Economic Commentary: Congdon and the Six Wise Men

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The Independent Online
Professor Tim Congdon caused a stir last week by publishing a trenchant letter on monetary policy to the other six members of the Treasury Forecasting Panel (including myself).

When I first learnt of the letter in the press last Saturday - the text duly hit my in-tray four days later - my first reaction was, in football parlance, to charge the author with 'bringing the game into disrepute'. It had always seemed likely that any argument within the panel would allow its members to be depicted as 'seven wise alley cats' by the press. And some of Professor Congdon's phraseology seemed a touch infelicitous.

But, after consideration, it has become clear to me that the Treasury's Forecasting Panel should not be a cosy group of chums meeting behind closed doors in Whitehall and then misapplying the rules of Cabinet collective responsibility to their discussions. The panel is neither in the Government, nor of the Government. If it has any value it will be to place in the public domain debates that have hitherto been shrouded in the murkiness of Whitehall. This is all Professor Congdon has done.

The substance of his argument is that other economists have for too long ignored the role of money in explaining economic activity. In fact, he believes that a pick-up in monetary growth is both a necessary and sufficient condition for the economy to recover. Furthermore, he concentrates on a particular measure of

the money supply - M4, which consists of the total of bank and building society deposits in the economy.

The annual growth in M4 is at present 3.2 per cent, the lowest it has been since the recession began. But Professor Congdon sees some signs of it picking up, and believes that the economy will now recover provided the Chancellor takes action to stimulate M4 growth by relaxing the 'full funding' rule in the Budget.

So powerful does he consider this aggregate that he says the Chancellor could raise taxes by pounds 12bn on Tuesday and still get an economic recovery - just so long as solid growth in M4 is restored.


What are we to make of these assertions? To start with generalities, there is little doubt that Professor Congdon is right to chide mainstream economists with having underestimated the impact of changes in the financial system on the economy in the past decade.

If his case had stopped there no controversy would have arisen. Furthermore, it is quite possible that the current sluggishness of M4 growth is once again telling us something important about the private sector's willingness to borrow,

and therefore about the likelihood of a recovery in demand. In fact, it is clear from the panel's report that all members have taken these factors into account.

However, Professor Congdon's argument becomes much more specific than this, and that is where the controversy lies. He claims that a simple change in the Government's funding rule, without any change in short-term interest rates, will guarantee economic recovery.

Note the italics. We are not talking about a conventional relaxation in monetary policy, in which the Chancellor brings down interest rates, thus stimulating additional private sector borrowing and monetary growth. If we were talking about such a change, once again all panel members would agree that this could, at least in theory, more than offset the impact of higher taxes. In fact, several of us argued that just such a policy mix might be desirable in the medium term.

Professor Congdon, in contrast, quite categorically opposes any further base

rate cut at present. Instead, he places the entire burden of his case on the potency of an apparently technical change in the funding rule.

The present funding rule states that the Government should sell enough gilts to the private sector to offset the monetary effects of a budget deficit. This works as follows. In the first instance, a budget deficit - an excess of public spending over tax receipts - adds to private sector bank deposits and boosts M4.

But when the Government funds its deficit by selling gilts to the private sector this drains the very same bank deposits, leaving M4 unchanged. Essentially, Professor Congdon wants to sell fewer gilts, allowing the private sector to hold more bank deposits than before.

The first effect of this change would be to leave the money markets flush with funds, which would tend to put sharp downward pressure on interest rates. If the Chancellor allowed base rates to tumble, the effects of underfunding on the economy could indeed be quite powerful. But there are plenty of other ways of cutting base rates if that were the Chancellor's intention - and, in any case, remember that we are quite specifically talking about what would happen if base rates did not fall.

To prevent base rates from falling the Government would need to increase the sale of Treasury bills into the market, thus mopping up the monetary surplus.

If these bills were purchased by the private sector, banks' deposits would be drained and underfunding would have no effect on M4. If, on the other hand, the bills were purchased to some extent by the banks themselves, as they probably would be, private sector bank deposits and M4 would increase.


Now we reach the nub of the argument. The only way the private sector can end up holding extra bank deposits is because individuals and companies want to hold them. Initially there would be no reason why they would want to hold them, since nothing else in the economy would have changed. Therefore the private sector would try to offload the excess bank deposits, either for goods and services or for other financial assets.

Monetarists tend to assume that purchases of goods and services would dominate, in which case national income and spending would increase, and this process would continue until the creation of extra income 'validated' the higher level of bank deposits. (The private sector's demand for bank deposits is assumed to be determined in part by the level of national income.) If this is what occurred, the economy would expand and Professor Congdon would be right.

However, it seems to most economists that the private sector would seek to off- load its excess bank deposits, not into goods and services but primarily into other monetary assets such as gilts, equities or foreign financial instruments. This would reduce the yields on these instruments, thus making bank deposits relatively more attractive, and encouraging people to hold more of them.

There would still be some beneficial effect on activity as, for example, gilt yields fell slightly and asset prices rose, but it would probably be minimal. Therefore the main consequence of underfunding would be to raise the level of bank deposits without having much effect on national income. In economists' jargon, the velocity of circulation of M4 would fall.

Virtually every careful attempt to measure the effect of M4 on the economy has suggested that its impact is highly unpredictable, with its velocity of circulation extremely mercurial. That is why the majority of the panel believe that Professor Congdon is greatly overstating his case - and why the Chancellor should not rely on underfunding to offset the contractionary effects of any tax increases he may be planning for Tuesday.