Confusion between money & credit has infected West's response to financial crisis
In my last columns on the ongoing global financial crisis, or GFC (“After the Great Fall”, published in October, November and December 2010, and consolidated in my book Lost Causes’ Chapter 10) I had argued that the “liquidity trap” cited by Keynesian fiscalists for the impotence of monetary policy was a paper tiger. The quantitative easing by the US Fed, the UK’s Bank of England, and the ECB had increased the broad money supply (M2/M3) in their respective regions, which through the “real balance effect” had led to a stalling of the deflationary impulse from the GFC, and led to economic expansion. But recently all these economies have stalled, with the UK in a double-dip recession. Why?
An excellent recent book by Britain’s leading monetarist Tim Congdon (Money in a Free Society, Encounter Books) provides an explanation. Growth of broad money (M3/M4) for the US, UK and eurozone is charted in the figures above. It shows that, after their periods of quantitative expansion (QE), instead of following the Friedmanite prescription of maintaining a fixed rate of increase, all three regions have seen sharp changes in the trend of broad money, with a crash to negative rates of growth since 2010. Given the usual lags in monetary policy outcomes, the current deflationary trends in these economies can be readily explained.
Why, despite seemingly accepting the monetarist case with their various episodes of QE, have the monetary authorities failed to keep broad money growing at a constant rate which would have seen an end to the continuing Great Recession? Congdon provides two sets of answers. The first concerns the monetary aggregates they seek to monitor (particularly in the US). The second concerns a theoretical muddle about the transmission mechanism of monetary policy which has been promoted, alas, by academic economists. (Click here for infographic)
US economists and policy makers have always considered narrow or “high-powered money” of the monetary base (M0/M1) to be the relevant monetary aggregate. UK economists, by and large, have looked at broad money (M2/M3) as the relevant aggregate. This is despite a tight relationship between broad money and nominal GDP in the US. Congdon estimates that the average annual percentage growth rate of M2 (between 1875 and 2010) was 6.45 per cent, and that of nominal GDP was 6.39 per cent. That is why, from Wicksell to Keynes to Friedman (except for a deplorable lapse in the early 1980s), the relevant monetary aggregate has always been broad money. Even though in the short run this relationship between money and nominal GDP breaks down — as it did seemingly in the 1990s — over the medium and long run the relationship is robust, and confirms the long-run stability of the money demand function. But, since the 2000s both the US Fed and the UK’s BOE (but not the ECB) have stopped even publishing figures on M3/M4. Why?
This is because of the rise of the academic theory of the monetary transmission mechanism christened and advocated by Ben Bernanke as “creditism”, to contrast with traditional “monetarism”. In a famous paper with Mark Gertler (Journal of Economic Perspectives, 1995) he argued that the relationship between money and economic activity was a “black box”, and that the relevant channel for monetary-policy transmission was the credit channel, i.e., bank lending to the private sector. But, following Freidman and Schwartz, Congdon argues cogently that money and credit are different, and it is money that matters for the economy.
This difference can be brought out most readily from a question I used to ask my Oxford undergraduates in tutorials in the mid-1960s about the effects of a large helicopter drop of money in the UK. The answer is that this increase in the cash holdings of all the private economic agents in the economy would lead to a deviation of the composition of their asset portfolios from the previously desired equilibrium ratios. As, in the closed circuit of the domestic economy (abstracting for simplicity from an open economy), this excess money could only be spent on goods and assets, it would only restore the previous equilibrium cash ratio in their portfolio balance — once the prices of all the other goods and assets, and thence in spending and national income had risen. This would happen irrespective of whether bank lending (the creditists’ lodestar for monetary easing) was flat or falling. As Congdon rightly notes: “Spending depends on money balances and not bank lending.”
Thus, unlike the US Fed, whose chairman described its QE policy in 2008 not as “quantitative easing” (boosting the quantity of money) but as “credit-easing” to lower credit spreads, the UK’s BOE in its brief reversion to “monetarism” in 2009’s QE used traditional open-market operations to buy gilts from the non-bank public to increase bank deposits to boost the broad money supply. This increase in deposits at banks (their liabilities) is entirely different from increases in bank lending (their assets). The former requires no increase in their capital, as these liabilities can be readily offset by increasing riskless assets in their “cash reserves” at the central bank, or purchases of government debt. By contrast, loans to the private sector, being risky, would require extra capital to cover any defaults.
This continuing theoretical confusion between “money” and “credit” has led to two dangerous tendencies. The first, clearly evident in the US, is that, to ease credit to the troubled housing market, the Fed (unlike the BOE) — instead of conducting traditional expansionary open-market operations to increase broad money — has purchased mortgage-based securities to reduce their interest rate. This is equivalent to the monetary authorities undertaking credit allocation, which should not be permissible in a market economy. The second is that by embracing financial repression by keeping interest rates artificially low (most recently through its Operation Twist) there is a bubble in Treasuries — which, when it bursts, will lead to the euthanasia of bondholders, much as happened in the decades after the Second World War. Perhaps the undisclosed intention is to mitigate the US’ large and growing debt burden. Thus, the failure of the world’s pivotal central bank to accept that broad money, and following the Freidmanite rule, matters, is likely to continue the Money Mischief of Friedman’s last book.
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