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Will the Reserve's monetary policy sink the Australian economy
Gerard Jackson
A great many people are greatly relieved now that the Reserve Bank of Australia has not upped the cash rate. I fear, however, that these sighs of relief might be a little premature. After all, what good is a falling or steady interest rate if you don't have a job?
For sometime we were warned that deficits raised interest rates. It logically followed that surpluses would lower rates. So why have rates been rising even though Australia is accumulating surpluses? Because there is a lot more to economics than our commentators are ever likely to discover — and that includes those economists who work for the RBA and who seem to see economics as consisting of a mass of simultaneous equations.
Our economic pundits' incredibly naïve views about interest rates and deficits is evidence enough that they have no business writing economic commentary. Interest rates are not a monetary phenomenon and are therefore not set by the demand for and the supply of money. Interest is the price of time and not money. Of course it is perfectly true that monetary policy can greatly influence rates. This is why so many business men argue that central banks should lower rates. But the result of a 'cheap money' policy is to set in motion economic forces that must eventually force the central bank to raise its rates. And this is precisely what has happened in Australia.
The cash rate now stands at 7.25 per cent as against 4.25 per cent in December 2001. That this inexorable rise had been initially triggered by pushing the cash rate below its market rate does not seem to have occurred to our economic mavens. In order to keep rates from rising more and more credit must be injected into the economy, which in turn distorts the capital structure by sending out false price signals to businessmen.
If this is so then there must have been considerable monetary expansion during the last 12 years. And indeed there has been. Now for some recent monetary history. 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 - A1). It is this monetary expansion that fuelled the housing boom, generated a massive current account deficit and a rising CPI. (By the bye, whatever happened to the view that a domestic surplus would also bring about a current account surplus?)
This brings us to the fallacy that inflation is caused by rising prices. Hence much of our present inflation is due to "soaring oil prices". The first thing to note is that we had the same problem under Gough Whitlam in the early 1970s and the same sorry excuse was used. It should be obvious that what is being argued here is that a reduction in the supply of petrol will cause all prices to continue to rise with a fall in their supply. But how can this be if the quantity of money remains unchanged?
If $100 buys x amount of goods it should be clear that if the prices of these rise the $100 will buy fewer goods. (I shall deal with the equation of exchange and velocity at another time). The only way this situation can be avoided is for the central bank to expand the money. Therefore one needs to make the distinction between goods-induced changes in purchasing power and money-induced changes.
Moreover, it has eluded them that the major element behind the current boom in oil prices may very well be a massive world-wide credit expansion. We should take as evidence the amount of "surplus saving" that emerged in the global economy. In fact, the idea that surplus savings can emerge is another economic fallacy. What economists were really looking at were accumulating bank deposits created by a massive credit expansion. But a link between credit expansion and the demand for commodities is not something our economic commentators even believe exists.
If economic commentators really had their eyes on the monetary ball they would have noticed an ominous change in the Reserve's monetary policy that began last December. It was then that monetary expansion reached its peak. Currency stood at 39.2, bank deposits at 187.1 and M1 at 226.4. This year has seen a remarkable change in these aggregates. 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 were down by 7.7 per cent and M1 by 6.5 per cent.
In case anyone has yet to get the message — this is called deflation. So while our economic pundits concern themselves with inflationary trends we find that the Reserve has put monetary growth into reverse. A deflationary policy always results in recession. For that reason Australia is truly on the edge.
Gerard Jackson is Brookes' economics editor
BrookesNews.Com
Monday 28 July 2008