There is no such thing as excess savings. This is an economic fallacy that can be traced back to Jeremy Bentham who later abandoned it after James Stuart Mill had explained to him its impossibility. (The fallacy was later resurrected in 1829 by Wakefield in his Letter from Sydney and then accepted in a diluted form by John Stuart Mill). What Stevens and so many others call "excess savings" is nothing other than inflation. Let us say that $1,000,000 is deposited in a bank which then then lent out according to the banking system's reserve requirements with the result that the original deposit is pyramided into $10,000,000 of deposits.

Does the banking system now have excess savings to the tune of $9,000.000 ? Of course not. What we really have here is credit expansion — and it is credit expansion that has been fuelling the housing boom, the foreign debt and the current account deficit. The Austrian school of economics has been pointing this fact out for decades. So what are savings? They are the process of transforming present goods (money) into future goods (capital goods). The only kind of savings that credit expansion can create are "forced savings". (See Jeremy Bentham, Thomas Malthus, Henry Thornton, Knut Wicksell , Ludwig von Mises, Friedrich von Hayek, etc.)

But the "excess savings" fallacy is just one of Glenn Stevens' erroneous economic doctrines. In an address to the Australian Business Economists and the Economic Society he explained 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).

Anyone central banker who considering using Wicksell's "natural rate" as a rule has to be advised that it 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. What this boils down to is that the Reserve is trying to target a phantom.

The fact that the Reserve has — so far — been forced to raise the target cash rate to 7.25 per cent is evidence of its monetary failings. Supporters of the bank argue that it is in an invidious position where its principle concern is how to take some heat out of the economy without raising unemployment and the amount of idle capacity. The only dilemma here is of the Reserve's own making.

Last December's quarter revealed that aggregate demand was racing ahead of aggregates supply with no slowdown in sight. (Demand is defined as total spending while supply as in broad agreement with GDP). Apologists argue that these facts leaves the Reserve with no alternative but to tighten rates. They argue further that this excess demand is spilling over into imports. At no time do these people mention the money supply. Demand is measured in dollars. To argue, therefore, that demand is exceeding supply is to argue that there are too many dollars about. This is why Bernie Fraser, when he was governor of the Reserve, was able to state:

If demand runs ahead of capacity, it will spill over into imports and widen the current account deficit (CAD). This is what happened in 1989-90 when the deficit reached 6 per cent of GDP. On this occasion the CAD is not expected to increase to the very high levels reached during the lat 1980s. (Reserve Bank Annual Report, 1994).

The following figures are what our economic punditry should be agonising over: From January 2007 to December currency rose by 8.7 per cent, bank deposits by 14.7 per cent and M1 by 13 per cent. Regarding money, two questions are frequently asked of me. The first one concerns the correct rate of expansion with respect to economic growth. The second question is closely related to the first one and concerns the response of the central bank to the public's demand for money.

The first thing to note is that any attempt to stabilise prices will distort the production structure and will eventually have to be liquated. One of the great lessons of the nineteenth century is that falling prices due to increased productivity do not squeeze profits even though they raise real wages. (Genuine profits are not made at the expense of labour). Price stabilisation schemes are in fact inflationary policies. It has been argued that after rapid inflation caused by the gold discoveries of 1848 and 1851 the steady gold supply stimulated output and stabilised prices for some 20-odd years. However, Cairnes pointed out that

the action of the new gold on prices will not be uniform, but partial. Certain classes of commodities will be affected much more powerfully than others. Prices generally will rise, but with unequal steps . . . The movement will be governed throughout its course by economic laws. (John E. Cairnes, Essays in Political Economy, Mcmillan and Co., 1873, p. 57)

Cairnes used the Cantillonian analysis in examining the consequences of the inflow on production and individual prices. His view was the sound one that the expansion of the gold supply (money supply) did nothing to add to the country's production structure and that nothing should be done to stabilise prices. An apologist for a stable price level policy could argue that the nineteenth century gold discoveries were followed by about 25 years of price stability and the era became known as "The Great Victorian Boom". Unfortunately, things were not that rosy. Interest rates were comparatives high as were prices, and the period suffered several financial crises. From about 1874, however, prices dropped relentlessly and real wages rose. And all without the appearance of mass unemployment and idle capital.

The idea that the central bank should take account of the public demand for money does not stand up at all. Some 200 years ago during the Bullion Controversy Lord Peter King explained:

It is manifest . . . that the proportion of circulating medium required in any given state of wealth and industry is not a fixed, but a fluctuating and uncertain quantity; which depends in each case upon a great variety of circumstances, and which is diminished or increased by the greater or less degree of security, of enterprise and of commercial improvement. The causes which influence the demand are evidently too complicated to admit of the quantity being ascertained by previous computation or by any process of theory. (Lord Peter King, A Selection from the Speeches and Writings of the Late Lord King, Longman, Brown, Green, and Longmans, 1844, p. 67).

In other words, there is no way any organisation can determine how much money is needed, not that this fact will be heeded by any central bank.

Once again we find that history provides us with a much better guide to monetary policy than that offered by the great majority of today's orthodox economists.

Gerard Jackson is Brookesnews' economics editor