It looks like the Reserve is going to give the Australian economy another inflationary shot in the arm

Gerard Jackson
BrookesNews.Com
Monday 4 August 2008

Having spent years distorting the economy's price and capital structures by flooding the economy with bank credit the Reserve finally found a cash rate that would haul in "excess demand". What most people don't understand is that there is absolutely no way that any central bank can determine the "neutral rate" of interest, the rate that equates the supply of capital with the demand for capital. (There is even some debate about the real meaning of a "neutral rate"). As the interest rate is a market phenomenon only the market can determine the true rate.

For years the Reserve has kept rates below their market level. This reckless monetary policy fuelled the housing boom, a borrowing boom and the current account deficit. And this is just some of the damage this monetary policy caused. Those who think I am exaggerating should take a look at the Reserve's monetary aggregates. There they will find that from March 1996 to December 2007 currency rose by 110 per cent, bank deposits by 178 per cent and M1 by 163 per cent (Bulletin Statistical Tables, Liabilities and Assets - Monthly).

They will also find that M1 peaked in December, after which it fell. While currency had virtually remained unchanged by May, bank deposits and M1 had fallen to 176.6 and 216.3 respectively. This means bank deposits contracted by 7.7 per cent and M1 by 6.5 per cent. This is what old-fashioned economists, the sort that Keynesians sneer at, called deflation. Going by these figures and the fact that the Reserve has yet to lower the cash rate, I think it is safe to assume that M1 has not risen. This I believe is the reason for the housing slowdown and the fall in demand for big ticket consumer items.

Even without a deflation, once the interest rate reaches a certain point it will have a detrimental impact on manufacturing. The same goes for housing and for similar reasons. However, it should go without saying that if the money supply contracts bank credit must eventually follow suit. Therefore this contraction must cause a manufacturing slowdown. And this now seems to be the case.

The Australian Industry Group PMI for July makes for sombre reading: the index dropped from 57.6 last July to 46.9. (Anything under 50 indicates contraction). Every measure of manufacturing activity was down with the exception of input prices (up from 61.1 81.3) and exports, the index for which remained basically unchanged. (I should add that it is still possible for manufacturing to contract and the demand for labour to rise even as the money supply grows).

Every economists knows — or should know — that monetary contractions always cause recessions unless they are reversed in time. (For those readers who have guessed that there is more to it than this, you are absolutely right). Yet not a single economic commentator that I know of has remarked on this situation. This can only be because our economic commentariat has no genuine knowledge of monetary and capital theory. Even worse, they utterly fail to make the connection between a loose monetary policies and the subsequent recessions.

Some commentators have said that the Reserve is trying to rope in demand to between 1 per cent to 2 per cent. It is this kind of sloppy thinking that led Terry McCrann into writing that consumer spending was "an unsustainable and economically dangerous 6-7 per cent growth rate". (Herald-Sun, Interest rate cuts aim to strike the right balance, 3 August 2008). By demand McCrann was clearly referring to dollars.

Therefore, to argue that there is excess demand is the same as saying that there are too many dollars about. Not only do our commentators fail to see this they also blame the hapless consumer for spending too much. But the whole idea of a loose monetary policy is to raise spending, particularly consumer spending. It is not so-called "greedy consumers" who are at fault but the lousy economics that central banks practise.

Now there are largely two chains of thought regarding monetary aggregates. One states that money cannot be defined and hence monetary aggregates are useless. The other declares that counting only bank credit and currency (M1) understates the quantity of money. Fortunately both these arguments were refuted more than 200 years ago by Walter Boyd.

By the words 'Means of Circulation', 'Circulating Medium', and 'Currency', which are used almost as synonymous terms in this letter, I understand always ready money, whether consisting of Bank Notes or specie, in contradistinction to Bills of Exchange, Navy Bills, Exchequer Bills, or any other negotiable paper, which form no part of the circulating medium, as I have always understood that term. The latter is the Circulator; the former are merely objects of circulation. (Walter Boyd, A Letter to the Right Honourable William Pitt on the Influence of the Stoppage of Issues in Specie at the Bank of England, on the Prices of Provisions, and other Commodities, 2nd edition, T. Gillet, London, 1801, p. 2).