(Not quite) the return of the monetarists

By: Wolfgang Munchau

Last week a group of well-known UK economists wrote a letter to the Financial Times, in which they criticised the Bank of England’s insufficient attention to money growth. Some of you might be tempted to say: here we go again. The monetarists are rising from the grave and have spotted a good moment to launch a counter-attack. But this would be unfair.

One of the signatories of this letter was Charles Goodhart, professor of economics at the London School of Economics and a former member of the Bank’s monetary policy committee. Professor Goodhart is certainly not under any suspicion of being a closet monetarist. But he has argued* that the fashion among central bankers and economists to ignore money altogether has gone too far. On this, he is absolutely right.


The subject of monetary aggregates has recently re-emerged as a subject of polite conversation among central bankers and monetary economists. As far as I can tell, nobody advocates a return to old-style monetarism, with its mechanistic approach to monetary targeting. The modern argument in favour of money is subtler. One of Professor Goodhart’s core arguments is about financial market friction. The New Keynesian framework, which is the basis of much of modern economics and central banking, assumes that financial markets work more or less perfectly. Every economic model uses simplifying assumptions that may appear counter-intuitive but which turn out to be perfectly reasonable. But there are assumptions worth challenging. The notion of a frictionless financial market is one of them.

It is true that financial markets are more efficient today than they used to be. But even in countries with highly developed financial markets such as the UK, it is not the case that individuals and companies have access to all the finance they need. While large companies can choose whether to issue corporate bonds or take up loans, many small and medium-sized companies have access to loans only, often at unattractive rates. When banks become more risk-averse, the constraints affecting the economy increase. Germany’s economic decline at the beginning of this decade was largely caused by a credit squeeze. Conversely, when credit grows at excessive rates for long periods, it can create bubbles, as we see in parts of the world today.

There is no mechanistic link between a monetary expansion and an overheating economy. For that to happen credit would need to grow as well. A monetary expansion can have many causes, many harmless. Investors might shift from long-term bonds into the money market. The carry trade might affect a country’s money growth if foreign cash piles in. But if money and domestic credit both grow at high speeds and for long periods, there is a much greater chance that the economy will overheat, creating asset prices bubbles and, ultimately, inflation.

Central banks are much better equipped to spot excessive growth in money or credit than asset price bubbles directly. In fact, there are perfectly sensible reasons why central banks should not try to prick bubbles. For a start, central bankers may find it impossible to spot a bubble when it hits them. But they have a much better understanding of the monetary transmission mechanisms. This is useful information for a central bank and should form part of an overall assessment of economic conditions.

The monetary policy committee of the Bank appears minded to ignore the present strong increase in monetary aggregates. Its persistent optimism will probably present us with a test case of Professor Goodhart’s modern critique. The committee’s optimism will almost certainly be vindicated in the short run, as UK consumer price inflation is bound to fall rapidly from its most recent level of 3.1 per cent for largely technical reasons. If inflation then remains within the target range, the present monetary expansion would have produced a misleading signal.

But if inflation were to rise back above the target range, and remain there for a prolonged period, the current expansion in money and credit would indeed have served as a useful warning sign. In that case, UK interest rates may have to rise to levels that could hit asset markets, in particular the property sector, and probably the economy at large. It would have been the Bank’s first serious policy error.

“We cannot guarantee that the next 10 years will be so nice,” the Bank recently wrote in a memo to the Treasury select committee of the House of Commons. In view of the latest monetary aggregates and credit growth data, I would expect that to be a reasonable judgment.

*Whatever became of Monetary Aggregates, National Institute Review, May 2007

© The Financial Times

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