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.



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”.



Cyprus, bailouts and NGDP targeting

Cyprus has received a bailout from the EU and the IMF. I don’t want to waste my readers’ time on my views on this issue, but I think that Ed Conway got it more or less right. This is from Ed’s blog:

Back in 1941, with the memory of the Great Depression still weighing heavy, an American wrote into the Federal Reserve with an idea. “Would it not be feasible,” the member of the public asked, “to impose a Federal tax on the deposit of funds in bank checking accounts?”

The reply from the Fed was polite but succinct: while there’s no doubt a tax on bank deposits would have “the advantage of administrative simplicity”, it is “not in accord with one of the fundamental principles of taxation in a democracy, namely, that taxes should be imposed in accordance with ability to pay”.

And that, when it comes down to it, is the most scandalous and worrying aspect of the overnight decision to impose a one-off levy on all bank deposits in Cyprus. There is no doubt the country is in big trouble: it was heading for a potential default and is in desperate need of another bail-out. However, trying to recoup some of the cash directly from bank deposits is a step across the financial Rubicon. Even in the depths of the euro crisis, none of the troubled countries had, until now, gone so far as to confiscate bank deposits. As the Fed said all those years ago, doing so involves arbitrary charges on those least equipped to afford them.

And so it will be in Cyprus. If you have anything up to €100,000 in a bank, by the time you next get access to your account on Tuesday (there’s a bank holiday on Monday) some 6.75% of your cash will have disappeared into the Government’s coffers to help keep the country afloat. That goes for everyone, from a pensioner to a small business owner to a millionaire (although Greek depositors get an exception). If you have more than €100,000 the charge is 9.9%.

In exchange, Cypriots will get a share in the relevant bank, equivalent to the value of the tax deduction – although this is unlikely to be of much consolation given the country’s current financial woes.

But why do we continue to debate the terms for bailouts in Europe? Because we got monetary policy terribly wrong. Had we instead had proper monetary policy rules in Europe then we would not have these problems. Let me quote myself on why NGDP targeting has a strict no-bailout clause:

“NGDP targeting would mean that central banks would get out of the business of messing around with credit allocation and NGDP targeting would lead to a strict separation of money and banking. Under NGDP targeting the central bank would only provide liquidity to “the market” against proper collateral and the central bank would not be in the business of saving banks (or governments). There is a strict no-bailout clause in NGDP targeting. However, NGDP targeting would significantly increase macroeconomic stability and as such sharply reduce the risk of banking crisis and sovereign debt crisis. As a result the political pressure for “bail outs” would be equally reduced. Similarly the increased macroeconomic stability will also reduce the perceived “need” for other interventionist measures such as tariffs and capital control. This of course follows the same logic as Milton Friedman’s argument against fixed exchange rates.”

I am not arguing that Cyprus would not have had problems if the ECB had targeted NGDP, but I am arguing that if the ECB had followed a proper monetary policy rule like NGDP targeting then a banking problem or a sovereign debt problem in Cyprus would never had become an issue for the entire euro area.

Update: David Beckworth and Nick Rowe also comment on the Cyprus. As do Frances Coppola  and Felix Salmon.

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