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Monetary policy in recent times

di - 25 Novembre 2022
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After a relatively long period of stable prices and steady growth around the world from the late twentieth century into the twenty-first century, turmoil followed. The Governor of the Bank of England at the time described the late 1990s/early 2000s as the NICE decade: non-inflationary constant expansion. And central banks were quietly taking credit for the stable conditions that prevailed. And yet many began to see, and warned of, difficulties that were emerging. Many of these were soon realised.

Three failures
The first failure to be exposed was to imagine that the stable monetary conditions (however they had come about, and there had been favourable global conditions) meant that stable financial conditions automatically followed. They did not. There followed perhaps the worst financial crisis of all time in the years 2007-09. The failing could have been avoided had policy makers known a little history. A brief perusal of the monetary and financial history of nineteenth-century England would have made obvious that that century was one of stable prices peppered with regular financial crises. The stable prices came from the gold standard and the financial crises came from the usual frequent bursts of euphoria that humans are subject to when some new market/innovation etc. is divined, and no rational discussion will deflect the enthusiasts from their path. Calamity follows.

However, in the nineteenth century after some experience they learned how to contain these crises and even prevent them from happening. The commercial banks learned the appropriate caution for their balance sheets. Government learned to keep out of the markets and a de-regulated system was able to emerge. And crucially the central bank learned how to behave in a crisis, essentially how to behave as a lender of last resort. This last meant injecting the necessary liquidity into the markets to allay fears that arose when bursts of euphoria emerged. As it began to be appreciated that the central bank would in future behave in this way, there was no need to inject liquidity; it was sufficient for the markets to know liquidity would be available. A very long period of stability followed from the middle of the nineteenth century to the third quarter of the twentieth century with no financial crises. But these lessons from the nineteenth century were slowly forgotten, and the danger of financial crises re-appeared.

The second and perhaps the biggest mistake made in the course of the late twentieth century was on the part of the commercial banks who began to believe that in a globalised world liquidity was something that would always be available in the markets. They therefore left themselves desperately short of liquid assets that could have been cashed in at the central banks if/when the need arose. The shortage of liquid assets was also brought about by the search for higher yield assets that was taking place in the benign world of low interest rates.

The third failure in the system was of the central banks and their neglect of money. This was another lesson still not fully acknowledged, that inflation is as Friedman said, essentially a monetary phenomenon. Of course reckless government spending and a supine central bank will produce inflation, and in that sense the inflation comes indirectly from fiscal policy. But the basic lesson is that too much money in relation to goods causes inflation. As a former Governor of the Bank of England titled an article in 2002, ‘No money; no inflation’.

The lesson had been made clear in the 1970s when monetary growth was running at high levels and inflation was following close behind. At the time that inflation was being explained in sociological terms. It was said to be the result trade unions exerting monopsony power and equally of monopolists exerting monopoly power. It took a long time to accept that excess money growth in relation to output growth was the fundamental cause and when that was corrected, albeit painfully, inflation came under control. Monetary variables were sometimes targeted after that but at minimum carefully watched. Central banks continued for some time to produce and publish data on monetary variables.

But then that awareness/grudging acceptance but not quite a belief in the importance of money began to weaken and instead the claim was advanced that central banks had cleverer ways of containing inflation through inflation targeting and central bank credibility. Governments would tell central banks what rate of inflation they wanted. The central banks were made operationally independent and asked to deliver that rate. The target was published and when consistently hit the public believed the bank would continue to deliver. And then it seemed that money could be ignored or even increased without the damaging effects formerly expected. Something called ‘Modern Monetary Theory’ appeared which said just that. (Some have likened it to the remark on the Holy Roman Empire, ‘It’s not modern, it’s not monetary, and it’s not theory’.) Its advocates say there is no problem. Where resources are unemployed they are available freely. Monetary expansion will simply bring them back in to use, and not cause inflation. There are at leas two errors there. One is to forget that if economic contraction is due to a fall in supply, expanding demand will not fix that. But more importantly money supplies expand much more than economies can plausibly expand to absorb them. History shows that when that happens inflation is the inevitable consequence.

The global financial crisis and after
When the global financial crisis (GFC) broke in late 2007 and more clearly in 2008 it was in big part a consequence of these failures. Nevertheless, the correct response was adopted. There was an early injection of liquidity by central banks in many of the large and leading countries. There were liquidity problems and there were also solvency problems. These two are often related but the latter is sometimes revealed only if the former has not been properly attended. In the normal pattern with crises the liquidity would be withdrawn after the markets had been calmed, initial problems resolved, and affairs were returning to normal. But that did not happen.

And separately, solvency problems being different from liquidity problems require different measures. Central banks do not have the resources to bail out insolvent institutions of any great size. That requires taxpayers. And that was done via the Treasury. But so serious were the problems of the GFC that following the bailouts it was decided that further measures were required. The solvency problems were said to have arisen because insufficient capital had been held by the banks in relation to their liabilities. This was in spite of the approved capital/asset ratios coming from the BIS and being adhered to by the banks. This was an example of regulatory failure of which many abound. Higher capital/asset ratios were therefore introduced. This could only mean that the banks could not lend on the scale that they had been lending. And since this meant a shrinkage in the banks’ balance sheets it would have meant a contraction in the money stock and a fall in real output/income. This was in part offset by the continuing policy of quantitative easing over the next several years.

But quantitative easing went on far beyond that. Indeed it never went away. And after money growth resumed there was still no inflation. Were we in a new world where ever greater quantities of money could be provided without any of the formerly believed inflationary effects?

Part of the explanation for that was that the excess money was finding its way not into the indexes available for capturing inflation but instead into assets not included in these indexes.

The response to the pandemic
The ‘cheap’ money that followed the GFC never ceased. Quantitative easing that began as an injection of liquidity that was needed at the time of crisis just kept on coming. What was a sensible crisis measure in 2008 had surely become ridiculous by 2020. And yet no sooner had the pandemic been signalled than schemes for large-scale spending were announced. This had become part of a pattern. As soon as the Conservative Government had been elected at the end of 2019 they made announcements that the high-speed rail project would go ahead. This is an enormously expensive and contentious project but there was no hesitation. Indeed any problem seemed immediately to call for further large injections of money.

So when the pandemic struck it was no surprise that that would be a big part of the response. There were the obvious necessary expenditures on medical equipment; new hospitals were built, vaccine development was hastened, and so on. But in addition a system of lockdowns was imposed on the population. In other words big chunks of the economy were closed down. But a system of paying people who were put out of work was introduced. A system more in conflict with the fundamental principles of economics would be hard to find – choke off supply and pump up demand. If the extra-ordinary money flows that followed did not trouble the monetary authorities surely nothing would.

More recently
No sooner was the pandemic resolved than Russia invaded Ukraine. Part of the British response was to provide resources and promise financial aid. So another inflationary pressure was introduced. But if there were any rise in prices a ready explanation was to hand; it was the war in Ukraine and the accompanying shortages together with supply-chain disruptions. All would be well once these had worked their way through. Inflation might appear but it would be a transitory problem.

Except that it wasn’t. The forecasts of inflation were hopelessly below what came next. And the problem persisted (and is still persisting). But it might now have dawned again that central banks do indeed control the amount of money in the system and it was time to exert that control. Around the world interest rates have been rising in a late attempt to regain that control.

The answer to the notion that inflation is caused by prices going up, that is by shortages because of wars or famines or supply chains or whatever, is that these events are not new to the world. History is replete with wars and weather extremes and shortages. And yet century after century passed without inflation. The pressures could not be accommodated because there was a metallic standard in place and the money stock could not therefore be increased much, and certainly not rapidly. Only when the standard was suspended on a relatively few occasions did we see sharp inflation. It was not until the twentieth century that these pressures began to be accommodated under paper money regimes and inflation became an accepted part of economic life. But to paraphrase Mervyn King, you can have whatever rate of inflation you want; you can go the Venezuela route or the Zimbabwean route, or you can adhere to sound principles and stick to 2% inflation (until you take your eye off the monetary indicator.) There is no need for inflation.

Most recently, as a consequence of the Ukraine War, energy prices have been rising. And once again government has decided that it will pay a large part of the bill. It seems to have become the knee-jerk response to any apparent difficulty – spend money on it. (We leave aside here any discussion of what might have been better energy policies over the last 20 years or so.) And alongside this extra spending, tax reductions have been announced. Tax reductions should surely in general be applauded. But immediate enthusiasm for these ones needed to be dampened. This was for two reasons. One was the scale of government debt. And the other was that there was no mention made of any cuts that could be expected in government spending.

It may well be that after the initial financial market turmoil it turns out to have been poor communication that was the problem. But for the moment we have been left wondering.

Of course a caution has to be added to all of this. We are not well served with our media. The English have long had a talent for self-deprecation. To this has been added the dismay in large sections of the media over the EU referendum result of some years ago. There is then currently in addition to the normal insatiable demand for stories of doom a desire to add that if the advice of the opponents to that result had been taken everything would be fine. Clearly that is not the case. So it would be unwise to rush to any conclusion on on-going policy changes until a clearer picture has emerged.

Good regulation is difficult to design and frequently is impossible. Even if it were good at the point of design it might become obsolete, or worse become part of the next problem. It should also be said that accompanying the failures discussed there was the steady socialisation of risk. There was a growing acceptance over a long period that banks would not be allowed to fail.

To reiterate, the belief that had taken hold by the turn of the century that financial stability could be taken for granted had a big part to play in the GFC. And in the last decade or so the main failing has been to continue to over-provide money and lose sight of the fact that money was indeed key. That meant that greater problems arose and more serious inflation appeared when the next problem emerged in the pandemic of 2020-22. More money was thrown at the emergency. And that response was repeated with the outbreak of the war in Ukraine.

Capie, Forrest (1986) ‘Conditions in which very rapid inflation has appeared’ Carnegie-Rochester Conference Series, Vol. 24
Capie, Forrest (2014) ‘British financial crises in the nineteenth and twentieth centuries’, in Nicholas Dimsdale and Anthony Hotson (eds.) British financial crises since 1825, (OUP)
King, Mervyn (2002) ‘No money; no inflation’, Bank of England Quarterly Bulletin, Q2.
King, Mervyn (2022) ‘Monetary policy in a world of uncertainty’, Institute of International Monetary Research, Conference Paper 1.



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