‘Quantitative easing may not have stopped the recession, but it certainly rescued Britain from an even greater one’
Over long periods, the growth rates of money and national income are similar, although not identical, in all countries. As Milton Friedman argued, the key policy implication is that the rate of money growth should be kept fairly stable over time. Stable money growth will not create paradise on earth, but it ought to avoid the severe macroeconomic turmoil seen in the Great Depression.
But maintaining stable money growth is a tall order. Bank deposits are the principal means of payment, and hence the main form of money, in a modern economy. The unfortunate truth is that bank balance sheets’ management is a hit-or-miss affair. In any one period, some customers use deposits to repay loans, which destroys money, while other customers want new credit. Banks meet this demand by adding to the borrowers’ deposits, creating money. The balance between these forces is volatile and difficult to predict.
In an ideal world, when banks and their customers behave sensibly, and bank credit, the quantity of money and nominal national income chug along at about five per cent a year, monetary policy can be “boring”. (This is the word Mervyn King, the Governor of the Bank of England, used to describe the conduct of policy in the dozen or so “nice” years from the mid-1990s.) But in mid-2007, one of bankers’ key assumptions in the nice years — that they could finance asset growth by borrowing from other banks — was shattered. Growth rates of credit and money started to slide and, by mid-2008, the world was in recession.
When the crisis escalated last year, policy-makers decided that mistrust in the international inter-bank market was caused by banks’ lack of capital. They then committed a horrible blunder, even though their actions seemed to be justified by the logic of events. They should have tried to boost the quantity of money by expansionary open-market operations, as Friedman had always advocated in such conditions, and given banks time to rebuild capital from the retention of future profits. Instead, they insisted not just that banks restore the level of capital that had been acceptable for regulatory purposes before the crisis, but that they aim for a level of capital much higher than had previously been the norm.
Banks had therefore to increase capital/asset ratios in an already sluggish economic environment. As capital was hard to raise in the traumatised conditions of late 2008, they reacted by tightening credit terms and trying to shrink their assets. President Barack Obama was later to endorse this process as part of an allegedly beneficial “shrinking” of the financial system. But one consequence ought to have been obvious to all: that the drastic increase in banks’ regulatory capital/asset ratios would reinforce the destruction of money. Paradoxically, official attempts to make bankers safer aggravated the recession.
By early 2009, macroeconomic conditions were so dire in the UK that a radical policy reappraisal had become essential. Some counterweight was needed to the destruction of money. The answer was for the state itself to create money on a massive scale. That was the thinking behind the Bank of England’s announcement in early March of a programme of so-called “quantitative easing” (QE). Until the end of October, it purchased £175 billion of government securities from the private sector, paying for them by crediting sums to the sellers’ bank deposits. This added to the quantity of money.
The good news is that this was a highly expansionary open-market operation, of the kind that Friedman would have blessed, and the positive effect on the quantity of money of these transactions has indeed been huge. If the official gilt purchases had not occurred, the quantity of money would today be more than £150 billion (almost 10 per cent) less than is the case. Most importantly, the economy is in much better shape now than it was at the start of the year.
The bad news is that the Bank’s creation of money has been offset by the continuing operation of the forces that were destroying money in late 2008. Indeed, in the QE period, the UK banks’ claims on private sector agents (both here and abroad) have fallen so much that the quantity of money has grown only slightly, if at all.
The critics will say that the failure of the quantity of money to grow demonstrates that QE has been futile. The truth is very different, that the Bank’s programme of money creation was bold, necessary and beneficial. It came too late to stop the recession, but it has rescued Britain from a recession much more catastrophic than the one which we have in fact suffered.