Evidence from the years of the Great Recession justify renewed attention to a broadly defined concept of the quantity of money in central bank researchControversy over the use of monetary aggregates undermined the impact of the monetarist counter-revolution of the 1970s and early 1980s. Top central bankers accepted Milton Friedman's dictum "money matters" was valid in some sense, but they were unsure exactly how and why it mattered. Practical application was elusive when their research departments produced data on half-a-dozen monetary aggregates. Which concept of money was of greatest importance - or at any rate of some relevance - to the determination of macroeconomic outcomes? Anthony Harris, one of the Financial Times' leading commentators, compared the quarrel to that between the 'Big-endians' and 'Little-endians' about the best way to open a boiled egg in Jonathan Swift's Gulliver's Travels. Some economists favoured 'broad money', which included all bank deposits and occasionally even included liquid assets that had arisen outside the banking system. Others supported 'narrow money' - generally taken to mean notes and coins in circulation plus sight deposits. The majority of monetary economists did not regard the monetary base (the liabilities of the central bank) as equivalent to 'the quantity of money' based on any definition. Instead, they believed the change in the base influenced the change in narrow money and hence affected expenditure at a further remove. However, some participants in the debate thought that the monetary base by itself, regardless of its role in banks' creation of money, had a significant bearing on spending and the economy.
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.
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
The following note gives my Powerpoint presentation to the IEA’s annual ‘State of the Economy’ conference on 23rd February. Comments are made on the 22 slides in the presentation. The main conclusion is on slide 21 that, “The Great Recession was due to blunders by officialdom, blunders which could be attributed – in large part – to shocking ignorance of basic monetary economics in the world’s leading central banks.”
The purpose of quantitative easing was to stop the quantity of bank deposits falling In 2009 and 2010 the quantity of bank deposits (in the USA, the Eurozone, the UK, etc.) would have fallen without QE, because of
- the officially-imposed sudden, large-scale bank recapitalisations,
- the related pressure on banks to shrink risk assets, and
- the widespread (and justified) concern in the banking industry that the Basle
Sharply contrasting verdicts on the Fed’s latest “quantitative easing” programme have appeared from the commentariat. At one extreme are the pundits who claim that QE doesn’t matter much to anything, such as Martin Wolf at the Financial Times; at the other are alarmists, like James Grant of the Interest Rate Observer and Liam Halligan of Prosperity Capital Management, who seems to believe that any money “printing” (as they describe it) has serious inflationary consequences. Who is right? What is the correct view? Serious answers to these questions need to be within a coherent analytical framework. That framework has to relate the Fed’s operations to ultimate policy targets, such as the price level and/or the inflation rate. It is taken for granted here that the equilibrium levels of national income and wealth are a function of a broadly-defined quantity of money, which in the US case is best represented by the M3 money measure. (The Fed’s discontinuance of M3 estimation in 2006 in no way altered its relevance to macroeconomic outcomes.) US M3 currently stands at about $14,000b. The $600b. of long Treasury purchases (which will be mostly from non-banks) announced by the Fed will lead in the first round to an increase in M3 of between $400b. and $600b. more than would otherwise have occurred. The first round will also be associated with an increase in banks’ cash reserves of the full $600b., unless the Fed neutralizes the increase by transactions between itself and the banks. There may be significant second-round and later effects if the banks respond to the extra cash by seeking more assets, but these are not discussed in any detail below. Assuming that the increase in M3 attributable to QE2 is indeed $600b., the equilibrium values of US national income and wealth are raised – relative to what would have otherwise have happened – by roughly 4% (i.e., $600b. divided by $14,000b., expressed as a %age). This seems appropriate and sensible, given the deflation threat facing the USA.
Unemployment in the USA remains at almost 10% of the workforce. Apart from a few quarters in late 1982 and 1983, the current level of joblessness is the highest since the 1930s. Policy-makers could justify high unemployment in the early 1980s by the need to reduce the annual rate of inflation, which had moved well into the double digits in 1979 and 1980. No such justification is available for the pain of unemployment today, as inflation is negligible. When President Obama was elected in November 2008, the unemployment rate was 6.9%. Unless unemployment falls significantly in coming months, his presidency will be blighted by the worst unemployment record since the Great Depression. Obama is clearly desperate to see unemployment on a downward path before the Congressional elections in November 2010, in which the Democrats are expected to suffer heavy losses. He has therefore sought advice from a group of well-regarded economists of known Democrat sympathies, including Larry Summers, who is head of the White House National Economic Council, Paul Krugman and Joseph Stiglitz. Krugman and Stiglitz won the Nobel prize for economics in 2008 and 2001 respectively, and their contributions to economics are much admired in the academic world. Summers, Krugman and Stiglitz are Keynesians, who believe in the effectiveness of fiscal policy and deny that the quantity of money is relevant to macroeconomic outcomes. Their recommendation to Obama has therefore been to engineer large increases in public expenditure and the budget deficit, in order to boost demand, output and employment. Obama is showing signs of frustration with the results of this fiscal expansionism; he will undoubtedly be disappointed if above-trend growth and falling unemployment are not restored soon. Evidently, the question “does fiscal policy work in the USA?” is fundamental. This note surveys some of the evidence.
Eurozone M3 fell by 0.1% in October, after a similar marginal decline in September. The Eurozone’s measure of broad money – at one time supposed to be lynchpin of European monetary policy – has barely changed for a year. (In fact, the increase in the 12 months to October was 0.3%.) This is the lowest rate of money growth, if “growth” it can be called, since the introduction of the euro in 1999. In fact, if a Europe- wide money aggregate could be compiled on a continuous basis since the 1930s (and for historical reasons this is of course impossible), the annual rate of money change in continental Europe is at present the lowest since the 1930s. Helped by the end of heavy de-stocking, output is recovering in the leading Eurozone economies (i.e., Germany and France), although growth remains at a beneath-trend rate. But in the so-called PIIGS (Portugal, Italy, Ireland, Spain and Greece), business surveys have been deteriorating since the summer. In their recent public statements the leading figures in the European Central Bank have shown no concern about this deterioration. They seem determined to do nothing particular either i. To raise broad money growth, or ii. To help the PIIGS. Sure enough, given the treaties that govern the workings of the Eurozone, the ECB cannot discriminate in any way in favour of the PIIGs and has to emphasize, for example, that the Stability and Growth Pact applies to all members. There is a growing possibility that the weakest member of the Eurozone – which is undoubtedly Greece – may leave the Eurozone. But in what circumstances might that occur? And what would be the knock-on effects to the next weakest members (i.e., Spain, Portugal and Ireland)? And what will the inevitable tensions in 2010 between the ECB and the PIIGS mean for the euro against other currencies?
So far this year US money growth has been negligible. From the end of January to early January the annualised rate of increase in M2 was under 2%. (M2 was $8,270.6b. on 26th January and $8,388.9b. on 9th November, up by 1.4%, which annualises in the 41-week period to 1.8%.) On the even broader M3 measure – for which good estimates are prepared outside the official machine by Shadow Government Statistics, the research company – the record is even worse. In recent months M3 has been falling. In view of the long-run similarity of the growth rates of nominal GDP, M2 and M3 in the USA, these monetary trends are disturbing. Output is growing at present because of help from virtually zero interest rates, the ending of inventory rundowns and upturns from very depressed levels in such areas residential real estate, but growth is not at an above- trend rate and unemployment is still rising. Money trends are not everything, but they argue that in early 2010 unemployment will continue to rise and – if output does grow – it will again be at a beneath-trend rate. American economists – like economists everywhere – are in a muddle at present, with droves of them advocating yet another so-called “stimulatory” fiscal package. That would be pointless. The key item on the agenda ought to be active measures to raise the rate of money growth by the necessary open market operations, including large-scale central bank and/or government purchases of long-dated government debt from non-banks. Ben Bernanke, chairman of the Fed, must be criticised for not heeding Milton Friedman’s warnings about the need to raise the quantity of money in order to head off deflationary forces.