Money easily crosses borders. Money theories have a harder time. The US monetary economy focuses on the central bank’s balance sheet. Some theories link the balance sheet directly to nominal GDP and inflation. Others link it to broad money via the monetary multiplier, the method favored by undergraduate textbooks and Milton Friedman and Anna Schwarz in their Monetary history of the United States.
Stephen Cecchetti and Kermit Schoenholtz did a quick job of these two proposed links between the central bank’s balance sheet and other macroeconomic variables.
In Britain, monetary theories developed differently. The focus of Britain’s monetary economy is not the central bank’s balance sheet, but the balance sheet of the entire banking system. This approach starts from the observation that money is mainly bank deposits, a liability of the banking system.
As a balance sheet item in the banking system, it can be impacted by changes in any other item on the balance sheet, known as balance sheet counterparties. The main counterpart is the loan to the private sector, but another important counterpart is the holding of government bonds, which means that monetary growth can be stimulated by fiscal and monetary policy. This happened in the United States towards the end of last year, when President Donald Trump’s budget deficits led to an increase in bond purchases by banks, leading to an acceleration in the money supply.
At the height of monetarism in the 1970s and 1980s, when money supply targeting was attempted in various forms, the UK relied on the offsets approach rather than the Friedman multiplier. Its main contribution to the British economy was not monetary, it was the vertical Phillips curve; the idea that there was no long-term trade-off between unemployment and inflation.
The difference in theoretical approaches across the Atlantic may be due to the different development of banking systems. British banks had achieved huge reserve savings at the start of the 20e century, due to a high degree of market consolidation and intermediaries called discount houses. This meant that the level of bank reserves was rarely constrained on UK banking activities. In comparison, the US banking system has remained very fragmented.
It can be narrow to call this a “British” approach; it has also been used in the rest of Europe and the European Central Bank includes analysis of counterparties in its monthly monetary statistics publications. It is difficult to understand currency changes without it. Either way, few American economists seem to have much knowledge of it. Ed Nelson, an economist at the Federal Reserve, criticized him in a must-read article on British monetary history co-authored with Nicoletta Batini, currently at the International Monetary Fund. The main argument is that the counterparts are based on an identity and not on a condition of equilibrium. It is therefore wrong to assume that the peers will be independent of each other.
For example, an increase in the budget deficit can lead to higher interest rates and lower private sector borrowing, leaving the currency unchanged. Independence will occur to a degree that will change depending on the economic environment, and with zero interest rates and other factors that could cause the counterparties to compromise against each other, this independence will continue. currently produced to a high degree.
Another problem is with data rather than theory. Cecchetti and Schoenholtz point out a lack of correlation between M2 and inflation during the 2010s, deducing that monetary aggregates are poor indicators of inflation. The reason there was no correlation is that M2 is a narrow aggregate. As the interest rate on long-term savings accounts fell, money was moved from long-term accounts not included in M2 to short-term accounts that were, creating an increase that did not reflect an increase in the global currency. This has also happened in the eurozone, with economists watching the cramped M1 publish inaccurate inflation forecasts.
A better US aggregate is M3, which can be estimated by adding institutional money market funds and long-term deposits to M2. The original M3, which the Fed stopped publishing in 2006, included Eurodollar deposits from US companies. Expanding the aggregate to include longer-term deposits shows a better trend – the 2010s of low growth and low inflation are accompanied by low money growth. M3 growth is a good indicator of demand-side conditions at all major epochs in U.S. macroeconomic history except the 1990s, when its volatility was neither reflected in the economy. inflation nor in nominal GDP, which has led many economists to abandon it as an indicator.
Due to changes in the financial system, definitions of money have to be updated every ten or twenty years. Current US data is therefore imprecise. The analysis of counterparties is also problematic. Complete balance sheet data is collected from US commercial banks, but less from money market funds that create money.
Strong monetary growth is expected to persist. Fiscal, monetary and prudential policies have shifted to a pro-employment stance instead of an anti-inflation and anti-deficit stance. Second, policymakers prefer to look at the labor market rather than monetary aggregates, the two currently giving opposite signals. Monetary aggregates fell into disuse during the 1990s due to a loss of utility and possibly associations with the free market policy of monetarism. But they turned out to be a reliable indicator of demand and inflation during the 2010s, more so than the labor market. If this continues, the United States will end up with high inflation, but no theory or data to manage it.
Chris Papadopoullos is an economist at OMFIF. He can be contacted at [email protected]