The Reserve Bank of Australia gets it Wrong on Financial Markets

By: Gerard_Jackson

Last week the Reserve Bank of Australia raised interest rates. Glenn Stevens, the Reserve's governor, told the house of representatives standing committee on economics, finance and public administration that he did not regret the decision. He said: “It has been a little bit difficult to read what the current trend in inflation is over recent quarters”. Let me see if I can help out here. Inflation, Mr Stevens, is a monetary expansion.

Unfortunately, Mr Stevens, along with the heads of just about every other central bank on the planet, thinks rising prices are what define inflation. These are the same people who warn us about cost push inflation. In this case it was wage rises not backed by productivity increases. When this happens, Mr Stevens, we call the result unemployment, not inflation. Of course, he and his supporters will say that such increases are passed on in higher prices. But how can this be if aggregate incomes remain unchanged? They can then respond that increased velocity would account for maintaining the level of employment as wage rates were pushed above their market clearing rates.

This is voodoo. There is no velocity of circulation because money does not circulate. It exchanges hands for goods and services, and as we can only spend our weekly or monthly — or whatever — income once, irrespective of changes we might make in our pattern of expenditures, it follows surely as night follows day that any wage push would only lift the level of unemployment and lead to what the late Professor Hutt aptly termed “withheld capacity”. As Ludwig von Mises trenchantly pointed out:

The mathematical economists are at a loss to comprehend the causal relation between the increase in the quantity of money and what they call “velocity of circulation”. (Ludwig von Mises Human Action ,3rd edition, Henry Regenery Company, 1966, p. 427).

In any case, defenders of Stevens' view cannot use the concept of velocity without bringing into the argument Fisher's “equation of exchange”. But if this is done then money becomes the dominating factor. Fisher's formulation has, unfortunately, served to discredit monetary explanations of inflation and the trade cycle. Benjamin M. Anderson's damning indictment of the quantity theory summed the situation up:

It is one of the great vices of the quantity theory of money that it tends to check investigation of underlying factors in a business situation.(Benjamin M. Anderson Economics and the Public Welfare , LibertyPress, 1979, p. 70).

To be fair, our economic commentariat also shares Stevens' views on inflation and costs, which accounts for the lousy economic commentary that the media is continually serving up. But that's no reason why our politicians should remain willfully ignorant. (Anyone who has talked economics with Liberal Party politicians cannot but be struck by their total ignorance of the subject. The same goes for their staffers and advisors). What has this got to do with interest rate and the current state of the financial markets? A lot Since Howard first became Prime Minister currency has expanded by 116 per cent, bank deposits by an astonishing 160 per cent and M1 by a remarkable 146 per cent. What Stevens and our economic commentators are saying is that these figures are absolutely irrelevant. So irrelevant, in fact, that they don't even bother to acknowledge their existence.

And yet these intellectual prodigies have proven incapable of linking the housing boom to our booming money supply. They cannot even make the link between the Reserve's gross mismanagement of monetary policy with our foreign debt and current account deficit. So much as hint at the possibility that the Reserve's criminally loose monetary policy combined with an over-valued dollar may have reduced manufacturing as a share of GDP and they'll immediately label you as a crank.

But this idea is based on the observation — supported by economic theory — that if a country's currency is devalued then import prices will rise and export prices will fall. Hence there will be a tendency for manufacturing to become more export oriented. It follows that the reverse must also be true. If a country maintains an over-valued exchange rate for some years then its export of manufactures will become uncompetitive. This means that these companies will either have to move offshore, close down or become more oriented toward domestic consumption. I guess the possibility of this situation emerging is too complicated for the Reserve and our economic commentariat to grasp.

Economics commentators have been waffling on for several years about how cheap Chinese imports have helped keep inflation low. More garbage. By exchanging dollars for Chinese goods we were in effect exporting our own inflation. This enabled the Reserve to make the ludicrous claim that inflation was under control. Bernie Frazer, a former governor of the Reserve Bank of Australia, stated that

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).

It seems that Bernie at least had a better grasp of the consequences of a loose monetary policy on our trade account. The technical side of the problem has been compounded by China's massive increase in the demand for our commodities which has helped to over-value dollar. I've said before that this is an unsustainable position and sooner or later there must be a monetary correction to bring the dollar in line with its domestic purchasing power. It's absurd to think that any country — no matter how powerful it is economically — can run our kind of monetary policy and still avoid a devaluation.

The international financial crisis that has panicked markets has also seen the Australian dollar drop. As soon as this was reported I thought that it won't be long before someone will tell us that devaluations are inflationary. And sure enough, someone did. St George Bank head of economic research, Steven Milch, claimed that any further falls in the Australian dollar could be inflationary. That this financial turmoil, including a falling dollar, is the fruit of inflationary policies by central banks is something that Mr Milch has evidently never given a thought to. Mr Milch is another economist who has no understanding of how loose monetary policies distort the pattern of international trade. Gottfried Haberler made this fact very clear when he wrote:

... the process of inflation always leaves behind it permanent or at least comparatively long-run changes in the volume of trade and in the structure of industry. The impact effect is a change in the direction of demand. At he points where the extra money first comes into circulation purchasing-power expands; elsewhere it remains for a time unchanged. (Gottfried Haberler The Theory of Free Trade , William Hodge and Company LTD, 1950, p. 54, first published 1933).

Nevertheless, we must be kind Mr Milch. After all, he is only echoing the conventional wisdom. So let me state my position once more: a massive monetary expansion, mainly in the form of credit expansion, has left the world in a financial mess. But how are we to deal with such messes if the vast majority of economists are truly clueless about the monetary roots of these crises? We can't, is the answer. Until the economics profession and the economics commentariat come to understand that money really does matter there will be no stopping these monstrous monetary roller-coaster policies.

Gerard Jackson
BrookesNews.Com

Gerard Jackson is Brookes economics editor.

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