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Money makes a comeback Samuel Brittan Financial Times 14/10/05 Something is changing in policy doctrine. After a couple of decades in which the money supply almost disappeared from view it is now coming back. It is far too early to say exactly how or in what form. But there are numerous straws in the wind. The European Central Bank has never stopped scrutinising the movement of monetary aggregates and has rightly resisted the many commentators who want to banish it from its status as a second pillar of policy analysis. In Britain references to the money supply have come creeping in with increasing frequency into the speeches of the Bank of England governor Mervyn King. There has been an article in the latest Bank of England Quarterly Bulletin showing "a remarkable stability" in the long term correlation between inflation and rates of growth of money in both the US and the UK." Correlation does not imply causality; but it is significant that the article appeared at all. This is not to say that there is a new monetarist ascendancy. The mainstream view is exemplified by what is I hope a temporary majority in the Bank of England Monetary Policy Committee. This is to look at the immediate prospects for economic growth, then check that the financial markets are not signalling a return to inflation; and if not to carry on pumping demand into the economy. The economy is seen as a sausage machine and the task of central bankers is seen to be to make sure enough meat is pumped into every sausage to secure full weight. The opposite view was recently put by one Fed governor, Don Kohn, when he said that "policymakers should be cautious about responding aggressively to estimated movements in economic slack". Last Tuesday the Bank of England governor, Mervyn King, explained in more detail why "the economy cannot grow at a constant rate in every single quarter". He rejects the view that central banks "can and should control the short run path of output". Not only are there lags between the recognition of economic shocks and the impact of corrective policies. There are also supply shocks to the economies of western countries which central banks can do little to change. The higher oil price for instance implies that "the purchasing power of wages and salaries must grow more slowly than would otherwise have been possible, by around 1-2 per cent in the major industrial countries, spread over a couple of years." The rebalancing of the composition of demand is likely to mean some volatility in its total. I would add that waiting for inflationary expectations to show up in the financial markets has its own risks. By the time they do it might be too late to correct them without a sharp policy shock. More important, attempts at fine tuning, which ignore monetary indicators can lead to cycles of boom and bust in asset markets which can be highly damaging even if they do not have much impact on the particular group of prices which it is conventional to put into consumer indices. A new paper by Tim Congdon has helped to codify the transmission mechanism between excessive monetary growth and inflationary booms (Money and Asset Prices in Boom and Bust, IEA). Congdon does convincingly show how a build up of financial balances in relation to income will lead - not always to a early rise in consumer prices - but sometimes to a preliminary rise in asset prices, notably housing, which will eventually make households feel wealthier and spend more. The spurt in the price to income ratio for US housing from around 3.2 in the late 1990’s to 4.2 today helps to justify the gradual levering up in official interest rates now taking place. Congdon has succeeded in showing that the relevant aggregates are very broad one and not, as some monetarists assume, very narrow aggregates such as M0 which consists of cash in the hands of the public plus bankers deposits with the Bank of England. It has escaped general notice; but the Bank of England is stopping publication of its series for M0 for the very good reason that its new policy of paying interest on bankers deposits is bumping up their size and destroying the continuity of the whole series. Monetarists have however long been their own worst enemy. One cannot get very far before civil war breaks out between those who think in terms of the money supply, credit or overall liquidity. One problem with the Congdon thesis is where to draw the boundary between money and other financial assets. For instance the inclusion of the deposits of home loan associations favour makes a difference. Another problem is that Congdon does not, at least in this publication, explain what normally determines the broad money supply. Moreover although credit is not the same as money its behaviour cannot be ignored. Lombard Street Research has a series showing world money growth creeping up towards levels last seen around the turn of the century when the world boom in technology shares burst. But the development looks more menacing if credit is taken into account. The reason for this is that American banks have been able to step up their lending on the basis of overseas deposits which do not count in official statistics of the US money supply. Liquidity is a vaguer concept difficult to quantify. Indeed the much-derided 1958 British Radcliffe Report which downplayed monetary policy, relied too much on this notion. Yet there is surely a contrast between the world in which most of us grew up when it was difficult to borrow money and the present situation when it takes courage and will power to decline the loan offers thrust at us from all directions. No doubt these issues are fairly superficial compared with the large changes in the world economy deriving from the entry of new cheap players such as China and India and the shift in the worldwide distribution of income from labour to capital. But none of these problems will be made any easier by resort to the printing press - metaphorical though this concept is in our electronic world.
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