By Michael Baxter 23 Dec 2009 [3 Comments | 1,801 views]
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Charles Goodhart is one of those rare individuals who has a rule named after him. It is one of those rules that has been re-interpreted so many times that it has evolved. Originally, Goodhart’s Law said that as soon as a given monetary policy target is set, that target would immediately lose credibility. These days the rule is said to apply to any form of economic policy. As soon as a policy is laid out, the very process of putting it into the public domain changes the effectiveness of that policy. There is a similar law in physics: Heisenberg’s Uncertainty Principle, which says the act of trying to measure something changes the thing you are measuring.
Anyway, Mr Goodhart, who was once a member of the Bank of England Monetary Policy committee, has said something somewhat startling.
At least, his statement should startle lots of people, but, we hasten to add, regular readers of this column should be distinctly un-startled.
Mr Goodhart reckons the recent contraction in the money supply could spell a return to recession next year.
“What was that?” we hear you ask “Am I going mad? Contraction of the money supply… don’t be soft.”
But if you were a regular reader here you would know this is precisely what is happening. The money supply isn’t just a matter of central banks printing money. The real money supply, the one that monetarists fret about, is determined most of all by bank lending.
Banks have gone all risk averse. Regulatory bodies such as The Basel Committee on Banking Supervision want to see banks rebuild balance sheets and work to a much higher capital ratio in the future.
The irony, however, is that by attempting to reduce risk in this way, banks may actually be increasing it. By cutting back on lending, banks cause the money supply to contract, aggregate demand falls, banks’ customers go bust, and they find they have to make huge write offs. Banking is risky. Lending is risky, because loans can go bad. But, equally, it is risky not to lend. And if bank policy becomes risk averse, leading to deflation, more businesses will fail and the capital Tier 1 ratio that prudent banks will require will increase. You see, it’s a form of Goodhart’s Law.
That is why the central banks in the UK and US are wise to create money. For while there are many who say that expanding money will inevitably lead to hyper-inflation. The reality is that the money supply is contracting.
Take another piece of news that hit the press yesterday.
Brits are saving again. According to the ONS the average British family saved £300 a month during the autumn. It’s the highest level of saving ever recorded.
There are those who will be surprised by this development.
After all, an army of economists worked out that falling house prices wouldn’t lead to falling consumption and rising saving.
It is just that this army got it wrong.
Surging house prices was the single biggest explanation of the consumer boom which underpinned the UK’s golden period of growth lasting 16 years and starting from the early 1990s.
You don’t need a PhD in economics to understand this. Neither do you need a Masters from the school of life. You just need a degree of common sense.
We have seen a cultural change. Saving is the new black. Consumers find it’s fun to save a little bit each month. Banks look macho if they seek to strengthen their balance sheets.
It’s the post credit crunch way.
That’s good though, isn’t it? Saving is rising at last; hoorah for that.
It is just that it’s not that simple. It’s a form of Goodhart’s Law.
As we save more, demand is sucked out of the economy. Unemployment rises. Deflation sets in. For those who use their savings to reduce debt a horrible new reality dawns. Thanks to deflation, the real value of their debt begins to rise faster than they can save.
It’s no wonder some are talking about a new credit crunch. The Bank of England warned recently that write downs in the value of commercial property could trigger another round of massive bank losses.
There are fears Japan could suffer a double digit recession next year.
What with fiscal deficits so high and the inevitability of public sector strikes in 2010, the outlook isn’t so rosy, is it?
Accept that it is.
For yesterday also saw a string of good news. Good news in the US, good news from China, and good news here in old Blighty
‘inevitability of public sector strikes in 2010′
This comment made me smile and cringe at the same time. Unemployment heading towards 3 million, tax receipts through the floor, public sector borrowing off the scale. You would have thought the unions and employees in the civil service would feel fortunate that they have been protected from the full effect of the recession.
However I heard our own Brendon Barber moaning this morning about the pay rises that have not kept line with inflation for the public sector. Needless to say that the strikes are coming because the unions really are spoiling for a fight and the public sector have had a comfortable existence for too long under Labour. That mindset is going to be difficult to change.
Looking at the prospect of strikes in a simplistic way, If the public sector goes on strike will anyone miss them ?
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