The victory for the Leave campaign in the UK’s referendum on EU membership has dominated financial news since 23rd June. It is of course a major event, not least because numerous forecasts of a mini-recession in the UK are now to be tested. The evidence so far is mixed, with the latest survey from the Confederation of British Industry (published a few days before 23rd June) reporting a rise in the balance of companies planning to expand output in the next three months. Elsewhere the main features are, first, in the developed countries continued growth of broad money at the almost ideal annual rate of 4%, and, second, in China and India signs of a slowdown in broad money growth. The slowdown in both China and India has come about suddenly, and may soon disappear from the data and not prove meaningful. On the other hand, the slowdown could last a few months, perhaps even more. Once a money slowdown/acceleration persists for six months or longer, it starts to matter to the cyclical prospect. My overall assessment is – despite the Brexit shenanigans – the global monetary background remains consistent with steady growth in world demand and output in late 2016 and into 2017. Far too much fuss is being made about Brexit. The UK’s share of world output (when output is measured on a so-called “purchasing power parity” basis) is modest, less than 2½ per cent. The credit downgrades faced by British banks have created possible funding strain for them, recalling the crisis of late 2008. The problem needs to be countered by the provision of long-term refinancing facilities from the Bank of England, just as Draghi handled a similar challenge in the Eurozone in December 2011
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.
The UK economy is clearly recovering and now achieving above-trend growth. Survey evidence is clear-cut, with the Confederation of British Industry’s monthly survey (of manufacturing, mostly) showing the highest balance of companies expecting to raise output since the mid-1990s. Past experience is that above-trend growth can be maintained for several quarters without provoking more inflation, as long as the revival is taking place from a depressed condition in which the level of output started well beneath trend. (The September 2013 CBI balance on price-raising intentions was in fact very low.) Money growth is satisfactory, but not particularly high. M4x (i.e., broad money excluding balances held by intermediate ‘other financial corporations’ or quasi-banks) was 4.5% higher in July 2013 than a year earlier, but the annualized growth rate in the three months to July was only 3.3%. Reasonably strong growth rates of demand can be reconciled with these rates of money growth, which are modest by long-run standards, largely because interest rates are more or less at zero, and people and companies are finding ways of economizing on their holdings of unattractive non-interest-bearing money. (In other words, the desired ratio of money to expenditure may be falling.) The argument for ending ‘quantitative easing’ (not in effect since the July meeting of the Monetary Policy Committee anyway) and/or raising interest rates has more cogency than at any time in the last five years. However, analysis of data from the Bank of England shows that over the last year money growth would have been negligible in the absence of QE.
The following note is work-in-progress. It is part of an attempt to bring to an end the great mass of confusions that have cluttered discussion of ‘quantitative easing’ in the UK’s monetary policy debate and indeed the monetary policy debates of many nations, in the last few years. Work on the note will resume next week…and perhaps in the following weeks.
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.
On 6th October the Bank of England announced a second round of ‘quantitative easing’, with £75b. of purchases of gilts (mostly mediums and longs in the hands of non-banks) to take place in four months from mid- October. This QE2 exercise follows the earlier programme (QE1), of £200b. of purchases in the 11 months to February 2010, which is generally regarded as having had a positive impact on demand and output. But, how, exactly does QE have its benign effects on the economy? And what does that imply about the conduct of monetary policy since February 2010? It needs to be restated that the levels of national income and wealth are functions of the broadly-defined quantity of money (i.e., M4 in the UK case). The first instalment of QE worked – in conjunction with virtually zero interest rates – because it resulted in M4 being about 10% higher than would otherwise have been the case. So equilibrium national income and wealth (i.e., the value of corporate equity, houses and commercial real estate) today are also higher, very roughly speaking, by about 10% than they would have been if QE1 had not been implemented. Nevertheless, officialdom’s pressure on the banks to shrink risk assets meant that the quantity of money did not in fact change much while the first QE operations were under way. That pressure on banks to shrink risk assets continues. As in 2009 and 2010, it is having the effect of reducing banks’ loan portfolios and so of destroying money, and the second instalment of QE is needed to balance the deflationary effects of banks’ shrinkage of risk assets and the associated decline in bank deposits.
Numerous commentators have been persuaded by what might be called the “consensus narrative” and the “conventional wisdom” about the Great Financial Crisis which began in 2007. (The GFC continues, although – like an old soldier – it may be fading away.) According to this “narrative” and “wisdom”, the banking system in 2007 and 2008 was at risk of not being able to repay depositors with cash. It was therefore “bust”. So it caused the GFC, and needs to be both comprehensively repaired and more heavily regulated. The repair is to involve banks holding more capital, cash and liquidity – relative to balance sheet totals – than before. The advocates of the conventional wisdom also assert that banks benefit from an alleged “implicit government guarantee” on their deposits. To compensate for the benefits supposedly derived from the guarantee, the banks are deemed liable for extra taxes and levies. The consensus narrative and conventional wisdom have been particularly influential in the UK. Some voices of dissent have been heard. One of their key points has been that – even if the consensus narrative and conventional wisdom were correct – the UK has enjoyed considerable advantages from the location of wholesale financial activities in the City of London, and onerous taxes and regulations could cause these activities to leave the UK. In its Interim Report the Independent Banking Commission pooh-poohs the dissenters’ claims. It says that the various reforms it recommends “would affect a relatively small proportion of the international financial services industry based in the UK” and, anyhow, these services should value the greater macroeconomic stability implied by a well-capitalized banking system. The purpose of this note is to show that – whether the Independent Banking Commission is right or wrong in its contentions – a remarkably large flight of risk capital from UK international financial services has occurred in recent months.
To QE or not to QE, that is the question. The focus in this note is on the UK economy. In contrast with the Fed in the USA, the Bank of England has decided – at least for the moment – that another round of asset purchases is unnecessary. The underlying assumption of the analysis here is that the equilibrium levels of national income and wealth in nominal terms are a function of the quantity of money (broadly defined). A key issue in macroeconomic prognosis is therefore the likely behaviour of the quantity of money at current interest rates, levels of bank capital, etc. The main conclusions are that
- the M4 money aggregate will grow only slowly, if at all, in the next three to six months, and
- ii. macroeconomic conditions are likely to be satisfactory, with perhaps trend growth, because at current interest rates interest-bearing deposits are an unattractive asset to hold and agents want to hold less money relative to their incomes and wealth.
Since the Great Financial Crisis began in mid-2007 several pundits have warned about the supposed inflationary threat from “printing money”. By “the printing of money”, they understand the expansion of the central bank balance sheet arising from so-called “quantitative easing”. At the most extreme, the pundits appear to believe that parallels can be drawn between quantitative easing and such episodes as the Weimar hyperinflation of 1922 and 1923. In the UK the most prominent of the alarmist pundits is Liam Halligan in his Sunday Telegraph column, but similar sentiments are found in many places. They appear to be even more common in the USA. Much of this commentary arises from a plausible, but mistaken form of monetary conservatism, which I will call “base-ism” here. Base-ism is false. The truth is that inflation occurs when the quantity of money – meaning a broadly-defined money measure – expands significantly faster than the quantity of goods and services. The naive conservative pundits are subject to (at least) two misapprehensions. The first is to believe that the quality of money – that is, its nearness to commodity form – is relevant to the value of money. The second is to confuse the monetary base (i.e., in modern circumstances, the legal-tender liabilities of the central bank) with the quantity of money (which is in fact dominated by the deposit liabilities of commercial banks). Associated with this second fallacy is a third one, that the critical variable is determining macroeconomic outcomes is bank lending to the private sector (i.e., the assets side of banks’ balance sheet) rather than the quantity of money as usually defined (i.e., an aggregate dominated by banks’ deposit liabilities). I have already written extensively about this fallacy – the fallacy of creditism – which has been particularly influential in the current cycle. Of course, the apparently theoretical discussion here is fundamental to the “inflation vs. deflation debate” and crucial to investment decisions.