Anyone who says “I told you so” is liable to make himself or herself unpopular, but it would require the humility of a saint to keep quiet when a bold forecast proves to have been largely correct.

In evidence to the House of Commons in February last year I warned that by the spring of 2008 the Bank of England would be “in quite serious trouble” by the standards of the Nice (non-inflationary, consistently expansionary) years from the early 1990s. I said an inflation rate of 4%-5% in 2008 or 2009 would not be “a surprising sequel” to policy mistakes “since mid-2004”. I suggested that interest rates might have to be raised to 6%-6.5% “to bring inflation back to target in 2009”. I did not give a precise forecast for the year from mid-2008, but proposed an inflation rate of 4%, an output growth rate of 1%, falling house prices and 6.5%-7% base rates.

This was — by a wide margin — the most pessimistic prognosis being given by any commentator at the time. It has turned out to be mostly right. Only on interest rates do I seem to have been too gloomy, since Bank rate is now 5%, though the credit crunch and the strains in the money markets did result in an average three-month inter-bank rate of 6.3% in the second half of 2007.

Why was I so worried in early 2007? And what had the Bank of England got wrong “since mid-2004”? The answer is that from mid-2004 to early 2007 the Bank of England had allowed too rapid growth of the quantity of money. In the balanced and stable Nice years — that is, the decade to 2004 — the growth rate of the M4 money measure averaged slightly more than 7.5% a year. But in the three years from mid-2004 this figure jumped to over 12%. (M4 includes notes and coin, and virtually all bank and building-society deposits.)

I am not claiming that money numbers are easy to interpret or that the inflation risks in the latest episode of high money growth were obvious. On the contrary, money numbers are complex and often baffling, and in the past few years they have been particularly so. As Milton Friedman famously remarked decades ago, the lags between money and inflation are “long and variable”.

Most money consists nowadays of bank deposits, but a deduction is necessary for artificial deposit creation between financial institutions and within banking groups. In 2006 and 2007 such artificial deposit creation was on a huge and bewildering scale, and undoubtedly puffed up money growth. Further, the inflation risks in double-digit money growth were far from compelling for much of 2005 and even in early 2006, since demand (consumption, investment and so on) was sluggish.

But by mid-2006 the Bank of England ought to have realised that something was wrong. As the Bank itself publishes enough information for an analyst to identify the scale of artificial deposit creation, it ought to have known that underlying money growth had accelerated to a double-digit rate and posed an inflationary threat. Companies were flush with cash, takeover activity was boosting share prices, rapid house-price inflation was stimulating consumer spending, and so on. The year 2006 and the early part of 2007 had several hallmarks of the upturn phase of earlier cycles. For me the similarities between the 18 months to mid-1973, to mid-1988 and to mid-2007, all of which included irresponsibly high money growth, were strong enough to raise the alarm.

In the last Inflation Report, the Bank had the gumption to publish a chart with a money-growth series adjusted for artificial deposit creation. With such deposits deducted, M4 growth in 2005, 2006 and early 2007 was a little lower than on the original series, but was still above 10%. Given the long-term relationship between money and inflation, the conclusion cannot be escaped: the Bank of England made a policy error in this period by failing to curb money-supply growth.

Where do we go from here? As far as the economy is concerned, the situation has changed radically since the start of the Northern Rock crisis a year ago. Banks are still expanding their balance sheets, by absorbing the business carried out during the boom by their prodigal offspring — conduits, special investment vehicles and such like. But they have cut back sharply on new credit to important outside customers, such as companies and homebuyers.

The chart of adjusted M4 growth in the May Inflation Report shows that the bank deposits of the latter are now growing much more slowly than in 2005 and 2006. Indeed, money held by companies has been falling in the past few months, while cost pressures — from higher energy and input prices — are severe. The result is a corporate liquidity squeeze reminiscent of that in the busts of 1974, 1980 and 1991. Speaking more generally, a large fluctuation in money growth has again been associated with a boom-bust cycle for the economy as a whole.

In his first year as chancellor in 1997 Gordon Brown gave the Bank of England operational independence on interest rates. This is widely viewed as the best decision he ever took and the Bank paid him back with several years of brilliant management. But the Bank has mismanaged money since mid-2004 and Nice-ness has been replaced by another boom-bust cycle. Brown must now cope with the political fallout. Some commentators have hinted that he may try to overcome the monetary straitjacket by “fiscal reflation”, with tax cuts and yet more increases in public spending. That would be the height of folly.

One of the prerequisites for the stable macroeconomic conditions in the 15 years to 2007 was fiscal responsibility. Both New Labour under the economic stewardship of Brown and the preceding Conservative administration were committed to sound public finances. Both Brown and all five of his Conservative predecessors made powerful statements on the case for directing fiscal policy towards medium-term objectives such as limiting the ratio of public debt to national income. They rejected the failed Keynesianism of the 1960s and 1970s, and eschewed the use of fiscal policy as a means of managing demand.

In truth, Brown — rather than chancellor Alistair Darling — continues to direct economy policy. He should remember that in 1981 the Conservatives, confronted by the same sort of trouble as today and way behind in the opinion polls, raised taxes in a recession to bring order to Britain’s public finances and to restore financial confidence. That did not stop the Conservatives winning the 1983 general election by a landslide. Now is not the time for “expansionary” fiscal measures. Such measures would further forfeit public respect for the government and make it more difficult for the Bank of England to cut interest rates.

Tim Congdon is an economist and businessman. Between 1992 and 1997 he was a member of the Treasury Panel of Independent Forecasters (the so-called wise men) which advised the last Conservative government. He is the founder of Lombard Street Research, one of the City of London’s leading economics consultancies

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