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Why money is making a comeback Samuel Brittan Financial Times 01/12/06 Any IoU that is accepted in payment for services rendered can be regarded as money. There is a legendary exam question about a traveller who paid for a meal on a remote island by cheque. The natives were so impressed by this strange piece of paper that they passed it from hand to hand without anyone attempting to cash it. Who then paid for the traveller’s meal? (Please don't tell me.) This story illustrates the difficulty of defining, measuring and controlling the money supply. The civil wars among the monetarists on such issues have put off a great many. More practically, the money supply has been out of favour because attempts to regulate the economy via monetary targets have proved unsuccessful. In addition, many economic technicians quite obviously hate money. They prefer to forecast the real economy directly from variables such as investment and trends in consumer spending. They then add on something for inflation which they try to relate to the degree of slack or overheating that exists at any one time. The drive to put money back has clearly come from the top - for instance from Mervyn King in the UK. The head of the European Central Bank, Jean-Claude Trichet, has reaffirmed the role of money as a check on the forecasts of the technicians, thereby disregarding the advice of all the many short term commentators who have campaigned for the ECB to jettison the money supply, even as one of the two "pillars" in the ECB’s analysis. If the welcome decline in the dollar goes much further we may also see a return of US interest in the subject. From a long term point of view these top central bankers are right and their critics wrong. In one of the last major articles he wrote before he died, Milton Friedman produced some dramatic graphs comparing the behaviour of broad money before and after the business cycle peaks of 1929 and 2001 in the US and in Japan in the 1990’s. (A Natural Experiment in Monetary Policy, Journal of Economic Perspectives, Fall 2005. A version of this article was printed in the Wall Street Journal immediately after Friedman’s death, but without acknowledging its earlier incarnation.) In the US there was a dramatic fall of 30 percent in the money stock, relative to trend, in the three years following 1929; but in a similar period following the collapse of the dotcom boom in 2001 the US money stock continued to grow "steadily and sharply", even though it was not explicitly targeted. Japanese behaviour was less dramatic. The money stock there did not fall but slowed down to a crawl. The results were meant to bring joy to any monetarist's heart. The national income (as measured by nominal GDP) fell dramatically in the US after 1929. In Japan it levelled off in the stagnant ’90s. On the other hand US GDP continued to rise after 2001 at more or less the pre-peak rate. Stock exchange movements were similar but more extreme. Please do not throw at me the old cliché "correlation does not imply causation". Friedman himself remarked in an earlier essay that such dramatic episodes were "potent in influencing public opinion", but that to establish the key role of money would involve looking at a long period of history and investigating the reasons for the changes in the money stock. (Contribution to Issues in Monetary Policy,ed K Matthews and P Booth, Wiley, 1966). This indeed is what he attempted in his Monetary History of the United States, written in conjunction with Anna Schwartz. Monetary analysis has recently made a comeback because of many signs that, in their efforts to avert the recession early this century, central banks permitted an excessive expansion. One of the best explanations is given by Andrew Smithers, the City economist, in his report World Liquidity. He notes that ratio of US broad money to GDP is higher than at any past time with the exception of the 1930s slump and World War Two. Eurozone money supply growth is well above its "reference range" and UK annual broad money growth is at its fastest since 1990. The OECD has just published estimates of "global liquidity" based on both money and credit measures which show that it is "abundant and continuing to grow". There are many indications that these are not freak results. Despite the recent correction in oil prices, other commodities are at nearly twice their 2000 level. More parochially, the announcement by Abbey National that it would be prepared to lend five times the gross income of the borrower for house purchase is surely telling us something. Is the moral that central banks should jam down the brakes and try to bring back monetary growth to its earlier trend fairly quickly? The case against such a draconian policy is that the conventional price and output output measures are still well under control; and there are worries about a possible recession, which could be set off by the collapse of house prices in key countries. We can argue for ever about how and why these bubble levels have been reached. But we are where we are. The main policy conclusion I would draw is that central banks should complete as soon as possible the withdrawal of stimulus administered earlier this century and move to a neutral interest rate policy. The monetary and related indicators also argue for the cautious option in short term policy decisions. Finally central banks should aim to pull back monetary growth, but over a much longer period than the two year horizon which they have created for themselves.
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