Download WHEN TWO TIMES TWO EQUALS FOUR

WHEN TWO TIMES TWO EQUALS FOUR
8
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MAY 2009
PROFESSOR ANDREW CLARE
WHEN TWO TIMES TWO EQUALS
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This week the Bank of England’s Monetary Policy Committee unsurprisingly kept rates at
their historically low level of 0.5%. Given the parlous and perilous state of the UK economy
this was hardly a surprise. Even City economists got this bet right. In fact, you would be
forgiven for thinking that these economists are getting bored. For years, the focus of their
commentary has been the imminent rate decision of the world’s central banks and now
even your average A level Economics pupil could forecast the likely path of UK rates with a
fair degree of accuracy over the next few months. So what are all those highly paid City
economists doing now?
The answer is that the focus of their attention, at least in the UK, has shifted to the outlook
for fiscal policy and to quantitative easing. Following its meeting this week, the MPC
announced the next stage in the policy of quantitative easing. This policy effectively
involves the printing of cash. The Bank have announced that they will be printing and
spending a further £50bn on top of the £75bn that they have already spent.
The rationale for this policy comes from an economic theory known as the Quantity Theory
of Money. To be honest, as theories go this is not up there with E=MC2. In mathematical
terms the quantity theory of money is an identity. In layman’s terms it is a statement of the
bleeding obvious (to quote Basil Fawlty).
The mathematical representation of the theory looks like this: MV = PT. Every ‘A’ level
economic student will recognise it. The “M” stands for the quantity of money in an
economy; the “V” stands for the number of times over a given period that a unit of the
currency changes hands; the “P” represents the average price level; and the “T” the total
number of transactions that take place in the economy. Effectively what it is “saying” is that
the amount of money used over a given period is equal to the value of all the goods and
services that the money is used to buy. It is rather like saying “2 x 2 = 1 x 4”. It is a banal
accounting identity really. And yet in the hands of highly paid economists it can become
much more!
The goal of QE is to increase the money supply, M, so that it ideally increases the number
of transactions in the economy, or less ideally the average price level, P, but more likely so
that it leads to an increase in both. So successful QE raises P at a minimum and therefore
sees off the spectre of deflation but also raises economic activity by stimulating higher
levels of transactions. The idea is that it can act to jump start economic activity.
But there is one snag; for the expansion in the money supply to work, that is, for it to lead
to an increase in economic activity, the velocity of circulation of cash – the speed with
which cash circulates – must not fall so that it offsets, or more than offsets the injection of
new money.
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The Japanese monetary authorities began their quantitative easing programme in the early
part of this century and announced its official end in early 2006. Over this period the
Japanese authorities – with their policy rate floored at zero – printed and then pumped in to
their economy the equivalent of 8% of Japanese GDP. However, rather than stimulating
activity the additional cash was simply hoarded by Japanese banks so the additional yen
did not change hands in the economy in the form of higher economic transactions.
Effectively as the “M” in the quantity theory of money identity was rising in Japan, the “V”
was falling to such an extent that the increase in the money supply had only a limited
impact on “P” and “T”.
Our chart this week shows the velocity of circulation of money in the Japanese economy.
The shaded region of the chart shows how it almost halved as the Japanese monetary
authorities implemented their policy of quantitative easing.
The velocity of circulation of money in Japan
Velocity of circulation of money
16.0
12.0
8.0
4.0
0.0
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
Source: Fathom Chartbook Service
So this is the risk for those central banks around the world that no longer have an interest
rate lever to pull. If they print the cash and it ends up gathering dust in bank vaults it will
have no impact on the current economic situation. Buying government bonds with the
newly printed cash runs the very real risk that this will happen. In our view, and as we
have argued before in this column, it would be better to use the additional money to buy
real assets and to lend directly to the corporate sector. Quantitative easing of this kind has
a better chance of stimulating economic activity, at least in the short-run.
The natural question to ask then is “How much cash needs to be printed?” While the
quantity theory of money appears to be a very simple algebraic expression, no-one really
knows how much extra cash will be needed. This is because we have no real way of
knowing how “V” will react. Basically this policy, once begun, has to be pursued
aggressively until it works, that is, until sustainable economic growth returns. Once we get
to that point we will know that we have spent enough cash and that it will be time to turn off
the printing presses.
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So even though it is pretty easy to forecast interest rate decisions in the UK right now, and
elsewhere, the uncertainties surrounding the general economic outlook and the appropriate
policy response have never been greater.
Words: 951
www.fathom-consulting.com
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