In a recent speech, Mervyn King, Governor of the Bank of England, claimed there was a shortage of money in the British economy. This shortage, he argued, was a drag on economic growth and threatened to push inflation below the 2% target over the medium term, a prospect warranting consideration of a further round of “quantitative easing” (QE).
 
Mr King’s diagnosis is faulty. Far from a shortage, there may be surplus money circulating in the economy at present. This means a further injection of liquidity by the Bank’s Monetary Policy Committee (MPC) could boost prices rather than economic activity, sustaining the current inflation overshoot.
 
The Governor’s claim stems from recent slow growth in the broad money supply – the stock of savings held by consumers and companies in the form of notes and coin and bank and building society deposits. Broad money has risen by only 2% over the last 12 months, compared with an average annual growth rate of 7% over the previous decade.
 
Any judgement about money supply adequacy, however, must also take into account the velocity of circulation – the rate at which the existing money stock turns over. A rise in velocity has exactly the same economic impact as an expansion of the money supply itself. Velocity has surged over the last year and there are grounds for believing this pick-up will continue. This means monetary conditions are much looser than Mr King and his fellow MPC doves claim.
 
Velocity is calculated by dividing gross domestic product (GDP), measured at current prices, by the money supply. The recent increase is unusual: over the last 50 years, broad money velocity has fallen by 0.5% a year on average.
 
To support real economic growth of 2.5% a year along with inflation in line with the 2% target, money supply expansion and the change in velocity must add up to 4.5%. If velocity were to decline at its historical 0.5% rate, broad money would need to expand by 5% a year rather than the current 2%. This explains why many economists are calling for a further infusion of liquidity.
 
The trend in velocity, however, is not fixed but depends on the relative attraction of money as a store of savings. When deposit-account interest rates fall below inflation, as at present, families and firms have a strong incentive to economise on money holdings, resulting in an increase in the rate at which the existing stock turns over.
 
One way of getting rid of excess liquidity is to spend it – this provides a direct boost to the economy and prices. Savers will also attempt to move money into other assets offering either higher yields or greater perceived protection from inflation. Resulting increases in asset prices lift wealth and confidence, thereby supplying an additional indirect stimulus to economic activity.
 
Recent news fits this story. Economic growth and, especially, inflation are running well ahead of Bank of England and consensus forecasts. Current-price GDP has risen by a bumper 6% over the last year. With broad money up by only 2%, velocity has climbed 4% – the largest annual gain since 1980.
 
Further evidence of a “dash from cash” includes record retail buying of mutual funds and a decline in institutional investors’ “liquidity ratio” – the proportion of their portfolios held in money and short-term securities.
 
Meanwhile, equities, bonds, housing, commercial property, commodities, art, antiques and fine wine have all appreciated, in some cases substantially, over the last year – strongly suggestive of surplus money rather than the Governor’s mooted shortage.
 
The recent pick-up in velocity contrasts with a slump during the financial crisis as investors scrambled to reduce exposure to markets. This decline, coupled with a slowdown in money supply growth, imposed a vicious monetary squeeze on the economy, explaining the recession’s severity and justifying the first round of QE launched in March 2009.
 
Those arguing favour of further monetary stimulus now implicitly assume that the velocity rise will slow sharply or reverse. The shift in financial behaviour, however, may be at an early stage, with many families and companies yet to take on board the MPC’s message – reinforced by the Bank’s Deputy Governor, Charles Bean, in a recent interview – that monetary savers should expect to suffer a sustained erosion of their real wealth.
 
In the 1970s, when interest rates were last held beneath inflation for a sustained period, broad money velocity rose by 39% over six years, or almost 6% a year. If such an increase were repeated now, the current 2% rate of broad money expansion would deliver a large inflation overshoot.
 
More QE, therefore, would be dangerous. Money supply trends may be starting to improve, with annual growth up from 1% in the summer. A further QE injection could have more powerful effects than last year, when additional liquidity was partly absorbed by capital-raising by banks. It could increase surplus money in the economy, resulting in higher inflation and new asset price bubbles.
 
Rather than further stimulus, the Governor and his colleagues should be discussing restoring positive real interest rates to reflect the normalisation of economic and monetary conditions. An increase would help rebuild the MPC’s tattered inflation-fighting credibility as well as promoting necessary economic balancing. The Governor should take away the punch bowl instead of threatening to spike the cocktail and turn up the party music.

An edited version of this article appeared in today's Daily Telegraph.