Realist, not conformist analysis of the latest financial, business and political news

The Unbearable Contradictions Of Monetary Policy

The creators of money

An interesting little note from Ambrose Evans Pritchard. There are two different things we’re trying to achieve at present. We’d like to have loose monetary policy, thus quantitative easing. We’d also like the banks to not fall over, thus higher capital requirements and restrictions upon lending. Yet, as we all know, 97% of wide money – credit that is – is created by the banking system itself. Thus, if we restrict the ability of banks to issue credit through capital requirements and the rest we do rather restrict our ability to have loose monetary policy through QE:

Europe’s banks will have to raise up to €400bn (£343bn) of fresh capital or slash lending to meet the draconian demands of Basel III regulations, risking an investment crunch across the region and a second decade of economic stagnation.

An expert report for the European Banking Federation (EBF) and UK Finance warns that the rigid, dysfunctional rules could shrink total bank lending by €2.9 trillion and slash economic growth by 0.5pc a year over the next decade, leaving the weaker economies with no safety margin against repeated recessions. The short-run shock could be even worse.

One way of describing that macroeconomic problem is to use MV = PQ. Money times the velocity of its circulation equals prices time quantity, that second pair also being equal to GDP or the size of the economy. Logically this holds. Market transactions do involve money, that’s why we define them as market transactions. The number of times money moves around is therefore going to be equal to the market activity in the economy, the number of transactions times their size. That#s also going to be equal to the amount of money (this time, base money) times the number of, erm, times it is used.

Our equation really does hold. So, one method of describing our current monetary woes is that V has declined, substantially. Thus, in order not to have either a depression or deflation (a reduction in either the P or the Q ) we increase the M. Which is what QE does, massively increase the amount of base money in the economy.

Hmm. OK.

So, one of the things which determines V, how often money is used, is how much that base money supply, call it M, or to be more accurate, M0, is multiplied by the banks lending it out and creating M4, that wide money supply. How much does base money get translated into credit? If we restrict this then we#re causing, again, the very problem we’re trying to solve, the decline of V.

We also don’t want the banks falling over again. We’d like them to have 11 and 12 and 13% capital as a cushion against loans going bad. Excellent. But that restricts their ability to issue loans, reduces V.

There isn’t actually any solution to this. It’s, as with so much, a matter of trade offs. We have less credit creation now at the benefit of a more robust banking system in a crisis. Or, obviously, we don’t.Shrug, make up your own minds as to what the correct balance is, my point is only that there are costs and benefits to any position here and that’s a choice that cannot be avoided.

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Gavin Longmuir
Gavin Longmuir
2 years ago

There is the Real economy of goods and services. Then there is the Financial economy. All these bright people playing with their little equations in the Financial economy have forgotten that they ultimately depend on the Real economy producing tradable goods & services that meet human needs. The big obstacle the Real economy faces these days is excessive counter-productive regulation and complex taxation which discourages production. To solve the problems of Monetary Policy, roll back excessive regulation and encourage innovation & production.

Spike
Spike
2 years ago

A problem I have always had with MV = PQ is that V is essentially a “fudge factor.” Dollar bills having no speedometers, we do not know the velocity of money. But when Obama guns the printing presses and the expected hyperinflation does not occur, the reason the US is not Zimbabwe is that he ALSO imposed regulation such that “money changed hands more slowly,” or something. Yes, logically, the equation always holds; and its inclusion of a fudge factor means it’s unusable.

Michael van der Riet
Michael van der Riet
2 years ago

QE, proof that open market transactions don’t work and a top-down planned economy is best.

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