Stephen King: If interest rate cuts cannot solve the money shortage, turn on the printing press
As people hoard money, so output weakens and prices fall, as in the 1930s
Monday 24 November 2008
For the Federal Reserve, the Bank of England and the world's other leading central banks, it is time for unconventional acts of bravery. These acts are needed because the financial crisis is mutating. No longer is this a story simply about the unwillingness or inability of banks to lend. It is fast becoming a crisis of liquidation. You can see it on the high street with sudden, and aggressive, pre-Christmas sales. You can see it in the stock market, where we're seeing renewed panic. You can see it in the property market, where prices are tumbling faster than ever before.
As prices of retail goods, equities and property come down, so we're edging towards a world of deflation. The conventional response to falling demand is to cut interest rates. The banking crisis, though, has reduced the effectiveness of rate reductions. While it's true that UK rates can fall quite a lot further, US rates are already at only 1 per cent. In a matter of months or even weeks, they're likely to have come down to zero. If our economies are still not responding, what then happens?
The problem can be simply stated. Despite the efforts of the various authorities, bank lending is severely restrained. There's a good reason for this. Some banks lent well beyond their levels of deposits, funding the additional loans through the sale of mortgage-backed securities and other esoteric assets. Those sources of funding have now collapsed and, as a result, the overall volume of lending is inevitably coming down. In an ideal world, of course, banks would be able to discover alternative sources of funding but, so far, they haven't done so. The net result is a lending drought.
So far, so conventional. However, we're now moving into what I'd describe as unconventional territory. In response to the lending drought, companies, households and investors fear a shortage of cash. Any cash they've got, they hang on to. Any cash they need, they raise via the sale of other assets which can be swapped into money. Panic takes over.
There's a very simple relationship in economics which helps to express this particular problem. It's known as the Fisher identity (after Irving Fisher) and is expressed as MV=PT. M is the stock of money, V is the velocity of circulation (the number of times that money changes hands through the course of a year), P is the price level and T is the volume of transactions. In modern-day parlance, PT is simple the value of national income.
The credit crunch has had a big impact on M. The amount of money being lent by banks has been severely reduced which, in turn, puts downward pressure on prices (P) and output (T). However, as people have begun to worry about where the next loan will come from, they've started to hoard money – stuffing what they've got under the mattress – and to liquidate. Their actions are driving down velocity (V).
This, though, leads to a much worse crisis. As people hoard money, so output weakens and prices fall. Falling prices, though, leave those who borrowed too much in the first place with even more debt relative to their dwindling incomes and shrinking assets. They hoard even more money, and the problem is magnified a stage further. This is what happened in the 1930s. As banks couldn't lend, so people hoarded money and, in the US at least, the economy collapsed.
The conventional response to all of this is for the government to borrow more money. In the UK, we'll be hearing more about that later today. This, though, may not be good enough. To understand why, it's worth having a look at Japan's experience over the last couple of decades.
Ever since Japan succumbed to deflation, the government has borrowed more and more in order to maintain levels of economic activity. The extra borrowing, though, has done very little to reinvigorate Japan's economy because every increase in public borrowing has been met by an even bigger increase in private saving, mostly by companies whose managers have been determined to pay off excessive debts in recent years. Japan's overall level of saving has, in fact, risen despite the government's efforts to borrow more. This has been reflected in an ever-larger balance of payments current account surplus.
In other words, higher government borrowing, on its own, may not be sufficient to kick-start an economy, particularly if extra borrowing today is to be met by higher taxes tomorrow. Something else needs to be done.
That "something else" has to be monetisation. The printing press has to be turned on. Monetisation requires the creation of new money which is then pumped into the economy. Why do this? It's simple. First, money supply will rise, thereby lifting M in the Fisher identity. Second, velocity is likely to rise so long as the new money is spent. And, in a recession, who is likely to do the spending? The government, of course.
The obvious criticism of this policy is that it debases the money supply and, therefore, creates inflation. In normal circumstances, that's true. Governments which have resorted to the printing press have often ended up with hyperinflation, as Germany's Weimar Republic discovered in the 1920s and Zimbabwe has discovered today. These, though, are exceptional times.
The problem in our newly deflationary world is a shortage of money. It's not so much that interest rates are too high, or that they can't fall below zero, but rather that, at any interest rate, there is an insufficient quantity of money. The quantity of money has to rise. Interest rate cuts, alone, cannot accomplish that task. Monetisation is a device which can be used to increase the quantity of money circulating in an economy where money is, for the time being, in seriously short supply.
Monetisation is often considered to be a version of fiscal policy for naughty governments. In current circumstances, though, monetisation should be regarded as monetary policy for wise central banks. To make the policy credible, then, demands for its introduction should not come from finance ministers but, instead, from the world's central bankers. They're the ones who should be pushing for an increase in the quantity of money. They're the ones who can make their demands without any suspicion of political incorrectness. They should do so because the traditional interest rate weapon is no longer working. Central bankers should prepare to be extravagantly effective rather than remaining conservatively impotent.
Monetisation isn't the answer to all of our financial ills. Banks will still be starved of cash. Governments will still have to step in to add capital to the financial system and, perhaps, to provide finance that banks in the private sector are unable to conjure up. However, the printing presses could at least prevent a collapse in velocity that would otherwise throw our economies into deep and long-lasting depressions. And it's our independent central banks, not governments, who should be insisting on grabbing hold of this opportunity.
Stephen King is managing director of economics at HSBC
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