THE ECONOMIST Milton Friedman once suggested the US Federal Reserve could be closed down and replaced with a money supply rule targeting the control of inflation.
I have been contemplating this while tapping into the proselytizing by Andrew Wilson and Tim Rideout and others close to the Scottish Government on the prospect of an independent Scotland with its own currency. The contrast is stark.
Monetary policy came to the fore in the 1970’s when inflation in the UK rose inexorably to 25 per cent per year. At that time ‘monetarism’, as it was glibly branded, was seen as an anti-inflation policy to protect older savers from penury and workers from unemployment. It sought to remove huge re-distributions to wealthy borrowers, property owners and those able to park their money overseas. Its success in curbing inflation led to the independence of the Bank of England in its pursuit of monetary stability.
Contrast those constraining aims with the present policy consensus that monetary policy can be used to boost economic growth and provide the wherewithal to develop a new Scottish economy to compete with the world. For those who want to try out Modern Monetary Theory, this new use of monetary policy is distinctly dependant on presumptions that public spending is politically desirable.
There are two core mischiefs in this new thinking. The first is a confusion between money and credit, the second that the connections between monetary policy and fiscal measures are often ignored.
A lesson from recent years is that simply reducing interest rates does not necessarily boost growth. It certainly increases the potential supply of credit, and in that sense the availability of money is greater. But just because cheap loans are available does not mean they will be taken up, or funding will somehow increase demand in a way that will not lead to a continuing increase in prices across the board – money inflation.
Inflation is generated through a change in the rate at which base money is created, and while there is an arcane debate to be had on how base money is measured, when that money is created and is a) seen to be created, and b) there is an expectation that its change in supply will enter into the wider trading economy that c) would not otherwise have increased production, then an initial specific sectoral price rise followed by a general rise in prices will follow some time later – usually around nine to eighteen months. As you can see, the mechanism whereby an increase in the rate of change in money supply leads to an increase in the rate of change in the general price level is not transparently obvious. Friedman himself, along with Anna Schwartz, spent half his career trying to dissect this mechanism; an effort that ended in him winning the Nobel Prize for his Theory of the Consumption Function, a highly technical exposition of how households do, or do not, hold and do, or do not, spend their money from savings and income. Probably one in a hundred economists has read and understood the entire paper.
The key takeaway here, however, is that enthusiasts of “using monetary policy” to generate growth are doing no such thing. They are increasing the availability of credit, probably by issuing new money, with little concern for its inflationary potential. That’s old-fashioned Keynesianism.
Will it boost growth? Well, having very low central bank interest rates is all very well, but banks are still lending to SME’s at interest rates at or near 8.5 per cent in my experience. A mix of risk aversion to non-property businesses that have a high failure rate, plus an ever increasing regulatory over-burden, means that banks have to do this to make any money themselves.
Businesses in turn look at their debt to equity ratios and design their growth plans such that any cash flow they generate (drastically depleted by NIC, VAT and Corporation Tax) is not swallowed up in perennial over-trading where their overdraught bails them out in constant struggle to pay their bills. Around half of the 99 per cent of small businesses that exist in Scotland partly or wholly fail in this attempt. The result is that growth plans are consistently submerged by the need to service their debt. Management choices and corporate fiscal realities in this situation combine such that creating new and faster business growth is near enough impossible.
Scottish monetary policy proponents neatly sidestep this problem by saying that they will boost public investment, yet another tenet of Keynesianism. They will create more boondoggles like the Scottish Investment Bank (which isn’t a bank), increase innovation spending through Scottish Enterprise (which does not innovate), and push vote-buying ventures like Ferguson ferry-builders, Burntisland BiFab and Prestwick Airport that burn up money. And those failures are before the public service sector constituency come knocking on Victoria Quay’s door for extra money.
It’s in this fiscal tendency of Scottish Government actions that the connection between monetary and fiscal policy becomes important. The so-called monetary freedom from having an independent Scottish currency is de facto linked to fiscal goals.
In short, the Scottish government’s use of fiscal levers has to be credible as a wealth-increasing activity that deepens Scotland’s capital base, not a generator of yet more public sector overheads.
If having a new Scottish currency is essentially about financing ever-greater public expenditure – as its advocates repeatedly suggest – then a Scottish Government with its own currency will simply keep creating new money to pay for its own failure.
In fiscal policy, one person’s gain is another one’s loss. MMT advocates think not, they plan to create money out of thin air to spend, but in reality this free lunch has fiscal consequences, not through money but through the perceptions of those with money. Their old-fashioned Keynesianism lives in a very different world prior to 1970 when exchange rates did not float internationally and free capital movement was not allowed.
Nationalists dispute the figures for Scotland’s trade balance, but the reality is that we do a lot of (often unmeasured) intra-UK and international trade and it is more likely that we generally run at a deficit in parallel with the UK. If the perception takes hold that our trade balance is deteriorating, that would be bad news for a Scottish currency, the reserves to stabilise that trend do not exist, and printing money to fund our imbalances would only make things worse.
Free capital movement means there is one obvious route for anyone with wealth in Scotland to protect their assets. Go. Money will vote with its feet if things look bad. And going south will be the route for most, strengthening (ironically) the economy of Scotland’s neighbour and now biggest competitor.
None of this means that Scotland is not a wealthy nation capable of being self-sufficient; the problem is that the statist mind-set, and the policy choices that such a mind-set induces in Scotland’s government denies Scotland the wealth it could obtain through tight monetary discipline and a reduction in the fiscal burden.
If an independent Scotland wants to have the economic growth and prosperity of economies that punch above their weight – like, say, Hong Kong and Singapore – then the mind-set has to be one that will deliver it, not that of growing an already dominant public sector so that revenues decline and government deficits and debt grows.
Photo of Milton Friedman courtesy of The Friedman Foundation for Educational Choice – RobertHannah89, CC0, https://commons.wikimedia.org/w/index.php?curid=16163396