Bubblenomics will fuel total demand in the British economy

Allister Heath

IF THE UK economic rebound continues, the total amount of demand in the economy is likely to rise more strongly than most people realise. I write this even though I don’t think that the recovery is ultimately sustainable: it remains based on rock-bottom interest rates, excessive consumption, insufficient investment and will in any case eventually be constrained by supply-side bottlenecks. But even though the medium-term outlook for the economy is grim, the short-term prospects for demand are good, thanks in part to chancellor George Osborne’s silly schemes to subsidise credit and home-buying.

One way of assessing this is to look at the supply and velocity of money. Simon Ward of Henderson believes that the adjusted broad money supply is up by 5.2 per cent on a six-month annualised measure. Given that the speed at which money is changing hands may also have risen because it is so costly to hold cash, demand is now probably growing at a rate which will eventually trigger inflation or greater bubbles and requires a tighter, not a looser, monetary policy.

If you remain unconvinced, another way to gauge demand is to look at national income growth, unadjusted for inflation – there was much talk a few months ago that Mark Carney would move from targeting consumer price inflation to targeting some measure of nominal GDP, but the Bank has now rejected this (using rather flimsy and unconvincing arguments). If the Bank of England is right that the economy will grow 2.4 per cent next year, and making a conservative guess that inflation (on some plausible measure) will come in at 2.6 per cent, nominal GDP would therefore increase five per cent.

That is the sort of growth that many of those who seek to target nominal GDP would be happy with. In reality, inflation will probably be higher on consumer price measures (though the GDP deflator measure, which is usually used for such matters and which includes the public sector, is a tricky beast to predict and understand). Regardless of details, this is not the kind of growth rate to panic about and suggests, given all the lags and uncertainties, that interest rates should be starting to go up now.

Some economists – following in the footsteps of F.A. Hayek, Dennis Robertson, Evan Durbin, Francis Edgeworth, Robert Giffen, Gottfried Haberler, among many others – believe that the best rule for monetary policy is the so-called productivity norm, which allows average consumer prices to go down when productivity rises and prices to go up when productivity falls. Crucially, this makes a distinction between good deflation (caused by technological progress) and bad deflation (caused by deficient demand). Under this rule prices would have risen during the past few years to reflect the collapse in productivity – but they would now have started to fall again to reflect its increase in 2013. Under a productivity norm, the central bank would target nominal GDP growth at the weighted average of labour (and possibly capital) input growth rates. Under this rule too, interest rates ought to be rising. This approach is explained in Less than Zero, a brilliant book by George Selgin of the University of Georgia published by the Institute of Economic Affairs.

One other interesting point to have emerged from the Bank of England’s shake-up is that it may be too optimistic about productivity growth and hence too pessimistic about the speed at which unemployment will fall. The Bank is assuming that GDP will rise by 2.5 per cent per annum over the three years to mid-2016. As Ward points out, its prediction that the unemployment rate will be a little above seven per cent by then assumes that productivity will increase 1.5-1.75 per cent per year, even though it grew by just one per cent a year over the ten years to 2012. No wonder the markets are so unsure about Carney’s guidance.

Follow me on Twitter: @allisterheath