The (Divisia) money trail – a very bullish UK story

Recently, the data for the UK economy has been very strong, and it is very clear that the UK economy is in recovery. So what is the reason? Well, you guessed it – monetary policy.

I think it is fairly easy to understand this recovery if we follow the money trail. It is a story about how UK households are reducing precautionary cash holdings (in long-term time deposits) because they no longer fear a deflationary scenario for the British economy and, that is due to the shift in UK monetary policy that basically started with the Bank of England’s second round of quantitative easing being initiated in October 2011.

The graphs below I think tells most of the story.

Lets start out with a series for growth of the Divisia Money Supply in the UK.

Divisia Money UK

Take a look at the pick-up in Divisia Money growth from around October 2011 and all through 2012 and 2013.

Historically, UK Divisia Money has been a quite strong leading indicator for UK nominal GDP growth so the sharp pick-up in Divisia Money growth is an indication of a future pick-up in NGDP growth. In fact recently, actual NGDP growth has picked up substantially, and other indicators show that the pick-up is continuing.

If you don’t believe me on the correlation between UK Divisia Money growth and NGDP growth, then take a look at this very informative blog post by Duncan Brown, who has done the econometrics to demonstrate the correlation between Divisia (and Broad) Money and NGDP growth in the UK.

Shifting money

So what caused Divisia Money growth to pick-up like this? Well, as I indicated, above the pick-up has coincided with a major movement of money in the UK economy – from less liquid time deposits to more liquid readably available short-term deposits. The graph below shows this.

Deposits UK

So here is the story as I see it.

In October 2011 (A:QE in the chart), the Bank of England restarts its quantitative easing program in response the escalating euro crisis. The BoE then steps up quantitative easing in both February 2012 (B: QE) and in July 2012 (C: QE). This I believe had two impacts.

First of all, it reduced deflationary fears in the UK economy, and as a result households moved to reduced their precautionary holdings of cash in higher-yielding time deposits. This is the drop in time deposits we are starting to see in the Autumn of 2011.

Second, there is a hot potato effect. As the Bank of England is buying assets, banks and financial institutions’ holdings of cash increase. As liquidity is now readily available to these institutions, they no longer to the same extent as earlier need to get liquidity from the household sector, and therefore they become less willing to accept time deposits than before.

Furthermore, it should be noted that in December 2012, the ECB started its so-called Long-Term Refinancing Operation (LTRO), which also made euro liquidity available to UK financial institutions. This further dramatically helped the liquidity situation for UK financial institutions.

Hence, we are seeing both a push and pull effect on the households’ time deposits. The net result has been a marked drop in time deposits and a similar increase in instant access deposits. I believe it has been equally important that there has been a marked shift in expectations about UK monetary policy with the appointment of Mark Carney in December 2012 (D: Carney).

Mark Carney’s hints – also in December 2012 – that he could favour NGDP targeting also helped send the signal that more monetary easing would be forthcoming if needed, as did the introduction of more clear forward guidance in August 2013 (E: ‘Carney Rule’). In addition to that, the general global easing of monetary conditions on the back of the Federal Reserve’s introduction of the Evans rule in September 2012 and the Bank of Japan’s aggressive measures to hit it new 2% inflation undoubtedly have also helped ease financial conditions in Britain.

Hence, I believe the shift in UK (and global) monetary policy that started in the Autumn of 2011 is the main reason for the shift in the UK households’ behaviour over the past two years.

Monetary policy is highly potent

But you might of course say – isn’t it just money being shifted around? How is that impacting the economy? Well, here the Divisia Money concept helps us. Divisia money uses a form of aggregation of money supply components that takes this into account and weights the components of money according to their usefulness in transactions.

Hence, as short-term deposits are more liquid and hence readably available for transactions (consumption or investments) than  time deposits a shift in cash holdings from time deposits to short-term deposits will cause an increase in the Divisia Money supply. This is exactly what we have seen in the UK over the past two years.

And since as we know that UK Divisia Money growth leads UK NGDP growth, there is good reason to expect this to continue to feed through to higher NGDP growth and higher economic activity in Britain.

Concluding, it seems rather clear that the quantitative easing implemented in 2011-12 in the UK and the change in forward guidance overall has not only increased UK money base growth, but also the much broader measures of money supply growth such as Divisia Money. This demonstrates that monetary policy is highly potent and also that expectations of future monetary policy, which helped caused this basic portfolio readjustment process, works quite well.

“Monetary” analysis based on looking at interest rates would never had uncovered this. However, a traditional monetarist analysis of money and the monetary transmission mechanism, combined with Market Monetarist insights about the importance of expectations, can fully explain why we are now seeing a fairly sharp pick-up in UK growth. Now we just need policy makers to understand this.

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Acknowledgements:

I think some acknowledgements are in place here as this blog post has been inspired by the work of a number of other monetarist and monetarists oriented economists and commentators. First of all Britmouse needs thanking for pointing me to the excellent work on the “raid” on UK households’ saving by Sky TV’s economics editor Ed Conway, who himself was inspired by Henderson Economics’ chief economist Simon Ward, who has done excellent work on the dishoarding of money in the UK. My friend professor Anthony Evans also helped altert me to what is going on in UK Divisia Money growth. Anthony himself publishes a similar data series called MA.

Second of course, a thanks to Duncan Brown for his great econometric work on the causality of Divisia Money and NGDP growth in the UK.

And finally, thanks to the godfather of Divisia Money Bill Barnett who nearly single-handledly has pushed the agenda for Divisia Money as an alternative to simple-sum monetary aggregates for decades. In recent years, he has been helped by Josh Hendrickson and Mike Belongia who has done very interesting empirical work on Divisia Money.

For a very recent blog post on Divisia Money, see this excellent piece by JP Koning.

And while you are at it, you might as well buy Bill Barnett’s excellent book “Getting It Wrong” about “how faulty monetary statistics undermine the Fed, the financial system and the economy”.

 

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Britmouse just came up with the coolest idea of the year

Our good friend and die hard British market monetarist Britmouse has a new post on his excellent blog Uneconomical. I think it might just be the coolest idea of the year. Here is Britmouse:

“Will the ECB will stand by and let Spain go under?  Spain is a nice country with a fairly large economy.  It’d be a… shame, right?   So if the ECB won’t do anything, I think the UK should act instead.

David Cameron should immediately instruct the Bank of England to print Sterling, exchange it for Euros, and start buying up Spanish government debt.  Spain apparently has about €570bn of debt outstanding, so the Bank could buy, say, all of it.

We all know that the Bank of England balance sheet has no possible effect on the UK economy except when it is used to back changes in Bank Rate.  Right?  So these actions by the Bank can make no difference to, say, the Sterling/Euro exchange rate, and hence no impact on the demand for domestically produced goods and services in the UK.  Right?

Sure, the Bank would take on some credit risk and exchange rate risk.  But they can do all this in the Asset Purchase Facility (used for conventional QE), which already has a indemnity from the Treasury against losses.”

Your reaction will probably be that Britmouse is mad. But you are wrong. He is neither mad nor is he wrong. British NGDP is in decline and the Bank of England need to go back to QE as fast as possible and the best way to do this is through the FX market. Print Sterling and buy foreign currency – this is what Lars E. O. Svensson has called the the foolproof way out of a liquidity trap. And while you are at it buy Spanish government debt for the money. That would surely help curb the euro zone crisis and hence reduce the risk of nasty spill-over to the British economy (furthermore it would teach the ECB as badly needed lesson…). And by the way why do the Federal Reserve not do the same thing?

Obviously this discussion would not be necessary if the ECB would take care of it obligation to ensure nominal stability, but unfortunately the ECB has failed and we are now at a risk of a catastrophic outcome and if the ECB continues to refuse to act other central banks sooner or later are likely to step in.

You can think of Britmouse’ suggestion what you want, but think about it and then you will never again say that monetary policy is out of ammunition.

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Update – this is from a reply below. To get it completely clear what I think…

“Nickikt, no I certainly do not support bailing out either bank or countries. I should of course have wrote that. The reason why I wrote that this is a “cool idea” is that is a fantastic illustration of how the monetary transmission mechanism works and that monetary policy is far form impotent.

So if you ask me the question what I would do if I was on the MPC of Bank of England then I would clearly have voted no to Britmouse’s suggestion. I but I 100% share the frustration that it reflects. That is why I wrote the comment in the way I did.

So again, no I am strongly against bail outs and I fear the consequences in terms of moral hazard. However, Spain’s problems – both in terms of public finances and the banking sector primarily reflects ECB’s tight monetary policy rather than banking or public finance failure. Has there been mistake made in terms and public finances and in terms of the banking sector? Clearly yes, but the main cause of the problems is a disfunctional monetary union and monetary policy failure.”

Mr. Hollande the fiscal multiplier is zero if Mario says so

 The newly elected French president Hollande’s rallying cry has been “Yes to growth and no to austerity”.

While I am certainly is no Keynesian (I my readers know that very well…) and my gut instincts are (very!) fiscally conservative I have some sympathy with what Hollande is saying. While I strongly believe that Europe needs massive structural reforms to bust productivity growth in the longer run I also believe that the present crisis has very little – if anything – to do with the lack of structural reforms. The crisis in Europe has nothing to do with tax evasion in Greece, rigid Italian and Spanish firing and hiring rules or an overly generous French pension system. These are all massive problems that need to be addressed, but they are not the causes of the crisis. The crisis is primarily a result of the massive drop in nominal GDP, which we have seen in the euro zone since 2008. And that problem can only be solved by the ECB moving towards a much easier monetary policy stance. There is no way around this.

While I have sympathy for Mr. Hollande’s concerns about the direction of economic policy in Europe I nonetheless think that his analysis of the situation is seriously flawed. Mr. Hollande fully well knows that no government, company or household in the long run can spend more money that it earns. This is simple mamanomics – my mom always used to tell not to spend more money than I earn. This is not economic Calvinism, but simple economic law. That said, how much revenue the French government brings in is crucially dependent on the level and growth of nominal GDP.

Mr. Holland understands this, but he is wrong when he seems to believe that you can increase nominal GDP by boosting public spending. Said in another way the fiscal multiplier is zero.

Lets imagine that we get a Hollande style European “growth pact” which dictates that fiscal policy will have to be eased by 5% GDP in all euro zone countries. Imagine then that this miraculously does not have any negative impact on market sentiment and that increases NGDP by lets say 2% across the euro zone. Hollande would be happy, but would the ECB also be happy?

We most assume that the ECB thinks that nominal GDP in the euro zone is exactly where it should be right now – neither too high nor too low – otherwise the ECB would have done more to boost NGDP. Hence, if Mr. Hollande is able to able to increase the euro zone NGDP by 2% then the ECB would be in a situation where it would face an level of NGDP which would be too high for its liking and as a consequence it would have to move towards a tightening of monetary policy. Hence, the ECB will always have the final word on the level of NGDP – no matter what Mr. Hollande thinks. This is why I have earlier argued that there really is no such thing as fiscal policy – at least in way Keynesians traditionally think about fiscal policy. Fiscal policy cannot on its own increase NGDP. Only the central bank can do this.

You might object and say that ECB does not think that the NGDP level is where it should be. Well, if that is the case then the ECB tomorrow can increase NGDP to exactly the level it want. There are numerous ways to increase NGDP and if you think that the central bank cannot do it then you might want to consult Gideon Gono.

So yes, Mr. Hollande is right when he says that we desperately needs growth (in NGDP) in the euro zone, but he is wrong if he think that it can be achieved by increasing the budget deficit in France or anywhere else in Europe. Only Mario Draghi and his colleagues in the ECB can increase euro zone NGDP.

At the core of Mr. Hollande’s failed analysis is that he is doing “national accounting economics”. He starts out with a national accounting identity: Y=C+I+G+NX. As a consequence he think he by increasing government spending (G) can increase GDP (Y). Had he instead started out with the equation of exchange (MV=PY) then he would have realised that recessions are always and everywhere a monetary phenomenon and that the fiscal multiplier is zero.

I am sorry for sounding like a broken record, but it is saddening and frustrating that nearly no European policy makers realise that at the core of our problems is an overly tight monetary policy and the crisis cannot be solved by more austerity nor can it be solved by a more expansionary fiscal policy. Neither the Keynesian nor the Calvinists are right. It’s not about fiscal policy. It is about monetary policy and if Ralph Hawtry, Gustav Cassel or Milton Friedman were alive they would scream it at you!

PS Maybe British Prime Minister David Cameron is the European leader who comes closest to understanding the need for monetary easing to solve the European crisis. See Britmouse’s excellent comment on Cameron’s recent speech on the UK economy.

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