The monetarists were right about inflation, but now they have a very different warning
Folklore has it that monetarists are hard-money evangelists, always on the hawkish side. They are nothing of the sort
Monetarists are suddenly the new superstars, and deservedly so. The score of the last 20 months is nul points for the hegemonic New Keynesian group-think: douze points for the forgotten quantity theory of money.
The tiny fraternity of monetarists who track esoteric M1, M3, M4 "aggregates" warned in late 2020 that the money supply across the West was becoming unhinged, and that this in turn was incubating double-digit inflation — or something close — with the typical lag of one to two years.
They argued correctly that the "velocity" of money would recover as western economies reopened, turbo-charging the enlarged stock of money. They expected the price shock to hit with full force more or less now.
They made these predictions before the war in Ukraine and before the global manufacturing supply-chain was again ruptured by China’s zero-Covid debacle. The sheer scale of combined fiscal and monetary stimulus would have guaranteed a price spike whatever else happened.
The central bank alibi does not withstand cross-examination. The monetarist vindication is total.
It is not a case of stuck clocks being right twice a day, as critics derisively assert. Genuine monetarists such as Tim Congdon and Juan Castaneda from the Institute of International Monetary Research supported quantitative easing after the Lehman crisis.
They did not claim that QE and zero rates then would lead to galloping inflation. How could it when the banking system was then broken, and regulators were forcing lenders to raise their capital buffers "pro-cyclically" into an economic depression? Asset purchases were absolutely necessary to prevent a contraction of the broad money supply (M3 in the US, and M4x in the UK).
Whether or not QE is inflationary depends on the circumstances, and these were very different in early 2020 when Covid struck. By then the banks were in rude good health.
It was already clear that broad money was catching fire before the Bank of England pushed through an extra £150bn package of asset purchases for good measure in November 2020. “It was an unforgivable mistake”, said Prof Congdon.
The monetarists were right too just before the global financial crisis, and that episode has resonance today.
This newspaper published a piece in July 2008 with the headline “Monetarists warn of crunch across Atlantic economies”. It began with the following two paragraphs. I was the author, so I remember it.
“The money supply data from the US, Britain, and now Europe, has begun to flash warning signals of a potential crunch. Monetarists are increasingly worried that the entire economic system of the North Atlantic could tip into debt deflation over the next two years if the authorities misjudge the risk.
“The key measures of US cash, checking accounts, and time deposits have been contracting in real terms for several months. A dramatic slowdown in Britain's broader M4 aggregates is setting off alarm bells here.”
It quoted dire warnings from Prof Congdon, from the shadow monetary policy committee hosted by the Institute of Economic Affairs, and from Roger Bootle at Capital Economics. Two months later Lehman Brothers collapsed and the western credit system suffered its near fatal heart attack.
What were the big central banks doing at that time? They were not looking at money. They were instead fretting about high oil prices and the risk of inflationary psychology feeding into expectations.
The Federal Reserve’s Ben Bernanke was tightening policy by word of mouth, talking up the yield curve by 100 basis points, even though Fannie Mae and giant pillars of the US financial system were already crumbling.
The European Central Bank actually raised interest rates into the teeth of the storm, after Germany and Italy had already tipped into recession.
The central bank fraternity got it disastrously wrong. For chapter and verse, read the Great Recession by Robert Hetzel, the insider account by a senior Fed economist.
The moral of the story is that monetarism may not be exact science — lag times are famously "long and variable" — but you ignore major monetary signals at your peril.
Has the economic establishment learned a lesson? No, it still ignores the monetary data, and still dismisses monetarists as little better than soothsayers.
The Fed no longer publishes key M2 and M3 data.
The ECB has forgotten that it even has a monetary pillar under its twin-pillar mandate.
Everybody worships at the New Keynesian altar, in thrall to the canonical "dynamic stochastic general equilibrium" (DSGE) model of Ivy league academia and modern central banking.
If monetarists have been right repeatedly at critical turning points, it behooves us to listen to what they are saying now, and crucially to understand what they are not saying.
Folklore has it that monetarists are hard-money evangelists, always on the hawkish side. They are nothing of the sort.
They follow a mathematical lodestar wherever it takes them, and over the last few months they have become increasingly worried that we will swing too fast from monetary bubble to monetary bust. What scares them is mounting evidence that the aggregates are buckling across the G7 economies.
They fear that central banks will again ignore the signals and hit the brakes after a cyclical economic downturn is already underway. In short, the monetarists are today's doves.
As you can see from the accompanying chart, from Julian Jessop, M4x growth in the UK has already returned to moderate levels. Inflation is likely to follow suit with the usual delay. Prices will settle down gradually without the need for scorched-earth policies. Goods prices are already falling in the UK on a month-to-month basis.
The danger is that the DSGE staff models that gave us much of today's inflation will ineluctably give us tomorrow's slump. If you think the cost of living shock is calamitous, just wait until that shoe drops.
Simon Ward from Janus Henderson says his key measure of the money supply — six-month real money (annualised) — is now sharply negative across the fourteen largest developed (G7) and emerging market (E7) economies.
“Current weakness is more pronounced than before the 2001 recession and almost on a par with early 2008 before the escalation of the financial crisis,” he said.
This does not automatically imply a bloodbath but it would be reckless for central banks to do what they seem intent on doing, which is to ram through staccato rate rises and a sudden lurch from QE to QT (quantitative tightening) in a bid to restore lost credibility.
The Fed’s Jay Powell professed an intent this week to raise rates beyond “neutral” — as if the Fed staff know what that is — and to inflict “some pain” to stop inflation becoming entrenched. This is on top of draining global dollar liquidity by $95bn a month through asset sales.
Mr Powell was telling markets that there is no longer a "Fed Put" to protect them. The institution is deliberately engineering a stock market slide to cool the economy.
This is the same Fed that insisted through 2020 and 2021 that inflation was well-anchored and that any spike was “transitory”. It now thinks it can control a calibrated market crash.
Such hawkishness beggars belief, given that the US economy shrank in the first quarter. The Fed’s own Beige Book is full of disturbing nuggets, including warnings that firms are planning “some attrition to reduce staff size”.
The US National Federation of Independent Business index is a little frightening. The numbers expecting the economy to improve have fallen to the lowest ever recorded, lower than the Lehman crisis and lower than the Volcker squeeze in the 1980.
It beggars even more belief that ECB governors have begun talking of 50 point rate rises just as the eurozone economy wilts — if it isn’t already in recession — with fast-track rate rises over coming months, and asset sales coming into the picture.
One thing is for sure: it will not happen because such a pace of tightening would tip the eurozone into a fresh debt crisis before getting there.
I am less pessimistic about the Bank of England, provided it is not bounced into overkill by a backbench mob.
The Bank is paying at least some attention to monetary data. Governor Andrew Bailey is more likely than others to spot the dangers and to take evasive action, subject to the exchange rate constraint.
It is tight fiscal policy in the UK that is the greater worry.
The monetarist fall from grace over recent decades has been strange. Yes, there were measurement problems in the 1980s but monetary analysis is rooted in the classical tradition of economics. John Maynard Keynes was a monetarist in much of his thinking.
Milton Friedman’s oeuvre with Anna Schwartz — A Monetary History of the United States — is still the definitive text on the causes of the Great Depression.
It concluded that monetary overkill by the Fed caused the collapse of the banking system and was the real culprit, not capitalism itself as the Left furiously asserted.
It is time to bring monetarists back in from the cold. Is it too much to ask that central banks in charge of money actually look at money? And why is there not a single monetarist on the UK’s Monetary Policy Committee?
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