In late 2008 several major economies, including those of the UK and the US, were about to suffer the Great Recession, the worst cyclical downturn since the 1930s. For some months they experienced outright falls in the main price indices or “deflation”. Some economic commentators, including the author of this column, argued that the situation was so bad that the nuclear option — a large-scale boost to the quantity of money by the state — had to be adopted. In both the UK and the US so-called “quantitative easing” measures were introduced, with the intention of creating enough money to boost demand and to offset the deflationary forces.
The improvement in economic conditions in late 2009, following the QE announcements, was dramatic. (Incidentally, by far the most important such announcement was not in the US or the UK, but in China, which for a few months in mid-2009 pursued hell-for-leather monetary expansionism.) However, quite soon a backlash against QE developed among a certain type of monetary conservative, whom I labelled and criticised as “backwoodsmen” in Standpoint in early 2011. Although QE embraced a range of complex open market operations, it was characterised by the backwoodsmen without much subtlety as “printing money”. It was then denounced as if it were on a par with the financial debauchery of Weimar Germany or Mugabe’s Zimbabwe.
According to the backwoodsmen, money printing was bound to lead to inflation, perhaps even hyperinflation. Liam Halligan, chief economist at Prosperity Capital Management, used his Sunday Telegraph column to lambast QE (“the last refuge of dying empires and banana republics”), and in his first article in 2011 said that I would be “wrong” on inflation. The main inflationary mechanism in Halligan’s world was not clearly spelt out, but it seemed to pivot on the rapid growth in bank lending that he thought would follow the increase in banks’ cash reserves attributable to QE. To quote his words, “the inflation has only just begun. The vast majority of the QE money in the . . . banking system, on both sides of the Atlantic, has yet to enter circulation. When it does, and is lent against many times over, we’ll see QE’s true inflationary impact.” (Halligan was far from being alone in his inflation alarmism. In the US such distinguished figures as Alan Greenspan and Allan Meltzer expressed similar views.)
My view was that the regulatory pressure on the banks to shrink their assets would lead to several quarters, perhaps even a number of years, of stagnation or weak growth in the quantity of money. By the phrase “the quantity of money” I understood the quantity of notes and coin held by the public, plus their bank deposits, in line with the conventional definition. The quantity of money is in fact nowadays dominated by bank deposits, which are banks’ main liabilities. The shrinkage of assets implied at best slow growth of deposit liabilities and hence of money. I expected inflation to stay down over the next few years.
It is now three years since the Congdon-Halligan exchange. Who has been right? Let me concede to Halligan that inflation in that three-year period has been higher than I expected, although not dramatically so. In the period of active QE measures, now almost five years long, increases in money national income have been very low, but productivity growth has been poor and until recently commodity prices have been strong. So the annual rate of inflation in the US and the eurozone has for extended periods been over 2 per cent, and in the UK — which saw a big fall in the pound in 2008 — it has briefly been over 4 per cent.
But it is very clear — absolutely clear — that Halligan and the backwoodsmen (including Greenspan) have been wrong on the substance of the matter. First, the inflation disappointments of the QE period have been due to the poor supply-side performance of economies and the externally driven commodity price pressure, not excessive money growth. Secondly, and much more fundamentally, inflation has been heading downwards throughout 2013 in all the major economies. Indeed, fears of resumed deflation are now being articulated for the US and the eurozone. In the eurozone the producer price index (prices at factory gates) was 0.9 per cent lower in September than a year earlier, with much larger declines in some of the more traumatised peripheral economies (Greece, Portugal and so on). In the US the finished-goods producer price index still reported a rise in the year to October, but at a mere 0.3 per cent it had almost passed the boundary into negative territory.
The current deflation talk refutes the backwoodsmen’s claims that QE would lead to inflation; it also validates the traditional monetary theory of inflation, in which the quantity of money (and not banks’ cash reserves or “the monetary base”) is the focus of attention.