Financial markets are concerned about ‘recession risk’, or so the newspapers tell us. When the world’s leading economies are viewed objectively, it would be hard to imagine circumstances in which recession was less likely. All recessions since the 1930s have begun with monetary policy tightening to curb inflation. This is true even of the 2008 � 2009 Greeat Recession, although officialdom’s reaction was disproportionate and misguided, and led to a few months of outright deflation. (Government, central banks and regulatory agencies imposed new regulations that acted like a punitive shock on banks, and stopped the growth of their balance sheets and hence of the bank deposits that constitute most of the quantity of money.) But today inflation in the leading economies (excluding India, and also such places as Russia and Brazil beset by corruption, political adventurism, misgovernment, etc.) is virtually zilch. The concern is not too much inflation, but the danger of deflation. In effect, there is no constraint on expansionary monetary policy. Objections to this argument are two-fold. The first is that in the United States of America the recovery is so mature that the labour market is showing signs of over-heating and a normalization of monetary policy (with higher interest rates) has become necessary. The weakness of this claim is that, although the unemployment rate has dropped to beneath long-run averages, many people have left the labour market temporarily because of lack of demand. The employment rate is still well below the 2008 level. Meanwhile the strong dollar is hurting manufacturing, reducing import costs (over and above the impact of low oil prices) and dampening inflation. Talk of four Fed rate rises in 2016 is starting to look very silly.
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.
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.
It is now time to bring the strands of the analysis together. There is no single, exact number for the damage that EU membership does the UK, but vast damage has been done. Chapter 1 established that the direct fiscal cost of the UK’s EU membership is now 1¼% of gross domestic product each year; chapter 2 examined the damage of EU regulation in terms of employment and energy use, and in the international financial sector (i.e., ‘the City’), and also discussed small business closures because of substance and product authorisation regulations, and arrived at a number of between 5% and 6% of GDP each year at present, but growing over time; chapter 3 borrowed from work by the OECD and Minford to reach an estimate that resource misallocation due to the EU’s trade regime costs the UK over 3% of its GDP each year; chapter 4 argued that, because the UK labour market had been too open to immigration from Eastern Europe, over 100,000 UK-born people had been without jobs over a significant length of time, with a cost that may be difficult to quantify, but might be 3/8% of GDP for the relevant period; chapter 5 surveyed the costs of waste, fraud and corruption, and argued that the Common Fisheries Policy, the Common Agricultural Policy, environmental directives, and fraud and corruption in EU- or EU-related administration led to waste that in total might be 3/8% of GDP; and chapter 6 looked at actual and potential losses from ‘health tourism’, ‘benefit tourism’, fines from the European Court of Justice and ‘contingent liabilities’, which added another ¼% of GDP.
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.
The Eurozone resembles a vast dyke which is full of holes and liable to disintegrate at any moment. This note concentrates on Portugal, where the recent resignation of the very able finance minister, Vitor Gaspar, was a huge disappointment. (It must be said that the Eurozone’s holes in Greece, Spain, Italy and France also remain large and conspicuous, despite international officialdom’s attempts to patch them.) Portugal’s problems arise partly because the economy’s trend rate of growth is now very low, perhaps even zero or negative. Gross domestic product per head is lower than ten years ago. With inflation almost zero, nominal GDP is at best flat. As a result, any deficit leads to an increase in the ratio of public debt to GDP. A May 2011 bailout negotiation with the ‘troika’ extended €78b. of loan and other financing, to help the Portuguese government and banking system. It must be acknowledged that Portugal has tried hard, with Gaspar at the finance ministry, to meet the conditions attached to the bailout plan. The cyclically-adjusted budget deficit fell from 9.0% in 2010 to 4.0% in 2012. Nevertheless, the debt-to-GDP ratio has kept on rising and is now over 120%, the kind of figure that was associated with the Greek dégringolade in 2012. (A fair verdict is that a debt-to-GDP ratio of 120% is sustainable when the nominal interest rate on the debt is 5% or less, but – once the interest rate goes into double digits – the debt interest burden runs amok like a Frankenstein monster.) The Portuguese people are apparently weary with austerity, and it has to be said that – without a resumption of growth and particularly of asset price appreciation, which would help banking solvency – the danger has to be that further deficit-reduction measures would not restore fiscal sustainability or national solvency. Holders of Portuguese banks’ bond liabilities and depositors with Portugal’s banks, you have been warned! PEXIT (Portuguese exit from the Eurozone) is – almost certainly – a better option than staying in.
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.)