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THE European Central Bank (ECB) has never stopped scrutinising the movement of monetary aggregates and has rightly resisted the many commentators who want to banish it from its status as a second pillar of policy analysis. In Britain, references to the money supply have crept with increasing frequency into the speeches of Mervyn King, the Bank of England governor. An article in the Autumn Bank of England Quarterly Bulletin noted "a remarkable stability in the long-term correlation between inflation and rates of growth of money in both the US and the UK". Correlation does not imply causality but it is significant that the article appeared at all.
This is not to say that there is a new monetarist ascendancy. The mainstream approach, exemplified by the majority in the Bank of England Monetary Policy Committee, is to look at the immediate prospects for economic growth, then check that the financial markets are not signalling a return to inflation; and, if not, to carry on pumping demand into the economy. In this view, the economy is seen as a sausage machine and the task of central bankers to make sure that enough meat is pumped into every sausage to secure full weight.
The opposite view was recently put by Mr King, who explained in a recent speech why "the economy cannot grow at a constant rate in every single quarter". He rejects the assumption that central banks "can and should control the short-run path of output". Not only are there lags between the recognition of economic shocks and the impact of corrective policies, there are also supply shocks that central banks can do little to change. The higher oil price, for instance, implies that "the purchasing power of wages and salaries must grow more slowly than would otherwise have been possible, by around 1.0-2.0 per cent in the major industrial countries, spread over a couple of years". The rebalancing of the composition of demand is likely to mean some volatility in its total.
I would add that waiting for inflationary expectations to show up in the financial markets has its own risks, By the time they do it might be too late to correct them without a sharp policy shift. More important, attempts at fine tuning that ignore monetary indicators can lead to cycles of boom and bust in asset markets that can be highly damaging, even if they do not have much impact on the particular group of prices that it is conventional to put into consumer indices. A new paper -- Money and Asset Prices in Boom and Bust, Institute of Economic Affairs -- by Tim Congdon, the monetary economist, has helped to codify the transmission mechanism between excessive monetary growth and inflationary booms. Mr Congdon does convincingly show how a build up of financial balances in relation to income will lead to a rise in asset prices, notably housing, which will eventually make households feel wealthier and spend more. The spurt in the price-to-income ratio for US housing from about 3.2 in the late 1990s to 4.2 today helps to justify the gradual levering up in official interest rates now taking place.
Monetarists have, however, long been their own worst enemy. One cannot get very far before civil war breaks out between those who think in terms of the money supply, credit or overall liquidity. One problem with the Congdon thesis is where to draw the boundary between money and other financial assets. For instance, the inclusion of the deposits of home loan associations makes a difference.
Another problem is that Congdon does not, at least in this publication, explain what normally determines the broad money supply.
Moreover, although credit is not the same as money its behaviour cannot be ignored, Lombard Street Research has a series showing world money growth creeping up towards levels last seen around the turn of the century when the world boom in technology shares burst. The development looks more menacing if credit is taken into account. The reason for this is that US banks have been able to step up their lending on the basis of overseas deposits, which do not count in official statistics of the US money supply.
Liquidity is a concept more difficult to quantify. Yet surely there is a contrast between the world in which most of us grew up, where it was difficult to borrow money, and the present one where it takes courage and willpower to decline loan offers thrust at us from all directions.
No doubt these issues are fairly superficial compared with the large changes in the world economy deriving from the entry of new cheap players such as China and India and the shift in the worldwide distribution of income from labour to capital. But none of these problems will be made any easier by resort to the printing press -- metaphorical though this concept is in our electronic world.
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FT Syndication Service
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