debts to the ECB and the ESM, the losses fall back on Germany. We are of course talking about losses that could reach €200b., €300b. or more. The following note (see chart on p. 3) also shows that the pattern of PIIGS’ borrowing from the ECB has changed. Whereas in 2009 the ECB was lending mostly to banks in Ireland, Greece and Portugal, in the last 18 months its new loans have been mostly – indeed almost exclusively – to Spain and Italy.
When the latest round of quantitative easing was announced by the Bank of England in October, it was reasonable to expect that a positive rate of broad money growth would be recorded while the QE operations were taking place. (When the state purchases assets from non-banks, it increases their bank deposits which are nowadays the dominant element in the quantity of money.) However, that is not what has happened in the first three months of the exercise. In the third quarter of 2011, when QE was not in effect, the M4x money measure (i.e., broad money, excluding the money balances held by the awkward, semi-bank “intermediate other financial corporations”) rose at an annualised rate of 5.0%. But in the fourth quarter of 2011, when the latest QE operations had started, M4x declined at an annualised rate of 0.8%. The latest credit counterparts data do show the imprint of QE. Particularly in October the Bank of England’s purchases of gilts led to a large positive “public sector contribution to M4 growth”. (However, in December QE operations seem to have been suspended for about three weeks over Christmas and the public sector’s financial transactions actually reduced M4, although not by much.) The main explanation for the failure of QE to increase M4 is that other transactions across banks’ balance sheets had the effect of destroying money. As has been true now for over three years, the destruction of money can be largely attributed to banks’ shrinkage of risk assets as they try to raise capital/asset ratios. Adam Posen, a member of the Monetary Policy Committee, has accused the banks of being “risk-averse jerks” because they are not lending enough. In fact, the latest round of asset shrinkage is partly – perhaps mostly – a response to the Vickers Commission report, which requires UK banks to hold more capital relative to their risk assets than their international competitors.
Mario Draghi became president of the European Central Bank on 1st November, 2011, at a critical moment for the euro. Banks – particularly banks in the Club Med countries (i.e., Italy, Spain, Greece) – were having difficulty rolling over their inter-bank lines. As the lines matured with little prospect of renewal, the banks were being forced to sell liquid assets. As these included bonds issued by Club Med countries, the price of the bonds fell and their yield increased. A surge in Italian and Spanish government bond yields was taken to constitute “the Eurozone sovereign debt crisis”. The media were full of talk of “a bazooka” of some sort to bring the crisis to an end. In October last year such talk usually focussed on the expansion of the European Financial Stability Facility, a back-up fund with resources provided by all Eurozone member states and able to extend credit to particularly hard-pressed governments. A widely-held view was that the EFSF might need to exceed 900b. euros, or even 2,500b. euros, if it were to have the fire-power to meet the crisis. In the event, negotiations for the EFSF have not got far enough, while its credibility in financial markets has been undermined by the credit rating agencies’ downgrading of several member states. But Draghi has found a big, powerful bazooka and aimed it with precision. Between 4th November 2011 and 20th January 2012 the ECB’s lending to banks has jumped from 580.0b. euros to 831.7b. euros, or by over 43%. The new lending has taken the form mostly of three-year facilities at 1%, which – on the face of it – are extraordinarily privileged loan arrangements for the banks. Further large expansion of such lending is to be envisaged. The banks have stopped selling government bonds, the yields on Italian and Spanish bonds have fallen, and the sovereign debt crisis is over, at least for the time being. This weekly e-mail analyses the effect of the Draghi bazooka on Eurozone M3 growth, because of the importance of money to macroeconomic outcomes more generally.
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.