In the City
Monetarism and gilts
Nicholas Davenport
It would appear to that distinguished City banker, Mr Walter Salomon, who objected to my recent criticism of the Governor oil the Bank of England, that I am one of the old Keynesians 'whose academic chastity has never been broken by any spell of practical experience'. Certainly I have never had any practical experience of banking but I have had plenty of experience as an investor, and as fund manager, of the practical effects of bad banking policy on the funds. It was because of the demoralisation of the gilt-edged market that I called attention to the disadvantages of having a monetarist Governor. It does not seem to have occurred to the City that monetarism could destroy the gilt-edged market.
Mr Gordon Richardson has lately explained his monetarism — or tried to explain away his monetarism — in the inaugural Mais lecture which he gave last week at the City University in London. He was extremely diffident about his new faith. No one could quarrel with his statement that there was 'an observable statistical relation between monetary growth and the pace of inflation . . . over the longer term'. He added: 'Some, I know, may still feel doubts as to how the statistical relationship between money and prices should be interpreted'. But Mr Richardson avoided giving his own interpretation. He was plearly anxious not to be dubbed a Friedmanite. But he had come to the conclusion that it was a good thing to have a monetary supply target. It represented 'a self-imposed constraint or discipline on the authorities'. This could at times, he said, seem irksome 'because the permissible thresholds cannot be precisely and scientifically set, envolving a considerable element of judgement', but the main purpose of the monetary target was to provide 'a basis of stability'. But, dear Governor, this is precisely what it does not and cannot do in the gilt-edged market.
If the Bank thinks that money supply is likely to exceed its target — hey presto — it puts up the MLR (minimum lending rate) and if the reverse — hey presto — it puts it down. The constant changes in interest rates which this monetary target policy requires must naturally upset stability in the gilt-edged market. And that means that it upsets the business world. Every businessman has to work out borrowing costs when he plans his growth programme and before he invests (unless he has lots of cash to use up). A constantly changing MLR would make business planning impossible. And if it goes too high it can make the difference between profit and loss on a long-term investment. For example a 10 per cent rate of compound interest would double the cap
ital cost in a little over seven years. So a stable rate of interest — and in particular a low rate of interest — is what the businessman requires for planning and expansion, especially in a time of world trade recession. But alas! this is denied to him by a monetarist policy.
The excuse for this perversity, according to Mr Richardson, is that in a world of rapidly fluctuating inflation it is impossible to define an 'appropriate' level of interest rates, so that to pursue an interest rate policy would be he said, to navigate without a chart. I cannot see the validity of this argument. The Bank does not have to know the 'appropriate' level of interest rates. It has to recognise that business life cannot function with constantly moving interest rates and that its job is to keep them as stable as possible and as low as possible. It was outrageous of the Bank to jump up the MLR from 5 per cent to 7 per cent on 25 November just because it thought that the money supply target was going to exceed 13 per cent, which turned out to be a false alarm. Not only did it upset the business ,world but it demoralised the gilt-edged 'market. What the Bank should aim at is a stable gilt-edged market — if possible — with a gradually rising trend so that the rate of interest can become low enough to entice the business world to invest and expand.
I have tried to keep monetarism out of this column because monetarist arguments are so boring but if any reader wants to know what the basic theory is about let him keep in mind this simple formula: MV = PC) that is, the quantity of money x its velocity = the level of prices x the level of output. If the level of output is at its maximum rate of
growth obviously an increase in the quantity of money will inflate the price level. But the level of output does not stay at its maximum; it falls rapidly below in a recession accerbated by inflation and this variable upsets the monetarist equations. Wages don't fall as the recession worsens; the trade unions are strong enough to exact the annual ritual of a rise in wages whatever the price level or the output level. The Friedmanitis say that they would quickly stoP that nonsense; they would tell the emplor ers that there is not enough money in the banks to pay for the rise in wages. A confrontation on that issue would have the workers picketing the banks to make sure that if money had to be rationed the unions would have the first pick. How much more sensible it was of the Government to tell the firemen that a 30 per cent rise in wages in the public sector would bring back a raging inflation of prices and allow common sense to prevail over the strike. How much more sensible of the Prime Minister to let the miners know that if they were to force through their outrageous wage claim they would force him to go to the country and perhaps let in the Tories. That clinched it! All these awkward questions of prices and wages are best settled not by monetarist equations, which no trade union leader or shop steward would understand, but by the exercise of the native common sense.
The Governor of the Bank certainlY revealed in his lecture that he was not a whole-hogging monetarist. He was not prepared to say, as the Friedmanites would, that demand management of the economy on the Keynesian principles did not matter. He believes in the management of demand and he believes in the management of the exchange rate. Above all he still believes 11) an incomes policy. This is the most vital point of all. Why then does he not see that what is important about the supply ni money is they way in which it is distributed? If the supply rose because it got into the hands of industrialists who were employing more people it would be admirable. If it got into the hands of spivs and speculators lt would be deplorable. The monetary inflation which the Tory government allowed was deplorable because it got into the hands of property speculators and share speculators and the managers of the fringe banks who financed their fantastic gaga+ ing. What shocked my confidence in the Bank of England was that it did not foresee this financial orgy and take steps to prevent it.
All this confirms me in my belief that the mechanical operation of monetary targets /5 lacking in common sense — quite apart froM the M3 calculation itself. It tends to make bankers and politicians forget that it is the quality of bank loans that is important. MU in this latest exercise of money supPlY targets it has caused the Governor of the Bank to forget that monetarism eV demoralise and lower the status of the got' edged market.
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