Like most subjects, economics has its fair share of -isms. In the present crisis some familiar -isms, notably Keynesianism and monetarism, have been invoked at different stages. In this article I will suggest that a straightforward solution to the crisis is available and, happily, policy in the UK has moved in the direction I favour. I will also identify and criticise a relatively new -ism, which I will call creditism. Statistical evidence from all countries shows that the rates of growth of the quantity of money and national income are similar, even if not identical, over the long run. The so-called "quantity theory of money" translates this evidence into the claim that "an excessive rate of money growth will cause inflation", which was then summed up by Milton Friedman in the aphorism, "Inflation is always and everywhere a monetary phenomenon". By extension, a sharp slow down in monetary growth is likely to be accompanied by a recession. Friedman, in fact, wrote at length about the falling prices experienced in the 1930s and could equally have said deflation is always and everywhere a monetary phenomenon. Does monetary analysis work in the current cycle? Over the 50 years to summer 2007, new lending to the private sector had been the dominant form of money creation. Banks added identical sums to both sides of their balance sheets – new loans on the assets side and new deposits on the liabilities side – and the extra deposits were money. Given that the banking system was profitable and dynamic, the main problem for policymakers for most of the 50-year period was to restrain the growth of money and the inflation which accompanied it. But two years ago the international market in inter-bank wholesale funds seized up. Banks too reliant on wholesale funding had immediately to restrict lending to their private sector customers. But all banks – suddenly facing large potential losses on some of their assets, and under hostile pressure from public opinion and their regulators – started to curtail credit to the private sector. Money growth collapsed. In Britain, for example, the growth of broad money – notes and coin, and bank and building society deposits – slumped from an annual rate in double digits in early 2007 to almost nothing in late 2008. In late 2008 companies' banks deposits were falling at a rate of ½pc to 1pc a month, similar to the monetary contraction in the US's Great Depression in the 1930s. What had to be done? A positive rate of money growth had to be restored. Instead of companies' bank deposits falling by ½pc to 1pc a month, policymakers needed to use every available instrument to ensure that these deposits – as well as the bank deposits of other sectors of the economy – were rising again. But by itself the private sector – the banks and their customers – were destroying money balances, because of the pulling-in of loans. So how could policymakers help? The answer is that the state had to replace the private sector in the creation of new money. Highbrow economists have befuddled themselves with all sorts of silly mathematical theories, which has led to much unnecessary confusion among policymakers. In fact the creation of money by the state is a simple matter. All that is required is for the state – either the government or the central bank – to make larger payments to the bank accounts of private sector agents (households, companies and so on) than these agents make to it. That increases the amount of money in private sector bank accounts, which (along with notes and coin) is the same thing as the quantity of money. The payments could be to finance a budget deficit, but large budget deficits may lead to an unsustainable accumulation of public debt. A much better alternative is for the state to borrow money from banks in just the same way that the private sector did for the 50 years to 2007 (by simultaneous additions to both sides of bank balance sheets) and then to use this money to purchase assets from the private sector. The least controversial assets to purchase in this context are long-dated government securities. Since these are claims on itself, the state can then cancel them. At the end of the process the private sector has less long-dated debt and more money, just as the doctor ordered. Now comes the good news. The Bank of England's current programme of "quantitative easing" is an illustration of these processes at work. The Bank has made many blunders over the last two years, but its announcement of QE in March this year was exactly the right thing to do. Since then asset prices have recovered and macroeconomic conditions have improved radically. If enough new money had been manufactured in recent months, the recession would be nearing its end even more definitely than is the case. But QE has hit a snag. In the first half of 2009 the volume of new loans to the UK's own private sector was falling, while banks were shedding claims on foreign private sectors (particularly foreign banks) at an astonishing rate. The Bank of England's creation of money did outweigh this destruction of money by the private sector, but only just. Money growth in early 2009 – when measured properly – ran at about ¼pc to ½ pc a month. This was better than in late 2008, but the low rate was still disappointing. In future QE must be calibrated so that the quantity of money is growing fast enough to stop the recession. Mervyn King accompanied Wednesday's Inflation Report with a pessimistic forecast, saying that the Bank of England expected a slow and difficult recovery. King has underestimated the power of the weapons in the state's macroeconomic armoury. The recession could be brought to an end – quickly and easily – if either quantitative easing were on a big enough scale or the government deliberately borrowed on a massive scale from the banks. What about "creditism"? Creditism is the doctrine that bank lending to the private sector is, by itself, the main determinant of aggregate spending. This theory has been prominent in central banks and finance ministries in the crisis, and has provided the rationale for the relentless official pressure for banks to raise more capital. The idea has been that – if they have more capital – banks can more readily embark on new loans and that will add to demand. But the theory lacks theoretical and empirical underpinnings. Most people have no bank debt whatsoever. Does that mean they don't spend? From 1929 to 1945 the advances of Britain's clearing banks to the private sector fell by almost 25pc, but national income rose by more than 100pc. Economists have been misled by the experience of the last 50 years – in which bank credit to the private sector and the quantity of money have risen in tandem – into confusing the effects of credit and money. Creditism is false and dangerous. Last autumn's official bullying of the banks to raise more capital led to an immediate intensification of the recession, whereas the announcement of QE in March was greeted enthusiastically by financial markets and signalled a turn for the better in the economy. The current cycle confirms that the quantity of money matters vitally to the determination of asset prices and national income. With deflation still a threat in 2010, the focus of policy should be to ensure that a positive rate of money growth continues over the next few months.Policy must focus on a continuing
positive rate of money growth
Sunday, 16 August 2009
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