Calls for further monetary expansion are cuckoo

In today’s Telegraph Ambrose Evans-Pritchard gives a splendid analysis of the dire fiscal problems facing the developed economies, but a dreadful analysis of their monetary problems.

With the UK debt to GDP ratio racing up towards 100%, there can be no serious question that the UK is approaching a fiscal precipice. The Government is indeed very fortunate to have kept its credit rating – even at the beginning of the year, one big bond investor was warning that UK Government debt was a “must avoid” as it was “resting on a bed of nitroglycerine” – but this cannot last unless the Government provides a credible plan to map the country back towards solvency.

We must also keep in mind that the ‘visible debt’, the debt on the Government’s balance sheets, is just the tip of the iceberg: when one takes into account all the hidden commitments the Government has entered into – PFI, public sector pensions, state pensions, etc. – the situation is far far worse: we are looking at debt to GDP ratios in the range of perhaps 350% to 500%.

The true fiscal situation is, thus, even more dire than Mr. Evans-Pritchard makes out. Nonetheless, he is absolutely right that fiscal expansion is not an option. Instead, the Government is drinking in last-chance saloon and it is a choice between painful spending cuts now and much more more painful cuts later.

However, Mr. Evans-Pritchard also tells us that “ultra-loose monetary is the only option for Europe, the US and Japan”. He suggests that in the US, M3 has fallen at a 10pc pace for much of this year, telling us that this was the “Great Depression rate” and so the economy hit the buffers with the “usual lag” along textbook Quantity Theory lines. The clear implication is that this needs to be reversed to get the US economy going again.

This analysis is nonsense. First off, there is no “usual lag” – Milton Friedman spoke spoke of “long and variable lags”, but most economists interpret this in the region of perhaps 12-24 months – so it is pushing it to blame very recent falls in M3 for the decline in the US economy. But in any case, the Fed discontinued publishing M3 statistics back in 2006 – one suspects, because they painted an embarrassingly expansionary picture about the true stance of US monetary policy in the bubble years.

Instead, we need to take a broader picture and look at how the monetary aggregates over a much longer period. If we do so – and lets look at the official statistics published by the St. Louis Fed on its Federal Reserve Economic Data site – we get a picture of seriously expanding monetary aggregates over a sustained period of time. Even if we look at the most recent year-on-year data we find:

  • St. Louis adjusted monetary base up by about 15% (though having fallen in recent months a little to $2 trillion, itself up from about $800 billion before the crisis – a big expansion in my book!);
  • M1 up about 5%;
  • M2 up about 2%;
  • MZM (the closest now to M3), down about 2 to 3%.

By contrast, in the early 1930s, US monetary aggregates fell by about a third.

And one should never look at monetary aggregates alone; we also need to look at real interest rates, and in this respect the difference between recent years and the early 1930s is again very pronounced. In recent years, real interest rates have been strongly negative – this of course has been a key problem, repeatedly fuelling boom-bust cycles; by contrast, in the US in the early 1930s, real interest rates were VERY highly positive, sometimes in double digits.

So the overall monetary policy stance in recent years is anything but contractionary, and there is no comparison to the 1930s.

Monetary expansion has merely created an inflation time bomb and fuelled repeated speculative cycles, the latest one being in the banking sector itself, by allowing the banks one last lending binge at negative real interest rates subsidised by the long-suffering taxpayer. Further monetary expansion would merely give the patient more of the poison that is already doing much to kill him.

Fortunately, there are solutions, but one has to think outside the washed up Keynesian macroeconomic toolbox. The reason the economy is doing so badly is because the banking system is still broken, and the economy will continue to do badly until the banking system is properly fixed. Some of us have been hammering on about this for years.

This is, I would suggest, also a matter of some urgency: the Bank of England’s latest Inflation Report suggests that CDS spreads on UK banks are rising very sharply, and are nearly as high now (200 basis points) as they were at the height of the crisis (almost 240 basis points, as opposed to a mere 10 basis points before the crisis hit). The storm clouds are gathering again for everyone to see, and no expansionist ‘solutions’ are going to help.


  • Kevid Dowd’s claims that “With the UK debt to GDP ratio racing up towards 100%, there can be no serious question that the UK is approaching a fiscal precipice.”

    Actually the figure rose to over 200% just after the Napoleonic wars and after WWII without any big problems. Thus I don’t see any serious “precipice”. (Which is not to say I’m in favour of large national debts: like Toby Baxendale, I actually favour printing money and paying the whole national debt off.).

    However the rating agencies and other idiots who make up “the markets” seem to think that the 100% figure is a problem, so we better keep these powerful idiots happy. (Warren Buffet pays no attention to rating agencies)

    The latter “idiot” point is nicely illustrated by the next sentence in Dowd’s article where he refers to a bond trader who claimed the UK national debt was “resting on a bed of nitroglycerine”. This trader was Pimco, who have recently decided UK debt is a good buy. Pimco is obviously clueless.

    As to Dowd’s claim that a large monetary base increase will be inflationary, this is grossly over-simple. If the base increase comes about because of QE there is little effect because government debt is little different to cash. Many of us predicted QE would have little effect 18 months ago, and we were right.

    Moreover, it is a fundamental law of banking that banks are capital constrained, not reserve constrained. And extra base does not improve bank’s capital. Ergo monetary base does not enable banks to go on a lending spree.

    On the other hand if the base increase is fed into ordinary household bank accounts rather than into the bank accounts of National Debt holders, there WOULD be a significant stimulatory effect. But I see nothing wrong with a bit of stimulation under present circumstances. Getting the amount of stimulation right is the only problem.

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