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Reserve Bank of Australia fails to understand the inflation threat
Gerard Jackson
Economic commentators from Terry McCrann to Des Moore have congratulated the Reserve Bank of Australia for its success in keeping Australia’s inflation rate within the 2-3 per cent bandwidth. This apparent success seems to support Mr Moore’s view that Australia can run an independent monetary policy. (In fact there is no reason at all why countries operating floating exchange rates should not implement independent monetary policies).
I believe Mr Moore represented the majority view when several years ago he confidently declared that the main argument today is not about how to get inflation down, but how to maintain medium term price stability without adversely impinging on growth (The Australian Financial Review, 22 May 2000).
Unfortunately for this view economic laws are no more determined by a majority view than are the laws of motion or gravity. The belief that there exists a rate of inflation that can be measured and controlled is an old and dangerous fallacy that permeates mainstream economics and leads to dangerous monetary policies.
Quite frankly, for anyone to express satisfaction at the present level of inflation is to admit to knowing nothing about the discoordinating effects of inflation. To claim, as our commentators do, that a low level of inflation is harmless is to accept the economic fallacy that money is neutral.
Economists of the standing of Friedrich von Hayek warned for years against the fallacy that a central bank can safely maintain a low level of inflation without causing any economic damage. Unfortunately for economic policy these warnings failed to take root and what one might call the Slichter view took hold instead.
In 1952 Harper’s Magazine published How Bad is Inflation by Sumner H. Slichter, a Harvard economics professor. A distinguished group of economists had warned that “inflation is a threat to the stability of the American economy and the security of the Western world”: Slichter responded by calling them “uncritical and almost hysterical”.
He argued that a low inflation rate, of say 2 to 3 per cent, is essential for prosperity. Dr Winfield Riefler of the Federal Reserve responded by pointing out that even if such a rate could be controlled “it would be equal to an erosion of the purchasing power of the dollar by about one-half in each generation”.
Slichter’s responded by arguing that it was wrong to believe that creeping inflation would eventually turn into galloping inflation. Twenty years later inflation had climbed to 13 per cent a year. The Carter presidency witnessed inflation wiping out over 40 per cent of the dollar’s purchasing power. And still the lesson has not been learnt.
The Austrian view, the one Hayek adhered to, does not argue that the threat of uncontrolled inflation is the real problem. It lies with the fact that money is not neutral. Therefore monetary expansion will distort the structure of relative prices even if general prices do not rise.
Once we accept that money is not neutral we are led to also accept the fact that monetary expansion, as Hayek heavily stressed, always “changes the distribution of the money stream between the various sectors and stages of the process of production. It should be obvious that this monetary process will direct factors into lines of production whose expanded output has become dependent upon the increased spending” (italics added).
Once this spending comes to an end, or becomes insufficient to cover rising costs, then unemployment will emerge. This is why even creeping inflation, which is what low levels of inflation were once called, tends to accelerate. As the effects of the increased monetary expansion work their way out misdirected capital and labour begin to appear as idle resources. This phenomenon usually induces government to inflate even further in an effort to restore output and employment.
The Austrians call misdirected production malinvestments. Now when I raised the problem of malinvestments with a well-known Australian economist, he merely smiled and then demanded to know where they are.
That protectionists do basically the same thing when they demand free traders tell them where the jobs will come from if tariffs are abolished never occurred to him. What he couldn’t grasp is that the money supply conceals the malinvestments during the process of creating them, just as protectionism tends to conceal malinvestments created by tariffs.
This means they only make their public debut when, as I have already said, the money stream slows or a profits squeeze develops due to costs rising faster than product prices. Denying the existence of clusters of inflation-created malinvestments is, as a friend of mine put it, like the captain of a ship claiming you don’t have to worry about reefs until you hit one.
Regardless of what this gentleman thinks, I do not stand alone on this issue. Dr G. P. O’Driscoll Jr wrote: “When a government’s monetary policy facilitates market pricing, individuals in that country enjoy greater economic freedom. Inflation, a sign of misguided monetary policy, not only confiscates wealth, it also distorts prices, misallocates resources [creates malinvestments] . . . .” (O’Driscoll devoted considerable time to analysing the microeconomic consequences of loose monetary policies).
What is particularly depressing is that there is nothing new in all of this. The process by which inflation misdirects production was brilliantly described by Richard Cantillon. In criticising John Lock’s theory of money and inflation Cantillon explained that though Lock
realised well that the abundance of money makes everything dear . . . he did not analyse how that takes place. The great difficulty of that analysis consists in the discovery by what path and in what proportion the increase of money raises the price of things. (An Essay on the Nature of Commerce in General, 1755).
Despite’s Cantillon’s brilliant contribution to the theory of inflation and money, I have yet to meet an Australian economist who even knows of his achievement let alone read anything by him. (Intellectual curiosity is not something Australia’s establishment right appreciates).
Denying the existence of inflation-created malinvestments results in the dangerous assertion that keeping inflation within a 2 to 3 per cent range does not pose a danger and that the real problem is to try and “maintain medium term price stability without adversely impinging on growth”.
This is like saying that even though several people just died of small pox we don’t have to take measures against it until an epidemic actually breaks out.
Gerard Jackson is Brookes’ economics editor
BrookesNews.Com
Monday 6 June 2005