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Deepak Lal: Money matters Welcome, Guest Login | Register Saturday, Jun 30, 2012 Home | Markets & Investing | Companies & Industry | Banking & Finance | Economy & Policy | Opinion Advanced Search RSS Content Guide Follow us on | Life & Leisure | Mgmt & Mktg | Technology | BS Products Section Home | Editorials | Compass | BS People | Columnists | Lunch with BS Live Markets | Commodities Home > Opinion & Analysis Email this Facebook Twitter 0 Keyword Keyword Text or company name Go Print this Share Deepak Lal: Money matters A confusion between money and credit has infected the West?s response to the financial crisis Deepak Lal / Jun 30, 2012, 00:11 IST Ads by Google Merrill Edge® Investing : Start Trading Today. 30 $0 Online Trades Per Month & No Annual Fee. www.MerrillEdge.com In my last columns on the ongoing global financial crisis, or GFC (“After the Great Fall”, published in October, November and December 2010, and consolidated in my book Lost Causes’ Chapter 10) I had argued that the “liquidity trap” cited by Keynesian fiscalists for the impotence of monetary policy was a paper tiger. The quantitative easing by the US Fed, the UK’s Bank of England, and the ECB had increased the broad money supply (M2/M3) in their respective regions, which through the “real balance effect” had led to a stalling of the deflationary impulse from the GFC, and led to economic expansion. But recently all these economies have stalled, with the UK in a double-dip recession. Why? An excellent recent book by Britain’s leading monetarist Tim Congdon (Money in a Free Society, Encounter Books) provides an explanation. Growth of broad money (M3/M4) for the US, UK and eurozone is charted in the figures above. It shows that, after their periods of quantitative expansion (QE), instead of following the Friedmanite prescription of maintaining a fixed rate of increase, all three regions have seen sharp changes in the trend of broad money, with a crash to negative rates of growth since 2010. Given the usual lags in monetary policy outcomes, the current deflationary trends in these economies can be readily explained. Why, despite seemingly accepting the monetarist case with their various episodes of QE, have the monetary authorities failed to keep broad money growing at a constant rate which would have seen an end to the continuing Great Recession? Congdon provides two sets of answers. The first concerns the monetary aggregates they seek to monitor (particularly in the US). The second concerns a theoretical muddle about the transmission mechanism of monetary policy which has been promoted, alas, by academic economists. (Click here for infographic) Table for Two Now available at Special price Rs.280/- Only Buy Now CHASE Official Site Get $125! Open a Chase Checking Account - Learn More. www.chase.com/$125Offer Payday Loans ($200$1000) 2-Minute Decision Payday Loans. No References & Credit Requirement! www.FlashPayday.com Also Read News Related Stories US economists and policy makers have always considered narrow or “highNow powered money” of the monetary base (M0/M1) to be the relevant monetary aggregate. UK economists, by and large, have looked at broad money (M2/M3) as - Sunanda K Datta-Ray: Loos the relevant aggregate. This is despite a tight relationship between broad money talk and nominal GDP in the US. Congdon estimates that the average annual - Asian shares down on EU percentage growth rate of M2 (between 1875 and 2010) was 6.45 per cent, and deadlock that of nominal GDP was 6.39 per cent. That is why, from Wicksell to Keynes to - MFs go social to increase Friedman (except for a deplorable lapse in the early 1980s), the relevant monetary penetration aggregate has always been broad money. Even though in the short run this Analysts see silver lining in relationship between money and nominal GDP breaks down — as it did seemingly India story in the 1990s — over the medium and long run the relationship is robust, and confirms the long-run stability of the money demand function. But, since the 2000s - SBI cuts interest rate for both the US Fed and the UK’s BOE (but not the ECB) have stopped even exporters by 0.5% publishing figures on M3/M4. Why? - MTS plans to launch app for mobile payment through cards This is because of the rise of the academic theory of the monetary transmission mechanism christened and advocated by Ben Bernanke as “creditism”, to contrast with traditional “monetarism”. In a famous paper with Mark Gertler (Journal of Economic Perspectives, 1995) he argued that the relationship between money and economic activity was a “black box”, and that the relevant channel for monetary-policy transmission was the credit channel, i.e., bank lending to the private sector. But, following Freidman and Schwartz, Congdon http://www.business-standard.com/india/news/deepak-lal-money-matters/478929/[6/30/2012 3:48:39 AM] BS POLL Should Rahul Gandhi join the govt and become a minister? Yes No Can't say Deepak Lal: Money matters argues cogently that money and credit are different, and it is money that matters for the economy. This difference can be brought out most readily from a question I used to ask my Oxford undergraduates in tutorials in the mid-1960s about the effects of a large helicopter drop of money in the UK. The answer is that this increase in the cash holdings of all the private economic agents in the economy would lead to a deviation of the composition of their asset portfolios from the previously desired equilibrium ratios. As, in the closed circuit of the domestic economy (abstracting for simplicity from an open economy), this excess money could only be spent on goods and assets, it would only restore the previous equilibrium cash ratio in their portfolio balance — once the prices of all the other goods and assets, and thence in spending and national income had risen. This would happen irrespective of whether bank lending (the creditists’ lodestar for monetary easing) was flat or falling. As Congdon rightly notes: “Spending depends on money balances and not bank lending.” Most Popular Read E-Mailed Commented Thus, unlike the US Fed, whose chairman described its QE policy in 2008 not as “quantitative easing” (boosting the quantity of money) but as “credit-easing” to lower credit spreads, the UK’s BOE in its brief reversion to “monetarism” in 2009’s QE Sensex zooms 439 pts on GAAR relief, EU - used traditional open-market operations to buy gilts from the non-bank public to increase bank deposits to boost the broad deal money supply. This increase in deposits at banks (their liabilities) is entirely different from increases in bank lending (their - Cinema on his mind assets). The former requires no increase in their capital, as these liabilities can be readily offset by increasing riskless GAAR may not apply to tax haven - assets in their “cash reserves” at the central bank, or purchases of government debt. By contrast, loans to the private investments sector, being risky, would require extra capital to cover any defaults. - Ratan Tata chairs final AGM at TCS This continuing theoretical confusion between “money” and “credit” has led to two dangerous tendencies. The first, clearly - Loan growth slows in infra, textile sectors evident in the US, is that, to ease credit to the troubled housing market, the Fed (unlike the BOE) — instead of conducting More traditional expansionary open-market operations to increase broad money — has purchased mortgage-based securities to reduce their interest rate. This is equivalent to the monetary authorities undertaking credit allocation, which should not be permissible in a market economy. The second is that by embracing financial repression by keeping interest rates artificially low (most recently through its Operation Twist) there is a bubble in Treasuries — which, when it bursts, will lead to the euthanasia of bondholders, much as happened in the decades after the Second World War. Perhaps the undisclosed intention is to mitigate the US’ large and growing debt burden. Thus, the failure of the world’s pivotal central bank to accept that broad money, and following the Freidmanite rule, matters, is likely to continue the Money Mischief of Friedman’s last book. New Ipad Application :Business Standard's all new IPad App Click here to download for free Ads by Google Merrill Edge® Trading :Why Pay Commissions? Get 30 FreeOnline Trades Per Month. Start Now. www.MerrillEdge.com 5.5% APY Bank CD Rates :Open A High Yield Jumbo CD AndGet 5.5% APY For 12Mo. FDIC Insured Tax Shastra Now available at Special price Rs. 360/- Only Buy Now Topicologist.com Other Stories - Find us on Facebook Markets surge as EU leaders unveil plans May infrastructure output up 3.8 pct y/y - govt Rupee gains most in 3 years as risk assets rally BMW, Toyota expand pact in challenge to rivals May infrastructure output up 3.8% y-o-y Login Business Standard Like Confirm Tags : money | credit | financial crisis | GFC | Lost Causes | US Fed | Bank of England | ECB | Money in a Free Society | Mark Gertler | 16,223 people like Business Standard.16,222 people like Business Standard. Read Business news in Advertisements - - Hassle-Free loans upto Rs. 30 lakhs. Click here - Subscribe now for Rs. 500. click here to know more - Choose a type of package deal. 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