No Cure For This Financial Disease

Are central banks a monetary disease?
Gerard JacksonBrookesNews.ComMonday 5 November 2007
Readers frequently ask me how long the American and Australian booms can last, which amounts to asking me if there are ‘natural’ limits on the length of booms. This is where economic history — as well as theory — once again comes to our aid. If a country on the gold standard inflated the money supply — usually through credit expansion — a gold drain would quickly emerge. In the case of the UK the Bank of England would raise the bank rate: this would reverse the drain by encouraging short-term capital inflows and contracting credit. The latter and most important effect is called a deflation.
Now if the central bank did not act quick enough an internal gold drain would also emerge. This development is called “a run on the banks”. In the early 1820s there was an almighty boom in Britain, with the usual consequences. On 31 January 1824 the Bank of England had £13,527,850 in gold reserves. By 31 December 1825 its reserves had plummeted to £1,260,890. How did it manage this disgraceful feat? From August 1823 to late 1825 it expanded credit from £17.5 million pounds to £25 million. In what became known as “Black December” the economy crashed and 1825 heralded what the noted British historian Paul Johnson called “the first world financial crisis”. (The Birth of the Modern: World Society 1815—1830, The Guernsey Press Company LTD, 1992, pp. 889-94. There is also Henry Dunning Macleod’s account in his The Theory and Practice of Banking, Longman’s, Green and Co, 1906, pp. 113-27).
Clearly a gold standard put severe constraints on a country’s ability to inflate its economy. But we are far more fortunate than those benighted nineteenth century economists who allowed themselves to be bamboozled by a “barbarous relic”, that John Maynard Keynes called gold. The economics profession overwhelmingly — and for the greater good — embraced Keynes’ monetary nostrums.
The result has been relentless inflation, international financial crises, exchange rate manipulation, rampant current account deficits, depreciating currencies, distorted trade flows, massive credit booms, etc. Nevertheless, the high priests of the central banks assure us that that this (with apologies to Voltaire) is the best of all possible monetary worlds.
I suppose it could be if this lot knew what they were doing. But then, if they really understood the nature of money, prices and interest rates they would probably turn into gold freaks. Speaking of things freakish brings me to the Australian economy, a wonder to behold in many circles. Regardless of commentary to the contrary there is nothing unique about the Australian economy: what it is undergoing at present is a typical example of the boom-bust phenomenon.
For years Australia — like America — has been running massive current account deficits averaging about 6 per cent of GDP. At the same time the Reserve Bank has the monetary accelerator scraping the road. From March 1996 to July 2007 currency grew by 101.6 per cent, bank deposits by 177.7 per cent and M1 by 169 per cent. Determined to demonstrate beyond a shadow of a doubt that it does not really know what it’s doing, the Reserve let M1 jump by 16 per cent from August 2006 to August 2007. Bank deposits were — as expected — even worse, climbing by 18 per cent while currency rose by a modest 6.6 per cent.
While this monetary lunacy is allowed to roam free our brilliant economic commentators manage to completely ignore the money supply. These are the same people who express concerns about the current account deficit and the fact that private debt is now an unprecedented 160 per cent of GDP. It just does not occur to them that there could possibly be a monetary link here. They even talk as if credit has absolutely nothing to do with the money supply! This is Panglossian economics with a vengeance.
Despite the fact that the Reserve has created a housing boom of grotesque proportions it denies any culpability because it apparently does not have any power to create money. (This was told to me by a member of the Reserve). And in any case, it reckons the real problem is that people are borrowing too much. (This is called begging the question). So what in heavens name does the Reserve thinks it does? It controls inflation, the key indicator of which is the CPI, or so it believes.
It is therefore denying the existence of a causal relationship between its criminally loose monetary policy and our asset bubbles, exploding private debt and current account deficit. These things are only to be taken into account where it is believed that they influence the rate of inflation. That these things are in fact a symptom of rampant inflation is a thought so shrouded in mystery that the Reserve cannot divine its origins or meaning. For those who think I exaggerate allow me to draw your attention to the words of Reserve Bank deputy governor Ric Battellino who proudly stated that
. . . deregulation, innovation and lower inflation have simultaneously increased the supply, and reduced the cost, of finance to households. (The Age, Marc Moncrief High debt leaves households exposed: RBA, 26 September 2007).
Permit me to humbly suggest that Mr Battellino has overlooked the fundamental economic fact that forcing the rate of interest below the market rate is in itself an inflationary policy. As Frank Fetter concluded after the 1920-21 financial crisis that swept America:
The whole policy . . . must be looked upon as a case of price-fixing by which the rate of interest . . . was kept artificially lower through an unsound use of government control over banking policy. The results were speculation, inflation of prices, and eventual disillusionment and loss to investors and to large numbers of other citizens. (Frank A. Fetter Modern Economic Problems, The Century Company, 1926, p. 136)
It is unfortunate for the public that because the media are what they are it is highly improbable that the masses will ever learn how central banks mismanage monetary policy to the severe detriment of the public welfare.