Whilst the international attention is all about the Greek crisis, last week’s report by the UK’s Office for National Statistics reveals our own country’s parlous financial condition.
As at May 31st 2011 Public Sector Net Borrowing (PSNB) was £920 billion, or 61% of GDP. When the present coalition government came to power twelve months ago the debt was £778 billion. When the UK went to the IMF for help in 1976, the inflation-adjusted figure was half of this.
And of course the £920 billion figure is the most understated representation of the national debt that the government’s statisticians can produce. A more holistic measure of UK debt would aggregate £250 billion of now on-balance sheet Private Finance Initiative (infrastructure) liabilities and £1.2 trillion of unfunded public sector pension exposures together with the PSNB figure. And this sub-total assumes no long-term cost in respect of the bailed out bank stakeholdings.
Excluding bank bailouts, the deficit (rate of growth of the debt) for May 2011 was £17.4 billion compared with £18.5 billion for May 2010.
The coalition have boasted of bold and brave cuts. Police budgets, armed forces expenditure and local government subsidies have been cut, yet total public spending is up 4% year on year.
Other cuts have been announced and then rescinded in the face of fierce counter campaigning. Forestry was to have been sold, the NHS was to have been radically restructured, and the welfare (benefits) system overhauled. These supposed cuts have either been officially rescinded (forestry) revised and watered down (NHS) or, in the case of welfare reforms, likely both to increase public expenditure and harden the divide between the generationally workless and those actively seeking work. Frank Field, a Labour MP boasting excellent social inclusion credentials, recently observed  that these two groups will be further divided as a direct result of two new Coalition proposals. He describes the combination of means tested benefits and lightly regulated government support for businesses taking on the unemployed, as “Gordon Brown on speed”. The recently laid off will be targeted by such businesses, not the long-term unskilled workless who will have little incentive under the benefits rules to apply for work.
International readers might think this a good opportunity for the opposition Labour party, ousted in 2010 after 13 years in power, to exploit the Coalition’s economic plight. Not so. Mindful of their role in presiding over the accumulation of the debt their Treasury spokesman, Ed Balls, refused  to regret any of his government’s borrowing. He explained that the need for retrenchment today stems only from the 2008 banking collapse which was a global problem and therefore not one to be laid at the door of the then incumbent government. He did admit that he and his colleagues were not strong enough on bank regulation. Far from criticising the Coalition for failing to get the debt under control today, Labour prefers to focus on the social costs of the modest cuts undertaken and argues that they would have made broadly the same level of cuts, but implemented them more slowly.
The two political sides therefore differ very little on the measures to be undertaken, giving little impression of expertise in addressing the impending debt crisis. Perhaps, however, both sides know what needs to be done but are scared to say so, let alone embrace the necessary policies.
One of the UK’s major problems is its appeal as a migration centre. The UK’s generous benefits system and lax checks on qualifications unsurprisingly sees the population growing rapidly. In the last 12 months, 87% of the 400,000 new British jobs have gone to migrant workers. Membership of the European Union is a common policy of each of the three major UK political groups, and all EU citizens are welcome and no British party has any plans to curb the steady influx of people as the EU enlarges itself.
The ONS report reveals that the national debt is no longer within the government’s control. A significant volume of the debt is inflation linked. The effect of near zero interest rates and money printing has caused retail prices to rise strongly. The interest bill for the last 12 months was £45bn, or 1/3 of the £133bn in the y.o.y. increase in national debt.
Borrowing is literally therefore out of control and truly radical measures are needed to address it. The benefits system and the National Health Service should be significantly pruned. The difference between the UK and Greece is that the UK has its own currency and can print more of it. Unless the Coalition gets control of its expenditure I fear the launch of our own QE2. A second dose of QE would be disastrous, leading to currency failure and hyper-inflation.
 June 19th Andrew Marr show, BBC2 – TV.
 Frank Field article, as at 1 above
“What if a powerful media conglomerate, such as modern day William Randolph Hearst, controlled the media around a major University to influence students and professors to directly advance his financial interests? I have found that person, HM Lord Lieutenant Richard Jewson, who 1) has a direct connection to the British monarchy, 2) is on the board of many multi-national “green” corporations, 3) directly controls a major media market servicing EA University and other British Universities, and 4) as a member of the board of EAU (sic), has significant control over their environmental studies department.”
“As at May 31st 2011 Public Sector Net Borrowing (PSNB) was £920 billion, or 61% of GDP.”
That’s not the correct term. Public Sector Net Borrowing refers to a flow, more precisely, the fiscal deficit in a given year, and not to a stock, in this case, the public debt held outside of the public sector.
Do you sometimes feel like the only sane man in a lunatic asylum? It is patently obvious we are heading over the cliff debt wise, yet all we get is the “savage cut” narrative.
Why would a second dose of QE lead to currency failure and hyper inflation? With interest rates at 0% and the economy not at full employment, more QE would have a limited effect in terms of inflation, and certainly would not cause hyper inflation. This is empirically demonstrated by events in America (as well as Japan in the late 90s), in which many parallels can be drawn with the UK case. Large increases in the monetary base did not cause a corresponding increase in the broad money supply M2.
I don’t agree entirely with Gordon Kerr’s article here. However, he is quite right to worry about the prospect of another round of QE.
“Full Employment” and 0% interest rates are not directly relevant to the situation. Money creation can still cause price inflation even if the interest rate is very low, and even if there is widespread unemployment. Though it’s certainly true that if price inflation does rise noticably then long-term and medium-term interest rates will rise soon afterwards.
I’ll deal with unemployment here, since the interest rate case is quite technical. Keynesian theory has it that if unemployment is low then when extra money income is spent it will lead to an expansion in output rather than price inflation. There are several problems with this. Firstly, employment is at least somewhat specific, so spending in certain sectors where employment is high will not have the results Keynesians predict. Where unions can control employment this has a stronger effect. Secondly, prices that are not directly to output can rise without much extra employment being involved. Extra income can be spent on existing goods such as commodities or assets rather than on output goods. Although these goods are not part of output they may cause output prices to rise either because they’re substitutable with output, or because they’re inputs to industrial processes. Lastly, although it’s normal to measure price inflation by measuring the price level of new consumer goods the inflation that normal people actually deal with is that of the prices they pay. That may be mostly consumer goods, but will not be exclusively consumer goods.
Current, my point on interest rates is actually quite simple. Ordinarily, asset purchases by the central bank would be highly inflationary as an increase in base money would directly translate through to an increase in the broad money supply.
However, in the special case we are in at the moment with interest rates near zero, further asset purchases have a somewhat limited effect. If companies cannot be persuaded to invest even at an interest rate of zero, further increases in the money supply simply cause money to pile up in bank vaults – we have seen this with the massive increase in excess reserves since the recession. So an increase in base money does not necessarily translate to an increase in the broader money supply in this case. This was the experience of Japan in the late 90’s, where a decrease in broad money, and hence deflation, occurred despite massive QE by the central bank. Therefore there is no reason to think that more QE will cause hyperinflation.
I’ll leave questions of hyperinflation to Current, but your comment made me wonder about a couple of things …
I see that Japanese interest rates are still low. They haven’t been above 0.5% since September 1995, and they’ve been at 0.1% since September 2001:
Is your view that interest rates can remain near zero forever? Do you think this is a good thing?
Also, do you think it likely that with rates near zero, it will forever remain the case that “further increases in the money supply simply cause money to pile up in bank vaults”.
Finally, is it a good thing that money piles up in bank vaults? It sounds to me like the Japanese people are being robbed.
Thank you for your questions.
In Japan, interest rates have remained near zero for around the past 15 years I believe. However, I don’t think that this will be the case for the advanced western economies as I do see some signs of recovery. I don’t think near zero interest rates are a good thing as they indicate a depressed economy and limit monetary policy responses by the central bank.
On your second question, yes, as long as interest rates remain near zero in a depressed economy, and the central bank attempts to expand the money supply, this will likely not lead to a corresponding large increase in broad money.
And on your final question, I’m taking this as a question on whether QE is effective. Although I think that its effectiveness is limited, in my view QE does not pose an inflationary risk in current circumstances, and may help the recovery by encouraging banks to lend and companies to invest. I don’t think that the Japanese people are being robbed.
We cannot say absolutely that QE2 will lead to hyper-inflation because we do not know all the precise details such a program will entail. Likewise, we cannot say that this has been tested empirically in the US since QE in the US was not a controlled experiment in a lab. What we can say, with confidence, is that QE2 is a further step on the road to hyper-inflation.
Regardless, even if we do not see hyper-inflation (as measured by the CPI or RPI), there is no doubt that any amount of QE is bad for the economy and will contribute to a longer recession (such as we have seen in Japan).
Thank you for your reply.
Yes, I agree that we cannot directly read across the result of QE in the US to the UK economy. However, this and other cases do provide strong evidence of what the effects of QE are in an advanced economy with near zero interest rates. Japan’s rate of growth of broad money actually decreased despite the QE, so this was hardly a step on the road to hyper inflation. Although this was an extreme case, it is relevant to the current situation.
You say that we cannot say absolutely that QE2 will lead to hyper inflation. Similarly, we cannot say that there is no doubt that QE is bad for the economy. Although I think that its effectiveness is limited, in my view QE does not pose a large inflationary risk in current circumstances, and may help the recovery by encouraging banks to lend and companies to invest.
I’m in Vienna, so in some ways it’s appropriate that I talk about monetarism :).
Am I correct in thinking you’re talking about the US not the UK?
One of the first things to understand about monetary policy is that it’s a very old idea. In one way or another it’s gone on for hundreds of years, and it went on many years before the paying of interest on loans was legal. Interest rates are related to monetary policy, but not a directly as many people today seem to assume.
Krugman has championed the idea that zero interest rates are special, this is dubious. Throughout much of history bank accounts paid zero interest or even less than zero, they charged fees. Many bank accounts still do. This happens because holding cash is not a strict substitute for holding a current account balance, it is merely a close substitute. Regular bills, for example, are much easier to pay using a bank account than using cash. For this reason people are prepared to continue using bank accounts even at zero or negative interest rates
There is a further argument that holding cash or a bank balance is equivalent to holding bonds or T-bills when the interest rate is 0%, this is even more wrong. Money is the medium of exchange, bonds are not. You cannot go into a strip club and throw treasury bills at the strippers at though they’re dollar bills. T-bills are only an acceptable substitute for money in the circles of high-finance, for that reason T-bills are already included in the wider monetary aggregates. Even in those circles most government bonds and private bonds aren’t considered equivalent to money because of the uncertainty around the future real interest rate they will earn.
Today asset purchases by central banks *do* lead to an increase in money supply. Even if commercial banks are keeping excess reserves this doesn’t change, that simply means there less no money multiplication. If you are talking about the UK here, not the US note that in Britain the money multiplier never fell to anything close to one as it did in the US. The only case where no money moves beyond the bank is if the bank holds reserves as bank capital. Banks aren’t doing that though, and didn’t to any great degree during 2008-2010 either. So, increases in base money certainly do increase money supply. Since they increase the money supply that means they can fuel price inflation, as long as the demand for money is lower than the supply of it.
Now, when I mean “price inflation” I mean the prices of goods, services and assets in general. Unlike Keynesians I don’t look at goods sold in this period as being particularly special. To buyers what matters is the prices of things they want, not if those things are a component of output. In the UK we certainly have price inflation in the sense of a high CPI. Some claim this is connected to the increased cost of imports caused by the fall in the pound. There is some truth to this, though I don’t think it’s the whole story. It seems to me, and many Austrian Economists, that the rise in prices of input commodities has been caused by the collective actions of world central banks to raise the money supply and inflation. The world’s central banks managed to cause inflation, but not where they wanted it, so now they’re busy arguing for removing the effects of input prices from consideration in CPI measurements in order to absolve themselves of responsibility. As I mentioned in my previous comment it’s quite possible for there to be price inflation without output and employment rising.
As I said earlier, I’m not really worried about hyperinflation. Inflation remains a real risk though and savers will continue to be hurt by it. For that reason I’m planning to take steps to protect my own assets from inflation soon.
Thanks for your reply. I’m glad that you’re not worried about hyperinflation. I think that these sorts of views are alarmist and bear little relation to the available evidence. I do share your concern on inflation, however I would take the Bank of England’s view that this is a temporary effect due to pressures on commodity prices, tax increases etc., and that base rate rises are not the answer – however you may well be right that there has been some inflationary effect due to the actions of central banks.
Firstly, for simplicity’s sake I’m talking about the US, but my point applies to most advanced western economies where interest rates are close to zero, including the UK.
You say that “The only case where no money moves beyond the bank is if the bank holds reserves as bank capital. Banks aren’t doing that though, and didn’t to any great degree during 2008-2010 either.” I’m taking this to mean that you don’t think banks are holding excess reserves. This simply isn’t the case – see link below for a view of how the recession has influenced excess reserves in the US.
The chart shows how much has changed due to the recession – there were zero excess reserves in US banks for the entire post WW2 period until the recent recession, whereupon excess reserves jumped massively. This is central to my point – in a normal situation the central bank would increase base money and the banks would lend out the proportion of that money above their reserve requirement, and the process would continue until broad money had increased proportionally. So the central banks had tight control of the broad money supply.
However, in the current situation the central banks have lost a lot of that control as the banks are reluctant to lend. Therefore when the central bank increases the money supply, this may just lead to an increase in excess reserves which will have no effect on the broad money supply (minimum reserves and excess reserves are not counted as part of broad money supply definitions, e.g. M1 and M2, because these reserves are not in circulation). This is illustrated by the extreme case of Japan in the early 2000’s, where the rate of money growth of broad money (M2) decreased despite large increases in the monetary base.
Dan, I would refer you to the response I made to Current (2011/07/05 at 21:03 | In reply to Current.)
re inflation only being made in GB, it is an impossibility to be imported in.
For the UK I do think there is more inflation in the pipeline. Recovery began properly in the UK almost a year ago now. That means that the easy money policies that are continuing are likely to cause inflation. The unemployment rate isn’t necessarily any protection from this.
As Andrew Lilico has pointed out, the VAT rise can’t be blamed for causing a rise in inflation since last year VAT also rose by nearly the same amount.
The Bank of England are ostensibly committed to an inflation target of 2.5%. They are clearly not meeting that or even coming close. The last figure was 5.2% for the more-realistic retail price index and 4.5% for the CPI. This means inflation targeting has become “a piece of surrealist theatre” as Andrew Lilico put it.
Without a clear monetary policy commitment how are debts to be organized? If I lend your business money with a fixed repayment schedule how can I calculate the real rate of interest I will earn? Back when the inflation target was vaguely credible this could be done, even if very approximately. The problem with the inflation situation as it stands isn’t just that it’s costing savers a huge amount. The permitting of inflation by the BoE is producing uncertainty for those drawing up contracts in money, which impedes recovery.
Toby makes a good point about “importing inflation” in his discussion of this, I’ll reply to him below.
I know banks are holding excess reserves. The reserve ratio in the US reached nearly 100% for a while, and in the UK it rose much higher than the normal “recommended” reserve. It didn’t rise as high in the UK as it did in the US though, I think it peaked at ~20%. All this depends on which monetary aggregate you pick.
What I disagree with is the argument you are making about excess reserves. Fiat money created by the state is what economists sometimes call “outside money” that means that it is money to everyone in the private sector. By comparison we have “inside money” which is what bank balances are. To those outside the bank the money is money, but to the bank itself it is a debt that it owes. Austrian economists often call this latter type fiduciary media.
On a banks balance sheet the liabilities side contains the bank balances of it’s customers which it owes to them. Some of these are money-like liabilities such as current accounts and some are not money-like, such as bonds. On the other side of the balance sheet are the banks assets. The assets are the streams of payments from those who have borrowed from the bank and the reserves of outside money the bank keeps. In most central banking systems (though not the UK) the central bank sets a regulation on the minimum reserve the bank can hold as a proportion of the current account balances it has outstanding. This is done in order to control the money supply, it isn’t a “reserve” against any sort of eventuality.
Normally banks operate close to the minimum required reserve. But we don’t live in normal times. Many of the banks the US government bailed out still have bad finances. They don’t dare take too much risk by lending, so they are holding “excess reserves” instead, that means reserves in excess of the required minimum.
In my opinion this is mostly the result of poor policies. The Federal reserve now pay some interest on excess reserves, and that gives some extra incentive for banks to hold them. More importantly though are bank licensing and bailouts. The bailouts have allowed many poorly run banks to stagger on, but many remain fragile and close to bankruptcy. That means they are not in a good position to make loans even at the current very low interest rates. It would have been better for these banks to have gone bankrupt and for their assets and reserves to have been dispersed to solvent banks. (The “contagion effect” of doing this is very over-rated, see George Selgin on that). Lastly, the US regulatory authorities have refused to grant new banking licensing to protect incumbents. Wall-Mart, for example, have been trying to get a license for years.
You’re quite right that central banks found they didn’t have the control over the money supply they once thought they had.
Let’s be clear about the situation…. Suppose that I own a bank and I want to hold more reserves. To do that I can sell some of my assets and buy reserves. The banking industry as a whole however can’t increase it’s total reserves by doing that. If the overall direction of the banking industry is towards increasing reserves then that will reduce the price of assets and increase that of reserves. This is a deflationary pressure on asset prices and on the banking system, but it is deflationary to the wider economy because the value of the asset pool that banks own falls meaning it can support less inside money on the other side of the balance sheet.
All this means that if there is an overall excess demand for reserves then supplying them is expansionary. Supplying them prevents monetary contraction cet paribus, even if we’re talking about excess reserves. Reserves may not be part of the M aggregates but that doesn’t mean they aren’t closely related.
Think about this…. When the fed buy a bond and pay for it using newly created reserves what is happening? Well to begin with two sides have exchanged what Krugman supporters allege are currently perfect substitutes. Why would they do that? since every transaction comes with a cost it makes no sense to make the exchange. Perhaps the Fed do it because they’re a government agency, that still doesn’t explain banks doing it. It makes even less sense either because the Fed have actually profited from this, they pay much less interest on reserve balances than they earn on the bonds they buy. The truth of the matter is that the banks have a demand to hold reserves and they are willing to pay for them. They have that very Keynesian preference – liquidity preference.
Hmmm, I’m not sure that the recovery has begun properly in the UK. The economy is still pretty much flatlining.
Yes, the VAT rise contributes towards inflation but I accept that it has not caused an *increase* in inflation. Inflation is a problem, but what would you do about it? Raise the base rate? In my opinion that would be an extremely dangerous step to take at this stage and would likely tip the economy back into recession. In my view the Bank of England is taking the right course. Inflation should subside towards the end of next year. However, if it is clear that inflation expectations are developing then of course the Bank should take action.
Many people think that we are in a 1970s stagflation type situation, but I can’t accept this. The situation we are in has much more in common with the 1930s than the 1970s. The evidence is fairly clear on this – no inflation expectations, little wage growth, oil prices not accelerating upwards.
I’m not sure what your disagreement is with my argument on excess reserves. All I’m saying is that an increase in commercial bank reserves through open market operations does not necessarily translate to an increase in broad money in the unusal situation we are in currently. All it does is pile up the excess reserves.
I’m assuming here you’re thinking about measuring it with conventional GDP statistics. In that case, no the UK isn’t “flatlining” it’s RGDP growth over the last 12 months was just below 2%. It did decline over the winter though that was made up in the first quarter of this year.
Great, I wish other folks would do that.
I presume the last line is a sort of sophisticated Keynesian joke. Inflation expectations *have developed* there is no question of them “developing”. RPI has been above 4% since November 2009! Even you yourself say that inflation will only subside towards the end of next year. That means *you* are expecting another year of high inflation, so even you have inflation expectations.
You are quite right that the Bank of England are in a quandary. On the one hand if they tighten then growth may suffer. On the other if they keep things as they are then there will be further inflation.
The issue here though is that the BoE have ostensibly committed themselves to a course of inflation targeting. They are not committed to targeting core CPI or “supercore” CPI or anything like that. That means uncertainty arises if they don’t target it. If they aren’t fulfilling their promise to the government then exactly what are they doing? Without some degree of confidence investment may not be very forthcoming, because as I mentioned above some confidence is needed to make money contracts.
The BoE could move to officially using a different sort of target. That may work at least in the short-run. In the long run we need reform of monetary institutions, such as free banking.
I don’t think we’re heading for either in the UK. I expect moderate GDP growth in the next two years and high inflation.
As I said earlier we do have inflation expectations. There may be little wage growth but I don’t think this is as important as Keynesians make it out to be, we can have high inflation without much wage growth. Although oil prices are not particularly high the prices of other commodities are and the effect of their recent increase may not yet have been felt on output prices.
I realise that’s all your saying, you’ve said it several times now. All I was saying is that you are wrong :)
Go back and read what I wrote in the post above. OMOs never do nothing. Production of new reserves by the central bank does one of two things:
* Causes the creation of new outside money.
* Prevents the destruction of existing outside money.
Both of these effects are expansionary.
In a fiat-based Central Banking system the Central Bank can always inflate even in unusual situations such as the past couple of years. The amount of OMOs necessary to bring about inflation change from time-to-time, but they can always do so.
Apologies, I wasn’t clear on the ‘inflation expectations’ part of my post. What I meant was that there are no *rising* inflation expectations. The Market expects inflation to return to the usual target of 2%. As evidence for this, have a look at the history of the UK 10 year nominal gilt yield, which is a good proxy measure of the Market view on inflation risk. This is low and steady at around 4% and has not risen throughout the recession.
I don’t think that we’re going to get to any agreement on bank reserves and broad money and will have to agree to disagree! All I can do is recommend you look into the case of Japan in the early 2000s which I have highlighted several times, where it is clear that an increase in bank reserves did not increase broad money.
And yes there are alternatives which B of E could target. In the current regime however I believe that keeping base rate low is the lesser of the two evils.
Well, you may be right about that. My point is that the inflation that we will get will cause a significant loss to savers and will harm the reputation of the BoE.
Quoting gilt yields to justify inflation expectations has two problems… Firstly, the relationship between inflation expectations and gilt yields isn’t necessarily robust at present, to perform QE the BoE buy gilts. Also, some pension funds must hold a proportion of their funds in gilts. Now, in this case I don’t think that the prediction this method gives is necessarily wrong, but I’m suspicious of this method.
Secondly, this is one of Scott Sumner’s ideas. If Scott is right about this then why am I wrong about the point on reserves? I’m just riffing on Sumner, Scott Sumner tells everyone who’s listening (and not listening) that central banks can always cause inflation if they want to, why is he wrong?
As you say, we may have to agree to disagree.
I don’t think the example of Japan really demonstrates anything useful. Japan has been mired in stagnation for a long time, in my opinion the cause of that lies on the supply side not the demand side. Government economic policies have been more important than monetary policy.
Japan’s low inflation rate is a separate phenomenon. As I said earlier, a Central Bank can always produce inflation and the Japanese Central Bank is no exception. They have not produced a steady price level because they have been unable to do anything else, they have produced a steady price level because that’s what they wanted in the long-term.
The increases in bank reserves that occurred in Japan prevented the decrease in money supply that would have happened otherwise.
For the sake of argument let’s suppose that the Japanese banks wanted to hold no bonds whatsoever. Let’s suppose they wanted to hold 100% reserves. In that case the Central Bank could accommodate that. Once they do that every yen of reserves that they sell will increase the money supply by one yen.
We’re not in the old regime anymore because the BoE have effectively given up inflation targeting. What determines the regime we’re in isn’t declared policy it’s the actions of government. If they give up a policy but keep it in name that doesn’t count.
I disagree with you about which is the lesser of the two evils.
“when I mean “price inflation” I mean the prices of goods, services and assets in general……Some claim this is connected to the increased cost of imports caused by the fall in the pound. There is some truth to this, though I don’t think it’s the whole story. It seems to me, and many Austrian Economists, that the rise in prices of input commodities has been caused by the collective actions of world central banks to raise the money supply and inflation.”
There is no truth to this. We have Sterling legal tender, we have one issuer in reality = the State. If some Arab wants more money for his oil, a wealth transfer takes place from UK motorist to said Arab. Arab wants payment from the oil company in USD, so the oil company sells Sterling to buy USD. This happens with all goods and services. If there are more Sterling money units circulating, for the same goods etc, there will be a money inflation and unless there has been big productivity gains there will be a price inflation also. Thus any inflation in GB area has a made on GB stamp on it. It is our inflation, our bubble , caused by our government and never by anyone elses. QED.
I think that you have quite a simplistic view on inflation. Although you are correct in the medium to long term, You are not in the short term. Increases in prices of imports can cause inflation in the short term without money inflation.
As an example, consider a country which is heavily import dependent (e.g. Iceland). If its currency weakens over a period of time, imports will become more expensive. People will become poorer and have less money to spend on other items. Demand will decrease, but this will have no effect on the prices of imports. Inflation will be the result, even without a money inflation.
And taking the case of the UK economy – you could argue that as demand decreases due to high import prices, prices will decrease in the non imported items with a fixed money supply. However, prices are downwards inflexible and this adjustment does not take place quickly. Therefore, in the short term, inflation can still be the result without money inflation.
This is quite a complex issue.
Prices can rise for temporary or permanent supply side reasons. If other countries increase their demand for oil then the price can rise without any monetary reason. Notice, by “increase their demand” I mean demand in the economic sense not just desire, that is the other countries are providing more goods for sale to owners of oil in exchange for oil. This is a change in prices from the goods side.
There is a difference though between temporary changes and permanent changes. By temporary I mean that the change is likely to reverse later. In that case altering the money supply to deal with it is the wrong thing to do because the change will be offset later anyway. The right thing to do for permanent changes depends on what you think about the “productivity norm” idea, that is the idea that changes in the value of money from the side of goods should be allowed to happen. This idea is associated with George Selgin today, but you can find Mises saying the same thing in several places.
In the discussion of oil we’re talking about British people using their wealth to buy oil and competing for it with the citizens of other countries who are using their wealth. In this case, if the citizens of Britain get richer compared to others then they can compete better and if they get poorer then they can’t compete as well. This is somewhat similar to the situation with internal productivity, if the capacity of the economy grows then prices fall, if it falls then prices rise. It’s not exactly the same though because the issue is comparative to some extent. That is, if one nation (such as China today) becomes richer more rapidly than a second nation then it will be able to purchase more, cet paribus, from all other nations. (Notice this doesn’t mean that the second country is harmed by the first countries newfound wealth, they may benefit from it through normal comparative-advantage type trades and probably will).
What Dan is essentially suggesting here is that Britain’s capital stock has become worth less and that’s reflected in the worsened exchange rate. That may be temporary or permanent, but the increase in the price of imports that it causes is a real effect. It logically follows from this that we should look at a rise in the exchange rate in the opposite way. If the exchange rate rises then imports become cheaper, which causes deflation. In this case logically the BoE should not aim to counteract this extra deflation using monetary policy. However, when push comes to shove Keynesians never argue this. When the pound climbed to 2$ over 2006-2008 I don’t remember anyone pointing out that this is importing deflation and therefore the BoE should target a lower inflation rate.
I’ve heard it argued here that the difference between temporary and permanent chnges are important. If a temporary change occurs it should not be corrected, but a permanent change should be. Anyone who argues this though should argue it consistently. It can’t be that every fall in the value of a currency is temporary and every rise is permanent.
The main problem with all this though is disambiguation. How can the central bank (or anyone else) tell if a change in the price level is due to real or monetary effects? Certainly, specific goods are imported and the price of those can be measured separately to a more general price level. From that we get core CPI and supercore CPI. But that doesn’t really solve the problem because imports may also be in a position in the production structure that makes them more susceptible to monetary influences.
I’d just like to add. I don’t generally oppose money creation like Robert Sadler, I think it’s usefulness is dependent on context. If you look through the archives of this website you will find me and Robert Sadler arguing about that quite a bit.
In addition, 0% interest rates and high unemployment are the crux of the situation we find ourselves in, and are the main factors to consider in any policy response, so are very relevant indeed.
I do sympathize with those who criticize “savage cuts”. Yes, we need cuts , but the innocent are the ones bearing the cuts, and the super-rich fractional reserve bankers who caused this mess, will not be affected. The poor are carrying this burden for the crooks. How can we bray for that ?! We require cuts, but we also require public trials and abolition of the debt based pyramid scheme. There can be no lasting recovery until this fiat system is replaced.
Just to clarify, I’m not saying that monetary policy can’t cause inflation when the base rate is zero. I’m saying that monetary policy loses much of it’s effectiveness. There are certainly many measures that can still be taken such as buying longer term government debt, and I think that the QE in the UK and US has been quite effective. However I also think that Japan shows that this isn’t always the case; in my view the Bank of Japan did make a concerted effort to cause inflation but didn’t succeed. In addition, I think that the crisis has shown that monetary policy on it’s own isn’t enough; fiscal policy has to be used in support.
You say that “For the sake of argument let’s suppose that the Japanese banks wanted to hold no bonds whatsoever. Let’s suppose they wanted to hold 100% reserves. In that case the Central Bank could accommodate that. Once they do that every yen of reserves that they sell will increase the money supply by one yen.” I don’t think your argument here is correct. Bank reserves are not part of the broad money supply as they are not in circulation. To see my point, suppose the Bank of England buys £50 million in gilts from a commercial bank and hands it £50 million newly created reserves in return. Now suppose the commercial bank does not lend any of those reserves due to lack of demand for loans, or because it is worried about getting its money back due to the state of the Market. In this case, base money has increased by £50 million, but there is no more money in circulation than before, so broad money (M1, M2 or whatever aggregate you choose) has increased by £0.
The problem with this example is why would the commercial bank buy these £50 million in newly created reserves?
What I have been saying in earlier comments is that the market for reserves is a market not unlike others. Reserves have a price and bonds have a price. Because of the issues you mention such as uncertainty banks may buy reserves simply to sit on them at least in the short-run. This doesn’t mean though that every $ of reserves must go into stocks that are unused. That would be like saying that if the supply of salt increased by 500 ton then every ton would go into stocks and none into the flow of salt into industrial uses. That isn’t plausible in any long run situation. That why I said earlier that the new supply of reserves is preventing a contraction of the money supply.
The point of my example of 100% reserves across the whole banking system is that once that point is reached there is no need for any bank to buy further reserves. At that point banks would only conceivably buy reserves if they could use them to match deposits. (Unless reserves paid more interest than other investments of-course).
I also didn’t mention the greatest weapon the Fed have for creating inflation that they haven’t yet used: charging interest on reserves. That is, the Fed are currently paying interest on reserves. If they really wanted to cause inflation they could charge banks for reserves. The Swedish central bank did that and it worked.
The core idea of the short-run AS-AD model is that output and the price level are closely linked. So, in the short-run if prices are pushed upwards then both output and prices will rise. Similarly, if the prices are pushed downwards then both output and prices will fall. I’m in the “Fractional Reserve Free Banking” camp of Austrians, and as such I don’t disagree that much with this Keynesian analysis in the short-run, I disagree about what happens on a longer time-scale.
So, I don’t see how a Keynesian can think that monetary policy can cause inflation but not be effective for expanding output. The tie between these things is the core of every Keynesian theory: IS-LM, AS-AD and New Keynesian theories.
I’ll comment on the second part tomorrow.
If the monetary policy succeeds in increasing the level of demand in the economy and hence causes inflation in wages and then prices, then yes, monetary policy will have caused inflation and expanded output.
Clearly however QE in the US and UK has not succeeded in increasing demand, reducing unemployment, increasing wages and therefore prices through this mechanism. I think that what inflation there has been is mostly of the cost push rather than the demand pull variety. Aggregate demand has not been influenced sufficiently through QE to cause inflation.
But this is not to say that QE on its own couldn’t affect demand enough to cause inflation, if undertaken on a large enough scale. But politically this may be very difficult to achieve.
Dan let’s consider the following;
Cost push, so oil goes up and we pay more for our fuel. I pointed out to you before, there is no such thing as cost push. You pay more for your fuel as you give more of your income to the Arab or the Russian who has oil to sell. You the have less money to spend , there fore cost push inflation is illogical .
Only State who are the monopoly issue of money can create inflation . In a Market with no state, you would have changes in purchasing power.
Toby, see my post above- July 7, 12:27, in reply to your last post where I have tried to put across how cost push can occur.
Today seems to be the day when 100% reserve advocates and Keynesians unite :)
Think about what you’ve said here more carefully. If the prices for some goods rise does this mean that the income of the consumer will constrain them in other purchases? No, not necessarily, firstly, because individuals have savings. They have expectations of the future, their expectation may not be that current conditions will continue. Your assumption is that current conditions will continue, which is something very close to the assumption made in IS-LM Keynesianism.
Friedman pointed out in his permanent-income hypothesis the problem with this. A person doesn’t necessarily change their other expenditures just because one type has risen in cost. The situation is more complex than that, it’s likely that only when it becomes evident that their real income potential has been permanently affected will people reduce their expenditures.
In a rational expectations model if there is a permanent change in income then people will respond straight away, whereas if it is transitory they won’t respond. This sort of thinking isn’t realistic though. People will continue “living beyond their means” until it become clear what their means are in the longer run.
Mises pointed this out in “The Theory of Money and Credit” too. I think Richard Ebeling said that his PhD was on an early form of short-run cost-push theory.
If I have £100 in my salary, I spend £10 of petrol in one month. In month 2 if I have to spend £20, I have less to spend on other things. This is a fact. If I choose to still spend £90 on the other items I did in month 1, I would have to spend £110. I could borrow it from someone. At some point in time , I would have to pay it back. Cost push is a myth.
I’m not disputing that you would have less to spend on ‘other things’ and that demand for ‘other things’ would then decrease.
However, why does this mean that the price for ‘other things’ then has to decrease? This is the key point; wages and prices do not adjust quickly and are downwards inflexible, therefore a decrease in demand will not necessarily cause a drop in prices in the short run, and inflation still occurs.
You must admit that it is at least theoretically possible for inflation to occur despite a constant money supply, if there is a supply shock.
Yes, temporary for sure, not in the round though ie not sustainable.
Dan’s original point was that the short-term inflation we have experienced in the last few months could be of the type he describes. He’s not saying it’s a long-run phenomenon.
Whether it’s sustainable or not is a difficult question but there’s no need to get into that here.
Current, spot on.
Toby, maybe the issue we have is one of definitions. I accept that cost push cannot cause a sustained, long term increase in prices. But I think it can cause increases in the price level over the shorter term, and you seem to agree with this in your last post.
“If I have £100 in my salary, I spend £10 of petrol in one month. In month 2 if I have to spend £20.”
Not if you’ve got £1000 saved you don’t, and most people have savings!
I know you yourself Toby are worth quite a bit, I expect if petrol double up you wouldn’t change your habits very much.
Yes, but my savings would go down as the Arab would have more of my money! Either way, no cost push possible!
Sure, your savings would go down, but would that immediately cause a fall in planned investment spending? Probably not. In time it would certainly, but not immediately.
This is a complicated issue. I agree of course that the US and UK monetary authorities have not done very well during this recession. As I mentioned earlier it’s wrong to claim that the UK is still in recession.
But, I think we can agree that policy hasn’t worked out so well. I don’t think though that the real reason is the alleged impotence of monetary policy. I’ll reply later to your discussion of excess reserves.
Let’s ignore the question of what started the recession and concentrate on why it has lasted so long. I think there are two principle reasons.
The first is uncertainty. The start of the crisis and its severity weakened the confidence of investors in the central banks and their policies. That made the holding of money more attractive. This was made worse by the lack of a clear direction for Federal Reserve policies. In some statements they seemed worried about inflation, in others about output. They didn’t declare any clear future path. Unlike other central banks the Fed have no clear targets, but in the past they have acted quite predictably. That lack of predictability makes things very difficult for bankers and those who deal with fixed price contracts. Imagine, for example, that you were negotiating a 5 year loan with fixed payments in 2009. How would you calculate the rate to charge? Importantly, what account would you take of future inflation? Uncertainty drives the demand for money and to some extent the demand for reserves and I think this is an important part of what drove it in 2008 and later. I don’t think this problem was as bad in the UK as the US, which I think accounts for why the rise in excess reserves in the UK was a lot less than the rise in the US and why the UK is now recovering. What Central Bankers seem to have forgotten is that they must make commitments about the future, if they don’t then they cause immense problems in the present. Larry White explained this quite well recently: http://www.freebanking.org/2011/07/08/is-the-euro-flawed/
Secondly, there is the state of the banks which I’ve already mentioned in this thread. They have been bailed out in such a way that many were barely functional afterwards. They were too concerned with the state of what’s on their balance sheets to worry about loaning more.
To begin with your earlier description of the problem of the cost of imports is a little different to “cost push” inflation. As I understand it “cost push” inflation is normally considered to occur when prices for certain things produced within a nation rise due to special conditions or expectations of the future. That’s something different to what I was describing at least. I thought you were talking about the purchasing power of British output abroad dropping. That is, our imports are getting more expensive because fewer people want out exports, such as banking services. I think that this latter explanation is plausible.
Of course knowing what proportion of inflation is caused by this and what is caused monetary policy isn’t really possible. You’re still holding the view that AD is the only thing that can affect inflation, which is isn’t. I mentioned why in my reply to you on July 3rd, 2011 at 23:56.
I think the “need” for vast monetary policy has only really been caused by the problems I mention above. You are right that very large QE isn’t politically acceptable, and I don’t think that’s a bad thing. Fiscal policy isn’t particular politically acceptable as an alternative, and I don’t think that’s a bad thing either. What is needed is a change in institutions. I’d prefer free banking, I don’t think we’ll get that in the medium-term, the best we can hope for is NGDP targeting.
You make some good points on why the recession has lasted so long. I agree with you on the state of the banks being one of the causes. However, I’m not sure on your point about central bank policy. Although you are right that this has introduced uncertainty, I think that if central banks had not acted aggressively with monetary policy the recession would have been far worse. In general I am in favour of more transparent, rules based behaviour from central banks. But there are situations, such as the deep recession we have been through, where rules devised for normal operation of the economy may not be enough.
I guess what you define as cost push varies depending on which textbook you read, see below for my definition:
I haven’t said that AD is the only thing that can affect inflation. Inflation can also result from a decrease in aggregate supply. See my reply to Toby on July 7 at 12:27.
Yes, NGDP targeting could be a good idea. I think that implementing this would give central banks more room for manoeuvre on interest rates and reduce the chances of getting caught in the zero rate trap. Another related idea is targeting a higher inflation rate – e.g. 4% rather than 2%. I believe that Oliver Blanchard of the IMF made this suggestion. Similarly, this would mean higher nominal interest rates and more room for manoeuvre by central banks. It may also make it easier for firms to cut real wages and thereby decrease unemployment (I know that this is a controversial point).
Free banking is an area I need to look into – I’m currently reading Friedman’s ‘A Program for Monetary Stability’ in which he has some sound arguments against free banking, although I know that Hayek and others have done some good work on how free banking could be implemented.
I agree with you there regarding the crisis in late 2008. At that time I think that major problems in the banking industry were inevitable because of the earlier boom.
At that time the central banks and especially the Fed didn’t respond quickly that meant that expectations of the future became more uncertain. That then led to greater demand for money and greater demand for reserves. This situation continued because the uncertainty continued.
This is the paradox of monetary policy. If the Central bank is clear about the future then it’s actions don’t have to be a dramatic. If it is unclear then only large actions will work and those may not be politically acceptable, or may be problematic.
Part of the problem here is the question of whether the rules have played a part in creating the situation we’re in. I think that they have, but that’s an issue regarding ABCT theory which you can read about elsewhere.
Apart from that though we still have a problem that is, if the rules don’t work in this kind of recession then they aren’t very good rules. We can’t throw away the rule book in a recession because the costs of doing that are too high. The last thing that we need from a monetary regime is one that creates uncertainty during recessions.
Fair enough, my definition is probably the esoteric one.
I agree. I’d add though that the prices that agents respond to are really those of all goods. For the purposes of some analysis we omit assets and goods that aren’t part of GDP output. But, when considering price inflation we must remember that doing that is rather artificial.
My point above is that Toby isn’t necessarily wrong. It’s an empirical question if price increases have come from the “real” cost-push effect you describe or the money creation cause Toby point to. Either can occur.
This whole “zero rate trap” issue is confused. In an interest-rate targeting system zero interest is somewhat special, and it’s somewhat special because of cash. But, in a system targeting something else it isn’t special at all. All Central Banking systems work through changing things to do with reserves and money, So, when banks reduce the interest rate that means they do OMO, when they do QE they do OMOs too. Zero interest currency isn’t really much of an issue either, current accounts are the main form of currency today. Central banks could set a negative interest rate for reserves and vault cash if they wanted. (The reserve demand issue is really separate).
I don’t like that idea. I agree that people have some expectations of the inflation rate, but I don’t think they’re perfect. For that reason inflation distorts relative prices and investment behaviour. This is all in the Austrian Business cycle theory.
It doesn’t really means more “room for manoeuvre” since as I said above, monetary policy is really about money not interest. There was monetary policy back in the 19th century in the times when there was a fairly stable long-run price level.
Yes. It may help psychologically if real cuts can be made without nominal cuts. But, this psychological issue demonstrates what I mentioned above, which is that people don’t account for inflation well. Often they use unadjusted money prices as a basis of calculation.
Friedman changed his mind later in his life. Hayek started the modern work on Free Banking. But there is much more detailed and careful stuff around now, such as Horwitz, White and Selgin’s work.
“This whole “zero rate trap” issue is confused. In an interest-rate targeting system zero interest is somewhat special, and it’s somewhat special because of cash. But, in a system targeting something else it isn’t special at all. All Central Banking systems work through changing things to do with reserves and money, So, when banks reduce the interest rate that means they do OMO, when they do QE they do OMOs too. Zero interest currency isn’t really much of an issue either, current accounts are the main form of currency today. Central banks could set a negative interest rate for reserves and vault cash if they wanted. (The reserve demand issue is really separate).”
I think zero interest is special no matter what target is used. Irrespective of the target, the bank would still be using the same tools, and changing the fed funds rate or its equivalent. Let’s take money supply targeting as an example. What the central bank would do in this case would be to try and increase some measure of the broad money supply by a set percentage each year. The central bank would be caught in the zero rate trap when it found that it was making large increases to base money, but this was not translating through to similar increases in broad money. In this case, the short term interest rate would be zero. Similarly with NGDP targeting.
Central banks could set a negative interest rate, but only on reserves parked at the central bank. Commercial banks could simply park their cash somewhere else. Therefore its effectiveness is probably limited.
“It doesn’t really means more “room for manoeuvre” since as I said above, monetary policy is really about money not interest. There was monetary policy back in the 19th century in the times when there was a fairly stable long-run price level.”
What I mean by room for manoeuvre is that, using this policy (4% inflation target), interest rates would be higher in normal circumstances. If this policy had been in place pre recession, central banks would have had much more room to cut the interest rate and may not have ended up against the zero lower bound, which would have meant that monetary policy would have maintained its effectiveness and the recession may not have been as severe.
As you’ll see if you subscribe to the Cobden centre RSS feed I’m busy arguing with 100% reserve advocates. Still, I’ll keep arguing with you because I find it a bit of a change :)
Yes they would. But the Fed do not simply “change the fed funds rate”. In detail what they do is they buy and sell bonds at current prices. That releases or removes reserves from the fed funds market thereby changing the price. They may at the same time change the rate charged at the discount window, but in modern central banking that’s not the same thing. So, central bank interest rate adjustments take place though changing *quantities* in order to change prices. That quantity change can occur whatever the price.
This is not the same thing as a zero interest rate. It happens very often that the correspondence between base money and broad money is not close. It has even happened in periods of growth that increase in base money have not led to the predicted increase in broad money.
As I said earlier this doesn’t mean that the Central bank have no control over monetary policy. The Central bank can always create more base, they can charge negative interest on base and they can create more hand-to-hand currency.
All reserves are today is an entry in a computer. The central banks control these computer systems and control the regulatory rules around reserves. So, they are quite able to use a negative interest rate. It would effectively be an “excess reserves fee”, as some have called it.
I understand your point. I think it would be correct if inflation had no other costs. But, inflation does have other costs because human foresight can’t be perfect. People will still often use money as a measure of purchasing power without deflating by the inflation rate. That will lead to misallocation of capital. Your proposed policy may make things easier for Central banks during crises, but it will make crises more frequent.
Current, I think we’ve gone as far as we can in this debate. Thank you, it has been most thought provoking.
Thanks, it’s been interesting for me too.
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