Where we should start
The Great Recession was caused by the regulatory attack on the banks that started, in its most intense form, in September/October 2008. By ordering large increases in banks’ capital/asset ratios and the jettisoning of risk assets, officialdom instigated massive and widespread shrinkage of bank balance sheets. The removal of risky loans and securities from banks’ asset led, inevitably, to the stagnation/contraction of the deposits which are the greater part of banks’ liabilities. Since bank deposits constitute most of the quantity of money, broadly-defined, and since national income and wealth in nominal terms are functions of broad money, officialdom – not the banks – is to blame for the Great Recession. (The banks were mostly aghast at the regulatory and legal upheaval with which they were confronted.)
I’ve made this case repeatedly throughout the current crisis perhaps does not need to be restated again today. However, it is important to appreciate that – in the UK case – the asset shrinkage imposed by officialdom is still not complete, mainly because the banks have yet to comply with the Vickers Report. This piece suggests that further declines in UK banks’ risk assets and deposit liabilities may well occur in the rest of 2012, unless offset by deliberate money creation by the state. However, in other jurisdictions the regulatory sadism seems to be largely complete, while reports are starting to be heard of loan offers (to British companies etc.) from international banks located outside the G20. So 2012 promises to be a better year for the world economy and indeed the UK, despite the damage being done by Basle III, Vickers, EU capital requirement directives and such like.
The cause of the Great Recession
The cause of the Great Recession was official pressure on the banks – particularly in the UK, but across the industrial world – to “deleverage” and shrink the risk assets on their balance sheets, and to hold more capital relative to such assets. (I do not deny that many banks – notably the leading investment banks – were doing silly things in the run-up to the crisis.) Official pressure was most forceful in late 2008, following the closure of the international inter-bank market in mid-2007. Because the availability of inter-bank lines was much reduced, many banks had difficulty in funding their assets and these difficulties were widely (if wrongly) interpreted as a symptom of insolvency. The result of bank deleveraging was a dramatic fall in the growth rate of the quantity of money, broadly-defined, in the top advanced-country monetary jurisdictions of today (i.e., the USA, the Eurozone, Japan and the UK). Despite slashing the short-term money markets rates to zero, central banks could not offset the deflationary forces which, to a significant extent, they had created. The UK banks’ stock of lending to the private sector, for instance, which had been growing at about 15% a year in 2006 fell by 5% - 10% a year in 2009 and 2010.
The slump in money growth had the predictable effect of motivating falls in asset prices, demand, output and employment. I say “predictable”, as some economists have insisted on the validity of the monetary theory of national income determination even in the last few years, when that theory has been unfashionable. But very few economists – if any – actually predicted the catastrophic slide in economic activity in early 2009, because no sensible observer could reasonably have anticipated the idiocy of official actions in late 2008. The major central banks gave every sign of not having any understanding whatsoever of the debacle for which they were largely responsible.
A variety of mistaken theories – that national income is a function of bank lending (the credit channel version of “creditism”) or the monetary base (“base-ism”, New Classical Economics) or the budget deficit (Keynesianism) or “financial frictions” (the asymmetric information version of “creditism”) - were propounded by academic economists. They then received attention, far too much attention, in central bank research departments. The correct theory, that national income and wealth in nominal terms are functions of the quantity of money (i.e., of the quantity of bank deposits, more or less), had been developed decades earlier by such figures as Wicksell, Irving Fisher, Keynes and Friedman. The correct theory was staring the economics profession in the face in the Great Recession, just as it was staring them in the face in the Great Depression 80 years earlier. But most economists did not recognise it.
Demands for more bank deleveraging continue
The point of this harangue is that – at least in the UK – the official attack on the banks is still not over. RBS is widely reported as being expected to shed about £120b. of non-core assets, in order to comply with the Vickers Report. £120b. is equal to roughly 8% of the M4x quantity of money. If RBS complies with the Vickers’ demand by selling the assets to non-banks, the non-banks will pay the banks by reducing their bank deposits. In other words, M4x will fall by 8% because of transactions being conducted by only one bank. In practice, RBS will no doubt sell the assets partly to other banks (when M4x would be unaffected) and partly to foreign buyers (when the monetary effects are complex), and the sales will be phased over time. Nevertheless, it beggars belief that officialdom appears to be indifferent to – and indeed even ignorant of – the monetary results of its regulatory decisions. This analysis is important in appreciating the disappointing response of UK money, broadly-defined, to the latest round of quantitative easing. This round was of £75b., about 5% of M4x, and compressed into a mere three-month period (i.e., the three months from early October, more or less) and ought to have meant an extremely fast money growth rate in that period. In fact, M4x fell slightly in the last three months of 2011. The discrepancy can surely be explained, mostly, by UK banks’ continuing measures to comply with official demands that they reduce their risk assets.
All is not gloom and doom. First, in the USA banks seem now to have gone a long way to meet the new and more demanding regulatory standards. In general, banks are maintaining capital/asset ratios about 50% higher than was normal during the years of “the Great Moderation” (i.e., the period of over 20 years from 1984 in which macro outcomes were much more stable than before). The American banking system appears to be expanding again, leading to low but positive rates of money growth. Secondly, in the Eurozone the European Central Bank has embarked on extraordinary measures (i.e., the “long-term refinancing operation”, with three-year facilities at 1%) to ensure that banks can fund their assets and so to prevent the monetary contraction that might otherwise ensue.
It remains my view that the central objective of monetary management should be to ensure steady growth – at a low, non-inflationary, rate – in the quantity of money (i.e., to repeat, of bank deposits). I cannot judge the exact severity of the balance-sheet shrinkage facing UK banks post-Vickers, but assume some further shrinkage is needed to comply with the Vickers’ prescription. A note in the appendix below shows the robustness in the UK of some underlying relationships in this area of monetary economics.
What should policy be?
For the time being I continue to favour a ½% Bank rate and receptiveness to yet another round of money creation by the state. (I would prefer that this money creation occur through the government/Debt Management Office concentrating its financing of the budget deficit at the short end from the banks, rather than by the complex and awkward operations known as “quantitative easing” now undertaken by the Bank of England, but let this pass. If officialdom does not see the rationale of stable money growth, it is unlikely to understand the purpose or the technicalities of operations which would facilitate that goal.)
2012 should see a relatively benign global outlook, with the USA leading the upturn phase of the global business cycle. The Eurozone is a mess, but the main message from the first few months of Draghi’s ECB presidency is that any deterioration in macroeconomic conditions is likely to be met by large and aggressive monetary stimulus.
Tim Congdon is the founder of International Monetary Research Ltd.