Gerard Jackson
BrookesNews.Com
Monday 2 February 2004

Rising interest rates has stimulated talk about Australia's so-called business cycle. There is certainly nothing new in this. In a paper delivered to the Melbourne Institute conference in late1997 Peter Downes, an RBA staffer, made the valid point that there is not really a business cycle because there is no regularity in these economic fluctuations.

Downes attacked the demand-side explanation for business fluctuations, asking that if we can forecast demand-driven movements in GDP in which economic activity and prices move in the same direction then why is it we cannot control these forces. The problem, according to Downes, is the complications and continual changes that influence these forces. Evidently the debate has not moved since Downes made these observations

Describing Australia as a commodity exporter and an importer of capital goods, Downes argued: "The leakage into imports of these latter items [producer goods] attenuates the impact of the investment accelerator and the inventory cycle, which consequently seem to play a lesser role here in propagating shocks over time than in other countries. This makes the movements in GDP more subject in the short term to movements in exogenous factors".

That Australia is especially affected by commodity prices movements, mining booms, wage pushes and drought means that these factors, according to Downes, influence the degree of any downturn or recovery, and three factors mainly determined short-run activity with a further five having a dampening effect on them.

The three factors are: the building cycle, the inventory cycle and the investment accelerator. The five factors are: short-term demand leaking into imports, responses from the state sector, the impact of rising labour costs as activity intensifies, higher prices as activity intensifies, higher interest rates and an appreciating currency as demand rises. And it is the labour markets and the financial market that have the most dampening influences on the business cycle.

The only thing right about this is the statement that there is no such thing as a business cycle. The business cycle is the name of the alleged boom-bust periods that are supposed to be an inherent part of capitalism. Now for some of Downes' factors: (a) there is no inventory or building cycle, (b) there is no accelerator, (c) demand does not leak into imports. Basically what happens is that the rate of interest is forced below the market rate which sends a false investment signal to businesses by expanding credit. The newly created credit is then employed in projects for which all the factors necessary for their completion are not available.

This is because the lower rate of interest has misled businessmen into thinking that real savings have increased. Interest is the means by which the supply of capital goods are brought into balance by the demand for capital goods. Artificially lowering the rate of interest therefore expands demand for producer goods without increasing their supply. (I'm ignoring the phenomenon of forced savings).

This 'cheap money' policy fuels speculation and housing; prices begin to rise as does the demand for imports in response to the increase in monetary demand which also misdirects production. As prices rise the price premium also rises causing nominal and eventually real interest rates to rise. At some point the government is forced to apply the monetary breaks, the country goes into recession, unemployment rises, excess capacity emerges and inventories pile up.

Of course, as Australia imports more capital goods in response to the lowered interest rates a great deal of the newly-created bank credit will immediately be directed to the foreign producers of those goods. So rather than attenuate any cycle we find that the rise in imported capital goods is only one of the ingredients of our credit-generated boom.

(The so-called accelerator has nothing to do with the above process. In fact, the accelerator is a myth — it does not exist. Therefore any economic analysis based on the concept of the accelerator is guaranteed to give lousy results. For a full refutation of the accelerator principle readers should turn to Professor W. H. Hutt's The Keynesian Episode: A Reassessment, chapter 17).

However, even if Australia implemented sound money policies the inflationary policies of other countries would still destabilise us. (This is not an argument against such money policies. Their absence has caused much damage to the economy). As other countries inflate they increase their demand for our products thereby causing us to direct investment into those lines of production; when they finally call a halt to their inflationary policies demand for our exports fall and this reverberates throughout the economy. The extent of the immediate damage is really determined by the degree to which resources were shifted to those export sectors.

Regular readers will have quickly realised that this is a very broad outline of the Austrian school's theory of the boom-bust phenomenon. However, it is clear that our economists are still stuck in a Keynesian mindset from which they have no intention of escaping.

Gerard Jackson is Brookes' economics editor