By Shiang Jin, Chin
Part of the article published on Felix , the imperial college student newsletter
When I read the book “Money Mischief – episodes in monetary history” by Milton Friedman borrowed from Imperial college central library, I was puzzled by the hypothesis story of money dropping out from Helicopter.
The story goes like this:
Suppose, there is a hypothetical community where the average annual income is ￡20,000 per person, and people like to keep a cash balance equal to 5.2 weeks of consumptions, which is about ￡2000.
At one day, a helicopter flies over one hypothetical community and drops additional printed paper of money equal to the amount already in circulation – say, ￡2000 per person, and people believe that the event is unique and will never happened again.
Now, what will the people do? Clearly, nothing have changed that made if more desirable to hold more cash balance than before, hence, people will like to increase their consumption and reducing cash balances until it is back to former level.
However, as the income of the people remains the same, he/she will eventually spend more than he/she receives.
But one person’s expenditure is another person receipt. The community cannot spend more than what they originally receipt, unless, they bid up the price of goods and services. At the end, the nominal income will be doubling the original income, while the number of real goods and services effectively remain the same.
Hence, Friedman concluded that “the usefulness of the money to the community as a whole does not depend on how much money there is, doubling or halving the number of dollars simply means that the numbers written on price tags are doubled or halved.”
If central bank can stimulate real growth simply by printing out more money, they will have already done so long time ago. The recent Bank of England (BoE) research report affirmed Friedman theory. While Quantitative Easing of ￡200bn may have an initial macroeconomic impact of 1.5% to 2% , it was quickly followed by the increase in CPI ( consumer price index, key index for inflation) about 1.5%, as shown in the graph below. Inflation may help reduced unemployment according to Keynesian doctrine, but it will not benefit the underlying economic at the long term.
Figure 1: the qualitative impact of QE, Source : Bank of England Quarterly Bulletin 2011 Q3
Hence, one would wonder why the Bank of England, fully aware of the benefits and danger of Quantitative easing program, still pressed ahead a new round of QE by creating £75 bn of “money” electronically to buy gilt (Uk government bond). My guesstimate for the reason behind Bank of England Monetary Policy Committee’s decision is that, despite lack of immediate threats that needed to use such desperate measure, approving this round of quantitative easing, was a logical , but not certainly right thing to do.
First, the negative effect of QE (inflation) appeared to be smaller than what we have feared. Although the BoE had injected capital equivalent of 14% of GDP into the economy, the inflation accounted by the QE so far, was 1.5% max, which is small compare with the money injected. Besides, since the broad money aggregate M4, reached its peaked at January 2010, the growth of broad money (M4) had been stagnant, and even declined since then. This suggested that given the velocity of circulation for Money unchanged, we will soon facing the deflationary pressure instead of an inflationary one. Hence, the inflation effect of second round of QE (QE2) will be small and offset by the deflationary pressure that we now facing.
Second, whether originally intended or not, QE2 will buy more time for the coalition government, for George Osborne fiscal consolidation plan and austerity measure to work. As the coalition government is freezing spending, cutting civil servant jobs, and reducing social welfare payments, UK economy, measured by gross domestic product figure (GDP), had grown slower than expected. This will hurt the growth of tax revenue, and delaying George Osborne timetable for deficit reduction. QE2 can help in 2 ways, on one hand it can create a positive impact on GDP growth in short time horizon, on the other hand it can inflate the economy, thus reducing the cost of any tax reduction the coalition government implement before ( such as the income tax allowance, if inflation caused the wages and price rise in nominal term, the actual income tax allowance that the workers get in real term will be smaller in real term). Besides, by lowering the yield on 10 year government bond through QE2, the BoE managed to reduce the borrowing cost for the coalition government, when interest payment for government debt already accounted for 7% of the budget expenditure.
Thirdly, QE simply distribute the price that we have to pay for the pass mistake we made regarding the UK economy. We decided to have a national insurance program that has funding deficit problem, we decided to have a trident weapon program, best of the thing that we would buy like we shopping in Harrods , when both the military strength and nuclear warfare threat is declining. We committed ourselves into war in Iraq and Afghanistan, when the royalists paramilitary group from Ireland had committed more terrorist acts to UK than Al-Qaeda and Taliban. We decided that finance sector is the future of the city and nation, hence adopting policy that gradually results in the declined of UK manufacturing sector. We voted that everybody should have right to access food, shelter, minimum expense for living, that we created a social welfare system to taxed the working class in order to feed those lazy to work. We are too optimistic that boom time will never end, house price will never fall, until we failed to fixed the budget and save for future during good year.
Hence, unless we want to shed more public sector jobs, significantly reduce the funding for school and hospital, or cutting off the support for those relied on public pension scheme and social benefits, everybody have to share the burden. Therefore, the BoE is simply making the decision for us. Unfortunately, middle-income class is always suffered worst when austerity measure or inflation is happening. The best advice is, think for the cost before we vote, cause we will need to pay for it at the end, one way or another.
Reference Bank of England Quarterly Bulletin 2011 Q3
Bank of England website
http://www.bankofengland.co.uk/
HM Treasury spending review 2010
Friedman, Milton. Money mischief: episodes in monetary history. 1. ed. Toronto: Harcourt Brace Jovanovich, 1992. Print.
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