Sunday, July 01, 2007
A gush of money, but what's it mean?
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


In the end, it comes down to money. Nothing is certain but an interest-rate hike this week by the Bank of England is seen as a “done deal” in the markets.

And a growth rate of 13.8% in the M4 measure of money (they all share names with parts of the motorway network), will help drive that decision.

Milton Friedman, the late lamented father of modern monetarism, told us inflation is “always and everywhere” a monetary phenomenon. Last week Sir John Gieve, a deputy governor of the Bank, said monetarism, cast into the wilderness after the rocky ride of the Thatcher years, was “not dead but only resting”.

Although he thinks targeting inflation is superior to targeting the money supply, he is concerned that the rate of growth of money and credit is too high. That is why he voted for a rate rise last month, along with three colleagues on the monetary policy committee (MPC). And it is why he will repeat that vote this month, with at least four others expected to join him.

Gieve is not alone. Bank governor Mervyn King, in evidence to the Treasury committee last week, said the rapid expansion of money and credit was an upside risk to inflation.

Gieve was at the Treasury during its experiment with money-supply targeting in the 1980s, and knows the pitfalls. It is interesting that Rachel Lomax, his fellow deputy governor, was also there and more closely involved in monetary policy. Bank insiders say she is contemptuous of the return of money to the debate, which makes for interesting MPC discussions. Lomax, who also testified to the Commons last week, appeared unpersuaded of the need for a rate rise.

Regular readers will know that the “shadow” monetary policy committee, which meets under the auspices of the Institute of Economic Affairs, has always attributed a big role to money, as you would expect with members like Tim Congdon and my namesake David Smith.

Last month the shadow MPC voted 5-4 to leave Bank rate on hold at 5.5%. This month it votes 8-1 to hike. Whether the actual committee comes out with as clear-cut a decision remains to be seen; I would have thought it unlikely. Interestingly, its most aggressive member, Roger Bootle, is not a monetarist but believes that the Bank should make a half-point rise this week.

Why has money, after a long absence from the policy agenda, come to the fore?

It is useful to have in mind what a “broad money” measure like M4 is. Though a tiny part of it is what we used to think of as money, notes and coins, M4 is driven by credit, or bank lending. So reducing the rate of growth of M4 is not a question of turning off the printing presses but slowing the growth of bank lending. If you raise the price of money by increasing interest rates, you should slow demand for it. Gieve does not think rates are high enough to achieve that.

Strong broad money growth is not purely a UK phenomenon. Europe’s relevant measure, M3, is rising by nearly 11%, the highest in a quarter of a century. The European Central Bank takes money seriously, it being one of its two “pillars” – the other is inflation.

On the face of it, a rise of nearly 14% in Britain’s money supply presents a straightforward argument for raising rates. Those who dimly remember the quantity theory of money, MV equals PY, will be aware that other things being equal, a given rise in M, money, leads to an equivalent increase in P, prices, and Y, national income.

If national income, or GDP, is rising by roughly 3%, then the consequences of 14% money-supply growth for inflation look to be genuinely alarming – not so much 2% but closer to 10%.

Fortunately, it is not so simple. The other component of the quantity theory, V, velocity of circulation, has been declining for decades. Think of it as money working less hard; a given rise in the money supply is associated with a smaller increase in “money” GDP (growth plus inflation).

That is why, in recent years, M4 has had such a weak relationship with either inflation or money GDP. Since early 1993, M4 has risen by 200% and inflation (measured by the retail prices index) by only 45%. GDP in cash terms, money GDP, has risen 105%.

There is another problem with M4 at the moment, which Gieve described. It has been significantly boosted by lending to “other financial companies”, or OFCs, some of which may simply be a technical change, these companies choosing to hold a higher level of deposits for a given level of activity than used to be the case.

Take away this component of M4, incidentally, and you end up with a growth rate of about 9%. This was what the Bank previously said was consistent with achieving the inflation target.

These are difficult waters for a Sunday morning, and I hope you have stayed with me so far. To risk losing you at this late stage, another money-supply measure the Bank produces, so-called Divisia money, more closely related to household spending, is rising by 7% and has slowed over the past couple of years.

That’s enough Ms and Ps. The question of money is a simple one. Is its current growth inflationary, or has the relationship between M4 and the things that matter broken down so irretrievably that we should cart it back to the funeral parlour?

The Bank’s hawks, and most members of the shadow MPC, would argue that M4 must be related to something, and this is probably asset prices, most notably shares and property. While they do not feed directly into consumer price inflation, they will eventually. Money is being held in the buffer of rising asset prices but will make its presence felt in general inflation.

It might, though that has not happened during some previous periods of strong money-supply growth, including in the 1990s. We should not ignore money but we should not elevate it too much either. The lesson of the Thatcher years was that the money supply responded only slowly to higher interest rates and frequently led to policy overkill.

What would I do this week if I were on the MPC? The committee, I think, has got itself into a position where it would lose credibility by not hiking, which is unfortunate. It has also given the impression that it has to move with haste, having long told us that differences of a month in changing rates make very little difference.

I would want to see whether the signs of a significant slowdown in high-street spending are more than just weather-related. I would also, as I suggested last week, want to calm things down ahead of a fuller review of the economy in August. I would vote to hold. I suspect, however, I would be in a minority.

PS: Professor Joe Stiglitz, Nobel prize-winning economist, was in London last week at an event hosted by SAB Miller, the brewer. Stiglitz is downbeat about America, seeing trouble from the sub-prime mortgage crisis, though his gloomy predictions of four years ago, in his book The Roaring Nineties, were off beam.

He also commented on the rise of protectionism in the US, fuelled by reports that male incomes, in real terms, are lower than in the 1970s. America’s Economic Mobility Project says the median income of men in their thirties was the equivalent of $40,000 in 1974 but only $35,000 in 2004. Globalisation’s effect on low-income workers is blamed.

I find this puzzling. Britain is a more open economy than America and inequality has also grown significantly. Yet the experience here has been different. Figures for median average earnings only go back to 1997, but by last year showed a 13% real rise for men, and 22% for women.

Average (mean) incomes more than doubled between the mid1970s and 2005. Median incomes, the closest thing to the American measure, rose 80%. This is what you would expect; over time incomes tend to outstrip inflation (or economies grind to a halt). Interestingly, real incomes have been flat over the past year and the savings ratio has slumped to a record low of 2.1%.

From The Sunday Times, July 1 2007


Is it a done deal with all this 'jostling for position' going on within the MPC?

Posted by: Mr Naresh Radson at July 1, 2007 12:16 PM

Whether or not it's a "done deal" - and that's the view of the markets not me - I don't recognise any of that. It's an insult to Rachel Lomax to suggest her voting behaviour is driven by ambitions of succeeding Mervyn King.

Posted by: David Smith at July 1, 2007 03:40 PM

I wonder if Stiglitz and the "Economic Mobility Project" are looking at all men or if they're looking at those who are actually earning incomes. In looking at the changes from 1995 through 2005, the number of low income earners has decreased substantially, even though the number of higher income US income earners (men and women) has increased (as well as the total number of income earners.)

While I have not yet examined the data going back to 1974 (at present, I'm looking to fill in the analysis from 1995 through 2007 as time allows), we should note that 1974 pre-dates the large scale entry of the U.S.' baby-boom generation and women into the workforce (sharply increasing the labor supply, particularly at younger ages) as well as massive shifts in the U.S. economy away from low skilled manufacturing to highly skilled service industries, which have tended to favor women over men.

We should also note that the decline in low skilled manufacturing has primarily been driven by technological advancement in automation technology (globalization is a more recent, and lesser, phenomena - the alternative to outsourcing is often outright job elimination through automation in this area).

If these non-trivial factors are not being even being mentioned, I would be concerned that there's quite a lot of cherry picking in the income-inequality data.

Posted by: Ironman at July 1, 2007 06:27 PM

Dear David,
Very interesting article indeed. To test the effect of money on inflation, monetarists typically consider (i) the direct impact of money growth on inflation, and (ii) the impact of increases in money above its "equilibrium" relationship with prices, income and interest rates. It seems that both money growth and money disequilibria currently have a very small impact on UK inflation.
A sceptical economist would argue, however, that the effect of money disequilibria is not appropriately measured since these typically ignore additional opportunity costs (in terms of house price growth and exchange rate growth). Both asset prices have recently played a prominent role in the UK economy. Even if these are considered, the conclusion is still the same.
Many thanks.

Posted by: Costas Milas at July 2, 2007 04:52 PM

Dear David,

As I had mentioned to you on several occasion, I have tremendous respect for the bank of england governor Mervyn King, this man really has been up against what can only be described as popular opinion stroking by most of his board. I am delighted he has now an outspoken deputy which has show finally and clearlywhere his sentiments are.
It doesn't take to many braincells to figure out that if inflation stems from too much over spending, that the supply of money may be a contributary factor.
Please David....spare me the sermon on all the different variations of M this and M that. Ultimately its money right?

Best wishes

Arik Schickendantz

P.s My prediction 6.00% by november 2007

Posted by: Arik Schickendantz at July 3, 2007 11:17 AM

"Ultimately it's money, right?" - no, most of it is credit, as I tried to explain, not sermonise. The search for a reliable single emasure of the money supply has dogged policymakers for decades.

Posted by: David Smith at July 3, 2007 12:13 PM


FWIW even Friedman seemed to think targeting quantily of money wasn't a great success.

In the FT:

"The use of quantity of money as a target has not been a success," concedes the grand old man of conservative economics. "I'm not sure I would as of today push it as hard as I once did."...

Simon London, "MILTON FRIEDMAN - The long view," The Financial Times June 7, 2003 Saturday, p. 12.

Posted by: kingofnowhere at July 4, 2007 08:23 AM


I am beginning to think the Bank will be making a mistake if they continue to raise rates. After years of Interest Rate stability, this continual rise in Base rate (if as predicted, they raise tomorrow) means the MPC are no longer waiting to see the impact of previous rate rises.

I think given the current circumstances (US slowdown, House prices seem to be coming off the boil, slowdown in Spending) the Bank would be well advised to not raise rates tomorrow.

Even if they do raise rates, I believe we are indeed nearing the top of the cycle, as if they go much higher the economy will be in danger or grinding to a halt - which in the long term might fit your view that the "neutral" rate for the UK is around the 5% mark

Posted by: Paul at July 4, 2007 10:17 AM