The US Federal Reserve seems to be handling the US financial crisis more intelligently than is the Reserve Bank of Australia, argues Colin Teese.
Trying to understand what exactly is going on in financial markets around the world isn’t easy. But surely we can call it a perfect example of market failure.
It is all too simple to proceed from this point and predict unremitting gloom and doom. But that is not necessarily the most responsible of approaches – nor may it be accurate.
To identify what precisely is happening and why is no less difficult in our own economy than in that of the United States. Mind you, in today’s economic world of unreality, market failure is routinely obfuscated by the perceived need, as the experts put it, not “to talk down the economy”.
Facing the truth
Do experts really believe that ordinary people are incapable of handling the truth about how the economy is playing? Actually, if this is the worry, then concerns would be better focussed on the shortcomings of the professional market-players.
We all know about their well-documented capacity both to create and react to market rumour. In the process, markets are talked up and down with only passing relevance to the real economy.
While all of this is going on, it doesn’t make sense to accept the notion of properly functioning financial markets – still less can we take seriously the current fashionable economic theory of “rational economic man”.
What can be observed in financial markets is totally irrational economic behaviour at work. Bang goes another popular set of economic theories!
Is it any wonder that we find it so difficult to connect what is going in financial markets with developments in the real economy?
Nowhere are these difficulties more clearly exposed than in our own country. Our own central bank, the Reserve Bank of Australia – responsible in law for both the maintenance of full employment and the containment of inflation within self-defined limits – can’t seem to find the right balance.
And for good reason. Put crudely, current economic theory holds that a certain (undefined) level of unemployment is necessary to keep the lid on inflation. If you believe the current theory (and the RBA seems to), then it needs to create unemployment to fight inflation.
Certainly, the Reserve Bank governor, Mr Glenn Stevens, keeps taking about pushing up interest rates to douse an overheated economy in cold water.
Unemployment will be the first consequence of such an approach – though, one assumes, the governor’s job won’t be under threat.
Meanwhile the new Rudd Labor Government holds its peace. Not so the current shadow treasurer, Mr Malcolm Turnbull. He wants the RBA’s governor to explain how, in September of last year, it was able to advise the then Howard Coalition Government that, despite strong domestic growth and falling unemployment levels, it could discern no sign of a wage break-out, or the attendant threat of inflation.
How could the same governor four months later advise the incoming government the exact opposite? In an overheated economy, Mr Stevens now insists, the possibility of a wage blow-out and a consequent rise in the rate of inflation are the bank’s principal concerns. His solution, up till now, has been to up interest rates. Why the back flip, Mr Turnbull wants to know.
(Since these words were written, the RBA has decided, after all, not to increase interest rates. That’s a good thing. But it doesn’t give any satisfaction to those asking why the RBA gave a different assessment about inflation and interest rates to the former Coalition Government than it gave to the incoming Labor Government).
Certainly, the facts don’t support the RBA’s conclusions. It would be interesting to know whether the bank’s deliberations are proceeding from a commitment to economic theory rather than observable fact.
No such question need be asked about the way Mr Stevens’s American counterpart Ben Bernanke, chairman of the US Federal Reserve, is tackling his job. He decides what he believes is happening in the US economy, and sets his policies accordingly.
Right now he is in no doubt where he wants the weight of his policy interventions to fall. He judges the risk of inflation to be of small importance when measured against the possibility of recession.
He chooses not to concern himself with whether or not the US is already in recession. But he assumes the possibility is very real. His policy steps are designed specifically to minimise the impact, if not arrest the possibility, of any serious economic downturn.
Untroubled by the burden of any economic theory, Dr Bernanke has cut interest rates in order to promote confidence and stimulate economic activity. He will do whatever it takes.
Furthermore, in the context of the problems of the US finance industry, he is also taking other alleviating measures with small concern for economic orthodoxy. Nobody can say for certain whether or not his package of policies will do the trick.
It may be that the breakdown of financial markets, which seems to have been driving the US into economic downturn, will defy Dr Bernanke’s best efforts. But even if this turns out to be so, we may conclude that his policies will certainly have helped limit the full impact of any economic downturn.
Some believe that there could be undesirable economic side-effects arising from the Federal Reserve chairman’s interest-rate policy. They may be right, but quite obviously Dr Bernanke believes that these would be of a lesser order of importance.
By contrast, his Australian counterpart, RBA Governor Stevens, seems to have been anything but resolute and decisive. How else could he have concluded that, at the end of last year, inflation and a wage blow-out were no problem, and yet, in the same overheated economy, declare those considerations to be the problem only a few months later?
Let’s look at the facts, and let us further assume that Mr Stevens is no better informed than the rest of us. Certainly his public statements do not suggest otherwise.
He tells us the Australian economy is overheated – true. But so it was six months ago, mainly for two reasons – first, the boom in our minerals exports driven by demand from a galloping Chinese economy; and, second, because of booming consumer spending funded by a flood of cheap offshore borrowings.
Only a small percentage of our borrowing is being directed towards investment in new domestic production Most of it funds consumer spending, overwhelmingly in support of house and share purchases.
The availability of a seemingly endless supply of cheap credit has generated asset-price inflation, in both shares and housing. The consequences of this obviously feed domestic inflation. Curiously, the Reserve Bank has never expressed much concern about this source of inflation; it seems only to worry about wages as a source of inflation.
That having been said, it does seem strange that, in the circumstances of the time, the RBA could assert that wages and inflation were well under control six months ago whereas now they are not – and all the more so when it is obvious that the economy is less overheated than it was six months ago.
We no longer have unlimited access to cheap money. Banks are strictly limited in the amount of credit they can offer, even at higher interest rates. Low-income Australians in the process of buying homes are having to find an extra $100 per week to meet rising interest payments. In addition, petrol prices have soared 25 per cent in the last six months; and, for a variety of reasons, including drought, food prices are increasing rapidly.
The Reserve Bank is probably right. These considerations will put upward pressure on wages. But it won’t be wages driving up costs; it will be cost-inflation, driven by factors mostly beyond our capacity to control, eating into the standard of living of ordinary wage-earners.
The one factor in this cost-push inflation which we could have controlled is asset-price inflation – and this the RBA has persistently ignored. For that part of Australia’s cost-push inflation the bank is actually to blame; and yet it wants wage-earners – with inescapable increased costs imposed upon them from external sources – to bear the brunt of any measures introduced to deal with rising inflation.
Given all the circumstances, the Reserve Bank’s idea of increasing interest rates in an effort to control inflation seems badly thought out. Significantly, it is not finding favour in some orthodox economic circles.
Economist and former federal Liberal leader John Hewson, in a recent issue of the Australian Financial Review, drew attention to the fact that, if inflation is cost-driven, then using interest rate rises to slow demand will have absolutely no effect. All the more is this so if the cost pressures are imported.
Quite obviously, in these circumstances using interest rates to curtail demand seems a sure way of pushing the economy into recession. What the RBA really needs to do, as Dr Hewson suggests, is to begin lowering rates. In this way it can help offset some of the effects of cost-price increases and help keep the wheels of our economy turning.
Which brings us back to our starting point. With what is happening around us, what are the dangers for our economy? We can’t expect to escape completely from the downturn in the US.
If, for example, a recession in the US slows Chinese economic growth, we will be affected. That having been said, our banking system is in a much healthier state than the US system. But our economy is delicately poised because of the externally generated cost pressures we now face, especially given the level of our private debt. We cannot avoid the consequences these factors will have on domestic inflation. What we don’t need is our Reserve Bank taking actions which could make things worse.
If the RBA cannot be persuaded to take actions appropriate to our circumstances, then our economy could sink into a protracted and painful recession from which recovery would be slow.
Such a prospect calls into question the wisdom of allowing a central bank, answerable only to itself, total control over interest rate policy.
– Colin Teese is a former deputy secretary of the Department of Trade.