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.
March and April have seen a marked 70% rebound in the oil price from the January lows of about $26 a barrel. The move owes much to the dynamics of the energy market itself, but it is being interpreted by financial markets as a sign that global demand should be sufficient to deliver at least trend growth (say, 3% - 3½%) in world output in 2016. The mood has changed sharply from January’s alarmist hysteria, much of it due to so-called “analyses” from the Bank for International Settlements, the International Monetary Fund and leading investment banks. (These organizations ought to have known better, bluntly.) The line taken in International Monetary Research Ltd. notes has been that recession in 2016 is extremely unlikely. Only hopelessly incompetent monetary policy decisions could cause a recession to start from a situation in which upward pressures on inflation have been and remains weak, and the price level has been and remains more or less stable. I don’t have much respect for the top brass in the major relevant institutions (i.e., the Fed, the ECB, etc.). But, to initiate a recession, they would have had to be yet crasser than they were in the last period of idiocy, in late 2008. In practice, the absence of upward pressures on the price level has allowed significant monetary-policy easing in China and the Eurozone. It seems that in China M2 growth has run about 1% - 1½% a month (i.e., at annualised rates of 13% - 20%) in early 2016. In the four major developed “countries” (i.e., taking the Eurozone as a country) – the USA, the Eurozone, Japan and the UK – the annual rates of broad money growth are currently 3.9%, 5.0%, 2.6% and 4.5%, and the three-month annualised growth rates are 5.1%, 4.4%, 2.8% and 5.0%. If asked for an ideal rate of money growth, Milton Friedman would typically reply – at least for the USA – “5% a year”. The Bank of Japan seems unable to see the light in the “broad money vs. monetary base” debate. But in truth money growth trends in the main countries are not far from perfection at present.
Debts have continued to build up over the last eight years and they have reached such levels in every part of the world that they have become a po- tent cause for mischief,” according to William White, former chief economist at the Bank for International Settlements in an interview for the Daily Telegraph on January 20. According to White, “the situation is worse than it was in 2007. Our macroeconomic ammunition to fight downturns is essentially all used up.” White’s pessimism chimes with warnings from Goldman Sachs last year. Andrew Wilson, chief executive of one of its fund management businesses, was reported on May 26, again in the Daily Telegraph, as saying that excessive debt represents “a risk to economies” and is a “major issue”. Specifically, in mature industrial nations populations are ageing and the proportion of working-age people to the total population is falling, presenting “us” with the question of how “we” are “going to pay down the huge debt burden”. The combination of the Bank for International Settlements, Goldman Sachs and the Daily Telegraph ought to be intellectually overwhelming. But they have indulged in rhetoric and used words sloppily. To whom does “us” refer? Who exactly are “we”? And, although the image of “the world drowning in debt” is often invoked, what is it supposed to mean?
Some commentators seem anxious that early 2016 feels like early 2007. But banking systems are not over-stretched and do not face heavy loan write-offs because of bad debts, while inflation is exceptionally low. Governments and central banks can readily implement expansionary policies (such as QE) if they have to. The overall prospect is for steady, if rather slow, growth of banking systems in the major countries, and so for moderate growth of broad money, and also of nominal GDP. There are worries (e.g., the oil market), but the world economy is not characterized by major macroeconomic instabilities In qualification, officialdom seems committed to imposing extra capital requirements on banks across the globe, in the belief that highly-capitalised banks are safe banks and that another Great Recession could not happen if all banks were ‘safe’. Key central bankers and regulators seem not to understand that the Great Recession of 2008 – 10, like the Great Depression in the USA 1929 – 33, was caused by a collapse in the rate of change of the quantity of money. They seem further not to appreciate that the effect of tightening bank regulation will be to depress the rate of growth of the quantity of money, with wider disinflationary/deflationary consequences. Although oil prices must be expected to spike upwards at some point in the next three years (as Saudi Arabia again restricts production), underlying, ex-energy inflation will still be low/negligible in 2017 and early 2018. Money growth has turned upwards in China and India in the last few months, which argues against too much pessimism about the global outlook for 2016. A truly alarming message is that officialdom still cannot see the connections between regulatory tightening in the banking industry and weak broad money growth, and then between weak broad money growth and sluggish economic activity.
The current weekly note attachment – like the last one – is about the consequences of confusing ‘the monetary base’ and ‘the quantity of money’. This confusion has plagued commentary on both the Japanese and American economies in the last few years. (There has also quite a lot of nonsense in the UK from, for example, Liam Halligan in his Sunday Telegraph column.) In the note – which has recently appeared in Economic Affairs, a magazine published by the Institute of Economic Affairs – I recall the inflation warnings given by American monetarists in early 2009, as they bewailed the then surge in the USA’s monetary base as a result of the Federal Reserve’s asset purchases. These warnings – which were neither dated nor quantified – have so far proved silly. In fact, in the year to autumn 2013 the USA’s finished- goods producer prices index is likely to be unchanged or even to be down slightly. The failure of American monetary-base-focussed monetarism demonstrates, yet again, that the measure of money that matters in macroeconomic analysis is one that is broadly-defined to include all assets with fixed nominal value that can be used in transactions. In most countries the total of bank deposits is the best approximation to that measure of money, which has the further implication that public policy should be concerned to maintain growth of the banking system balance sheet at a low and stable rate. It should be a low rate to combat inflation, and at a steady rate to help in securing wider macroeconomic stability (i.e., stable growth of demand and output). Anyhow it is the quantity of money, not the monetary base by itself, that matters to macroeconomic outcomes.
And what will happen if QE is tapered or stopped?‘Quantitative easing’ is understood in this note as the purchase of assets from the non-bank private sector by the central bank. (Other definitions are available!) The central bank finances these purchases by issuing cash reserves to the commercial banks, while the bank deposits of the non-bank private sector increase as it receives the proceeds of its asset sales. As bank deposits can be used to make payments, they are money. The effect of QE is therefore to cause an increase in the quantity of money, with bank balance sheets showing extra deposits on the liabilities side and extra cash reserves on the assets side. The change in banks’ cash assets measures, more or less, the effect of QE on the quantity of money. (I say ‘more or less’ because there are some technical caveats. They may become important, but they are not relevant to this note and are not further discussed.) The Federal Reserve’s ‘QE3’ operations are an example of this form of quantitative easing. The Fed has purchased mortgage-backed securities, mostly from non-banks (but also to some extent from banks, one of those ‘technical caveats’), and that has boosted banks’ cash reserves enormously and been a major positive influence on the quantity of money. QE is expected to be ‘tapered’ soon and ended at some point in the next few months. What effect will that have on the growth of the quantity of money in the USA? Will M3 – which has been rising slowly since 2011 – continue to increase? The analysis in this note suggests that, unless banks were to resume the expansion of ‘bank credit’ in the usually understood sense (i.e., of claims on the private sector), the growth of US broad money would come to a complete halt with a cessation of QE. It is very important for International Monetary Research subscribers to realize that the Fed does not analyse the monetary situation by inspection of quantity-of-money data; its officials would have no interest in the conclusion I will now reach.
Press reports have suggested that the International Monetary Fund has become unhappy with the Greek government’s austerity measures, since it felt not enough was being done to maintain fiscal solvency. Anyhow the latest tranche of money has been credited to the Greek government and life goes on, although Greece’s international creditors are watching the budget numbers month by month. The following note recognises that the Greek government is not far from achieving a ‘primary budget balance’ (i.e., non-interest public expenditure is only slightly above tax revenues). In that sense, much has been done to restore the creditworthiness of the Greek state. However, the cost has been calamitous, with falls of about a quarter in real terms in both national output and government expenditure. Even worse, it is not clear that the big austerity drive so far will be sufficient. Two points have to be emphasized. First, output has fallen so heavily from the peak (i.e., in 2007), and is still falling at such a rate, that a budget surplus would be needed to stop the debt/to/GDP ratio from rising further. There is no sign of that. Despite the defaults to private sector creditors, IMF data show the debt-to-GDP ratio now at about 175%. Second, the drop in output has of course a large cyclical element and, sooner or later, a cyclical recovery must surely happen. However, a deeper problem is now emerging, that international investors are shunning Greece and the trend level of output may be going down. To halt the rise in the debt-to-GDP ratio, Greece therefore needs an overall budget surplus over a series of years and not just a primary surplus in an emergency period Again, there is no prospect of that in any relevant planning horizon.
More on the structural flaws of the EurozoneThe following note is in response to the call for evidence on ‘”Genuine Economic and Monetary Union” and its implications for the UK’ from the House of Lords’ European Union Committee, made on 24th April 2013. The main points of the note are
- banks’ risks of future loss, and hence their need for capital to protect depositors, depend heavily on future movements in asset prices, since these asset price movements determine the value of loan collateral,
- ii. a single set of capital rules (such as the Basle III rules now being imposed on advanced country banking systems) cannot be appropriate for all countries at all times, and undermines the flexibility of national regulators to deal with specifically national problems,
- banks’ loan losses in the Eurozone periphery nations are so large that depositors can be repaid in full only by capital injections from the state which affect these nations’ credit rating,
- the interaction between banks’ solvency problems and their host nations’ sovereign default risk has created a vicious downward spiral of fiscal and monetary retrenchment, and losses of output and employment, and
- this downward spiral is much worse than in a traditional monetary jurisdiction because governments in a multi-government monetary union such as the Eurozone cannot borrow from the central bank
Four years ago, at the worst point in the Great Recession, several leading American economic gurus said that the Fed’s easy monetary policy risked higher inflation which might imperil the recovery. In some of the early commentaries from International Monetary Research (in the spring and summer of 2009), I argued that these gurus – who included the revered Alan Greenspan and Martin Feldstein, a prominent adviser to President Reagan – were seeing ‘ghosts’. I brought together evidence from earlier recoveries to show that the typical US recovery was accompanied by the continuation of low inflation and indeed often by falling inflation. In other words, the macro news tended to be excellent during recoveries, with above-trend growth in output and profits associated with declines in inflation. This sort of macro backdrop usually saw strong gains in equity prices. Monetary policy is nearly always controversial, and the last four years have seen even more bitter and intense controversies than usual. Expansionary open market operations of a traditional kind have been labelled ‘quantitative easing’, and described as ‘unconventional’ and innovatory. Silly rants – such as those from Liam Halligan in his Sunday Telegraph column – have claimed that by its very nature QE (and regardless of the quantities and timing involved) is inflationary, redolent of ‘banana republics’, ‘the last refuge of dying empires’, etc. In fact, QE has barely failed to offset the contractive effect on money growth of tighter bank regulation and officialdom’s determination to raise banks’ capital/asset ratios. Anyhow, the latest American data show that inflation is under good control, and is in fact much lower than in 2007 and 2008. (It is not lower than in 2009 when the price level, not the level of inflation, was falling, and observers were understandably concerned about deflation)
A critical question for financial markets over the next two to three years is the timing of a return to historically normal short-term interest rates, i.e., interest rates which are in the low or middle single digits instead of being close to zero. Although views on the Eurozone are far from unanimous, a case can be made that the macroeconomic plight of its periphery is intensifying. The next significant upward move in euro interest rates is therefore still distant. Conditions are very different in the USA, where a cyclical recovery is clear and definite, even if it is not impressive by the standards of past upturns. Given the relationship between the quantity of money and national income, a rise in the quantity of money is a precondition for a more meaningful and robust recovery. The quantity of money, broadly-defined to include all bank deposits and money-like assets, has been rising in the USA since late 2010. Indeed, in recent quarters its annual growth rate has been in the 2% - 5% vicinity, which has been consistent with progress on output and employment. The banking system in the USA – like its counterparts in Europe and Japan – still has to grapple with the Basle III burden of regulations from the Bank for International Settlements, Even so it has been expanding its risky non-cash assets at about 4% a year. A significant proportion of the money expansion since late 2010 reflects so-called ‘quantitative easing’ operations conducted by the Federal Reserve. The purpose of this note is to identify the effect of such operations on the money growth recorded in the last year or so. (It is similar in approach to earlier weekly e-mails on 19th November 2010 and 22nd June 2011, which endorsed the QE packages then being implemented.) The main conclusion is that the American recovery ‘has legs’ and would be maintained even if QE were halted. Short-term dollar rates may need to rise in 2014.