That Australia is especially affected by commodity price movements, mining booms, wage pushes and drought means that these factors, according to Downes, influence the degree of any downturn or recovery, and three factors mainly determined short-run activity with a further five having a dampening effect on them. The three factors are: the building cycle, the inventory cycle and the investment accelerator.

The five factors are: short-term demand leaking into imports, responses from the state sector, the impact of rising labour costs as activity intensifies, higher prices as activity intensifies, higher interest rates and an appreciating currency as demand rises. And it is the labour markets and the financial market that have the most dampening influences on the business cycle.

The only thing right about this is the statement that there is no such thing as a business cycle, the name of the alleged boom-bust periods that are supposed to be an inherent part of capitalism. Now for some of Downes’ factors:

1. There is no inventory or building cycle

2. There is no accelerator

3. Demand proper does not leak into imports

Basically what happens is that the Reserve drives rate of interest below its market rate and expands the supply of credit. The newly created credit is then employed in projects for which all the factors necessary for their completion are not available. In other words, the lower rate of interest has misled businessmen into thinking that real savings have increased and that additional capital goods are now available for lengthier projects.

Now interest is the means by which the supply of capital goods are brought into balance by the demand for capital goods and which allocates them through time. It follows from this line of reasoning that artificially lowering the rate of interest therefore expands demand for producer goods without increasing their supply. (For the sake of simplicity I have ignored the phenomenon of ‘forced savings’).

This ‘cheap money’ policy fuels speculation and housing: eventually prices begin to rise as does the demand for imports in response to the increase in monetary demand which also misdirects production. As prices rise the price premium also rises causing nominal and eventually real interest rates to rise.

At some point the central bank is forced to apply the monetary breaks, the country goes into recession, unemployment rises, excess capacity emerges and inventories pile up. Of course, as Australia imports most of its capital goods a great deal of the newly-created bank credit will immediately be directed to foreign producers of capital goods.

So rather than attenuate any cycle we find that the rise in imported capital goods is only one of the ingredients of our credit-generated boom. Even if Australia implemented a sound money policy the inflationary policies of other countries would still destabilise us. (This is not an argument against such money policies. Their absence has caused much damage to the economy).

As other countries inflate they increase their demand for our products thereby causing us to direct investment into those lines of production; when they finally call a halt to their inflationary policies demand for our exports fall and this reverberates throughout the economy. The extent of the immediate damage is really determined by the degree to which resources were shifted to those export sectors. (Although members of Australia’s so-called economic commentariat casually dismiss this view they still refuse to debate it).

Regular readers will have quickly realised that this is a very broad outline of the Austrian school’s theory of the boom-bust phenomenon. Downes and MacFarlane have, however, made it clear that our economists are still stuck in a Keynesian rut despite any protestations to the contrary.

We now come to Knut Wicksell, a prominent Swedish economist of the late nineteenth and early twentieth centuries. It is necessary to refer to Wicksell because Glenn Stevens, the RBA's current governor, stated that in targeting the correct rate of interest the Reserve relies on Wicksell's "concept of the natural or neutral interest rate". (Recent Issues for the Conduct of Monetary Policy, 17 February 2004).

However, the "natural rate" rule — as it is normally understood — is based on the marginal productivity of capital as it would be in a barter economy. This would be impossible because of the heterogeneity of capital goods. (Additionally, he also assumes that productivity directly influenced interest rates). What Wicksell overlooked is that a uniform rate of interest can only emerge in a monetary economy[1. What this boils down to is that the Reserve is targeting a phantom.

Despite the RBA's use of Wickell's natural rate of interest it seems to me that no one at the Reserve has actually read the man, suggesting that their knowledge of his work comes from third-hand sources. How else can one explain the Reserve's ignorance of Wicksell's work on the relation between interest, prices, investment? Wicksell — unlike the Reserve — understood that there exists a production structure. As he put it:

Now let us suppose that the banks and other lenders of money lend at a different rate of interest, either lower or higher, from that which corresponds to the current value of the natural rate of interest on capital. The economic equilibrium of the system is ipso facto disturbed. If prices remain unchanged, entrepreneurs will in the first instance obtain a surplus profit (at the cost of the capitalists) over and above their real entrepreneur profit or wage. This will continue to accrue so long as the rate of interest remains in the same relative position. They will inevitably be induced to extend their businesses in order to exploit to the maximum extent the favourable turn of events. And the number of people becoming entrepreneurs will be abnormally increased. As a consequence, the demand for services, raw materials, and goods in general will be increased, and the prices of commodities must rise. (Knut Wicksell, Interest and Prices, Sentry Press New York, 1936, pp. 105-106).

In other words, when the money rate of interest falls below the "natural rate" economic expansion will be stimulated. Let's us look at this in terms of the current situation. From March 1996 to December 2007 currency rose by 110 per cent, bank deposits by 178 per cent and M1 by 163 per cent. (These are the kind of monetary figures that would have appalled Wicksell. Moreover, this monetary explosion happened during Macfarlane's governorship).

However, from December last year — when money supply peaked — to May, bank deposits and M1 fell to 176.6 and 216.3 respectively. This means bank deposits contracted by 7.7 per cent and M1 by 6.5 per cent. While June showed an increase in these aggregates they still remained below the December level.

Now Wicksell pointed out that if a cheap money policy is maintained then the continual rise in "commodity prices" must eventually raise interest rates[2. Now this was not a business cycle theory, even though Wicksell came tantalizingly close to making it one. In fact he called the business cycle an "enigma" (Ibid. p. 223) and a "puzzling phenomena" (Knut Wicksell, Lectures on Political Economy Vol. II, George Routledge & Sons LTD, 1935, p. 209).

1.Arthur W. Marget argues that Wicksell's "natural rate" was wrongly translated with "deplorable results". (Arthur W. Marget, The Theory of Prices, Vol. I, Prentice-Hall, Inc., 1938, pp. 201-204).;

2. It was Wicksell's opinion that it was not possible to permanently keep the money-rate of interest below the "natural rate" because the continual monetary expansion this policy requires would lead to a disproportional rise in commodity prices that would force the banks to adjust the money rate to the "natural rate". Unfortunately he did not describe the process by which this occurred. It was von Mises who carried Wicksell's insights to their logical conclusion.

Gerard Jackson is Brookes’ economics editor

Subscribe to BrookesNews Bulletin