This article from the October 2019 IPA Review is by IPA Research Fellow, Kurt Wallace.
For a supposedly free market economy where prices are formed by the market, an inordinate amount of attention is given to a small group of bureaucrats sitting around a table discussing monetary policy on the first Tuesday of each month. The Reserve Bank of Australia (RBA) attracts this level of public scrutiny because of its role manipulating the credit market to set the economy’s most important price: the price of money.
In July 2019, the RBA deemed it necessary to cut the cash rate (the interest rate on overnight loans between banks) to a record low of just 1 per cent and has kept it there since. Never before have Australia’s interest rates been this low, and we are not even in a recession. The interest rate has now been held at record lows for more than 80 months. While price fixing may seem more at home in the Soviet Union than in a market economy, monetary policy has enjoyed a widespread level of unquestioned legitimacy in otherwise market economies for over a hundred years.
The prevailing view at most central banks is that the market needs technocratic management. The market cannot be left to its own devices, it needs guidance from all- knowing central bankers to smooth over its propensity to periodically boom and bust. Interest rates are lowered to stimulate investment and consumption when the economy is teetering, and raised to limit price inflation when the economy is booming toward full capacity. This approach is just another government attempt to mould economic reality into a centrally planned ideal. The economic destructiveness of price fixing is understood when it comes to most commodities. Artificially lowering or raising prices can lead to severe unintended consequences, because prices reflect an important economic reality that cannot be wished away by bureaucrats. Central bankers engage in a similar folly by fixing interest rates. Interest rates, like all prices in a market economy are the result of market forces. Muting this important signal leads to a misallocation of resources that undermines economic stability.
The RBA has failed even according to its own model of monetary policy. Despite years of accommodating policy it has been unable to ignite the economy since the Global Financial Crisis (GFC) 10 years ago. In response to the GFC, the RBA slashed the cash rate from 7.25 per cent to an emergency 3 per cent. Despite an attempt to normalise interest rates, rate increases were abandoned by 2011 and since December 2012 every policy decision has either held rates at record lows or set a new record low rate. The RBA’s radical experiment with low interest rates has simply not worked, and now it is faced with the predicament of responding to a future economic downturn with little room to move below 1 per cent. Before the GFC a rate of 7.25 per cent allowed the bank to slash the rate by more than 4 percentage points.
RBA governor Philip Lowe gave a clue to what future monetary policy might look like in an economic downturn when he appeared before the government’s standing economic committee in August. Lowe stated, “We are prepared to do unconventional things if the circumstances warranted it.” When asked to outline what ‘unconventional things’ were being considered, Lowe spoke about the possibility of implementing negative interest rates. This would be the complete reversal of the relationship between creditor and debtor; creditors charged to lend, and debtors paid to borrow.
Despite the ineffectiveness of monetary policy, the logic of the central banking model is rarely questioned. Month after month, the RBA’s predictions around employment, wages, and inflation prove to be overly optimistic. According to standard monetary policy theory, prolonged ultra-low interest rates should be fostering substantial economic growth. Remarkably, the RBA still upholds a belief its low interest rate approach will generate growth. The RBA’s official policy statement from September concludes:
It is reasonable to expect that an extended period of low interest rates will be required in Australia to make progress in reducing unemployment and achieve more assured progress towards the inflation target.
Never mind the fact we have now had an unprecedented period of low interest rates with little to show for it. The reality is, the RBA’s models are broken, and its technocratic approach is built on little more than hubris. Manipulating interest rates is not just a matter of price fixing by decree; it involves the use of the RBA’s monopoly over the creation of money. In order to supress interest rates the RBA purchases securities from commercial banks with money created out of thin air. This newly created money flows into the economy through the credit market.
Monetary policy is a blunt instrument and this new money has not flowed into business investment. Even with record low interest rates, private business investment as a percentage of GDP is just 11 per cent, a low not seen since Australia’s last recession in the early 1990s. The new money has flowed largely into inflating asset prices in housing and the stock market. This has been viewed as a positive by the RBA in its attempt to create ‘wealth effects’. Inflating the wealth of those in the stock and housing market is an indirect way of stimulating consumption spending. At the centre of this theory is the faulty Keynesian economic reasoning, that a struggling economy is a result of a lack of overall demand.
In reality, an economy needs saving and productive investment to produce economic growth. No matter how much monetary manipulation takes place, the economic reality will always remain that growth can only be achieved by diverting resources away from present consumption to investment in productive capital with the ability to produce a greater amount of goods in the future. There needs to be an increase in real savings by individuals that cannot be replicated by monetary policy. The great 20th century economist Murray Rothbard points out:
… economic development takes place through greater investment in more roundabout processes of production, and that investment is the result of greater net savings brought about by a general fall in rates of time-preference.
Instead of real sustainable growth in Australia, we have an illusory prosperity based on an inflated financial and housing market. RBA policy has been so ‘successful’ at generating a ‘wealth effect’ in housing that Australia’s capital cities are among the least affordable cities in the world. The house price-to- earnings ratios in Sydney and Melbourne are double that of New York, and yet the RBA sees falling house prices as a cause for concern, noting in a recent meeting that “declining housing prices had also contributed to low growth in consumption”. While there are other contributing factors to rising house prices, such as development restrictions and immigration, monetary expansion enabled by the RBA has played a significant role. Since the GFC, house loans have grown at more than three times the pace of loans to business. This has resulted in a banking sector highly dependent on the housing market.
Australian banks have by far the highest rate of residential mortgages to total loans in the
world. Australia’s 63 per cent mortgage share is more than double the OECD average and more than three times the rate in the United Kingdom. RBA policy has inflated mortgage debt and risks crowding out loans to small and medium business. According to Joseph Healy of Judo Capital, as reported in the Australian Financial Review (Banks are too addicted to property, 27 March), a generation of bankers “have lost the ability to bank SMEs”.
Monetary intervention in the market diverts resources from other productive use toward an interest rate sensitive housing market. The resulting intensive residential construction can be seen on our city skylines. The Rider Levett Bucknall crane index found Sydney and Melbourne last year each had more cranes working on residential buildings than 10 major cities in the USA combined. But this wealth effect is far from inclusive. It benefits the first receivers of newly created money who can spend before the money flows through the economy and increases prices.
This comes at the expense of those who see their living expenses rise before their incomes. The monetary expansion has not produced broad-based growth. Philip Lowe even admitted in a speech in August that “relying on monetary policy risks further increases in asset prices in a slowing economy, which is an uncomfortable combination.” Unfortunately, asset price inflation is all the RBA has been able to achieve.
If it is any consolation, the RBA is certainly not alone in its failure to deliver economic health to a nation. They find themselves in the same predicament as nearly every central bank in the world, led by perhaps the world’s most powerful institution, the United States Federal Reserve. In response to the GFC, the Federal Reserve administered the economy with a series of doses of quantitative easing. This involved buying up $3.5 trillion of financial assets.
The Fed more than quadrupled their total assets by spending money into existence, and they only started unwinding the unprecedented monetary expansion at the start of last year. Awards have been given and books written celebrating the response of the Federal Reserve led by Chairman Ben Bernanke. Bernanke’s own memoir bears the title, The Courage to Act.
Enacting a radical high stakes policy experiment may have been courageous, but it remains to be seen if the Fed can normalise interest rates and reduce its bloated balance sheet without taking the world economy down with it. Despite a high US stock market and historically low rates of unemployment, fears of a recession on the horizon are growing by the day. The Fed has increasingly been drawn into the spotlight by a President trying to shift blame for any future economic downturn. In 2016, candidate Donald Trump criticised the Fed for “being more political than Secretary Clinton” by creating a “big fat ugly bubble” with low interest rate policy to accommodate the economy under Obama’s presidency.
When the stock market rallied following Trump’s election however, he quickly took credit and therefore ownership of the economy. But since the Fed has raised rates under the leadership of Jerome Powell, Trump has blamed it for not keeping rates low to support the economy. “My only question is, who is our bigger enemy, Jay Powel or Chairman Xi?” asked Donald Trump on Twitter.
Needless to say, comparing the Federal Reserve chairman to a communist dictator and spelling his name wrong (corrected later) are unprecedented actions by a US president. But the comparison is not entirely without merit. Both head up regimes involved in a large-scale manipulation of markets.
As a bad omen for the economy, the interest rate yield curve in the US recently inverted. An inverted yield curve is the result of the interest rate on short-term government debt spiking above the interest rate on longer- term government debt. This runs against the rule of higher returns for debt with longer maturities. The interest rate on the three-month treasury exceeded the rate on the 10-year treasury in May this year.
A prolonged inverted yield curve has long been known to be a reliable predictor of a coming recession. This can be understood by examining the effects of monetary policy on the boom-and-bust cycle. When the monetary supply is expanded, the newly created money flows into the loan market and pushes down the interest rate.
This induces investment in interest- sensitive projects (usually longer-term projects) and generates a boom. Importantly, these investments are not backed by real saving in the economy but by monetary manipulation. To maintain this boom, the central bank needs to continually pump money into the economy and supress the interest rate. When the monetary expansion ceases or declines, the downward pressure on interest rates is lifted. Many investment projects are exposed as short-term interest rates, which are more sensitive to manipulation, increase. The jump in short-term rates inverts the yield curve and pricks the bubble economy.
Murray Rothbard sums up this cycle in his work, America’s Great Depression:
Thus, bank credit expansion sets into motion the business cycle in all its phases: the inflationary boom, marked by expansion of the money supply and by malinvestment; the crisis, which arrives when credit expansion ceases and malinvestments become evident; and the depression recovery, the necessary adjustment process by which the economy returns to the most efficient ways of satisfying consumer desires.
In a free market without manipulation from central banks, interest rates play a central role in allocating resources in line with consumer preferences. When consumers decide to increase their savings to consume in the future, the increased supply lowers the interest rate and spurs investment in production for the future. This reallocation of real resources leads to economic growth. An overemphasis on high-level aggregate statistics causes central banks to miss crucial structural changes in the economy and misunderstand the causes of sustainable growth.
Currently, the RBA is mandated to target a price inflation rate between 2 and 3 per cent. By seeking to manage this highly aggregated price level, the RBA ignores the distortion of relative prices in the economy caused by their own meddling. F.A. Hayek pointed this out nearly 100 years ago in his work that earned him a Nobel Prize in economics, Prices and Production (1931). What matters most is not that prices remain ‘stable’, but that prices are able to perform their role as indicators of relative values between goods. Central banks would do well to heed Hayek’s advice for monetary analysis:
Not a money which is stable in value but a neutral money must therefore form the starting point for the theoretical analysis of monetary influences on production…
The great irony of monetary policy is that the very institution engaged in technocratic management of the economy to ensure stability is itself the great enabler of the monetary manipulation causing the economy to boom and bust in the first place.
On October 1 the RBA announced a further 0.25 per cent (25 basis points) reduction in the cash rate to 0.75 per cent.