The RBA and monetary policy

Gerard Jackson
BrookesNews.Com
Monday 28 February 2005

My last article on the Australian economy caused some readers to raise questions about the “right quantity of money” and how to adhere to it. One wrote: “Presumably when you refer to them [our economic commentators] not being alarmed you are referring to their incorrect thinking that the boom will continue.”

This is not what I meant. I don’t believe for a moment that the RBA (Reserve Bank of Australia) believes the boom can be sustained indefinitely. What bothers me is that it is not alarmed by its reckless monetary policy. The fact that none of our economic commentators seem to think there is any connection between our so-called boom and the RBA’s loose monetary policy is equally alarming.

The same reader asked: “what is the right rate [of monetary growth] and how is this determined?” There is really no answer to this question when countries are on fiat standards. If the world were on the old gold standard then the market would decide the optimum quantity of the stock of money.

For example, during the period 1874-1900 wholesale prices fell by over 30 per cent in Britain while both real wages and money wages rose considerably. These trends were created by new cost-reducing technologies that were quickly embodied investments that increased productivity at a rate that exceeded the output of gold.

As Britain was on a gold standard the result of increased productivity was a steady fall in prices. Of course, as prices fell the value of gold rose, which is another way of saying the demand for gold increased. Nevertheless, most economists and economic historians still describe the period as one of deflation

The point is that the market basically determined the quantity of money (gold), the supply of which at any time was always sufficient to meet the demands of a growing economy while equitably spreading the fruits of technology by lowering prices.

Under the present regime of monetary mismanagement any general fall in prices is defined as deflationary, and the ideal state as one in which the price level remains unchanged. As we just saw, not every fall in general prices is caused by deflation, a situation of monetary contraction.

Moreover, attempts to stabilise the price level will not prevent booms and busts, as shown by America’s 1920s boom that was followed by the Great Depression. The result is that there is no monetary “middle ground.” So long the world sticks to fiat money booms and busts are inevitable.

It’s easy to assume that the RBA doesn’t even believe that money really matters all that much. In case anyone thinks I’m drawing a long bow here I should draw their attention to the report of England’s 1959 Radcliffe Committee that concluded money supply didn’t matter because the velocity of money was uncertain and what really mattered was “total liquidity.”

This view should have been permanently put to rest in 1969 by A. A. Walters of the London School of Economics when he showed “total liquidity” to be an empty concept.

Nonetheless, I suspect that the conclusion of the Radcliffe Report still carries influence in the Reserve and the Treasury. Several years ago a former Treasury official argued with me that one can target or even measure the money supply because of ‘money substitutes.

This is an extremely dangerous error. Money supply can be targeted and money defined. I pointed out, to no avail, that so-called money substitutes, sometimes called intermediaries, quickly lose their alleged status as money substitutes when the RBA slaps on the monetary breaks.

Gerard Jackson is Brookes’ economics editor