(Transcript of the podcast is given below.)
The video mentioned in the introduction can be found here.
Meyrick Chapman
Geoffrey, I'm very pleased to have Professor Geoffrey Wood with me today to talk about issues. Professor Wood has lectured in economics at the University of Warwick, and in Banking and Finance at City University in London, where he has been Professor since 1986. He worked at the Bank of England as an economist and later as a special adviser on financial stability. He was also a visiting scholar at the Federal Reserve Bank of St. Louis. He's acted as economic adviser to various firms and organizations, including the New Zealand Treasury, and the Bank of Finland. He has visiting professorships that have taken him to universities around the world, including South Carolina, Harvard, London, Athens, and Oxford. And since 1991. Well, he's been an author, or co author, or editor of over 20 books. And he's published over 50 papers in academic journals, as well as doing a good amount of written and broadcast journalism. So, Geoffrey, thank you very much for joining me.
Geoffrey Wood
I like the sound of that, by the way, Meyrick, because it mentions my most Northern and my most Southern; Finland and New Zealand.
Meyrick Chapman
Good. Yeah, absolutely. Yes, covered the whole whole world. So thank you very much for joining me today. I, the reason I was particularly keen to talk to you is that there are some important monetary conditions which are, which are currently developing, particularly the tightening from the Federal Reserve, and the tightening from the Bank of England and other central banks. And I thought it was particularly interesting that there's been a rather surprising development of the last year. There appears to been emerged a concerted effort on the part of establishment figures to to denigrate what's become known, or what is known as the Quantity Theory of Money, which is that the amount of money in the system determines both nominal growth and inflation. And I was particularly startled to hear a comment from a former Bank of England Monetary Policy Committee member at a recent conference, where in responding to an accusation that Quantitive Easing may have contributed to inflation, he made the following remark. And I quote; "I think it's a commentary on the sad state of the economics discipline, and the sad state of central banking community that people like Tom Tugendhat, a British politician, essentially get succour from people, including former governors of the Bank of England, there is a former governor of the Bank of England going around telling the story that this inflation that we've seen was completely predictable on the basis of monetary aggregates. And I mean, what he's forgetting is that it was the monetary aggregates that abandoned us rather than the other way round, and that these monetary aggregates have given us false signals on many occasions. But for some reason, parts of Andrews party, (by which he means the Conservatives, Andrew was another member of the panel that he was sitting on), have completely focused in on monetary aggregates, then, you know, from there, they go to QE. And it's a lot of that debate is just intellectually dishonest, if I may say so. And very depressing."
I will put a link to that particular video in the notes to this talk. But I think starting from that point of view, I found that very surprising comment from a member, a previous member of the Monetary Policy Committee. So I'd like Geoffrey, if you could talk to us about the quantity theory of money. And we should remember that the scientific definition of it or the conventional definition of a theory is that it's a proof that it's not a conjecture. So if it is a theory, in the sense that I've just described, then surely it does have relevance today and can't be consigned to the dustbin of discredited economic theories, as this gentleman suggested, such as the Real B ills doctrine, which some PBX some people obviously wished that quantity theory of money would be consigned to the bin. How would you respond to those points?
Geoffrey Wood
Well, let me let me take some of these points individually a little bit. He spoke was a he I believe from what you said, He spoke of a former governor of the Bank of England, the former governors of course, Lord King, known as Mervyn King in real life, and who is undoubtedly more distinguished economist than anyone who has been on the MPC, in the past, say, five years. And more interesting than anyone who is there now. So if you were to argue with him if you get your facts right. This person also said that the money supply and Quantity Theory of Money has left us, we haven't left it. I have to say, I really don't know what that means. How can that have left them? What he surely is saying is that the naive mechanical interpretation of the quantity theory doesn't always predict accurately. But of course, that's absolutely right. We then look back through history and see considerable fluctuations in the price level not produced by fluctuations in the monetary aggregates. For example, let me look back to the gold standard of the 19th century. The money supply by and large after the Napoleonic Wars, when we went back to gold - we being Britain - went back to gold, grew fairly steadily, not in a straight line. And there were increases in the demand for it, particularly when the US economy started to open up to world trade. However, there were also big shocks to the price level, it may surprise the current MPC and particularly that ex member that there had been shocks to the price level in the past. These shocks came primarily as indeed, to an extent they have now, from the price of grain. The shocks, however, produced deviations from a trend in the price level to which we reverted. So the trend was steadily determined by the behavior of money, money growth relative to income growth. Fluctuations were produced by all sorts of things. That is exactly what the quantity theory of money says. If the gentleman in question reads, for example, David Hume, distinguished philosopher, historian, an economist, he would get that story. If he reads Milton Friedman, not a philosopher, but certainly a distinguished economist and Anna Schwartz, he will get the same story. And he will get it more recently, too. So he is quite simply wrong.
Why then, does he say this, why then, does he say this? I think he says it because in recent years. Incidentally, I should note purely as an aside, he focused his attention on Tom Tugendhat who I'm sure is a very nice and sensible chap, but he isn't an economist is therefore focusing on someone who can't really respond I also note that. Why did he make this attack ? Because in recent years, the money supply behaved very well, it'd be just to pick up a few statistics, you have to look at the numbers here. Average rate of consumer price inflation was around 2.1%, which is just over target. Since since the financial crisis, to now, and the annual rate of money growth was in round terms, 4%. So in other words, inflation was money growth minus real growth. That fitted. What went wrong in this relationship is probably the bank either panicked or succumbed to political persuasion, I can believe either, over the COVID crisis, we had a fundamental misdiagnosis of what was going on. They simply got the economic, the basic economic analysis wrong and eased money. At that point, let me stop and say first of all Meyrick, do you have any questions anything you want to take up? Or should I carry on?
Meyrick Chapman
No, but please, please carry on?
Geoffrey Wood
The basic analysis they got wrong was, but let me compare with the financial crisis. And, and let me call it the COVID crisis. The financial crisis threatened a collapse in the banking system. Just as had happened in the interwar years in the United States, and then spread from there elsewhere and as an aside not to Britain. This collapse in the banking system would have produced the violent stop and indeed did produce the substantial crash in the quantity of money. And the consequence of this was a major recession in the United States. And some would argue that a major inflation followed by recession in Germany, followed in turn by the Second World War. But setting this extension aside, what happened then was just like that; a collapse in the money supply, which would have produced a collapse in demand and a really serious recession, just as happened in the 1930s. If we come now to COVID, what happened? Was that a collapse in demand? Oh, no, there was a collapse in supply. Because people were no longer working supply chains were disrupted. And that was very, very important. If you look, as I'm sure you and some of your listeners do at containers, containers, thus using Container ships, they are still mal-distributed around the world and international credit is disrupted, sluggish and costs are high, because COVID stopped trade for a bit and thus, things which transported goods got out of place. So, what was happening was a supply contraction in the face of a supply contraction, a contraction in the supply of goods, what can an increase in the money supply do? Absolutely nothing. All it would do was raise the price level. So the central bank panics confused, looked at a prospective fall in output, and decided all falls in output were the same. They made an elementary mistake, confusing supply and demand that in my view should fail a first year economics student. So they lost their nerve, pumped the money supply in and now prices rise. How do we know it's not just the nasty foreigners doing things to us with Bank Rate and others? Well, we can compare ourselves with Switzerland, Switzerland is a smaller economy than us. That's true. But it's a very open economy. What's the inflation rate in Switzerland? Two and a half percent? Why? Because the central bank kept control of its own balance sheet and didn't inflate the money supply.
Meyrick Chapman
Well, that that's fascinating. And I think very revealing, and fascinating and true. In fascinating doesn't necessarily mean it's untrue. I have a recurring thought that was prompted by some of the comments that you made there, that the main reason that policymakers are so determined to denigrate Quantity Theory of Money is because if the theory is accepted, then policymakers would have to admit that they are responsible for the current bouts of inflation. And if that's true,
Geoffrey Wood
Let's be fair, they're responsible for part of the current bout of inflation. They've inflated, inflation, the base from which the external shocks pushed up inflation in the UK, they have inflated the base the growth rate prices. Now, again, on this point, the Bank of England says that about 20% is due to monetary policy, I find that statement extraordinary. And I find it extraordinary that nobody's done some simple arithmetic. 20% of the current inflation rate, takes us back to around 2%, which is the bank's target. So we are expected to accept from the banks ex cathedra pronouncements, that the bank is actually doing a brilliant job and is on target. That strikes me as a self serving calculation.
Meyrick Chapman
I wasn't aware of that. So that's, that's fascinating. Maybe we could also think about why they want to continue denying that the quantity of money has an impact. Because surely, if they continue to deny it, they're just going to compound the error in the future. So why do you think they deny this so vociferously? Is it because they don't want to be blamed? Or, or is it something else?
Geoffrey Wood
There are two parts to it, first of all, is the simple desire to shirk responsibility, which they do. I noticed, for example, some people in the Bank of England having previously been in charge of regulation and failed, are now saying we need to maintain regulation as it was after the financial crisis, although that didn't work all that well. But setting aside from the desire to shirk responsibility, there is another reason. The Bank of England has a very complicated macro economic model, a dynamic stochastic general equilibrium model. And this works very well, so long as there is no are no surprises. If surprises come along, then the model does not work well at all. It gives you great, great, pretty good accuracy, in a period of price stability. Again, Mervyn King, governor of the Bank, commented on this how well the model seemed to work, and also how it always predicted that we're going to come back to the 2% inflation target by the end of the forecast period. Well, that was fine, so long as the world was stable, and price expectations were stable. But the model does not cope well with shocks. A simple Quantity Theory of Money model does not predict, so well, the details in periods of stability. That doesn't matter, the details don't matter, they didn't matter in the 19th century so long as we have long run stability. But it does work well when the world is shocked. That's important. So there's a fundamental difference in the model central banks have been using over the 10 years of stability after the financial crisis to now and a model that actually works in times of crisis. Let me think how to illustrate that. But one illustration is, of course, exceedingly sophisticated models of bank risk. These models of bank risk, were apparently very finely detailed with small errors around the actual forecast and so forth. And they were very reliable, we were told, because they had an enormous number of data points. You could if you wish to have a data point every every day or more often for 10 years. Many models did that it was easy to do, given modern computer actually caught given modern computers statistical powers. But unfortunately, if you take all your data from a period of stability, you will get stable results. You would have had more interesting results if instead of taking instead of taking let's say a daily observation for the past 10 years, we had taken annual observation for the past 120 years. This would have included Great Depression changes to currency standards, two wars and so on and so forth. In other words, a period when interesting things were happening in the world. So you must look outside your data period. These models are very bad at doing that. And they produce disasterous forecasts but they're committed.
Meyrick Chapman
Yeah. For what it's worth, I think that quantity theory of money also poses a threat, in some sense, to the widely held assumptions that government policy can be deployed to solve almost all of society's problems. It acts as an unwelcome constraint on politicians.
Geoffrey Wood
Of course it does. It reminds people that resources can't be conjured out of thin air by somebody cracking a printing press.
Meyrick Chapman
In the defense of the Bank of England, we spent a lot of time perhaps criticizing the Bank of England so far, but in its defense, it was not the Bank of England that initiated such a gargantuan money printing exercise in recent years, but the US Federal Reserve. Money supply there, broad money, by which I mean, what they call M2 grew at an annual rate of 26% in 2020.
Geoffrey Wood
Well, in response to that, Meyrick, let me see if I can find you an email from a friend of mine. Here we go. "As far as inflation are concerned, we are lucky because of the X CPI (I'll tell you which one it is in a minute) rose by only, is rising by only about 3%. The National Bank tighten monetary policy earlier than the ECB, and allowed the currency to appreciate against the euro."
This is a textbook case of a country insulating itself, at least to some extent, from foreign inflation. That central bank was, of course, the Swiss central bank which controlled its own balance sheet. In consequence, Swiss inflation was I should say the word 'only' was in quotation marks - my author, my correspondent, does not regard that as 'only'. And this led to an exchange exchange rate appreciation against the euro. We could have done exactly the same against the US dollar. Who was my correspondent? A former research director at the Swiss National Bank.
Meyrick Chapman
But is it not true that the Fed as it occupies a very special place in the global architecture, which this blog, ExorbitantPrivilege attempts to highlight, maybe we shouldn't blame local policy policymakers completely for this alarming growth in inflation. Because it mostly in anything that was denominated in dollars, for instance, has been, perhaps we should lay the blame at the at the door of the Fed.
Geoffrey Wood
Well the Fed was a big factor. But as I've said, we can let the exchange rate float, that's the purpose of floating exchange, or one of the purposes of floating exchange rates is to insulate us from foreign monetary shocks. You no doubt remember that Canada, which is contiguous to the United States, and then they have a great deal of trade with the United States did not have a Great Depression. Because Canada, even then had a floating currency, did not import a banking crisis, because it left the gold standard under pressure but it left the gold standard, had its own monetary policy and did not experience the kind of monetary contraction that the Fed forced on itself. And an interesting parallel to now on every country, which stuck to the dollar. Same policy as now just sign reversed.
Meyrick Chapman
So now, what if we run this up to date, and perhaps we could expand a little on how exchange rates should react right now. So
Geoffrey Wood
How should, should should react in theory, they won't react instantaneously, they won't behave in an orderly fashion, because there's all sorts of random noise. But if we strip out all the random noise, and think about the question, should we act? Let's suppose the only disturbance is monetary now proceed.
Meyrick Chapman
Well, the Fed is raising interest rates, it's reducing its balance sheet and broad money growth in the US is now close to if not actually shrinking on a year on year basis, it might even be shrinking,
Geoffrey Wood
which suggests will be a recession in the US,
Meyrick Chapman
it suggests certainly a very significant slowdown, yes. So, how, how should we, this tightening is propagating through anything which is denominated in dollars. So there are essentially fewer dollars available for the rest of the world to to transact with how how do you think the UK and elsewhere should react to this is that is it largely the case that the exchange rate should take the strain so just as we should have appreciated before Now we should depreciate, against the dollar.
Geoffrey Wood
If we've got to have an inflation rate that is faster than the US is going to end up, and it looks like we are, then our exchange rate should depreciate against the US dollar. And if we believe Madame Lagarde's, vigorous statement of future policy from the ECB, we should also depreciate against the Euro. As madam Lagarde's recent press conferences, which she I think, surprised people by predicting quite happily that they're going to raise rates by 50 basis points every month or so for the next infinite horizon as far as I could tell from her remarks.
Meyrick Chapman
Well, that rather suggests that there is monetary policy sovereignty to a considerable extent, do you think that's true, in a world that's dominated by the dollar?
Geoffrey Wood
It doesn't suggest that at all. Countries can choose their own inflation rate and the exchange rate is simply a price that lets them do that. If they choose the same inflation rate as the dollar, then they will, the currency will be roughly stable against the dollar. If they choose inflation rate, less than that of the dollar, currency will appreciate gradually against the dollar. Again, consider the example of Switzerland. I used to go to Switzerland very regularly, which I enjoyed very much. There is as you may know, a handbag shop on the Bahnhofstrasse Mädler (M A D with an umlaut LER) very elegant fine leather handbags. I used to buy one for my wife now and again, I noticed an interesting thing, the price in Swiss francs and never ever went up, but the price in Sterling did. And there was a reason for that.
Meyrick Chapman
Turning back to the UK. The bank, how aggressive should the bank be with its monetary policy currently with the inflation rate we have and and the inflation rate rate that they predict
Geoffrey Wood
If we look at the recent money numbers in their direction of money. Money growth was don't have precise up to date figures to hand. Do you have them there?
Meyrick Chapman
I don't, I don't have them to hand.
Geoffrey Wood
Money growth should be being pulled steadily and predictably back to a trend rate of growth between one and a half and 2% faster than the expected growth rate, which is of course being depressed by an extraordinarily inept budget that produced by Chancellor Hunt and Prime Minister Sunak an extraordinary inept budget, slowing growth, of that there is no doubt at all. And it doesn't just mean economic activity it means a slowing trend growth rate, but that's for another another chat.
Meyrick Chapman
Well, in the November Bank of England monetary policy press conference, senior members of the bank were at pains to point out that the current market pricing at that start time, the current the market pricing of interest rates was much, much higher than the bank expected to emerge in future. And that was leading their forecast based on market interest rates. That meant that their forecasts showed a very long recession with a sharply slowing inflation rate. Do you agree with that assessment?
Geoffrey Wood
Well, first of all, we should think why are market interest rates at that level? Market interest rates are in general nominal interest rates through interest interest rates in money terms, they are driven up by expected inflation. The level of market interest rates suggested to me at that time that people didn't really trust the bank to get inflation down and they might have to raise rates quite aggressively later. So interest rates suggest to me the belief in the market, if there is such a person as the market, the widespread belief on average, that the Bank of England was being too lax.
Meyrick Chapman
Well, I'd like and now if, if you if you don't mind to turn to a couple of issues that have emerged because of the very large quantitive easing program that has taken place in the UK. And this these, these affect any country that's had a very large quantitative easing program. And what I mean is the term fiscal dominance, and in the case of UK housing dominance. Fiscal dominance is when the central bank does not have free rein on monetary policy because of the net negative impact that their policy would have on the government's funding program. And housing dominance, which is a phrase that I think I've coined, that describes a similar limitation on central bank policy due to the particular structure of the UK housing market, namely that mortgages here in this country are overwhelmingly dominated by short term fixed rates that will move much higher over the next year or so because of monetary policy rate rises. And that itself could constrain Bank of England policy. So can you respond to those issues?
Geoffrey Wood
Well on fiscal dominance, first of all, we need to remember there is a very important fiscal theory of inflation. There is a very nice exposition by the Stanford economist John Cochrane of this fiscal theory of inflation which is, in fact, if you think about it carefully, fully compatible with the quantity theory. The fiscal theory of inflation tells us that fiscal balance is in the long run, what determines inflation. We can tie that back, if we recollect the monetary policy if we think about the government budget constraint, because governments can get resources from three means: taxes, borrowing and printing money. The fiscal balance is one of the determinants therefore, of how much of each of these they do and how much monetary monetary easing there is, how much monetary finance theories determines inflation. So theories are compatible. And we can perhaps talk about that on a future occasion.
But coming now, to your other point, housing dominance, your say the structure of the housing market makes it impossible to cure inflation in the UK. Well, you need to remember, one needs to remember in a general point to be made. Some groups are concentrated, and there are also general groups, the concentrated groups are very effective lobbyists, because you don't find consumers of bananas, complaining violently because there is a tariff on bananas, they don't know it's there, whereas producers of bananas were we to produce such a thing in the UK, which we don't, but supposing we did, would be lobbying for higher tariffs to push up the prices, there are many fewer of them. So concentrated groups lobby. Now, who are the concentrated groups, the concentrated group in the UK are in this particular instance, mortgage holders and mortgage holders on short term interest rates in particular. Something I always remember Peter Middleton was permanent Secretary of the Treasury many years ago, was given to observe that for every mortgage holder, there were at least 10 Building Society depositors, but the latter were not concentrated, so we never heard them complaining. So this is undoubtedly a problem for some mortgage holders though not for all, sure, but it's a problem for some and the price for dealing with inflation is unfortunately their discomfort. We've put up with that in past, I feel we need to do it again. There's no such thing as a free lunch even if the Bank of England would try to persuade you that.
Meyrick Chapman
Well, if things look a little tricky in the UK, don't they look a whole lot worse in the euro zone, especially if Mrs. Lagarde is true to her word and does rate raise rates?
Geoffrey Wood
They look spectacularly difficult. Some countries will soon be in difficulties. The only one that probably wouldn't be is Germany among the big ones only Germany. Italy, Portugal, Spain could all be in difficulties with the borrowing costs and solvency. France is not in as good shape as Germany, in that regard. The smaller companies that actually don't know, I imagine, the Nordics are fairly prudent, they're quite close to Scotland, so I guess they're prudent.
Meyrick Chapman
I'm wondering, earlier this year, the ECB announced its Transmission Protection Instrument, which was a program which they could deploy, to intervene in fragile bond markets, and what they term aid monetary transmission.
Geoffrey Wood
As you may know, Meyrick, they had not read David Hume. Because one of David Hume is David Hume was a refusal of metaphors. One of the metaphors he used was water. If you pour water in at one place, eventually the water, level of water has to be level wherever, everywhere. It's inescapable. Water does that. Money is like that. So they can't protect one market, keep it separate, keep it separate from one another by having special tools. They may be able to delay adjustment. But let me suppose an example, to get personal that the ECB decides by one means or another, it has to buy Italian government bonds. If it buys government bonds, Italian government bonds increases the money supply. The only way it can stop that is selling somebody else's bonds. What transmission protection is there there? Again, they're confused because they're thinking of the transmission of monetary policy and they're confusing it with the policy instrument. The policy instrument is the interest rate of transmission. There are many channels of transmission measure of monetary policy is basically the quantity of the quantity of money.
Meyrick Chapman
Interesting. Returning to the quantity of theory of money, there seem to be two schools of thought running through that, that school at the moment that I suppose the dominant strand asserts as we've already observed this morning that money growth is falling sharply. And therefore, with a lag inflation will also fall sharply. The second strand, if I just say, the second strand says that, although the quantity of money has slowed and may even contract, but that the velocity of money has yet to peak, because there was lockdown and that demand was suppressed, and is now released, that the velocity of money is has been picking up strongly. And that historically, there tends to be some covariance between the rate of growth of money and the velocity of money, the turnover, the actual numbers of transactions per pound, per dollar. And I wondered how, which side you sit on? And what do you think is most important?
Geoffrey Wood
I don’t think there are two sides. You have to distinguish between the short run and the long run. If you remember Philip Kagan’s book, The Determinants and Effects of Changes in the Stock of Money in the United States, 1860 to, 19, 60 something, he found that velocity was fairly stable on trend but in the short term, in a monetary squeeze, for example, initially led to a rise in the velocity of circulation. So the rise in velocity, temporarily, for a time, offset the effects of the monetary squeeze. Other economists have used the metaphor of money as a shock absorber that’s also quite handy. That’s what we’ll see now, we’ll see that now. So this will mean, we’ll slow the slow the slowing, that’s nicely put. It will slow the rate of fall in inflation by a rise in velocity, for a time but it will be a transitory effect. How long is transitory? I would guess 18 months, but that’s only a guess. It depends if inflation expectations have been affected by the extraordinary levels of inflation that the Bank of England has led to us suffering.
Meyrick Chapman So do you think there is likely, taking all this in the round, do you think its likely there’ll be a rethink by policymakers about the Quantity Theory of Money anytime soon?
Geoffrey Wood
Yes, I do. There will attempts to be an elegant shift saying ‘money, we need to take this into account after all’. They have to find a way of doing that that doesn’t leave them all open to nasty recriminations.
Meyrick Chapman
Okay. Geoffrey, this has been a really interesting talk and I know a lot of people will be interested in your thoughts. I’d like to thank you very much for your time and hope we can come back and revisit some of these issues, possibly when policymakers have realised the error of not taking note of the Quantity Theory of Money. Thank you very much.
Geoffrey Wood
I’ve enjoyed it. You’ve asked me very interesting and thought provoking questions. Bye-bye.
Meyrick Chapman
Thank you, Goodbye.
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