IoD Chief Economist Graeme Leach examines the significance of the money supply to the UK economic outlook in 2011-12
Future economic historians may look back on the 2011-12 period in the UK and argue that contemporary macroeconomic discussion took its eye off the ball. In other words everyone was focussed on the economic consequences of the Spending Review and as a result missed the threat from dangerously weak money supply.
Very few commentators at the present time are discussing the macroeconomic consequences of broad money M4 performance in the UK. Even those who place greater emphasis on the role of broad money in the economy often cite the rising velocity of money (for explanation see Box 1) as reason not to be too concerned.
All the emphasis appears to be on fiscal policy and above target inflation in the short-term, when attention also needs to be placed on monetary policy and the deflation threat in the medium term.
The latest aggregate M4 broad money supply (the Bank's favoured measure, excluding intermediate other financial corporations) figures from the Bank of England are shown in Chart 1. In the year to May 2011 M4 excluding intermediate OFCs rose just 1.7 per cent. Over the past six months this measure has averaged 1.7 per cent growth (year-on-year) also. Annualised growth in the latest three month period is even less, at just 1 per cent.
This performance contrasts with received wisdom that 7-8 per cent growth in the money supply is consistent with trend GDP growth of 2.5 per cent and hitting the inflation target of 2 per cent. Consequently the sustainability of the recovery must be in question without acceleration in the money supply. Whilst the MV=PT identity (see Box 1) does not prevent an acceleration in GDP growth which is facilitated by a higher velocity of money, depending on this factor for a sustainable recovery is risky.
Some may argue that any emphasis on broad money is irrelevant because the velocity of money is unstable or the money supply is endogenous i.e. the money supply is a consequence not a cause of economic activity. This can be debated. But those holding New Keynesian model views also have to acknowledge the limitations of their approach. Central bank reaction functions based on a Taylor Rule, relating how interest rates should respond to changes in inflation and the output gap, are little use when the bank rate is 50 basis points - and there is a significant output gap. Something was missing from the MPC tool kit prior to QE.
With near zero interest rates in place and the need for further economic stimulus to head off deflation and depression, broad money supply stimulus using quantitative easing came to the fore in 2009. Arguably it should have been there already, but surely the significance of the money supply can't be questioned in a post financial crisis environment of deleveraging and balance sheet reduction in the banking system.
Chart 2 shows the performance of nominal GDP over the past 3 years. Clearly nominal GDP is much stronger now than when QE was introduced in 2009. However, it is also the case that broad money supply is now weaker than in 2009 (see: Chart 1). Moreover, the outlook for the money supply is highly uncertain, with a real risk that it could get worse before it gets better – due to further deleveraging in the banking system and more onerous capital requirements.
Broad money growth is now the lowest it has been on a sustained basis since modern statistics were first compiled. In the near future banks need to contend with the legacy of the financial crisis and the tightening in bank capital rules under Basle 3. Further pressure from provisioning for bad debt is also likely to erode capital over the 2011-12 period. In other words we face a drawn out process of flat money supply extending over years not months. Even if the banks raise capital from the nonbank private sector, this will reduce the money supply - because it will reduce the bank deposits of those who provide the capital.
To raise interest rates at this stage in the economic recovery, when money supply growth is so weak, would be unprecedented. Table 1 shows that over the past 25 years interest rates have only been increased when money supply growth was in double digits.
For those of a Keynesian economic view there are also, surely, strong pragmatic reasons at present to recognise at the very least that the money supply might be the swing factor between recovery and a double-dip recession:
- - We are seeing the sharpest squeeze on real pay in decades. This year will mark the 4th consecutive year of falling real earnings. According to Capital Economics, this will be the first time this has happened since the 1870s. The wider measure of real household disposable income is equally bleak and this year is likely to record the biggest drop since records began in 1955. The outlook for next year is also pessimistic, if the OBR's projections for tax receipts prove correct.
- - The household savings ratio fell to 4.6 per cent in 2011Q1. We are doubtful that the savings ratio can fall much further on a sustained basis. To do so would be to reach the low levels associated with the peak of the boom, not a hesitant recovery.
- - Business and consumer confidence is not helped by the crisis in the Euro-zone and above target inflation in the UK. The level of economic uncertainty at present is particularly high, impacting on business investment and big-ticket consumer purchases.
- - We think that pessimistic assessments of the impact of the Spending Review, with positive fiscal multipliers well above 1, are not in accord with latest estimates from the IMF and ECB. Our view is for a low positive multiplier, below 0.5. There is also the possibility of a very small negative multiplier - a so-called expansionary fiscal contraction - although this is not our central forecast. However, the possibility of an expansionary fiscal contraction cannot be dismissed in the economic literature. The evidence is surprisingly strong.
Given that those economists who tend to dismiss the importance of the money supply are also the ones who see the greatest risk from fiscal policy (high positive fiscal multipliers) their bleak views at present are understandable. But to pile zero or negative money supply growth on top of all these factors surely risks a double-dip recession.
The counter argument that a fiscal expansion is what is required is not, in our view, credible. Leaving aside the fiscal multiplier debate above, analysis of the IMF’s series on the change in the UK government’s structural balance over the past 30 years, shows that changes in the cyclically adjusted deficit (increase) were not associated with subsequent periods of above trend growth (a fall in the output gap). If anything, reductions in the deficit or increased surpluses tended to be associated with above trend growth.
The standard Keynesian argument of course is that in a world of bank balance sheet reduction and near zero interest rates, monetary policy has become impotent – there’s a so-called liquidity trap. But this is to make the mistake of viewing monetary policy as just a matter of interest rates – ignoring the potential contribution from money supply expansion (QE). And changing fiscal policy – slowing deficit reduction – would not be a painless experience. There would undoubtedly be a rise in long-term interest rates. As a result any temporary economic gains could be quickly lost and we would also have damaged long-term growth prospects because of the subsequent taxation required to pay off the higher deficit.
Let’s not make the mistake of viewing money as irrelevant to the future economic outlook. It is central.
© Institute of Directors. Used with permission.
Many poor people no longer live in poor countries. Of the 10 countries that contribute most to global poverty, six are middle-income countries. For many aid organisations, 'middle-income' means they no longer qualify for the same financial aid. This column argues that such a policy would be failing up to a billion people.
In 1990, 93% of the world’s poor lived in low-income countries (LICs). Now, more than 70% – up to a billion of the world’s poorest people or a “new bottom billion”– live in middle-income countries (MICs) and most of them in stable, non-fragile middle-income countries (see Institute of Development Studies for discussion).
Many of the world’s poor live in countries that have grown richer in average per capita terms and have been subsequently been reclassified as MICs. According to the World Bank’s Atlas GNI per capita data and country classifications, over the last decade the number of LICs has fallen from 63 to just 35 countries in 2011.
Most of the world’s poor live in countries that have moved from low- to middle-income country status since 1999 when China graduated to MIC status – notably Pakistan (2008), India (2007), Nigeria (2008), and Indonesia (2003). China is now an Upper MIC as of July 2011. This concentration of the world’s poor in relatively few countries is a key part of the story. Although 28 countries have graduated from LIC to MIC since 2000, about 60% of the world’s poor now live in just five populous new MIC countries – those mentioned above.
Indeed, of the top ten countries by contribution to global poverty only four are LICs – Bangladesh, DRC, Tanzania, and Ethiopia. In other words, most of the world’s poor do not live in countries classified by the World Bank as LICs and most of the world’s poor do not live in fragile and conflict affected states.
This new geography of global poverty raises some basic questions about aid to help the poor of the world. Although the details vary from scheme to scheme and agency to agency, the current architecture of development assistance, especially grants and concessional loans, ‘graduates’ countries from assistance when they transfer from LIC to MIC status. As a result, all major forms of global official aid are rapidly disengaging from the bulk of the world’s poor. Is this a desirable outcome?
- , pockets of poverty call for aid no matter where they occur. It could be argued that the poor in LICs are poorer than the poor in MICs. However, this is not necessarily the case. Especially when dimensions other than income such as health and nutrition are included, the depth of poverty in some MIC enclaves can be quite severe. It can also be argued that the persistence of poverty in a MIC, when the country as a whole now has resources to address poverty, shows a lack of political will and so aid would be wasted. But political inertia can be an issue in LICs as well – poverty reduction performance can be assessed on a per-country basis, without a blanket withdrawal of assistance from all MICs.
- , actions of MICs on carbon emissions, on deforestation, on water usage, etc, have consequences that spill across borders and have a global impact. Bringing MICs into global agreements, which may require them to implement policies that will have negative effects on their growth in the short term, will require resources for compensation. The large sums being discussed on funds for climate change agreements are an indication of this requirement, and of the fact that flows of assistance will be needed for MICs, including those who have recently switched or will soon switch from LIC status. To the extent that large pockets of poverty in MICs exacerbate the negative externalities, the argument for continued support is further strengthened.
- , by engaging with MICs, development agencies gain knowledge, for example on implementation of social safety nets, which can then be useful for development assistance to LICs.
These issues can be seen clearly in the case of assistance from the World Bank’s soft loan agency, the International Development Association (IDA). The threshold for the agency was an income per capita of $1,175 in 2010, compared to the LIC/MIC threshold of $1,005. Access to IDA loans ceases when the country’s GNI per capita exceeds the threshold three years in a row.
If current rules of graduation continue to apply, over the next decade and a half the major sources of concessional finance to poor countries will find themselves disengaged from the bulk of the world’s poor. Moss and Leo (2010) have forecast IDA graduations on the basis of IMF World Economic Outlook growth projections. Their conclusions are sobering. By 2015, IDA will only be serving around 30 countries, mostly in Africa, and many of them in the fragile-states category. If the current level of IDA is maintained, the per capita allocation to the remaining countries will double, while the allocation will of course fall to zero for countries where the bulk of the world’s poor live – not only the top five countries mentioned above but also countries like Vietnam, Ghana, Sri Lanka, Zambia, and Bangladesh.
- Either the donors could declare victory and dramatically scale down contributions to IDA – enough to maintain the current per capita allocation for the countries that do not graduate.
- Or, in recognition of the fact that poverty persists in MICs, and that the MICs are an integral part of solutions to global problems such as climate change, mechanisms could be developed to continue flows of development assistance to MICs.
We make the case for continued engagement of IDA with MICs. The LIC/MIC threshold is too sharp a cutoff when poverty persists to such a great extent in these countries. A specific proposal (Kanbur 2011) is to consider opening a second window, from the threshold to twice the threshold, where countries would have access to IDA funds but for projects specifically and sharply targeted to pockets of poverty in these countries. Further, these countries could use funds for activities that supported global public goods like climate change mitigation – this could be a separate window by itself.
While the operational details of these windows of continued engagement with MICs need to be worked out – for example, whether the lending terms would progressively harden as countries GNI per capita increased, and how a performance based allocation of IDA across countries would work – it seems clear that something like this transformation of IDA will be needed if it is not to be become irrelevant to countries where the vast majority of the world’s poor will continue to live.
The new geography of global poverty throws into question development assistance policy towards MICs. A policy of cutting, or entirely stopping, development assistance to MICs needs to be examined closely when the bulk of the world’s poor live in these countries. We show that there is no justification for a blanket exclusion of MICs from development assistance. Rather, we argue that the policy has to be crafted on a country-specific basis, taking into account the detailed nature of poverty in each MIC, the role of that MIC in addressing global challenges such as climate change, and the specific institutional and implementation context of development assistance.
Kanbur, Ravi (2011), “Aid to the Poor in Middle Income Countries and the Future of IDA”.
Kanbur, Ravi and Andy Sumner (2011), “Poor Countries or Poor People? Development Assistance and the New Geography of Global Poverty”, CEPR Discussion Paper 8489, CEPR.
Moss, Todd and Benjamin Leo (2011), “IDA at 65: Heading Toward Retirement or a Fragile Lease on Life?”, Center for Global Development, Working Paper 246, March.
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