BrookesNews.Com
Monday 22 August 2005
Every recession, like every economy, has its own characteristics, even though the cause is always the same. (I am, of course, talking about the ‘trade cycle’ and not simply economic fluctuations). This means that, irrespective of what some critics think, the Austrian theory of the trade cycle applies equally to the Australian economy.
Regular readers will know that the Austrian theory of the trade cycle explains how credit expansion triggers a boom that eventually results in recession. Because of the nature of economics there is no law that can tell us how long the boom will last or how deep and lasting the recession will be.
Let us assume that every dollar of massive credit expansion goes into investment. The situation becomes fairly clear cut to those who subscribe to the Austrian view. There will be over-investment in the higher stages of production relative to the consumptions stages. In due course the higher stages will undergo a profits squeeze while demand for consumer goods will accelerate.
It has been specifically argued that the Austrian analysis ignores the fact that a great deal of credit is spent by consumers, thus invalidating the analysis. Douglas Jay is one of those economists who tried to stress this objection. (Sterling, Oxford University Press, 1986, pp 196-197). But Jay wrote a grossly misleading description of Austrian trade cycle theory.
Any Austrian would readily accept that if consumers commanded all the newly created credit this would start a consumer boom. But the chief characteristic of the trade cycle is that it appears to be driven by business investment and not consumer spending. There are profound differences between the two situations that completely escaped Jay.
Let us return for a moment to the Roaring Twenties. It is generally believed that the US economy enjoyed an uninterrupted boom from 1921 to 1929. Not so. In 1924 the economy slowed considerably. The Federal Reserve Index of Industrial Production dropped from more than 100 at the beginning of the years to 85 by summer time. It was clear the economy was going into recession. The Fed’s response was to raise the reserve of the member banks by 17 per cent. (The expansion actually started in December 1923). Member banks deposits grew by over 14 per cent from March 1924 to June 1925.
Naturally there was a significant increase in deposits outside the system. This monetary stimulus quickly turned the tide and production speedily picked up. There was another rapid monetary expansion in 1927. In December 1928 the Fed froze the money supply and in July 1929 it became clear that the economy was sliding into recession.
What we see is that rapid monetary spurts in 1924 and 1927 halted a slide into recession. However, once the monetary tap was completely turned off output contracted and the economy went into recession. Therefore the behaviour of the monetary authorities can even confound predictions based on observable trends and output data.
In early 1999 business investment in Australia took a turn for the worst and the current account deficit had blown out to 5.2 per cent of GDP. Things were beginning to look grim. Now the March quarter for 2001 revealed that manufacturing output fell by 2.2 per cent, a figure that exceeded industry predictions and which followed successive falls in the December and September quarters. Furthermore, output had been falling during the previous 12 months. Firms were cutting back on investment, shedding labour, introducing short-time working, and profits were declining.
These indicators for 1999 and 2001 clearly signalled, as I said at the time, an impending recession. So what happened to it? Nothing and that is why I drew attention to monetary policy and the 1920s boom. The following chart reveals a relentless monetary expansion from January 1996 to June 2005. The unbroken line represents M1, the broken line is bank deposits and the dotted line is currency. It is clear from the chart the credit expansion is the prime component of money supply.
A more detailed look at the chart would show that M1 rose by 22 per cent in 2001 and that credit exploded by 25 per cent. The following year saw M1 contract by -9 per cent and then expand in 2003 by 10 per cent and 2.4 per cent in 2004. The next chart shows the change in M1 from last January to June. There was a steady increase from about the middle of until late April when money supply quickly accelerated from 167.7 to 176, a 5 per cent rise. This gives an annual average increase of 20 per cent.
The last chart came from the RBA’s Liabilities and Assets - Monthly - A1. This shows that the bank’s assets had increased from 69,715 (these figures are millions) in April to 86,221 in June. This is a 19 per cent rise in three months. In order to acquire assets the bank must write out cheques. In other words, this is more evidence that the bank has been expanding the money supply. It certainly helps explain why M1 started to rapidly rise in April.
I think readers can now see why I believe the 1920s Federal Reserve’s monetary policy is so instructive. The RBA’s monetary policy reminds me of the inter-central bank conference at New York, in July, 1927. It was here that Benjamin Strong told Charles Rist, Deputy Governor of the Bank of France, that he was going to give “a little coup de whiskey to the stock market,” meaning he was going to give it another monetary shot in the arm. It looks like the RBA has the same idea. And like Strong, I very much doubt if it really knows what it’s doing.
Gerard Jackson is Brookes’ economics editor