Should the recent strong growth in broad money be cause for alarm? David Smith can offer satisfactory explanations for now but will be watching it carefully for signs of returning inflation.
A couple of months ago a curious event, noticed mainly by financial aficionados, occurred. The annual growth rate of the so-called broad measure of the money supply, M4, moved into double digits.
Not only that, but the broad money supply in other leading economies also accelerated, although to rates of growth well below those in Britain.
I hope I have retained the attention of most readers after that opening paragraph, for some words of explanation are due. First, what is this broad money - after all, surely money is money? The answer to this is, unfortunately not, because life would be a lot easier if it were.
In the old, pre-credit days, money was certainly money, either in the form of gold coins or, as the banking system began to develop, banknotes backed by gold holdings. We had a largely cash economy and the money supply was easy to define. Indeed, one measure of the money supply still monitored and targeted by the Government, M0, largely consists of cash - to be precise, of notes and coins together with the balances held by commercial banks at the Bank of England.
Only part of the story
But a cash measure of the money supply can never tell us the full story in a modern credit economy. This was why, when the Thatcher government came to power in 1979, it embarked on the search for a truly representative measure of the money supply: finding and controlling such a measure meant they would also control inflation.
The chosen measure was sterling M3, which consisted of notes and coins plus sterling bank deposits. It had the virtue of being a broad measure and, because deposits grow in line with lending to both private and public sectors, of chiming with other goals of policy.
Lending to the private sector is credit growth; government borrowing is the result of growth in the public sector borrowing requirement. Controlling sterling M3 therefore required limiting the growth of credit (by setting interest rates at appropriate levels) and bearing down on government borrowing by clamping down on public spending.
Still with me? The next step is easy. Moving from M3 to M4 was necessary when the barriers between banks and building societies were removed, thanks to the liberalisation of the latter. M4 covers both bank and building society deposits and, therefore, lending. Its growth is thus unaffected by, for example, a change in mortgage market share between the banks and building societies.
Second question: what might strong growth in broad money, M4, still close to 10% in the latest figures, be telling us? Here, we need to go back to the central idea behind monetarism, namely that when the money supply is growing fast, there will be two consequences. Initially, growth in the economy will be stronger - lending generates investment and consumer spending. Milton Friedman, the world's most famous monetarist, likened this initial phase to the effects created by drinking alcohol. After a few glasses you feel on top of the world, often ready to take on all comers.
Alcohol unleashes one's natural exuberance. Afterwards, of course, comes the hangover or, in monetarist terms, inflation. All that exuberance unleashed by fast money supply growth spills over into rising prices. The inflation cat is let out of the bag.
Is inflation dead and buried?
A textbook example of this was provided by the British economy. in 1987-88, when after several years of strong growth in broad money (in the order of 20% a year), we were in the exuberant phase. The economy boomed but inflation was apparently under control. It was not, of course. A couple of years later we had the hangover, double-digit inflation, followed by the pain of recession itself a result of actions taken to bring that inflation under control.
Which brings me to my third question: is history repeating itself? Is all this talk of inflation being dead and buried pure wishful thinking?
Tim Congdon, of Lombard Street Research, who made his name during the late 1980s episode, perceives a risk.
'It may be an old gramophone record but the tiresome message has to be repeated,' he says. 'In the long run 10% broad money growth cannot be reconciled with inflation of 2.5% or less.'
True, there is one distortion which has caused a little extra growth in broad money, a spurt associated with the introduction of the new gilt 'repo' market in the City. The new market, for the sale and repurchase of gilt-edged securities by banks and other institutions, has created a more liquid market. But it also, in increasing transactions between these institutions, boosts lending and therefore M4.
No cause for complacency
By far the most important factor in M4 growth, however, has been borrowing by companies to finance takeovers. This, which has come at a time when the financial position of firms is generally healthy, appears odd. But it appears to reflect, in a period of low interest rates, a preference for bank financing over rights' issues. It is a structural shift, rather than a warning signal.
Surely, however, borrowing by companies to finance takeovers finds its way back into the economy and so is potentially as inflationary as a consumer credit boom? If sustained for a very long period, it may well be. So far, however, the main beneficiaries of such activity have been institutional investors, the owners of the companies acquired in takeovers. These additional funds will, in the long term, provide for more generous pensions and term insurance payouts. But we are talking of a very long time-lag.
This does not justify complacency over high levels of broad money growth, however. If the figures hover around the 10% level for more than another few months, or if we begin to see M4 growth accompanied by a genuine boom in consumer credit and mortgage borrowing, alarm bells should start to ring. Strong growth in broad money does not, yet, presage either an economic boom or a return to high inflation. When I think it does, you will be the first to know.