Monetary policy stays tight as economy tanks

Gerard Jackson
BrookesNews.Com
Monday 13 July 2009

The AIG report for June shows the performance manufacturing index fell "fell for the thirteenth consecutive month", though at a moderated pace. That manufacturing has clearly been contracting since last May should have told our economic commentators that Australia was sliding into recession. Instead we got the usual nonsense about a dual economy, with consumer spending holding up while manufacturing output dropped. The economic punditry simply refuses to even consider the fact that manufacturing might be a leading indicater, so convinced are they that consumption drives the economy. Even the ramifications of the fact that the first quarter experienced a record drop in investment spending by business does not seem to have sunk in.

It is true that there is a great deal of confusion abroad, with some commentators warning that there is still much pain ahead while others claim to see a pick up in the demand for labour, particularly in construction, finance and the property sectors. That this 'demand' might be due to unsustainable government spending was a thought that never occurred to them. Reserve Bank credit figures show that from March 2008 to last March credit to business plunged from $143 billion $15billion, a drop of about 90 per cent. Perhaps I'm blind but I don't see any green shoots there.

No matter how many commentators one reads there is never a single reference to money supply. For this lot, money truly doesn't matter. According to the AIG reports input prices for manufacturing peaked in January 2008 at 75.8. The index then gradually declined, falling to 62.8 last January, after which it dropped to 52.1 in June. The PMI peaked at the same time at 51.3 and stood at 38.4 last June. Since January 2003 M1 has increased by 64 per cent. And this in a mere 6 years. The chart shows that from January 2007 to October 2008 M1 grew by 20 per cent, which gives us an annual average of about 10 per cent. According to the monetarist way of thinking this should have sent manufacturing into overload. So why didn't it? The Austrian take on the subject is far more sophisticated than the Chicago approach. (As expected, the Keynesians are at a loss to explain the situation). Austrians stress that money is not neutral. In other words, prices do not change in a uniform way to increases in the money supply. This fact leads to distortions in the pattern of production and create what Austrians call malinvestments¹.

To cut to the chase, the result is that an ever increasing quantity of money is required to get the same amount of output. This is why the monetary injections have been getting bigger. What this means — and I am leaving an awful lot out — is that eventually the economy will start to slow even though the money supply is still expanding. Unlike the Fed the Reserve Bank of Australia is running an extremely tight monetary policy. M1 was 242.2 last October: the latest figures are for April put M1 at 243.6. It's no wonder that business investment has dived.

In days gone by, when this kind of situation emerged it was usual for interest rates to fall fare below their normal levels². The main problems could be the fact that the Reserve is targeting the cash rate which is now 3 per cent. It's a truism that if you target interest rates you cannot control the money supply. That this seems to be the case is supported by figures showing that from November last year to May the Reserve's total assets fell by 29 per cent. So rather than letting interest rates fall under their own momentum it looks like the Reserve is holding them up.

Some could argue that the increase in the demand for loans for new houses — thanks to government intervention — is the force that is putting a floor under rates. If this were so the Reserve would not have to sell assets to maintain the cash rate at 3 per cent. There is also the view that the increase in demand for housing will spark a new bubble. This is the equivalent of saying that booms are always triggered by an increase in the demand for loans. It's exactly the reverse.

Forcing interest rates below the market clearing level excites the demand for loans that is then met by the banks expanding credit. It is self-evident that for this to happen bank deposits must expand. But bank deposits have only risen by nine-tenths of one per centage point between last September and April. The opinion that deposits are not expanding to meet the surge in the demand for mortgages is reinforced by the Commonwealth Bank's action in raising rates in order to ration the supply of credit.

Therefore it's not easy money that is driving the demand for mortgages but government subsidies, the effect of which must be to raise the prices of new houses to the point where the subsidies are neutralised which in turn will reduce the demand for loans while leaving houses at a higher price plateau. It seems that government meddling has created a perverse situation where interest rate have now been temporarily driven up by housing subsidies while the Reserve has been active in preventing rates from falling.

Obviously, something has to give. In the meantime, the economic punditry will continue to flounder while ignoring the fundamental fact that it was credit expansion that created the mess in the first place, just as it did in the US, the UK, etc.