Asset booms and monetary policy

Gerard Jackson
BrookesNews.Com
Monday 24 March 2008

The fallacy that increases in household net wealth as a result of rising real estate prices and share prices makes household spending more vulnerable to movements in asset prices has become the current orthodoxy. Changes in asset prices — irrespective of the nature of the assets — do not change aggregate spending, particularly household spending. The increase in net household wealth is largely the product of the RBA’s (Reserve Bank of Australia) reckless monetary policy. This policy fuelled the housing market, inflated GDP and has blown the current account out to about about 7 per cent of GDP.

Thanks to deeply ingrained Keynesian thinking the connection between these economic indicators and the money does not “compute” with our economic commentariat. None of it even shows up in so-called computer models because they too are based largely on Keynesian fallacies. Let us do what our economic commentariat never does, and that is look at the RBA's monetary aggregates.

From March 1996 to January 2008 currency grew by 110.7 per cent, bank deposits by 186 per cent and M1 by 169.2 per cent. These are massive increases by any measure. Any old time economist would have had no difficulty in relating our housing boom, current account deficit and foreign debt to the Reserve's reckless monetary policy. (Is monetary policy destroying the country's manufacturing base?).

Some years ago I started warning that the RBA will eventually have to apply the monetary brakes, which it now seems to be doing. However, it ought to beggar belief that the RBA cannot distinguish between cause and effect. That our media economic commentators cannot do so is to be expected, given their economic illiteracy. That the RBA and Treasury economists have also failed to do so is an intellectual disgrace. (How high must interest rates rise? exposes a serious error in the RBA's thinking).

Let me make this so clear that even journalists can grasp it: monetary expansion created masses of credit which was used to bid up shares and real estate. The rise in these asset prices probably encouraged households to increase spending by borrowing, which the RBA’s loose monetary policy kindly accommodated. It should be clear that the source of most of the increase in asset prices is the RBA.

If, for instance, investors lose confidence in the share market and a massive sell-off occurred this would not affect aggregate spending unless people stopped borrowing. They would only do so if they feared the onset of a recession or if there was a sufficient rise in interest rates. But once again, this brings us right back to the RBA’s monetary policy which started the process in the first place.

What we have here is the old fallacy of assuming that it is consumption that drives economies. Therefore, if consumption falls the economy will slide into recession. It is argued that a fall in consumer spending must spark a recession because it is the main component of aggregate spending. Wrong again. It is the smallest component with business spending greatly outstripping it. The reason this has escaped attention of mainstream economists — but not the Austrians who have frequently pointed out this error — is that gross domestic product is not gross at all. In fact, it leaves out a great deal of business spending on the spurious grounds that it is double counting. No wonder we keep getting into a mess.

It isn’t asset prices, household spending or the housing market we have to watch but the RBA’s monetary policy.

Gerard Jackson is Brookes’ economics editor