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Good for writing an essay, hopeless for understanding the economy
Beoordeeld in het Verenigd Koninkrijk 🇬🇧 op 22 juni 2022
Richard Murphy is wrong, the book refers to money as IOUs which, ever since I was at school, mean 'debt.'
However, this book does show how badly the study of economics has gone awry. Chapter 10 addresses the subject of the book’s title directly and opens by comparing QE to the actions of the woke thieves in the Spanish TV hit Money Heist who break into the Madrid Royal Mint and who morally justify their motives because they are printing new money, not taking it from anyone’s bank account. For starters, this is not actually a victimless crime because printing money debases all other money holdings by at least the proportion of total money supply. More accurately, rather than being victimless, everybody in the whole economy is a victim. However, the authors then gaily observe that “in truth, this isn’t a million miles from what central bankers have been doing, legally, for the last decade… The Bank of England has created almost £1 trillion of new money and used it to buy things in the economy.”
The authors, two young economists at the Bank, explain how conventional easy monetary policy, via lower interest rates, leads to “increasing demand and so an increase in inflation,” but that uncertain lags mean “the effects of monetary policy take between six months and two years to be seen in the (sic) price inflation.” Faced with the uncertainties of negative rates in the 1990s however, the Bank of Japan “increased the quantity of money… and so it became known as quantitative easing (QE).” Apart from the fact that it became known as ‘quantitative easing’ because at the zero bound, the BoJ targeted the quantity of asset purchases from banks, not money, as opposed to the level of interest rates, it appears the authors are blissfully unaware that Japan’s so-called QE was still almost entirely conventional policy, aimed at banks’ holdings of short-dated assets and not at the expansion of money supply at all. Even the most casual of glances at Japan’s broad money growth in the 1990s and 2000s reveals that for 25 years, money supply only grew +2.5% on average, but why let the facts get in the way of a poorlythought-through theory?
As you might hope, the book does at least explain western-style QE, an “ingenious mechanism if we do say so ourselves,” rather more accurately than the coverage given to Japan’s version. Another factual error of Mr Murphy's. “The central bank buys something from people or companies in the economy…(and) simply adds some money to the account that the seller’s bank holds” with it. The real economy, non-bank counterparty is the absolutely crucial difference between conventional and unconventional policy but is however, glossed over. This means that central banks today no longer differentiate sufficiently between short (bank-to-bank) and long-dated (non-bank) asset purchases, despite the fact that only the latter purchases increase money supply. The error is compounded when they add that “by the mid-2000s, the Bank of Japan was doing this on what felt like a huge scale.” The BoJ was clearly not growing money supply, or its balance sheet for that matter, on even a relatively minor scale at any time during the mid-2000s.
The reason why the BoJ didn’t print money aggressively was outlined by the BoJ Governor at the time, who argued that as a bureaucrat, it was not within his remit to pursue money printing, which the BoJ saw as regressive fiscal policy because of the redistributive implications and, as such, required sanction by the politicians in the Diet. This is counter to the fallacious claim that the BoJ did print money (see above) but that the decline in the velocity of the newly created money prevented it impacting demand. The velocity of Japan’s money supply has been in an unbroken and highly stable range since records began in 1980, back during the boom. The annual trend decline rate of Japanese velocity is -2.4%, so only a bit above the 1-2% range expected by Friedman.
Therefore, Bernanke was trying something completely different when he initiated US QE. Quoting Bernanke’s famous ‘joke’ that “the problem with QE is that it works well in practice, but not in theory,” the authors reveal that as far as the BoE is concerned, “this wasn’t a criticism of QE per se, more a recognition that, while economists have found that QE does prove effective at lowering interest rates and boosting inflation, we don’t yet have a full understanding of how”. So, central bankers do apparently accept that printing money (QE) is inflationary, they just don’t understand how. That’s comforting to know. As for Bernanke’s tired insistence that his forecast that QE would lower yields was proven accurate, the UST sell-offs during QE are surely all the evidence required to show that, precisely because it is inflationary, QE raises yields, it doesn’t lower them. All these years later, you would hope the young guns at the BoE had realized that.
They say they do: “obviously, we have theories on how increasing the money supply would drive inflation,” but the fear after the GFC was that “people had all the money they needed: if you gave them more they would just squirrel it away.” Central bankers feared that the Keynesian liquidity trap wouldn’t just cause a temporary decline in the velocity of money due to precautionary savings, but a semi-permanent one. If the velocity of money is not relatively stable over time as Milton Friedman had argued, adding more money wouldn’t generate more nominal demand (inflation). “So why did economists turn to QE?” Good question. In the case of the BoE, it was because then Governor, Mervyn King, was a monetarist. As he said last year, “QE is an expansion of the money supply, although most central banks are reluctant to describe it as such.”
However, here we see a new breed of BoE staffers, working under the strict anti-monetarist Andrew Bailey, now admitting that QE not only increases money supply but is inflationary too. This would not have been the case if velocity had collapsed to accommodate the increase in money, as the neo-Keynesians explicitly assumed it would. Instead, as with the velocity of Japanese broad money supply, the UK velocity of money has also been stable within a fairly narrow trend since 1980, with a slightly smaller annual decline rate than Japan of -1.8%, well within Friedman’s 1-2% range.
If QE money printing is inflationary, and velocity is trend-reverting, then “all this means central banks can print more money (but only) up to a point.” Readers hoping to learn what that point is, will be disappointed. “Once (QE) begins to push inflation too high, printing more will become a problem.” Well duh. No wonder the central banks have got themselves into such a bind. It appears they were waiting for inflation, a lagging indicator, to appear before they thought to stop printing. I say that, but to be fair, the BoE was still printing right up to end-2021, when RPI in December was already +7.55%, whilst the US Fed was still doing QE last week, with CPI already at a 40-year high +8.6%. So, God knows what they were waiting for.
The book traces the academic course of the BoE’s confused approach. In the beginning (1973) the theory de jour was old fashioned Keynesianism and inflation was seen as being driven by (wage) cost-push, or the ‘animal spirits’ that drive demand-pull. Then Friedman and Schwarz came along and argued that not only was the growth in the money supply the main driver of demand-pull but that inflation was ‘always and everywhere a monetary phenomenon.’ This, however, is a foreshortened and dangerously simplified version of Friedman’s quote. He went on to add “in the sense that it can only be produced by a more rapid increase in the quantity of money than in output.” In other words, inflation is always and everywhere an excess money phenomenon; a nicety always ignored by modern academics.
The book summarises Friedman’s Quantity Theory of Money as meaning “you can increase the amount of money in circulation, but that increase won’t increase the amount of actual economic activity going on. The inevitable result according to monetarists? Inflation.” Q1 2022 UK GDP is only +0.7% higher than pre-pandemic, but broad money supply (M4ex) is +22.2% higher and the (lagging) retail price index is already +14.6% higher, so this seems to neatly sum up what has happened. Yet Andrew Bailey, who wrote the foreword, but doesn’t seem to have read the contents, said on almost the day of publication that he rejected the argument that his Monetary Policy Committee (MPC) had “let demand get out of hand and thus stoked inflation.” Yet just as real GDP was falling due to COVID, Bailey was printing up a storm, driving an unprecedented surge in Friedman’s excess money supply.
Sadly, for the rest of us, central bank fashions moved on from this sensible and logical view of the world because, “the empirical relationship between the quantity of money and output and inflation…started to break down.” Only, it didn’t. There has always been a close relationship between money supply and nominal GDP in the UK. In the US, Friedman’s excess money supply growth has likewise always had a visibly close relationship with inflation, just as he said it would. At the very time the claim was made that the relationship broke down in the 1990s, there was something else entirely going on. Federal restrictions placing caps on bank deposit rates, to save the thrifts from competition, drove US savings into 401(k) pension accounts. Only these were not included in money aggregates, so though money supply growth appeared to stall, leaving CPI unaffected, it was all due to a mismeasurement issue, not a fault in Friedman’s theory. No matter, monetarism was summarily junked. Resistance by the mainstream to new ideas means science is said to advance one funeral at a time. The ‘soft’ science of economics suffers from the opposite; an addiction to new fashionable theories that means it could be said to regress one funeral at a time.
To try and explain how changes in money supply might not impact inflation was left to the residual, the so-called ‘velocity’ of money. “A fundamental part of how monetarists viewed the world was the assumption that velocity was relatively stable (and) evidence since the 1980s has shown that velocity can change a lot”. This is simply not true for broad money, but it is true that the velocity of various components of the money supply can change a lot. For example, when deposit rates are high, as in the 1960s-1980s, demand for M2 savings deposits is relatively high and when deposit rates are low, like over the last 30 years, no one is much bothered, so money stays in M1 checking accounts. The velocity of M1 and M2 therefore can be shown to be quite (inter)changeable, but this is just another reason why one should always only use broad money aggregates. Demand for money balances, i.e. money velocity, has been in stable, slow decline over time in both Japan and the UK. This implies that the only way, short of destroying money, that increases in money supply can adjust is for the nominal, but not the real, GDP to rise to meet them, i.e. inflation.
The velocity of broad money supply in the US, derived from the flow-of-funds data, can be traced as far back as 1950 and, like Japan and the UK, displays a stable range though an even slower annual decline rate of just -0.6%. There have been only two material deviations from the 70-year trend. The first was caused by money being materially under-measured during the 1990s, as discussed above. The second has been due to COVID money printing. Whether velocity again now reverts to trend remains to be seen, but it is a brave man who bets against a 70-year trend; and beware, reversion means inflation.
However, despite the two main planks of monetarism, stable velocity and (excess) money supply’s relationship with inflation being accused (albeit falsely) of being invalid, aided by the 1990s mismeasurement of money aggregates and its misinterpretation as a breakdown in trend velocity, new theories rushed in from the ivory towers of academia to fill the gap. As the authors admit, generally left-leaning academic economists always prefer Keynesian (fiscal) solutions to monetary ones because Keynesianism is basically pro big government and redistributive policies. Nonetheless, “since the 1990s, the debate about the causes of inflation has moved on again, this time to…inflation expectations in determining what actually happens to prices (which) has been demonstrated time and time again”.
This is yet another boldly inaccurate statement, given that Fed economist and insider Jeremy Rudd famously broke ranks in September 2021 with a policy note whose abstract is worth quoting in full: “Economists and economic policymakers believe that households’ and firms’ expectations of future inflation are a key determinant of actual inflation. A review of the relevant theoretical and empirical literature suggests that this belief rests on extremely shaky foundations, and a case is made that adhering to it uncritically could easily lead to serious policy errors”.
Seemingly ignorant of Rudd’s damning indictment of both the theory and evidence supporting expectations theory, the authors state that according to the standard neo-Keynesian model, “if QE worked, it was only because it helped to shape people’s expectations”. Indeed, so effective was central bank credibility at guiding expectations assumed to be, that “Columbia University economist (and expectations theory cheerleader) Michael Woodford had argued that the best way to keep the long-term interest rate low was ‘forward guidance’.” Central bankers believe they can now just tell the bond market what to do and where to go. It must be authoritarian heaven.
“If you believe policymakers are good at keeping inflation at a healthy level – and the data suggests we are – then people know what inflation is likely to be” say the authors. Not just the bond market then, but even inflation too, like a pair of mildly unruly children, both will do what they are told to do by central bankers. How’s that for hubris?
Yet there’s a problem. Inflation expectations are derived from bond yields, and Joseph Gagnon and Madi Sarsenbayev at the Peterson Institute (PIIE) have shown that bonds are poor predictors of inflation, instead having their best correlation with historic 10-year average CPI. Expectations theory was starting to look an awful lot like driving with only the rear-view mirror. As the authors put it, “all this made perfect sense (their words, not mine), until it collided with economic reality.”
Woodford’s argument has proved wrong because even at zero rates, bonds and money are imperfect substitutes. Time to return to the ideas of James Tobin. In short, “signalling, yes, but also by rebalancing the amount of bonds and money that people hold – known as portfolio rebalancing. And it works. After all, QE clearly has a beneficial (if poorly understood) impact on the economy. But there’s a limit. You can’t keep ramping up the money supply indefinitely”. When central banks were mere tools of government, the temptation was for politicians to juice the economy every time there was a bad by-election result. The solution? In 1997, the BoE was granted operational independence to pursue a fixed 2% inflation target.
“The success of independent central banks targeting inflation directly has been palpable” we are told but, in a nod to the Spiderman generation, the authors warn that “with great power comes great responsibility – and the flipside of independence for central banks is they are tasked with protecting the value of our money and keeping inflation low and stable.” The authors must have been so busy with their heads down writing their book that they clearly haven’t had time to look up and see what has been going on around them for the last couple of years. Indeed, the whole book reads like a self-congratulatory, coming-of-age biography of the BoE and economics theory in general, but penned before the events following March 2020. Perhaps the authors were warned off making any comments about their boss Bailey’s tenure, which has left all the admonitions not to over-use QE hanging, bereft of either context or criticism.
The latest new untested, fashionable academic theory adopted enthusiastically by the central banks, but one which isn’t even mentioned by name in the text, is of course, Modern Money Theory (MMT). According to MMT, whenever the, inconveniently unobservable, output gap is thought to be large, then money-printing can fund fiscal ‘stimulus’ without risk or limit. If inflation, albeit a lagging indicator, does then rear its head, because presumably the output gap (still unobservable) has now closed, then MMT ‘theorists’ advise that money can be drained from the economy by increased taxation.
MMT is thus a fast-track way to affect a double, socialist-style redistribution and impoverish the national account in the process. Madness, for sure, but nevertheless a madness willingly embraced on an unprecedented scale by the (unelected) boards of the BoE, the Fed and the ECB. Whilst the central banks have no authority to unwind MMT-generated inflation with higher taxes, this would not work anyway because tax revenues go to the state, which then just recycles them, usually unproductively, back into the economy. MMT is thus patent nonsense from start to finish, but nonetheless the best description of the various national COVID responses that put us in this mess.
“Once (QE) begins to push inflation too high (which in terms of the BoE inflation target we can date precisely to March 2021) printing more has a cost to the public – reducing their spending power and…increasing the cost of doing business. Increases in money must be just right. These are the decisions that we at the Bank of England spend our days grappling with.” Seriously? Given the events of the last 15 months, and Bailey’s unforgivable refusal to shoulder any blame for either the cost-of-living crisis or a summer of public sector industrial action and disruption, we should heed his staffers’ own last words on the subject. The chapter on QE ends: “printing money can…raise inflation when it looks like it might otherwise be too low (eg. during resolution), but there’s a limit. If central banks were to continue to print more and more without limit, the result would be too much inflation – potentially making people worse, not better off. This is why the Bank of England’s money printing has been done in pursuit of a very clear objective. It is aiming for an inflation target – one that means money-printing is unlikely to spiral out of control in future”.
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