Let's hope the money supply stops slowing and starts to pick up, says David Smith.
Remember monetarism? In those far-off days when Margaret Thatcher was freshly elected to 10 Downing Street and John Major was barely a twinkle on the back benches, it was all the rage. Politicians like a simple idea to present to the public, and monetarism, as then presented, was indeed very simple.
The economy could be pictured as a giant plumbing system. Coming in at one end was the supply of new money. Coming out at the other was inflation and growth. By regulating the tap letting in money, governments could, in effect, control inflation. If they turned off the tap too abruptly they might also restrict economic growth, but that was an unnecessary complication. We now know that it was not as simple as that. In Britain there were problems over the choice of money supply measure to target and control, and, once that little difficulty had been overcome, overhow to control it. It was not just a case of controlling the presses at the Royal Mint. Money in a modern credit economy is a complex animal.
The Government chose the sterling M3 measure of the money supply (cash plus most sterling bank deposits), and had great difficulty in controlling it within the target ranges it set itself. But inflation fell anyway. But the mid-1980s monetarism appeared obsolete. Inflation, which averaged 3 to 4%, was respectably low, even if the growth of the chosen money supply measure was uncomfortably high. Nigel Lawson, as one of the architects of the monetarist experiment, decided to free himself from its yoke.
The rest is history. The credit boom that followed the abandonment of the sterling M3 target spawned the inflation of the late 1980s and the action taken to deflate the boom led to the subsequent recession. We cannot know with any certainty how things would have been different if the target had remained in place. At the very least it would have caused a few more sleepless nights at 11 Downing Street.
Monetarists such as Tim Congdon of Lombard Street Research and Peter Warburton of Robert Fleming who warned against abandoning the target and predicted the subsequent inflation more accurately than most, had their revenge. Perhaps, that is water under the bridge. Of more pressing concern is the fact that the money and credit boom of the late 1980s has been replaced by a snail's pace rate of growth that may be insufficient to support a meaningful economic upturn. M4, the successor to sterling M3 (a wider money measure because it also takes in building society deposits) is growing at its slowest rate for over 20 years - and still decelerating.
And this is not just a British phenomenon. All over the world money supply growth has slowed sharply. In America they talk of a credit crunch - the fact that lower interest rates are not stimulating credit growth because the banks are reluctant to lend. A more appropriate description, which fits Britain pretty well, is credit crumble. This describes a situation where banks, having made some poor lending decisions in the recent past, are beset with caution. But, equally importantly, borrowers - having had their fingers burned as a result of irresponsible borrowing in the 1980s - are not willing to stick their necks out again. Both money supply and money demand are weak.
And it is not the case, unfortunately, that higher spending can easily be financed out of savings. Most savings are insitutionalised, representing people's contribution to pension funds and the like. In Britain, a fall in the saving ratio (and therefore a boost to spending) typically requires an increase in borrowing.
In Germany, money supply growth is beginning to slow after the unification boom. In Japan falling property and share prices are leading to a credit crumble. Weak money and credit growth may be a natural response to the excess of the 1980s. The problem is: if this response is long-lasting then the outlook is for weak or non-existent growth in the world economy. Lord Rees-Mogg, a former editor of The Times, has warned on this basis of a prolonged world slump in the 1990s.
If we go back to our plumbing system, we can see that very weak growth in the money supply does not necessarily mean that economic activity will be subdued. It is possible that inflation will take the strain. The world money supply figures may be telling us that the 1990s will be an era of very low inflation, perhaps even stable prices. Perhaps even, and this possibility should not be discounted, falling price.
The difficulty here is that the adjustment from a period of rising prices to one of stable or falling prices is unlikely to be straightforward. Unpalatable though it is, economic activity appears to be stimulated by some rise in prices. Workers who achieve pay rises are subject to Keynes's money illusion - the belief that they are making real gains even if the rise is ultimately eaten up by rising prices. When the pay rises stop, a justification for increasing spending may well disappear. Companies seek to raise money for investment on a rising stock market. Much bank lending is secure against rising property prices. A little bit of inflation, once people have become accustomed to it, may oil the economic wheels.
Another possible let-out is that it is not clear how much predictive value the money supply has. Weak money and credit growth may tell us that economies are not performing now, but very little about how they will be doing in one, two or three years' time. Even if this was true, however, it would be a lot easier to feel reassured if money supply growth was stabilising, rather than continuing to decelerate.
The experience of the 1980s was that there was a rapid growth in credit for some time before it kicked in to bring about economic boom and rise in inflation. Indeed, for much of the period a rise in personal and corporate debt appeared to be benign because, on the other side of the balance sheet, there was a rise in the value of personal and company assets. Now the opposite situation is with us. Assets, notably property, are declining in value and this is adding to the reluctance of people and firms to take on debt. The danger, plainly is that the major economies will lock themselves into a period of falling asset prices alongside weak or declining economic activity.
The revenge of the monetarists, therefore, may be an uncomfortably long affair, taking in both the boom of the late 1980s and prolonged slump in the 1990s. One hopes not. The money supply figures have, after all, given unreliable signals in the past. But I, for one, will feel a lot more comfortable about economic recovery when money supply growth picks up.
David Smith is Economics Editor of The Sunday Times.