ERC Research Papers
Playing with Monetary Fire
Published December 2007
By Professor Tim Congdon CBE
The Economic Research Council's latest research paper 'Playing with Monetary Fire' by Professor Tim Congdon argues that the recent banking crisis is likely to reduce mortgage availability sharply in 2008. He argues that banks will want to improve both their liquidity positions (i.e., their ratios of cash and liquid assets to total assets) and their solvency (i.e., the ratio of capital to assets), in order to avoid a repetition of the Northern Rock fiasco.
In the year to September 2007 new lending by the UK's banks and building societies amounted to over £240 billion, with mortgage finance accounting for almost half of the total. In 2008 new lending is likely to under £150 billion, with mortgage finance being two-thirds or less the 2007 figure. Lower house prices will be welcome to first-time buyers, but first-time buyers may find it difficult to obtain finance.
Congdon's paper surveys the facts of the relationship between the quantity of money - dominated by bank deposits - and the levels of national expenditure and income in the 43 years from 1963 to 2006. He attacks claims that the 'velocity of circulation is unstable'. He shows that the growth rates of households' and companies' money holdings over this very long period were similar. The ratio of households' money balances to national income did change, going up by 2 and a half times because of such developments as the payment of interest on current accounts. But money balances themselves have soared by almost 87 times and national output by 40 times! Congdon's verdict is that 'the behaviour of bank deposits is basic to the determination of national income and asset prices in the UK, as in other economies'.
Congdon's paper is highly critical of two schools of economic thought, the New Classical Economics favoured particularly in American universities and the so-called 'New Keynesianism' now widely adopted in central banks. Both these schools claim that the rate of growth of money (in the sense of money in bank accounts) is unimportant to macroeconomic outcomes. As Congdon notes, one message of the Northern Rock affair is that events in the banking system have a powerful influence on aggregate demand and inflation. In the paper's words, members of the two schools should 'check the facts and reorganize their theories in the light of the facts'.
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