Balanced sustainable growth with low inflation requires the monetary authorities to maintain money and credit expansion at a moderate and steady pace. Policy-makers are apt to portray the financial / economic crisis of 2008 as a “black swan event” outside their control but its roots lie in their failure to prevent a monetary boom over 2005-07. In the UK, broad money M4 and M4 lending – both adjusted to exclude the activities of non-bank financial intermediaries – grew at annualised rates of 11.8% and 12.7% respectively in the three years to end-2007. In time-honoured fashion, monetary buoyancy encouraged excessive bank risk-taking while generating higher inflation, creating the conditions for an eventual bust.

Sir John Gieve, departing deputy governor of the Bank of England, recently defended the monetary policy committee’s failure to restrain credit expansion and asset prices, arguing that higher interest rates would have depressed economic growth and it lacked other policy tools. The former point is no doubt true but the MPC’s remit is to target inflation not activity – the CPI overshoots in 2007 and 2008 are prima facie evidence that rates were too low in 2005-06. Sir John is right to highlight the need for a broader range of policy tools – including the ability to vary banks’ capital requirements and “overfund” to curb monetary growth – but the committee could have requested the necessary actions by the Treasury and Financial Services Authority under tripartite arrangements yet it failed to do so.

While monetary policy errors mirror those made in prior boom / bust cycles, the current financial crisis has proved much more severe because banks have suffered significant damage to their regulatory capital early in the economic downturn. This reflects a combination of factors, including greater exposure to securitised assets and international rules requiring “mark-to-market” accounting and linking capital requirements to credit agency ratings. With banks forced to adjust to losses “up front” rather than over several years, as in previous cycles, monetary retrenchment has been accelerated – adjusted M4 rose by just 3.7% in the year to September, down from 11.5% in the prior 12 months.

In the same way that policy-makers should have acted to restrain excessive money and credit expansion over 2005-07, their focus now should be on keeping annual M4 growth above 5% – the minimum likely to be compatible with trend growth and 2% inflation over the medium term. A key aim should be to foster banking sector recuperation and discourage balance sheet contraction; this requires the authorities to offer generous liquidity support, tolerate temporarily lower capital ratios and allow banks to widen interest margins in order to boost retained earnings. Direct action to support money and credit growth should also be considered, such as “underfunding” the fiscal deficit, an extension of government loan guarantees and Bank of England purchases of private-sector assets.

Unfortunately, policy initiatives to date have reinforced rather than eased the pressure on banks to retrench. Capital requirements have been raised rather than temporarily lowered while liquidity support and recapitalisation funds have been provided on onerous terms, creating an incentive to husband resources in order to make early repayment. Banks have also been prevented from widening interest margins by government demands to “pass on” Bank rate cuts, despite a smaller decline in their funding costs. Meanwhile, the authorities have so far eschewed direct monetary intervention – in contrast to the US, where the Federal Reserve is now buying private-sector assets on a large scale.

Rather than tackle the problem of inadequate money and credit growth at source, policy-makers have sought to address the symptoms by slashing interest rates, expanding the fiscal deficit and encouraging a mega-devaluation of the exchange rate. Such measures, however, are unlikely to be effective while the banking system remains dysfunctional. Indeed, cutting rates to below the Eurozone level and fostering expectations of a bottomless decline in sterling could worsen the credit crunch by triggering an outflow of foreign capital: UK banks are reliant on overseas funding to bridge a large gap between their domestic sterling lending and deposits.

The above assessment warrants a grim view of economic prospects for the first half of 2009. Monetary trends lead activity by about six months so M4 weakness during the second half of 2008 suggests further declines in output through mid-2009. If GDP were to follow an average path based on the last three recessions – a reasonable base-case scenario consistent with current economic evidence – it would fall by 0.6% per quarter over Q4 2008-Q2 2009, matching the drop in Q3 2008 and implying a cumulative 2.4% decline from the Q2 2008 peak. The average path then entails several quarters of broadly flat output before a recovery begins from Q2 2010.

Contrary to much defeatist economic commentary, however, the outlook for the second half of the year has yet to crystallise and will depend critically on money and credit trends in early 2009. A further slide in adjusted M4 expansion would signal an ongoing contraction in activity while a stabilisation at current low levels would be consistent with stagnant or slightly rising output, as in the historical average GDP path. By contrast, if the authorities took technically-feasible action to boost annual M4 growth towards 10% in early 2009, the economic recovery forecast by the Treasury and Bank of England for the second half of the year would still be achievable.

The ability of policy-makers to influence monetary trends is illustrated by recent US developments. Following the failure of Lehman Brothers in September, the focus of Federal Reserve policy shifted from interest rate cuts to direct quantitative measures to support credit and money growth. The Fed has purchased over $300 billion of commercial paper since October and plans to buy up to $500 billion of mortgage-backed securities – the combined total of more than $800 billion represents 10% of the broad money supply M2. These initiatives have contributed to a pick-up in annual M2 growth from 5.3% in August to 9.6% by mid-December. This revival justifies optimism that the US economy will hit bottom by the spring and recover later in 2009, with positive global implications.