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Thursday, August 12, 2010

More Detail on the Proposed BOE Act - Part Two

Note: As many say, the devil is in the details. This series fills in details of the Proposed Bank of England Act on which I posted seven articles here from July 31st to August 3rd. I posted Part One of this "details" series on August 7th as "How the Proposed Bank of England Act Works - Part One". Bill Totten

Guarding Against Inflation

At the suggestion that we should allow government - or even an independent agency of state - to create and spend new money, many people immediately think of the farcical scenes in Zimbabwe in recent years. Indeed, the most common misguided criticism of the type of reform that we are proposing is that it will cause significant inflation, as an irresponsible government prints as much money as it requires for its own needs.

There is absolutely no risk of this happening in the environment created by this reform. For one thing, decisions on changes in the money supply will be made not by elected politicians but by an independent body (the Monetary Policy Committee). Politicians will have no influence whatsoever in the amount of money that will be created.

The Monetary Policy Committee will be instructed to consider the needs of the economy as a whole in deciding how much new money should be injected into the economy. The needs or desires of the elected government do not factor in this decision at all. In fact, the members of the MPC should be explicitly forbidden from considering political matters or the intentions of the current government in making the decision.

Over the last forty years, the banks have been inflating the money supply by an average of 10.7% per year, through creating endless amounts of new debt. This has led to inflation over that time of hundreds of percent, especially in the housing market. From this we know that annual rises in the money supply of seven to ten per cent will cause inflation, so we already know our upper-limit on how much new money should be created. As long as the MPC keeps the annual increase under seven per cent per annum (the average growth rate since 1980) then inflation should be less than it has been under the old system.

In other words, inflation is significantly less likely under the reformed system than under the existing system.

If further safeguards are needed to reassure people that hyper-inflation is not a risk, the following safeguards could be put in place (but note that they are not included in the reform proposal at this stage):

* The absolute amount of the increase in any one month must be no more than x% greater than the previous month. This prevents any wild fluctuations in the amount of money created from month to month, and depending on the level of 'x', ensures that it would take decades before they could create sufficient levels of money to cause hyperinflation.

* The total annual increase in the money supply should not exceed y% of the current total money supply. If you doubled the money supply in the space of one year, you would cause asset bubbles and very high inflation. If you cut the money supply by fifty per cent, in one year, you would cause an economic collapse. Common sense suggests that the 'safe' rate of growth in the money supply will be somewhere close to 0%, and almost certainly in the single digits.

* At no point must the annual increase in the money supply exceed the average of the last thirty years in which banks issued the money supply. This would provide a limit of around 11.8% growth in the money supply per annum. It seems logical that if creating ten per cent per annum leads to a six-fold increase in housing prices, and the worst financial crisis since the 1930s, then staying below this limit should have a less destructive effect.

The last point actually requires more investigation. A ten per cent rate of growth in money supply is a very different thing when that ten per cent growth comes from the state, rather than from commercial banks. When commercial banks increase the money supply, they do so by creating an equivalent amount of debt. The new money acts as a stimulus to the economy, but the new debt acts as an immediate drag on the economy. (If you accept and spend a personal loan in August, you will start repayments in September. In September you are immediately poorer than you were before you took the loan (even though you may have more 'stuff') as your disposable income is reduced by the amount of the repayments. You spend less in the shops and the real economy loses your regular spending).

Allowing banks to create money is therefore akin to pressing both the accelerator and the brake at the same time - and the results are equally painful to watch!

In contrast, the debt-free injection of money from the Bank of England is free from the immediate sedative of an equivalent amount of debt. This is akin to pressing the accelerator with your foot clear off the brake. Which system would you expect to have the greatest stimulating effect on the economy?

For that reason, we can assume that a ten per cent increase in the money supply at the hands of the Bank of England would be far more of a stimulus to the economy than the same rate of increase when caused by commercial banks. Whether we should aim for five per cent instead (to avoid any risk of inflation) or stay at ten per cent (to pull ourselves out of this recession and enable the nation to reduce its debts) needs further analysis.

In short, however, inflation is much less of a threat under the reformed system, whereby the state creates all new money, than under the existing system (whereby new money is created as debt by private commercial banks).

Note: The Measure of Inflation Must Include House Prices

For inflation to be effectively prevented, it is essential that the measure of inflation used by the Monetary Policy Committee includes house prices.

For that reason, the Consumer Price Index (CPI) currently used by the government is completely inadequate. It is incredibly misleading to claim that inflation is around 2.5% per annum when the cost of housing - which makes up around thirty per cent of people's expenses - is inflating at ten per cent per annum. Consequently, for the Monetary Policy Committee to be able to make good decisions about the money supply, it must use a 'basket of goods' that really represents how ordinary people spend their money, including housing costs.

One of the arguments for excluding housing cost from the existing Consumer Price Index is that, since mortgage costs are determined by the current interest rate, under the current regime the MPC may increase the interest rate to limit inflation, but then see the CPI rise due to the effect of higher interest rates on mortgage costs. This argument is no longer relevant, as under this reform, the MPC will cease to make a decision on the base interest rate.

The actual measure of inflation that will be used after the reform requires further consideration.

Bill Totten


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