The recovery of the UK economy has puzzled many economists. It contradicts the views of those that have warned for a prolonged recession because of the country’s fiscal consolidation. That the anti-austerians have dominated the economics debate about the UK economy is an understatement and their not so graceful attempts now to suggest that this view actually is compatible with the recent recovery are not convincing. If their previous view had been correct this recovery is yet to happen because the government is still consolidating the fiscal stance (the fiscal tightening this year is equal to average tightening since 2010) and there is not much of help coming from international demand.
But economists with less uncompromising views on fiscal consolidation have been puzzled, too. And they seem to have settled on a combination of new credit and improvements in the housing market as reasons for what they think is a sudden and unexpected recovery. Yet it is difficult to accept the view that annualised growth for several months at 5 percent would be unexpected. The problem is rather than the macroeconomic frameworks that guide thinking has been misinterpreting the effects of monetary policy.
The recovery is not puzzling at all for those unreconstructed monetarists that continued to pay attention to money aggregates, and how economic agents are managing money balances, despite monetarism going out of fashion. A forceful school of macroeconomic thought in the 1970s and the 1980s, it subsequently lost traction as it became increasingly difficult to create meaningful measures of monetary aggregates. The academic development moved in the direction of new Keynesianism – and the world witnessed a rush to central bank policies aimed at keeping the inflation at a low and stable rate through predominantly interest rate instruments. One does not have to be very clever to understand that monetary policy has something to do with money, but the consensus that emerged in the early 1990s missed that link.
Modern versions of monetarism should be one of the macroeconomic views that will stand up when the dust of the crisis has settled. For anyone who keeps track of developments in the Eurozone, it should be obvious how the monetary famine in crisis countries – driven by a conservative ECB that has sterilised all its unorthodox operations and attempts by banking authorities to quickly push up the core capital targets of banks – has reinforced the economic contraction.
A new excellent piece at the Wonkery blog shows how modern money aggregates help to explain nominal GDP. The piece walks through different episodes of the UK economy since the early 1990s and finds cause-effect relation between how the Divisia money aggregate evolves and nominal spending/output. The piece says:
”The most important point I intended with this post is I think fairly clear from it: the heavy emphasis many people put on credit measures in assessing the prospects of the macroeconomy really isn’t warranted for exactly the same reasons that those same people typically disparage money supply measures. In fact, monetary aggregates tend to suffer much less from the problems of volatility and unstable demand than do credit aggregates, and for very sound theoretical reasons. After all, people borrow money for a wide range of reasons, to advance future income as well as to allow a bringing forward of expenditure. Their preferences on borrowing shift for a wide variety of reasons too. But finding yourself with excess or deficient money balances can be much more simply explained as a cause of changes in spending (…) the evidence here suggests that the pendulum may have swung too far from monetary aggregates. The use of Divisia aggregates, which weight monetary assets by the ‘monetary services’ they provide, demonstrate a more predictable relationship with nominal spending and with interest rates, and Granger-cause nominal spending. (…) Divisia holds up better than the more widely used M4 because of the Granger-causation, which is not demonstrated with or without the financial sector.”
This is related to the UK recovery. As noted by Simon Ward and Ed Conway, the UK recovery has been driven by a change in the household money balances – that people has moved money from the capital account into the current account and started to spend a bit more after a couple of years of improving the capital account. It is not that credit is expanding quickly, but that people have changed the intertemporal balance between saving and consumption. This has also been the intention behind several moved by the Bank of England – and it proves the potency of central banks that use money supply measures to stimulate the economy.