Is the Australian Economy Heading for Recession?

By: Gerard_Jackson

The situation could become very nasty for the Australian economy. For years I have been warning that the Reserve Bank's reckless monetary policy would eventually end in tears. Since March 1996 bank deposits have risen by more that 224 per cent and M1 by 200 per cent. Regardless of views to the contrary, Australia cannot continue to escape the consequences of the Reserve's delinquency. Glenn Stevens " the Reserve's governor " recently made it clear that he wants to slow aggregate demand, reducing it to a rate that is "significantly slower than it was in 2007".

Stevens statement amounts to a confession that the Reserve's monetary policy has been too loose. This strikes me as code for: "I haven't got a clue". Be that as it may, the new monetary policy has severely hit monetary growth. Last week I drew readers' attention to the fact that in December 2007 bank deposits peaked at 191.3 per cent while M1 peaked 231.3. Come February we find that bank deposits had dropped to 181 and M1 to 220.4. In December the Reserve's total assets stood at $92,812., by January they had fallen to $86,886 and then to $82371 in February. (The Reserve's assets are expressed in millions).

These figures strongly suggested that the Reserve was using money market operations to reign in the money supply or, as they prefer to say, aggregate demand. Therefore the drop in assets were reflected in the rapid fall in bank deposits and M1. (During this time currency remained flat and in doing so underlined the fact that M1 consists largely of bank deposits).

I noted at the time that the Reserve's assets had risen in March to $89,711, thus indicating that the Reserve was attempting to arrest, if not actually reverse, the monetary contraction. Therefore I figured that the April figure for assets would provide a stronger indication of where the Reserve's monetary policy is heading. Well it looks as if my first hunch was right. Assets for April stood at $89,284 with bank deposits at 181.4 and M1 at 220.7.

Stevens recently said that evidence is mounting that aggregate spending is slowing. But spending is bound to slow when the monetary brakes are applied. So what the Reserve will do now is anybody's guess. However, it has been hinted that the slow down in demand might make further interest rate rises unnecessary. What is missing here is the possibility that the Reserve overshot the target.

We must also entertain the thought that the swiftness of the monetary contraction panicked the Reserve into trying to reverse the trend. If this is so, then I very much doubt that further interest rate rises are on their way. This doesn't mean that a recession can be avoided or that rates for business will not rise, even if monetary growth is held constant. The Reserve's monetary expansion has badly distorted the production structure*. As Wicksell 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, p. 106).

As Hayek observed, the demand of business "for savings [credit] will depend on the extent to which the investment has been completed". This means that, irrespective of the Reserve's interest rate policy, projects in the advance stage of development will make these firms' demand for credit inelastic, resulting in rising rates as they compete with each other for funds.

I have been asked why I ignore M3 in favour of M1. The reason is that M3 includes deposits from building societies and credit unions with banks. Any money that is deposited with non-bank institutions is part of the currency base. Including these deposits would lead to double-counting. Furthermore, all bank deposits are already included in M1.

On a final note, I don't include as part of the money supply "near-liquid" assets. I don't care how "liquid" (meaning that it can be quickly cashed) an asset is: If an asset has to be sold in order to obtain money it cannot be defined as money. In other words, if you cannot spend the asset it is not money. The difference between money and non-money assets was clearly laid out more than 200 year ago by Walter Boyd.

By the words 'Means of Circulation', 'Circulating Medium', and 'Currency', which are used almost as synonymous terms in this letter, I understand always ready money, whether consisting of Bank Notes or specie, in contradistinction to Bills of Exchange, Navy Bills, Exchequer Bills, or any other negotiable paper, which form no part of the circulating medium, as I have always understood that term. The latter is the Circulator; the former are merely objects of circulation. (Walter Boyd, A Letter to the Right Honourable William Pitt on the Influence of the Stoppage of Issues in Specie at the Bank of England, on the Prices of Provisions, and other Commodities , 2nd edition, T. Gillet, London, 1801, p. 2).

Boyd's definition of money should be considered essential to any debate on monetary policy.

*Stevens refers to Wicksell with respect to the "natural rate of interest" but not to Wicksell's reference to the production structure, making me think no one at the Reserve, including Stevens, has actually read Wicksell.

By Gerard Jackson
BrookesNews.Com

Gerard Jackson is Brookes' economics editor.

Copyright © 2008 Gerard Jackson

© 2005-2022 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.