Tuesday, 1 April 2014

Interest rates - how not to manage the money supply

How central banks thought they had slain the main threat to the economy but the real menace was lurking elsewhere

Economics is a narrative on how the economy is supposed to work, but the path to economic success and riches is often fraught with danger.  The cautionary tale of interest rates and money supply serves as one such example.  The hero of the story was meant to be central banks whose role was to control monetary policy which involves looking after the amount of money in the economy.  Interest rates were deemed the best weapon to regulate the money supply and a couple of decades of success ingrained a belief in this view of the world.  However, the global financial crisis put an end to hopes for a happy ending and economists are still struggling to come up with a new script.

What was supposed to happen

The original scenario relied on central banks being able to influence the money supply by setting interest rates to the appropriate level.  Central banks would not target money supply directly but focus on inflation instead.  Economic theory states that inflation is the result of an expanding amount of money in the economy.  More money equals higher prices.  So, if prices are rising too fast, this is due to an excess of money in the economy.  Higher interest rates act as a damper on inflation because the amount of money moving around the economy drops off as the demand for loans falls and consumers leave more cash in the bank.

The focus on inflation also stemmed from its leading role in telling how well the economy was doing.   Inflation has gotten out of hand and wreaked havoc in the past so economists are determined that this storyline was not to be repeated.  Inflation is also easy to keep tabs on compared to money supply which is tough to define, let alone measure (the money supply could include cash as well as money in banks (current or savings accounts) and other funds).

All good in theory.  And it even worked in practice for a couple of decades from the late 1980s.  Economists thought that their ideas had enabled them to conquer inflation and smooth out the boom and bust cycles.  But all of the good work of economic policy was undone due to an inherent flaw in the theory.  Growth in money supply not only affects consumer prices, which central banks watched over-closely, but also in asset prices, which were not seen as a concern.

Need for a new narrative

It is no surprise that the villain in this story is the banking sector.  Banks were left in charge of setting the money supply which rises and falls depending on the amount of lending.  The volume of loans (along with the money supply) exploded during the favourable economic conditions over the years leading up to the global financial crisis.  Banks were able to take advantage of the growing demand for credit due to innovations in finance that meant that banks could pass loans onto others and not have to worry about loan repayments. 

A large portion of the loans was used to buy existing assets such as houses or shares.  The resulting gains in asset prices, which surged ahead of growth in the underlying economy, sowed the seeds for the crisis to come.  Meanwhile, a dramatic increase in global trade meant that inflation was no longer determined in the domestic economy but was highly influenced by global markets.  Cheap imports from China reduced the prices of products like clothes and electronics.  Imports were also on the rise and the prices of any internationally traded goods no longer depended on the money supply in any one economy.

Subdued inflation meant that the results of the rampant increase in money supply did not jump out at central banks.  Their focus on consumer inflation led central banks to disregard the asset price bubble growing in their midst.  Instead, it was argued that financial markets would always set the appropriate prices and that central banks should not get involved.  The irony is that any extra cash tends to influence asset prices even more than consumer prices (as shown by the effects of quantitative easing) but this effect is near impossible to separate from other factors (hence the reliance on inflation).

It was revealed that central banks had been setting interest rates too low to keep the economy from getting into trouble.  The whole messy chapter could have been avoided if the money supply had been kept under control.  A simple solution would be for the economy to be left to its own devices with a relatively stable money supply.  Greater demand for loans would push up interest rates, stopping debt levels from becoming excessive while also benefiting savers. 

Despite the obvious solution, economists are loath to give up on the fairy tale they always believed would come true.  It may take time for a new economic story to be written but the changes should mean a brighter turn in the future of the economy.  With this, at least the sobering ending to the latest chapter of the economy should come with a silver lining. 


  1. Do we think the solution might be to change or improve the benchmark against which we base monetary policy (by not relying on RPI/CPI but a measure that better reflects asset price inflation) or is the answer to introduce other tools by which to alter the money supply (since at present, as you say, the only tool the BoE has is to attempt to control the price of credit via changing base rate).

    1. It is difficult to gauge what the correct level of asset prices (such as stocks or houses) should be and this makes it difficult to create an appropriate benchmark with which to interpret the effects of the money supply. Central banks could (and should) react in an ad hoc manner to excessive gains in asset prices. However, central banks prefer to act in a systematic manner so retaking control over money supply would be the better option. This is something that could be achieved considering the prevailing mood to rethink the role of the overall banking section relative to the economy. Would you agree???

  2. I agree, but this would inevitably involve hiking the cost of credit in the good times, which will be politically unrealistic. Also, the very suggestion of a move to a more credit controlled/state controlled system would inevitably spook the market, and then affect governments' cost of borrowing, amongst other things. If the financial crisis was not enough shake this dogma and encourage the growing of a pair by ministers, what will?

    1. Central banks already increase the cost of credit to restrict any increases in inflation during periods of economic growth. So, it is not so politically unrealistic as you might think. Rather than the focus on consumer price inflation, central banks could justify higher interest rates by pointing to the potential for asset price bubbles. The global financial crisis would make investors more willing to accept this line of thought compared to in the past. It is economic theory which is lagging reality and the shift to a new paradigm in managing the economy. Do you agree with this argument???

  3. But the proof is in the pudding - we have Help to Buy! If there was a political will to target asset price inflation as well as CPI in setting base rate wouldn't we have increased rates already?

    I suppose we need to distinguish between things that increase the cost of credit (raising base rates, capital requirements, reserve requirements, Glass-Segal type splits etc) and things which directly limit/prevent lending (such as old school credit limits and margin controls, which indirectly will also result in a higher cost of borrowing by virtue of a more limited availability of credit). I would argue the former (which more or less we have) is a weak means to discourage borrowing/credit creation, the latter is stronger, and hence politically unviable.

    Ultimately the base rate is just passed through to the borrower - assuming that you have a relatively stable base rate, it doesn't matter what it is, does it? What matters is simply the spread between base rate and what the consumer can access.

    Sorry, this is a stream of consciousness.

    1. No apologises needed. It is always good to follow up on ideas to see where they take you.

      Policies such as Help to Buy show why monetary policy is overseen by central banks and not governments. The Bank of England has tried to mitigate some of the results of attempts by the government to inflate the property market to win over voters (http://yourneighbourhoodeconomist.blogspot.co.nz/2013/12/uk-property-market-prudence-over.html).

      I would argue that the means which is used to restrict lending is mostly irrelevant. It is whether the central bank can have a substantive effect which has not been true in the past. Whether or not central banks will take a tougher line on lending in the future remains to be seen but the signs are not good considering the growing house price bubble in the UK.