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.
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.
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
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 recurrent theme of media commentary and punditry in recent years is that ‘extra bank lending’ (in some sense, usually left vague) is a condition of wider macroeconomic recovery. This contention tends to be the prelude to another round of bank-bashing, with politicians and others blaming banks’ actual or alleged reluctance to lend as the reason for the sluggishness of demand, high unemployment and so on. The whole approach depends on the existence of a relationship between bank lending to the private sector and aggregate expenditure (or perhaps some subset of aggregate expenditure with an assumed powerful influence over the total). The claim that there is a relationship of this sort has no place in standard monetary theory, but has become fashionable in the last 20 years or so largely because of papers written by academics from the leading universities on the USA’s East Coast (Harvard, Princeton, Columbia, New York University and so on). Arguably, the current chairman of the Federal Reserve, Ben Bernanke, is the principal exponent of ‘creditism’, the set of ideas that pivots on the lending-expenditure relationship. The current weekly e-mail note is the first of a series that will criticize ‘creditism’. (In my opinion they will demolish it, but others must decide for themselves.) My focus here will be on the UK in the period of the Great Recession, but I believe the arguments to have wider validity. At any rate, I will show both that no relationship holds between bank lending to the private sector and nominal GDP in the UK in recent years, and that there are good reasons why a relationship between the two variables is not necessarily to be expected. (I do not deny that, in the normal course of events, new bank lending creates new bank deposits, which are money, and that a relationship holds between the quantity of money and nominal GDP. But it is the quantity of money as such, not bank lending, that is doing the vital work in the determination of nominal GDP.)
This week’s e-mail note is by my colleague, John Petley, and compares Spain with Greece. As the note points out, the situations are very different. No doubt the Spanish banking system has its problems, but there is no certainty that future real estate losses will wipe out its capital. Indeed, if the Eurozone (and hence Eurozone asset prices) were to return to growth as European politicians promise, such losses might be easily manageable. Further, so far Spain’s money supply has not suffered severe contraction, as in the Greek case. The yield spread between German and Spanish government bonds in the one- year area has recently been about 500 basis points. If the banking situation were normal, with readily available inter-bank lines, and 100% certainty about the contractual stability of banks and sovereigns, this would be a fantastic profit opportunity. (Assume internal management capital allocation to the trade of 5% [whatever the Basle rules say], then the return on capital – from an inter-bank borrowing costing 50 basis points with the proceeds invested in Spanish government debt – would be almost 100%.) The reluctance of German banks, and of other banks, to sell one-year bunds and to buy one-year Spanish government paper speaks volumes about the lack of confidence in the permanence of the Eurozone. Even if the Spanish banks were over-capitalized relative to other EU banks, the uncertainty about the Eurozone’s survival would limit their ability to maintain their inter-bank funding. Ditto., as regards sovereign risk. Even if Spain has low government debt (as a % of GDP) relative to other EU nations, the uncertainty about the Eurozone’s survival undermines the Spanish government’s credit-worthiness. That is the Eurozone’s real problem. In this sense the Eurozone is inherently dysfunctional.
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.