Money, Credit & Quantitative Easing
Paul, in the comments over at Hopi, asked about my views on money supply in particular and my views on ‘broad Keynesianism’ versus monetarism in general. (Warning: Potentially technical and boring post).
To start with, I don’t think of myself as typical Keynesian. I’m certainly not a ‘New Keynesian’ either, rather I’d be more comfortable being described as a ‘Post Keynesian’ in the tradition of Robinson, Kaldor and Minsky.
As Wiki puts it:
The distinctive feature of Post-Keynesian economics is the principle of effective demand, that demand matters in the long as well as the short run, so that a competitive market economy has no natural or automatic tendency towards full employment.
There are a number of strands to Post-Keynesian theory with different emphases. Joan Robinson regarded as superior, to Keynes’s, Michal Kalecki’s theory of effective demand, based on a class division between workers and capitalists and imperfect competition.
More specifically on ‘money’. This is quite a big issue (and as I health warning, my old job at the Bank of England involved compiling the UK’s monetary data).
I’ll talk mainly about broad money (i.e. the widest measure of money supply) and mainly about the UK. In the UK the broad money measure is M4 which is currently, and correctly under review. The background to the review really is worth a read if people are interested in this area – which I’d argue given quantitative easing is very important.
As the BOE puts it:
The United Kingdom currently has one broad money
aggregate, M4. Broadly speaking, M4 measures the amount of
cash (in sterling) held by the public, together with their sterling
deposits held at banks and building societies. The Bank defines
M4 as the UK private sector’s(1) holdings of:
• sterling notes and coin in circulation;
• sterling deposits with UK-resident banks and building
• sterling holdings of certificates of deposit, commercial
paper and debt securities of up to and including five years’
original maturity issued by UK-resident banks and building
• claims on UK-resident banks and building societies arising from sale and repurchase agreements in sterling.
The two key decisions when deciding what constitutes broad money are (i) what is the money creating sector? (I.e. what should we decide are the institutions that (mainly through fractional reserve banking, can be said to create money?). In the case of the UK – that is currently only banks and building societies.
(ii) What is the money holding sector? As the Bank puts it (MFIs are monetary financial institutions (banks and building societies):
Once the money-creating sector has been defined — whether
on a functional or an institutional basis — a decision regarding
the people and institutions which are considered to be holders
of money is needed. MFIs are generally defined as lying
outside the money-holding sector, as one bank’s liability to
another bank (so-called interbank lending) cancels out across
the whole MFI sector. Although the money-holding sector can
be determined as all people and institutions that are not MFIs,
it tends to be defined more narrowly in practice. The UK
money-holding sector is currently defined as the UK private
sector other than MFIs, covering: households (including
unincorporated businesses, such as sole traders); non-profit
institutions serving households (eg charities and universities);
non-financial corporations; and all financial corporations
except banks and building societies. Some so-called ‘other
financial corporations’ (OFCs) specialise in financial activities
that closely resemble those undertaken by banks and building
societies. That raises questions about the appropriate
boundary between the money-creating and the money-holding sectors, which are explored in more detail in the next section.
I’ll not post it all up but the next section is a very interesting discussion. Basically the growth of the shadow banking system and the use of Special Purpose Vehicles (SPVs) in securitisations has potentially ‘broken’ the monetary data. Simply put there are now lots of quasi-banks which are not technically banks and so not treated as banks in the official data. Their holdings of money are included in the monetary data and have the effect of inflating the numbers – even when it will have no effect on economic activity in the traditional sense.
The effects have been dramatic. It’s worth taking a look at the ‘sectoral’ monetary data that the BOE produces monthly. In February M4 growth has a rapid +18.7%, but the growth of housholds’ money was a very modest +4.2% and the growth of non financial corporations’ money was actually a negative -2.1%! This was all hidden by non-bank financial business holdings of money growing at a staggering +55.6%.
I would argue that, in the absence of the shadow banking system – if all the new ‘non-bank financials’ were treated as banks, then money supply growth would be very, very slow indeed. This explains the rationale behind the decision to embark on a policy of quantitative easing (QE). It is certainly worth remembering when right wingers such as John Redwood bang on about money supply growth being too fast.
I take, unsurprisingly, a quite Post-Keynesian view on all of this. To an extent I reject the classical economic distinction between ‘real’ and ‘nominal’ variables. I think this distinction misses out the role of debt in the economy, which is typically not inflation adjusted. This is important.
A monetarist would argue that if we double money supply then we simply double prices and have no real change on economic activity. I’d argue that if we double prices, we typically don’t double debt and so the debt burden on consumers and corporates is reduced in terms of spending power available after debt payments and economic activity will shift as a result. Similarly if prices move down, and debt stays constant in nominal terms, then spending power – and hence effective demand, is reduced. This is what worries me about the prospect of deflation – we step outside the typical bounds of the business cycle and face disaster.
I’d argue further that money supply in and of itself is not the crucial variable – the crucial variable is credit, i.e. lending. It is lending that drives economic activity not money. Economists have focused on money for a long time. For decades this was reasonable. As most credit came from banks, money growth was a decent proxy for credit growth. As deposits (money) grew, and the liability side of the banks’ balance sheets expanded, credit also grew (the asset side of the banks’ balance sheets).
This cozy relationship though may no longer hold. The growth of ‘other credit providers’ – specialist mortgage lenders, credit card companies, car finance, store cards, the shadow banking system, etc – might have caused this relationship to break down. So money supply might soar with little impact on inflation or activity. Or banks might want to reduce their loan to deposit ratio from 130% to 100% (or even 90%) – again money supply (deposits) could soar with no growth in lending and hence little impact on activity. Mechanical monetarism doesn’t work.
So, will QE (an active attempt to increase the money supply) work? I don’t know is the honest answer. Paul Tucker, now Deputy Governor, made an interesting speech back in 2007 on these sort of issues. The important issue is the ‘bank lending channel’, i.e.the extent to which monetary policy works through the effect on bank lending. As the ECB put is in 2001:
The mechanisms through which the monetary policy of central banks affects real activity are not completely understood. A relatively recent strand of the literature emphasizes the special role of banks in the transmission mechanism through the so-called credit channel of monetary policy. According to this mechanism, monetary policy affects the real economy not only through the impact of interest rate on the aggregate demand but also through shifts in the supply of bank loans.
The literature, in as much as there is any, on this is scare. I suspect, given my views on credit, that the bank lending channel is one of the more important ways that monetary policy effects the economy. I also suspect that the bank lending channel is currently blocked. If I am right, QE will see an extra £75bn pumped into the economy (as gilts are taken out and cash put in through central bank purchases) and, probably, a £75bn rise in the money supply. The worry is that this will have little effect on the actual economy.
So, should we try QE? Of course. Either it works and provides a stimulus that prevents, or lessens, a slide into deflation or it doesn’t and nothing happens. Either way it does not cause hyper inflation as some seem to suggest. Hyper inflation is not caused by monetary policy alone, it caused by monetary policy in conjunction with social and political breakdown. Zimbabwe and Weimar Germany ‘printed money’ to finance most government expenditure in the absence of a functioning tax base. The UK is a long way from that.
In addition QE makes it easier to finance the budget deficit. The budget said we were going to borrow £175bn this year (12% of GDP) – if the Bank buys £75bn of gilts, the net effect is £100bn of new borrowing – about 6.9% of GDP, less than in the early 1990s. A good side effect of QE.
To conclude, after a bit of a ramble, I am suspicious that monetary policy can achieve much whilst the banking system is undergoing problems – one of the main reasons I argue for more use of fiscal policy to maintain demand.