The following piece was written as Tim Congdon’s most recent submission to the Institute of Economic Affairs’ Shadow Monetary Policy Committee. It has here been expanded slightly, compared with the original submission.
What urgently needs to be refuted the notion that a UK recession is inevitable in 2012. The creation of money by the state – as in the current QE2 exercise – is an immensely powerful instrument of monetary policy. In essence, the effect of a 1% increase in the quantity of money broadly-defined (i.e., M4 in the UK) is to raise the equilibrium levels of national income and wealth also by 1%, give or take relatively small amounts due to changes in the attractiveness of money compared with other things and non-money assets, a non-unitary income-elasticity of the demand for money, and changes in banking institutions. Over the 1963 – 2011 period in which modern statistics have been prepared in the UK, the average annual rate of increase in M4 has been 10.6%, compared with 8.7% for nominal GDP. The difference in growth rates is readily explained by banking deregulation, which has made money-holding more worthwhile compared with other kinds of asset-holding.
Since the state can always purchases assets from non-banks (and thereby boost non-banks’ bank deposits, i.e., their money balances), it can always and in any country prevent a recession. Admittedly, the relationships between money and demand are far from 100% reliable in the short run, but I expect the current QE2 exercise to be associated with relatively buoyant UK domestic demand in early 2012. Some of the early reports of Christmas trading are encouragingly good. -238 13 18 23 28 Money and nominal GDP in the UK, 1979 - 2011 - Charts shows 20-quarter (i.e., five-year) moving average of quarterly increases in M4 minus 2% and nominal GDP at % annual rates M4 Nominal GDP %.
QE to the rescue
Many commentators, even on the Right, have to face up to their istorically misplaced doubts as to the effectiveness of QE. It has been called into question in some recent newspaper articles, such as that in the Financial Times of 25th November by Professor Robert Skidelsky. The central proposition in the argument for QE during and since the Great Recession has been – or at any rate ought to have been – familiar from traditional monetary economics. This is that an increase in the quantity of money is associated with (indeed, usually causes) a proportionally similar increase in the equilibrium levels of national income and wealth. Nowadays the quantity of money is dominated by bank deposits, which in the UK are more than 30 times larger than the note issue in non-bank hands. The relationships between money on the one hand, and national income and wealth on the other, hold regardless of banks’ asset composition. Contrary to a widespread misunderstanding, the change in bank lending to the private sector is by itself neither here nor there. I don’t deny that new bank lending creates new bank deposits, in the normal course of events. But it is the deposits that matter to macroeconomic outcomes, not the loans.
Since 1979 M4 has tended to grow - until recently - by about 2% a year more than nominal GDP. Economists such as Skidelsky might expect that the turmoil and confusion of the last few years would have destroyed the relationship between money and money national income. But that is not so. In the five years to the third quarter 2011 the increase in money gross domestic product at market prices was 13.8% (i.e., with a compound annual rate of increase of 2.6%), while the increase in the quantity of money (as measured by the M4x measure) was 16.0% (i.e., with a compound annual rate of increase of 3.0%). The medium-term similarity of the rates of change of money and nominal expenditure has survived the Great Recession, just as it survived the various bouts of macroeconomic instability in the 1970s and 1980s, and the happier Great Moderation in the 15 years to 2007.
Policy to expand quantity of money always available and effective
My point in emphasizing these facts is to assert that a policy-driven acceleration in the rate of money growth – which can undoubtedly be delivered by sufficiently aggressive expansionary open market operations and/or by monetary financing of the budget deficit – can check emerging recession pressures in any economy at any time. A recession in 2012 would be justified only if the inflation outlook were dire and monetary restraint were needed to check an unacceptably large rise in prices. In fact, inflation is going to fall in 2012. At least three immediate causal considerations could be mentioned, the easing in oil and gas prices since early 2011, the ending of the early-2011-VAT- increase effect on the annual comparison, and the high margin of slack in the UK economy associated with modest increases in wages. In the background the key influence at work is the very low rate of growth of the quantity of money.
Given the widespread anxiety about the return of recession in 2012, I endorse the Monetary Policy Committee’s decision to pursue another £75b. of QE and would hope that it will lead to a burst of suitably positive money growth in the October 2011 – March 2012 period. The first set of money supply numbers affected by the UK’s QE2 programme shows the clear impact of the bond purchases. The public sector contribution to M4 growth – which had been a relatively minor influence on the quantity of money in the months leading up to October – became massively positive in October itself, the first full month in which the asset purchases were being conducted.
The main caveat here is that Britain’s banks remain under a regulatory cost. Their shrinkage of risk assets may to a large extent offset the increase in their claims on the Bank of England and the government which is implied by QE. Happily, the October numbers hint that UK banks’ asset shrinkage is now proceeding at a more moderate pace than in 2009 and 2010. Unhappily, the numbers over the last few months indicate that it is still continuing. Banks’ loan portfolios keep on falling, although – if the data are to be taken at face value – the drive for extra capital is now largely over. It is important to understand here that the banks themselves do not want to be reducing their loan portfolios, but are subject to the Basle rules and the UK’s gold-plating of these rules because of the Vickers Commission’s recommendations. The depressing truth is that key officials in the Bank of England and the Treasury do not see the links, first, between the shrinkage of banks’ assets that they have ordered and the stagnation of the quantity of money, and, second, between the stagnation of money and the persistence of balance-sheet strains (and hence weak demand) in the economy.
Public debt management and monetary policy should be coordinated
My main criticism of official policy is one I have stated many times and remains unchanged. In making this statement I am taking the regulatory attack on the banks as a given. If there were some hope of squashing the Basle rules/Vickers etc., I would be in favour, but this is – for the moment – a pipedream. The objective of QE is to increase the quantity of money (and/or its growth rate), in order to counter the money stagnation/contraction attributable to the regulatory attack on the banks. The increase in the quantity of money is the variable that matters, not the location (in terms of personalities, institutions, etc.) of the official decision to boost it. In my view, by far the simplest way of increasing money growth is for the government to stop selling long-dated gilts to non-banks, and to issue large quantities of Treasury bills and short-dated gilts with the intention that these will be acquired by the banks (i.e., resulting in the creation of new money balances).
The enormous expansion of the Bank of England’s balance sheet since mid-2007 has led to administrative awkwardness and extensive misinterpretation. Thus, for example, Liam Halligan has said in his Sunday Telegraph column that the increase in the monetary base – an increase which is clearly a by-product of QE – will result in rapid inflation and currency debauchery. The latest business surveys – which show a sharp loss of business confidence and clear declines in plans to raise prices – contradict the Halligan “forecasts”, although Halligan does not in fact commit himself to a precise forecast of a particular inflation rate at any particular date. Ideally, an increase in the quantity of money can and should be organized without any significant effect on the monetary base.
The trouble is that the Bank of England – or at any rate its current governor, Mervyn King – believes that the Bank of England should have exclusive responsibility for monetary policy and, hence, for the specification of QE policy. I would strongly prefer that the Bank and the Treasury (and the Debt Management Office, to the extent that it has its own separate voice) work together, with a view to achieving stable, moderate growth of the quantity of money. The management of the public debt undoubtedly has implications for the rate of money growth (or money contraction), and – willy-nilly – the central bank must always work with finance ministry on the practicalities and tactics of debt issuance. An exaggerated sense of its own importance is one reason that the Bank of England has bungled so often in the last few disastrous years.
How bad a threat is Eurozone turmoil to the UK economy?
Thousands of words have already been written about the dysfunctionality of the Eurozone, and there is no need in this article to yet again rehash increasingly well-known analyses. Eurozone sovereign debt (and also, importantly, inter-bank claims between Eurozone banks) have become unsafe assets. There is little doubt that – if their assets were marked to market – virtually all the Eurozone’s banks would now have deficiencies of capital. These deficiencies would take both extreme and mild forms, with equity capital either negative in the worst cases or far beneath the regulatory norms in the more satisfactory instances. Big Bang recapitalization (i.e., a comprehensive and sudden imposed recapitalization, compressed into a short period of time) would then be intensely deflationary and could plunge the Eurozone economies into a second Great Recession, less than five years after the supposed end of the previous one. For evidence, consider what happened to the East Asian economies in 1997 after Japan’s banks were told to recapitalize in a hurry, or to our own economy in 2009 after the bank-bashing of October 2008. Given that the IMF and the BIS appear to favour a bank recapitalization of the Big Bang type, the risk of a second Great Recession is high.
However, a major recession in Europe can be easily avoided, if policy-makers use some common sense and do not insist on a Big Bang recapitalization. Frankly, the banks could not – in 2007 and earlier – have been expected to foresee either the Eurozone’s disintegration or the traumatic effect on their solvency of that disintegration. Policy-makers must give the banks an extended period of time to recapitalize, with steady growth of the quantity of money as a key desideratum while that recapitalization is taking place. In practice early 2012 could be chaotic. We must envisage finance ministers in Eurozone countries instructing the ECB governing council to expand its balance sheet rapidly in 2012, if a serious recession materializes. (A minor recession seems to be under way already.) At this stage no one knows the eventual resolution of the huge row between Europe’s politicians and the ECB that seems imminent. Since writing the original version of this piece, David Cameron has wielded his veto on the EU’s proposed “fiscal union” treaty and the new ECB president, Mario Draghi, has given the green light to massive bank borrowing from the Eurosystem’s central banks (i.e., from the ECB). Heavy bank borrowing from the ECB will facilitate the financing of Eurozone governments in early 2012 and should mitigate recession pressures.
Recession is easy to avoid
As long as the UK’s policy-makers keep the quantity of money growing at a reasonable rate (say, about 5% at an annual rate) in the next two or three quarters, the UK should be able to handle the side-effects of the Eurozone recession without too much trouble. The British government’s efforts to curb the budget deficit are appropriate and desirable, and – at last – there are signs that UK officialdom is rethinking its commitment to such expensive, growth-destroying follies as renewable energy and EU social legislation.
Tim Congdon is the founder of International Monetary Research Ltd.