In my last monthly e-mailed note (on 28th June) I said that money growth patterns in the four leading advanced country jurisdictions (USA, Eurozone, Japan and the UK) were more or less perfect. To recall, “4% a year is a more or less ideal rate of broad money growth in developed countries, with a trend rate of output growth of 1% - 2% and an aim to keep inflation around 2%. Amazingly, and no doubt more by happenstance than design, 4% a year is at present common to the USA, the Eurozone, Japan (just about) and the UK.” Well, not much has happened since then to alter the assessment. The picture is as follows,The numbers for China and India, the two big developing countries (both with trend growth rates of output of over 5% a year), are as follows
Japan’s ‘Abenomics’ is reported to have three arrows, - a ‘revolution’ in monetary policy with ‘the Bank of Japan injecting huge amounts of “money” (whatever that means) into the economy’ (or something of the sort), - a short-term fiscal stimulus accompanied by long-term action to bring the public finances under control, and - ‘a growth strategy’ (which means in practice shaking up such over-protected parts of the Japanese economy as farming and retailing). Commentary on the last two of the three arrows has often been sceptical. Initial ‘stimulus’ (i.e., a widening of the budget deficit) is not easily reconciled with ultimate fiscal consolidation (i.e., a narrowing of the budget deficit), while Abe’s Liberal Democratic Party has drawn much of its traditional support from groups that benefit from protection and restrictive practices. By contrast, most media reporting has suggested that the Bank of Japan has definitely changed course and that a major upheaval in monetary policy is under way. This note argues that, although Japanese monetary policy has indeed shifted in an expansionary direction, the shift is far less radical than the rhetoric that has accompanied it. Japanese policy-makers and the greater part of the commentariat seem to believe that the monetary base by itself has great macroeconomic importance. This is a mistake. National income and wealth in nominal terms are a function of the quantity of money, which must be distinguished sharply from the base. Movements in the monetary base and the quantity of money may be related, but the relationship is not necessarily all that precise or reliable. It is the quantity of money, not the monetary base by itself, that matters to macroeconomic outcomes.
Its membership of the European Union requires the UK government to make certain payments to EU institutions, and entitles it to a number of receipts. How much are these direct fiscal costs and benefits, and what is the net position? That may seem like a simple question which can be answered with a single number or set of numbers. Surely, when the government spends £100 million, it spends £100 million, and it does so without fuss or ambiguity. In fact, a range of complexities mean that no one figure for many EU financial concepts is exactly ‘right’. Like love, the UK’s financial contribution to the EU is a ‘many-splendored thing’. Again like love, it causes many squabbles.
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’. Also at that time Liam Halligan of Prosperity Capital Management used his column in The Sunday Telegraph to attack ‘quantitative easing’ (i.e., the large-scale creation of money by the state) as aggressive ‘money printing’ which would lead to a sharp rise in inflation. In a letter to the Financial Times published on 19th June, I showed that the inflation jeremiahs had been wrong. The last five complete years (i.e., the five years to 2012) saw the lowest increases in nominal GDP in all the G7 economies since the deflationary 1930s. The jeremiahs of 2009 made a serious analytical mistake. They thought that inflation was caused by excessive growth of the monetary base, not of the quantity of money broadly-defined to include all bank deposits. In future economic commentators should pay more attention to the quantity of money as such and de-emphasize the monetary base by itself.
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.)
A commonly-expressed view in the media is that Chancellor Osborne’s failure to curb the budget deficit is due to weak tax revenues, which in turn are to be explained by the economy’s weak supply-side performance. According to this analysis, the economy’s inability to generate more tax revenue is attributable to its more fundamental inability to increase output at all. Since supply-side remedies take a long time to work. Osborne is by implication not to blame for the persistence of budget deficits in the range of 5% - 10% of gross domestic product. In the note below I dispute this position. I show that in the last few quarters the Conservative-LibDem coalition government has let general government consumption rise faster than total national expenditure, which is dominated by the private sector. General government consumption is not to be seen as equivalent to total public expenditure, which also includes capital expenditure and transfer payments [i.e., welfare expenditure, pensions, debt interest]. Nevertheless, a government genuinely committed cutting the deficit would have made a better job at trimming public expenditure.
Rising employment in Britain in recent quarters argues that a recovery is under way, even though it is disappointing by the standards of the past. Official data in recent quarters almost certainly understate the level and rate of growth of output. The understatement may arise because of the difficulty of calculating price indices in an economy dominated by service output, and characterised by extensive product innovation and improvement. (I have no idea how the national income accountants measure the output of Facebook. Twitter and Google.) At any rate, the persistence of employment growth suggests that macroeconomic conditions are normalizing after the trauma of the Great Recession. How should monetary policy now be organized? Do policy-makers need to ‘do more’ to stimulate the recovery? Or is monetary policy already on the right lines? The following note proposes that low and stable growth of the quantity of money remains the key to achieving macroeconomic stability with low inflation in line with the official target. It is suggested that the annual growth in the quantity of money, broadly-defined, should lie between 3% and 5% (or perhaps 2% and 6%) if policy-makers want to maintain consumer inflation of about 2% and moderate output growth at roughly the trend rate (which does not seem to be much above 1 ½% a year and may be lower). For the moment banks seem reluctant to expand their loan assets, despite the continuing verbal assault on them from Mervyn King, the media and others. But money growth at the desired low rate can easily be attained by varying the degree to which the budget deficit is financed from the banks rather than non-banks. Theological debates about ‘quantitative easing’ are unnecessary; they symptomize widespread misunderstanding about how monetary policy can and should be conducted. (This is the first half of a note which will be completed next week.)
Official statistics say that UK output has still not recovered its previous peak in the first quarter of 2008, but that employment has risen to an all-time high. By implication, recent productivity performance has been appalling. Indeed, it seems to have been worse in the five years to end-2012 than in any comparable peacetime period since the start of the Industrial Revolution. In a presentation I gave earlier this year at Investec I argued that one reason – but only one – for the weakness of productivity was that the composition of the labour force had changed during the Great Recession. (See the 21st May weekly e-mail on ‘UK productivity check’.) The opening of the UK’s borders to East European workers in 2004, as eight former Soviet bloc countries joined the EU, was followed by heavy immigration from these relatively poor countries. The immigration was mostly from people of working age and seeking employment. I suggested that, because on average the immigrant workers had lower pay than their UK-born counterparts, they were on average less productive. It followed that – if their share of employment increased – productivity would fall. This suggestion has often been met very critically, not least because it seemed to imply that the East European migrant workers were in some sense unsatisfactory. I meant nothing of the sort and have no personal animus towards East Europeans whatsoever. However, it must be possible to make statements about the pay and productivity levels of groups of workers, while a 2010 ONS paper confirmed that East European employment has been particularly ‘at the bottom end’ of the labour market in terms of pay and productivity. (See footnote 6 below.)
The UK has had a deficit on the current account of its balance of payments in every year since 1984. On average in the 28 years to 2011 the deficit was 1.8% of GDP, implying that – cumulatively – the UK’s net ‘indebtedness’ to the rest of the world climbed by something of the order of a half to 75% of GDP. Logically, the UK should have been by the early 21st century a heavy net payer of investment income to the rest of the world. In other words, it should have had a deficit on international investment income. But that has not been the position at all. In fact, the UK has achieved a surplus on this account in most recent years. Somehow or other, the UK’s external payments have performed a miracle, a miracle that has been very much to our advantage as a nation and particularly to our ability to consume a rising volume of imported goods. Unhappily, the very latest numbers – for the second quarter of 2012 and published at the end of last month – suggest that the miracle may be coming to an end. The UK had a deficit on international investment income for the first time since 1999. This may be a flash in the pan or it may be the beginning of a trend. At any rate, the adverse developments on the investment income account will make it more difficult to restore overall balance on the current account. By implication, the UK will need in the next few years to grow its exports of goods and services faster than its imports. Although consumer spending has been in retreat during the Great Recession, it would be unwise to expect a meaningful recovery in the next few years.