While austerity receives the bulk of attention for the United Kingdom’s rising unemployment, the real culprit is tight monetary policy.
In the third quarter of 2008, the United Kingdom and Canada had roughly similar unemployment rates (Canada at 6.1 per cent, the U.K. at 5.9 per cent). Canada’s rate rose rapidly until mid-2009, and has been in slow decline ever since. The U.K., on the other hand, had a much smaller increase in the unemployment rate until mid-2009. Unemployment stayed relatively level until late 2011, when we saw a sharp increase. (See attached chart)
If the same global trends were affecting both the U.K. and Canada, we would expect to see the unemployment rates in the two countries move in tandem. But that has not at all been the case. We need an explanation to the following two questions:
Why was the spike in the unemployment rate so much more pronounced in Canada than the U.K. immediately following the financial crisis?
Why has unemployment escalated in the U.K .since mid-2011 while Canada has enjoyed modest improvements?
The answer lies in monetary policy. The Bank of Canada allowed the growth rate in the M3 money supply in Canada to fall sharply during late 2008 and 2009, while the United Kingdom’s growth rate stayed relatively stable until 2010. M3 is a broad measure of money which includes bank notes and coins, deposits in banks along with money market funds. (The M3 money supply should be seen as a potential target, not a policy instrument controlled directly by the central bank) Given that the U.K. faced a banking crisis while Canada did not, it is a remarkable achievement that the UK was able to keep its unemployment rate lower than Canada’s until mid-2009. (See second chart attached)
In 2011, however, the Bank of England put the brakes on M3 growth, with M3 year-over-year growth falling each quarter. At the same time, the Bank of Canada kept M3 growth at a steady 7 per cent and saw unemployment fall over the year.
The behaviour of unemployment in the two countries is exactly what monetarist theory would predict – a sharp fall in the growth of the money supply will lead to reduced economic growth and an increase in the unemployment rate. Of course, that should not be taken to mean that high levels of monetary growth will lead to higher levels of prosperity; the 1970s taught us the folly of that kind of thinking. Rather, we should understand that a “ sustained decline of the money supply” leads to a rise in the unemployment rate.
While fiscal policy and austerity receive the brunt of attention, the growth rate of the money supply does a much better job of explaining the rise of the Canadian unemployment rate in 2008-2009 and the U.K. unemployment rate in 2011-2012.
Mike Moffatt is an Assistant Professor in the Business, Economics and Public Policy (BEPP) group at the Richard Ivey School of Business – Western University. Mike also does private sector consulting for the chemical industry and can be found on Twitter at https://twitter.com/#!/MikePMoffatt.