Will the Federal Reserve Bank Sink the Australian Economy?

By: Gerard_Jackson

Dr Stephen Kirchner figures that the Reserve should have acted sooner with respect to inflation. (Centre for Independent Studies Reserve Did Not Go Far or Fast Enough ). Unfortunately Dr Kirchner's article did nothing to illuminate the present inflationary situation and the role of interest rates. In fact, I got the distinct impression that he believes that monetary expansion[1 does not matter. This view was reinforced by his opinion that:

If the RBA's forecasts are right, then the Australian economy will need to slow dramatically by the end of this year, just to bring inflation back to the top of the target range by the end of 2010. 

This was followed by: The larger and more persistent the inflation target breach, the more painful the subsequent disinflation must be.  This is why breaches of the inflation target need to be taken more seriously.

That the reserve is now running a deflationary and not a disinflationary monetary policy seems to have completely eluded him even though the Reserve's monetary figures can be found on the its web site. So let us now take a gander at what our economic punditry ignore. 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 ).

Because the economic commentariat ignores monetary aggregates it has missed the important fact M1 peaked in December, after which it fell. 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 contracted by 7.7 per cent and M1 by 6.5 per cent.

It is this irresponsible monetary policy that created imbalances[2 in the production structure by distorted the price structure and which fuelled the housing boom and the current account deficit. When the Reserve — or any central bank — reverses monetary expansion these imbalances reveal themselves in the form of idle capital and rising unemployment. It says much about our economic punditry that this fact is never discussed.

Dr Kirchner informs us that the Reserve's model predicts "two years for the full effects of a change in the cash rate to flow through to economic activity". This is just more evidence that the Reserve has no genuine understanding of the power of money, the nature of capital and the role that interest plays in shaping the capital structure.

Take its approach to the cash rate. The result of artificially lowering this rate was a massive monetary expansion. As Wicksell would have said: the cash rate is now below the "natural rate". (I sometimes wonder whether anyone at the Reserve has actually read Wicksell). Looking at it from this angle we can now spot the Reserve's error. So long as the interest rate is below the "natural rate" the demand for loans will continue to rise.

It's apparent that the Reserve's model does not account for this fact. More importantly, no model — no matter how mathematically sophisticated — can predict what the "natural rate" should be. The fact that the money supply has contracted since last December suggests to me that the cash rate now exceeds the "natural rate".

It should not need to be said that a monetary contraction is quickly reflected in economic indicators. The Australian Industry Group national indexes for manufacturing paint a grim picture. The figures on the left are form July 2008 and the figures on the right are for December 2007. As we can see, there has been a significant drop in key indicators, signaling a recession. So much for the Reserve's model.

Business and consumer credit have virtually come to a halt. Needless to say, the credit crunch has led to a drop in retail sales. Bank lending for housing has also fallen significantly. Lending by non-banks to owner-occupiers has dived from about 13,000 a month to less than 7000. I doubt very much that even if the Reserve interest rates down in the next couple of months that will prevent the slide into recession, even a mild one.

Irrespective of what the Liberal Party will say, the Labour Government cannot be justly accused of causing a recession. The culprit — as always — is lousy economics. Unfortunately Australia's self-appointed (and self-anointed) defenders of the free market strongly believe that the current state of economic theory should not be publically debated. So much for their belief in the market place of ideas.

1. More than 200 years ago Walter Boyd provided a definition of money that would have averted much economic hardship if it had been generally accepted by the economics profession.

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).

2. These imbalances are caused by the fact that money is not neutral. As Richard Cantillon explained in considerable detail, monetary expansion does not bring about a uniform advance in prices. ( Essay on the Nature of Commerce in General , Transaction Publishers, 2001, written about 1734 and first published in 1752). Cantillon's analysis was shared by most classical economists. John E. Cairnes (sometimes called the last of the classical economists) explained how the gold discoveries in the United States and Australia had distorted the price structure. (John E. Cairnes, Essays in Political Economy , August M. Kelley, 1965, Chapter II).

By Gerard Jackson
BrookesNews.Com

Gerard Jackson is Brookes' economics editor.

Copyright © 2008 Gerard Jackson

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