March and April have seen a marked 70% rebound in the oil price from the January lows of about $26 a barrel. The move owes much to the dynamics of the energy market itself, but it is being interpreted by financial markets as a sign that global demand should be sufficient to deliver at least trend growth (say, 3% - 3½%) in world output in 2016. The mood has changed sharply from January’s alarmist hysteria, much of it due to so-called “analyses” from the Bank for International Settlements, the International Monetary Fund and leading investment banks. (These organizations ought to have known better, bluntly.) The line taken in International Monetary Research Ltd. notes has been that recession in 2016 is extremely unlikely. Only hopelessly incompetent monetary policy decisions could cause a recession to start from a situation in which upward pressures on inflation have been and remains weak, and the price level has been and remains more or less stable. I don’t have much respect for the top brass in the major relevant institutions (i.e., the Fed, the ECB, etc.). But, to initiate a recession, they would have had to be yet crasser than they were in the last period of idiocy, in late 2008. In practice, the absence of upward pressures on the price level has allowed significant monetary-policy easing in China and the Eurozone. It seems that in China M2 growth has run about 1% - 1½% a month (i.e., at annualised rates of 13% - 20%) in early 2016. In the four major developed “countries” (i.e., taking the Eurozone as a country) – the USA, the Eurozone, Japan and the UK – the annual rates of broad money growth are currently 3.9%, 5.0%, 2.6% and 4.5%, and the three-month annualised growth rates are 5.1%, 4.4%, 2.8% and 5.0%. If asked for an ideal rate of money growth, Milton Friedman would typically reply – at least for the USA – “5% a year”. The Bank of Japan seems unable to see the light in the “broad money vs. monetary base” debate. But in truth money growth trends in the main countries are not far from perfection at present.
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.
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.
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’. I brought together evidence from earlier recoveries to show that the typical US recovery was accompanied by the continuation of low inflation and indeed often by falling inflation. In other words, the macro news tended to be excellent during recoveries, with above-trend growth in output and profits associated with declines in inflation. This sort of macro backdrop usually saw strong gains in equity prices. Monetary policy is nearly always controversial, and the last four years have seen even more bitter and intense controversies than usual. Expansionary open market operations of a traditional kind have been labelled ‘quantitative easing’, and described as ‘unconventional’ and innovatory. Silly rants – such as those from Liam Halligan in his Sunday Telegraph column – have claimed that by its very nature QE (and regardless of the quantities and timing involved) is inflationary, redolent of ‘banana republics’, ‘the last refuge of dying empires’, etc. In fact, QE has barely failed to offset the contractive effect on money growth of tighter bank regulation and officialdom’s determination to raise banks’ capital/asset ratios. Anyhow, the latest American data show that inflation is under good control, and is in fact much lower than in 2007 and 2008. (It is not lower than in 2009 when the price level, not the level of inflation, was falling, and observers were understandably concerned about deflation)
A longer version of the following noteconcerning QE2 will probably be published by one of the Thatcherite/free-market think-tanks in the next few months. It should be seen as a continuation of the argument in commentaries I wrote in the second half of the Thatcher government, when – in my view – many of the gains of the first six years (i.e., from 1979 to 1985) were frittered away in a foolish boom-bust cycle and other policy mistakes. Famously, Lady Thatcher was not for turning. Both of the excellent biographies that appeared shortly after her death drum the message home. The first volume of the official biography by Charles Moore, which ends the narrative at a well-chosen ‘half-time’ in 1982, carries the subtitle ‘Not for Turning’. The biography by Robin Harris, who had helped to prepare Thatcher’s own memoirs, covers her full career. His book is actually called Not For Turning. But is that the right characterisation? The argument here will be that the no-turning-back mantra overlooks some inconvenient monetary statistics. The control of inflation was basic to the Thatcher agenda at the start of her administration in 1979. The unfortunate truth is that the Thatcher government committed a massive U-turn in anti-inflation policy and, within a few years, the U-turn had disastrous consequences. Of course Thatcher herself is not the same thing as the Thatcher government, and the allocation of blame between her and her colleagues may be complex. All the same, as will soon emerge, the data have a clear message. In a key area of public policy a major priority in her original programme was abandoned and forgotten while she was in power. (Let me emphasize for clarity that I have a great admiration for Thatcher’s courage and abilities, and have always been a strong supporter of her overall project. This piece is written more in sorrow and regret than in anger and resentment.)
Mario Draghi denies that he is an actor. But in July last year he is reported to have paused, with great effect, between two sentences in an interview for the Financial Times. The two sentences were, ‘Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And, believe me, it will be enough.’ On the basis of these two sentences, which were followed by a spectacular rebound in the euro on the foreign exchanges and in European share prices, the FT made Draghi its ‘Person of the Year’ for 2012.* But Mario Draghi, like King Canute, is not omnipotent. He cannot break the laws of arithmetic and the principles of accountancy which depend on those laws. He cannot – by mere pronouncement – conjure up the real resources required to fill the hole in Cypriot banks’ balance sheets. Equally, if that hole is €17b. (or about 80% of Cyprus’s GDP of €22b.), the Cyprus Parliament cannot by rejecting the terms of an international bail-out make the people of Cyprus richer in any meaningful sense. The cost of filling a hole of €17b. is the cost of filling a hole of €17b. It was supposed to be met by an increase in Cyprus’s public debt of over €10b. and the highly controversial deposit haircut of €5.8b. The Cyprus Parliament’s unanimous rejection of the haircut does not mean that – automatically, immediately, magically and finally – the €5.8b. has fallen like manna from heaven. We have a stand-off. The ECB has indicated that, on the provision of the appropriate collateral (Greek government bonds?), it will lend to the central bank of Cyprus sufficient amounts for it to meet cash calls from the commercial banks. These banks would then have enough cash to repay depositors with legal-tender notes. But do Cyprus’s banks have appropriate collateral in sufficient amounts? Do they, in Draghi’s terms, have ‘enough’?
The following note – or rather set of notelets – is heavily based on my latest submission to the Shadow Monetary Policy Committee, a body set up by the Institute of Economic Affairs in July 1997. In my comments on the UK, I argue that recent monetary trends argue for the validity of the monetary theory of national income determination. Hence, they do not justify alarmism about the inflation outlook, although it is true that the supply-side performance of the UK economy has been poor in recent years. This has been a key reason that low growth of national output in nominal terms has been accompanied by disappointing inflation numbers. I also discuss output growth trends at the world level, to see whether similar concerns about supply-side performance apply more generally. The results came as a bit of a surprise. Of course it is well-known that growth was strong in the global boom of 2004 – 07. In fact, the global boom of 2004 – 07 was the most powerful since that of the early 1970s, which also had to be aborted as rising commodity prices were accompanied by a more general inflation problem. 2009 was the first year since the Second World War in which world output fell. However, the last decade has in fact been an outstanding one for growth. Despite the 2009 dip, the ten years to 2012 saw an average annual growth rate of output of 3.8%. That is a fantastic rate of growth by any past standards. (A 3.8% annual rise in real incomes would imply an almost 14-fold rise in a lifetime of 70 years.)
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.”
A recurrent theme in the e-mails from International Monetary Research Ltd. since early 2009 has been that sudden, large-scale bank recapitalizations – of the kind implemented in the UK particularly (but also elsewhere) in late 2008 – are deflationary. (See, for example, the weekly e-mail of 14th September 2009, with its account of ‘the paradox of excessive bank regulation’.) This has often puzzled people, since – surely – recapitalization makes banks safer and the safer are banks, the less likely are crises. (As far as I am aware, no evidence has been produced [by e.g., Mervyn King, John Vickers, the Basle regulatory bureaucracy etc.] for the theory that macroeconomic instability [as measured, e.g., by the standard deviation of GDP growth] is inversely related to the banking system’s capital/output ratio. I am indeed pretty confident that – when tested against data – the theory does not hold up, but let this pass for now.) So this week I explain, again, why bank recapitalization is deflationary. What evidence can I call upon to substantiate my argument? Well, in effect the whole sorry financial and macroeconomic mess in the leading industries countries since mid-2007. Officialdom has repeatedly demanded that banks have more capital and, for all their problems, banks have higher capital/asset ratios today across the industrial world than they had in mid-2007. Yet the four years have been a misery and officialdom wants the banks to raise still more capital! How many more times does it have to be said that the key to macroeconomic stability is steady growth of the quantity of money at a low, non-inflationary rate? That is what matters, not the current rigid and ideological approach towards banks’ capital being taken in the Bank of England, H M Treasury, the US Treasury, etc. (Mercifully, not every country’s official economic policy agencies have been captured by the unfortunate and false doctrine that ‘the more capital banks have, the better for the world’.)
As in the USA’s Great Depression of the 1930s, its Great Recession of the last few years has been accompanied by a collapse in the growth of the quantity of money. Analysis of money data – in the USA, as in other countries – is bedevilled by institutional arcana, as well as the extreme difficulty of differentiating erratic shocks from underlying trends. In my work I emphasize broadly-defined money, including all relevant bank deposits, although I concede that this notion is itself ambiguous and elusive. In the USA my preference is for the M3 money measure which the Federal Reserve stopped publishing in March 2006. Fortunately, an alternative series is prepared by the Shadow Government Statistics research company and I am using its data in the present note. For all the data problems, the M3 numbers published by SGS tell an alarming story. The annual growth rate of M3 – which peaked in the high teens in late 2008 – had crashed to a negative value less than two years later. On the historical record, more or less constant growth in the quantity of money – at a moderate but positive rate – is a condition of macroeconomic stability. Last summer M3 was still dropping. Although the Federal Reserve denies that it pays any attention to broad money, the weakness in money growth had been associated for some quarters with a disappointingly sluggish recovery. In early November Fed chairman, Ben Bernanke, announced a ‘QE2’ programme. Heavy purchases of long-dated US Treasuries (with five or more years to redemption), amounting to $600b., were meant to boost the US economy. The present note surveys the evidence of QE’s effects. It shows that – as would be expected with a QE programme – banks’ cash holdings have increased dramatically, in fact pretty much in line with the targeted amount. But US banks’ non-cash assets have fallen a little since last October and showed no meaningful sign of returning to growth. When QE2 ends, M3 is likely for some quarters to grow very slowly or not at all.