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Right Aims, Wrong Means

The Chancellor and PM believe the tax and spending measures announced in the Autumn Statement are the right way to tackle inflation. But, as John Greenwood explains, the inflation problem is not fiscal, but one of monetary growth and that’s a blind spot of both the Government and Bank of England.

Ahead of the Autumn Statement the PM Rishi Sunak said, ‘The best way to get inflation down is to get mortgage rates down … by reducing government borrowing.’  In yesterday’s Autumn Statement his Chancellor, Jeremy Hunt, repeated the heresy saying that he set out  ‘to ensure that national debt falls … and supports the Bank of England’s action to control inflation’. Both sentiments include laudable aims, but their underlying inflation theory is flawed.

Government borrowing and spending do not, on their own, create inflation – and they have not created the current inflation. What is critical is how the deficits are financed. If the funds are raised either through taxation or borrowing, then spending is simply transferred from the private sector to the government sector. With no change in incomes or money supply, total spending cannot rise, and inflation will not rise.

It is only when government (or private sector) spending is accompanied by or financed by a substantial increase in the quantity of money that inflation rises.

Consider two contrasting cases and what they have to say about the outlook for the next few years.

At the time of the Great Financial Crisis (GFC) in 2008-09, the UK, the US and other developed economies were plunged into recession by the credit crunch that hit banks and shadow banks, forcing them to contract their lending dramatically as they de-levered and then re-capitalised their balance sheets. In almost all the advanced economies government budgets went into deep deficit – some as large as 10 per cent of GDP — as government spending supported both the economy and the financial system during the recession that followed.

However, in all cases the recovery was unusually slow and painful, but not on account of the large deficits of governments, nor because of the alleged switch in 2010 to ‘austerity’– i.e., tighter government spending plans under Messrs. Cameron and Osborne. The reason for the prolonged pain was that despite QE in the UK and the US, the growth of money in the hands of the public – broad money supply or spending power – remained anaemic. In the UK M4x grew at only 1.6 per cent p.a. between the start of the crisis in 2008 and 2012 Q3 – about one third of its appropriate growth rate.  Consequently, nominal GDP in the western world remained very weak, recoveries were delayed, and several economies suffered deflation.

By contrast, in November 2008 China announced an RMB 4.5 trillion fiscal stimulus (6 per cent of GDP at the time) but instead of financing it by borrowing alone (as western governments did), they arranged for all of the funding to come from the banking sector. China’s M2 accelerated from 15 per cent p.a. to an average of 25 per cent for two years. The result was that equities doubled, property and commodity prices soared, and the economy revived by mid-2009. Naturally, there was a price to pay: inflation rose from -1.6 per cent in early 2009 to 6.6 per cent by mid-2010.

The key point is this: China was the only economy to embark on a monetary expansion (as opposed to the fiscal expansion which all economies undertook) and therefore the only economy to enjoy a rapid recovery.

The lesson for Messrs. Sunak and Hunt is first not blindly to endorse the Bank of England’s recent strategy – as Hunt did in his Statement – and second to ensure that the BOE does not cut off an incipient recovery at the knees.

The truth is that it was Andrew Bailey and the MPC’s decisions in early 2020 to ‘Go big’ with QE that created the current inflation – not supply chain problems or Mr Putin’s war in Ukraine. We know this because China, Japan, and Switzerland have all experienced the same supply disruptions and the same abrupt shifts in energy and food prices, yet they all have inflation rates of just 2-3 per cent. The reason? None of them allowed the doubling or trebling of money growth that we  saw in the UK or that Mr Powell presided over in the US.

An alternative strategy was available, but simply not considered or adopted. Since the central banks had done QE in the aftermath of the GFC and it did not create inflation, they naively thought they could do the same thing again during the pandemic without inflationary consequences.

So why did the central banks make these mistakes? Fundamentally it is because the current generation of central bankers ignore the growth of money and try to steer the economy only with interest rates, supplemented, when necessary, by QE. The last three or four decades of relative price stability have allowed them to forget what created inflation in the 1970s and 1980s.

So instead of reaffirming the Bank of England’s remit – as mentioned in the Statement – the Chancellor should have seriously considered tweaking the mandate to ensure that the Bank of England does not ever again allow M4x, the broad measure of money, to grow either at 15 per cent year-on-year as it did in 2020-21 or 1.6 per cent p.a. as it did in 2009-12 – respectively about three times and one third the appropriate rates for hitting the 2 per cent inflation target.

Sadly, because both the BOE and the Fed, having pressed too hard on the accelerator during Covid,  are now stepping too hard on the brake. This implies stagflation ahead in 2023, and a deeper and more prolonged recession than necessary. Fiscal adjustments cannot cure monetary mistakes.

John Greenwood

John Greenwood is the founder and Chief Economist of International Monetary Monitor Ltd, and was  Chief Economist at Invesco, based in London, from 1999 to 2021. A pioneer of monetary research in Asia, he was the publisher, editor and lead author of Asian Monetary Monitor, a bi-monthly publication which operated from Hong Kong between 1977 and 1996.

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