23 July 2020

Money in the Great Recession:

Did a Crash in Money Growth Cause the Global Slump?

Edited by Tim Congdon
2017, Edward Elgar, 288 pages,
ISBN 9781784717827

Reviewer: Christine Shields

With contributions from nine eminent economists, this collection of papers aims at ensuring that any lessons of the Great Financial Crash (GFC) are now learnt. And it considers whether there are similarities to the Great Depression that could offer further lessons. Rather than just blame the bankers as was popular in both episodes, could policy makers also bear some of the responsibility for the outcomes? Somewhat tediously, many of the papers discuss which definition of money is the most appropriate to target. Others concentrate on monetary theory, especially the Quantity Theory of Money and the relevance of Milton Friedman. One – interestingly – attempts to frame how Keynes might have interpreted the GFC.

Congdon himself concentrates on setting out the causes of the GFC. He sees bank illiquidity, not insolvency, as the pre-crisis weakness in the financial system. The hurried tightening of regulation from October 2008 tipped parts of the sector from mere illiquidity into insolvency by causing the collapse of monetary growth until quantitative easing helped restore some notion of stability. In particular, bank recapitalisation – and its speed – is seen as an important contributor to the weakness in credit growth.  He goes on to discuss the UK’s experience of QE, a tool that he sees as the equivalent of nuclear weaponry to defence. However, he blames subsequent events on the misunderstanding of how QE actually works. The separate requirement for banks to rebuild their capital bases meant that new lending largely stopped even as QE was in full swing, while the option of issuing either bonds or equity was not available thanks to the absence of investor appetite. Selling of banks’ non-core assets exacerbated the squeeze on money supply. M4 rose by 11% a year 2003-08, but by less than a third that pace in the following five years: hence the subdued economic performance.

So macro-prudential policies were not the panacea many believed at the time.

Some discussion follows about changes in the velocity (V) of money. V might be expected to rise with QE. But it had been falling before QE started, possibly due to increased precautionary demand for money. This seems plausible as risk appetites diminished and there was a preference for the holding of more liquid assets. V did rise but not by as much as it might have done, and activity remained subdued no matter what monetary growth was. And this was less than QE may have implied because of leakages.

A rather damning section on the ECB begins by stating that the role of central banks is to prevent macro shocks, not cause them. Yet the ECB did the latter. It was inconsistent from the outset in its approach to monetary growth so that by mid-2014, monetary growth was only some 5% above its GFC nadir because the ECB separately imposed more rigorous bank regulation as its policy priority. However, this badly compressed credit growth and contributed to subdued economic growth across Europe. But the peripheral economies had a different experience to France and Germany. In Italy’s case, this may have reflected the habit of avoiding holding assets in places the authorities could easily track in order to avoid tax. And monetary growth in Greece and Ireland was especially hard hit. So their horrendous economic collapse in the GFC was as a result of ECB policy choices which caused their monetary growth to plummet. While the ECB has been generous with its subsequent emergency liquidity assistance that has helped cushion the periphery somewhat, its focus on the core at the worst of the crisis did the periphery no favours. This is because the peripheral banks tended to borrow on the interbank market while the core country banks lent, a key factor the ECB failed to consider.

Consequently monetary balances were destroyed by deleveraging. Hence, it posits that government policy led to the GFC. Yet the regulatory emphasis was logical in microeconomic terms, but not in its macroeconomic results. Indeed, the regulation may arguably have turned the possibly manageable banking crisis of 2007/8 into the GFC and its aftermath. Systemic consequences of regulation were ignored, and international cooperation could have been better. The UK and the US were most affected by the new regulatory climate – though, arguably,  it was their monetary excesses before that sowed the seeds of the crisis in the first place.

Charles Goodhart made the very good point that the collapse in the money multiplier was another casualty of regulatory excess. Maybe it would have been better to have raised new bank capital by issuance (and, ideally, at a better time) than at the worst of a downturn. Asset sell-offs exacerbated the problem. But there was a concerted mood to bear down on bank excess to avoid another similar crisis in future.

Steve Hanke takes a swipe at Mervyn King. In his discussion of the collapse of Northern Rock, Hanke describes King’s unwillingness to provide liquidity, saying “it is not our job to support commercial takeovers”. Tensions with the FSA were acute and reflected King’s long-time aversion to the City and bankers in particular. Hanke posits that King’s view that the central bank should not be lending long-term to commercial banks was dangerous for banks and, arguably, for the entire financial system. Strong stuff. And he states directly that excessively high bank capital ratios after recapitalisation was a structural impediment to the supply side of the US economy. Better for the banks to return to less stringent capital requirements and more market discipline so the banks have to again manage risk rather than regulators.

The final section draws on Friedman and Keynes as well as Austrian monetary theory. Robert Skidelsky’s piece on how Keynes might have viewed the GFC is part theoretical and part presumptive. Keynes is quoted as saying that “banks and bankers are by nature blind”, an observation that is fair to make. In that there are parallels between the 1930s and in 2008/9. Bankers had indeed not seen the crisis coming. Skidelsky presumes that Keynes would have approved of QE but not of ending it too early in 2010; he would not have blamed over-investment or too low interest rates for the crisis, but nor would be have imposed austerity policies. Importantly he would not have seen higher asset prices as a secure base for recovery – as has, indeed, not been the case.

So overall, this book constitutes a wide-ranging analysis, technical in parts and not always captivating in the monetary detail but, nonetheless, an important contribution to the debate and the analysis of the lessons from the Great Financial Crash. I wonder if the post-pandemic lessons will be as long-lasting, given the limited input that economists have had to the policy choices.