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Australian economy: how the money supply is affecting the trade deficit and output
Gerard Jackson
Although a great deal of ink has been spilt over the state of the Australian economy the one thing that never gets a mention is the money supply, particularly the credit component. The mere thought that credit expansion has generated imbalances (malinvestments) and fuelled the current account deficit is totally alien to our economic commentators.
Growth for the December quarter came in at only 0.1 per cent. Even though this figure may be adjusted later on there can be no doubt that a slowdown is emerging. Terry McCrann argued that if we put the “September and December quarters together, demand was growing at an annual rate above 4 per cent. But overall growth was just 0.6 per cent annualised — an economy stalled”. (Herald Sun, Reason behind the rate rise, 3 March).
Producer prices are now rising at over 4 per cent a year. (The figure would have been higher if it were not for the overvalued dollar). But what seems to be overlooked by most economic commentators is that producer prices have been steadily rising since late 2001.
On closer inspection we find that from 1988-99 to 2003-04 the index of domestic materials used in manufacturing rose by 32 per cent. Thanks to the overvalued dollar imported materials rose by a mere 1.5 per cent giving a total increase of 19 per cent.
These figures should come as no surprise given our monetary expansion with M1 rising by 22 per cent and credit exploding by 25 per cent in 2001. The following year saw M1 contract by -9 per cent and then expanded in 2003 by 10 per cent and 2.4 per cent in 2004.
However, the slowdown suggests that rising producer prices are heading for a peak. Why should this be so? Last year M1 fell to 2.4 per cent over the previous year while credit dropped to 1.5 per cent. This was a per centage fall of 76 per cent and 86 per cent respectively. Nevertheless the Reserve has still left the economy awash in credit.
The following two charts amply demonstrate the RBA’s (Reserve Bank of Australia) dangerous roller-coaster monetary policy. Both chart begin with the 1996 and finish in December 2004
The Reserve’s monetary policy has distorted the pattern of production and fuelled the current account deficit. By driving interest rates down below their market levels it caused credit — I should say phony credit — to rapidly expand.
When credit expansion is allowed to continue several symptoms eventually emerge: producer prices begin to rise. This is then misinterpreted as inflationary rather than a product of an inflationary policy. “Bottlenecks”, “capacity constraints” and “skilled labor shortages appear. These too are mistakenly thought of as inflationary. Problems with debt and the current account also materialise.
In the case of the former our economic commentariat fallaciously warn that demand is exceeding production. As real demand always equals production (Say’s Law, which is greatly misunderstood), what is really being said here is that we are suffering from inflation.
Our economic commentariat are being equally fallacious when they call the current account deficit a constraint on growth, and devaluation an inflationary process. They appear unable to grasp that these problems are a product of the RBA’s inflationary monetary policy.
When the RBA expands the money supply it causes credit to expand and nominal incomes to rise. This process also increases the demand for imports as well as domestic products. Hence we can see the fallacy behind the orthodox view that “we as a nation are living beyond our means”.
Those make this argument then, without realising it, undermine it by stating that the problem is one of “excess spending across the economy”. But it should be perfectly clear where this “excess spending” originated.
An economy is like a multi-storey house. If someone allows the upstairs taps to run eventually the whole house will be flooded. Although turning the taps off will obviously stop the flow it will still take sometime for the house to dry out.
And so it is with credit expansion. The RBA can stop the flood of credit but it cannot avoid its consequences. There will always be a drying out period: this is called a recession or what the Austrian school calls the readjustment period.
So at the moment it looks as if the RBA is going to hang the Australian economy out to dry. Of course, it can always reverse itself as it did in 2001 and 2003. But that would be like a drunk reaching for another bottle in the hope it will save him from a hangover.
What is causing the falling dollar?
Peter Costello’s trade deficit fallacies and the credit crunch, part I
Peter Costello’s economic fallacies and the credit crunch, part II
Australian Reserve Bank blames others for its own folly
Gerard Jackson is Brookes’ economics editor
BrookesNews.Com
Monday 7 March 2005
