Money in Britain is held in the three components of the private sector:
* the household (or personal) sector, which usually embraces charities as well,
* the non-financial corporate sector (which consists of mainstream “industrial and commercial companies”, which do not derive the bulk of their profits from financial activity, but by selling something), and
* non-bank financial institutions.
All private sector agents have to balance their money holdings against their on-going expenditure on goods and services, and their non-monetary wealth. Squeezes on the private sector’s money balances – as reflected for example in the growth rate of its real (inflation-adjusted) money – tend to be accompanied by under-valued assets and weak aggregate demand, a pattern which was obvious in the sharp downturn in 2008 and early 2009.
Analysis of monetary trends in the corporate sector is complicated, because most companies not only have a positive sum in their bank deposits, but also run – on a fairly permanent basis – an overdraft and/or have term loans from their banks. In other words, they are consistent net borrowers from the banking system, and manage a net debit balance rather than a positive money balance. They are net borrowers because the return on capital is expected to be higher than the cost of bank finance, so that bank borrowing improves the return on shareholders’ equity. For the corporate sector it therefore makes sense to relate what might be termed “companies’ liquidity ratio” (i.e., the ratio of bank deposits held to bank borrowings) to an expenditure variable.
Let’s consider the relationship in question from 1963, with the inception of UK monetary statistics in their modern form. In the third quarter of 1963 UK companies held £2,388m. of sterling deposits with their banks, whereas in the third quarter of 2011 they held £247,748m. of such deposits, a rise of over 100 times. But the ratio between their money holdings and their bank borrowings was much the same at the end as at the beginning of this period of almost 50 years. (To be precise, the ratio was 68.6% in Q3 1963 and 54.5% in Q3 2011.) Casual inspection of the figures confirms the relationship suggested above, that when companies’ balance sheets are weak and they are holding inadequate cash relative to their bank debt, domestic demand is weak. (The relationship also applies vice versa when their balance sheets are strong and their cash balances ample.) The pattern is obvious in all the severe downturns of the post-war period up to the Great Recession (i.e., in the 1974 liquidity squeeze, the recession of 1981 and the recession associated with membership of the exchange rate mechanism in 1991 – 92). There is, towards the end of the period, an obvious parallel between the collapse in the corporate liquidity ratio (from peak values in 2004 to a trough in late 2008) and the Great Recession.
A striking feature of this relationship is its robustness. To repeat, the quantity of money held by British companies climbed by over 100 times in the period under consideration, but the ratio between bank deposits and bank borrowing changed only a little from start to finish. Indeed, the reliability of this relationship was one reason for expecting that - if in the traumatic and potentially deflationary conditions of early 2009 the state conducted operations deliberately to expand bank deposits, and hence to increase the corporate liquidity ratio – the economy would recover. (The argument was set out on pp. 27 – 31 of my February 2009 pamphlet on How to Stop the Recession for the Centre for the Study of Financial Innovation).
Corporate liquidity ratio is now up to its long-run average in the 1963-2011 period. Despite the buffeting that British companies have had in the last few years of boom and bust, and of credit feast and famine, their underlying monetary behaviour – and crucially, their attitude towards the management of their bank balances – has not changed. A clear and fundamental message from this evidence is that, if officialdom is silly enough to take decisions which lead to large fluctuations in money growth, the result is likely to be severe macroeconomic instability.
Tim Congdon is the founder of International Monetary Research Ltd.