Keith Rankin's Thursday Column

 Don Brash has no Plan B

20 January 2000


Yesterday we were subject to the embarrassing experience of the Reserve Bank tightening monetary policy just two hours before the public announcement of a December quarter inflation rate of just 0.2 percent. The Bank had forecast that the inflation rate would be much higher.

Despite the 1990s' experiences of the United States and Australia, Governor Brash believes that inflation follows economic growth and that growth must therefore be checked. Whereas the Keynesians in the 1970s couldn't explain simultaneous high inflation, low growth and high unemployment, the monetarists of today cannot explain simultaneous falling unemployment, high growth and minuscule inflation. So they are in denial, basing policy on their own flawed beliefs about inflation.

While the Reserve Bank certainly is "trigger-happy" (as the Minister of Finance said yesterday), its problem is much deeper than premature tightening. The Bank is unable to develop alternative views on inflation because to do so would be an admission that the last 15 years of monetary policy had been an expensive failure. Unlike Alan Greenspan who uses intuition to override the monetarist manual, Don Brash continues to be guided by a rulebook that owes much to clapped-out ideology and virtually nothing to the scientific method.

For the best part of 8 years, Greenspan has refrained from tightening monetary policy despite forecasts of rising inflation. Following his reappointment to a fourth term as Chairman of the US Federal Reserve Bank, Greenspan hinted at a return to the rule book. Economic progressives (including Robert Reich who came here as a guest of the New Zealand Labour Party) plus political conservatives in the Republican Party, rushed to suggest that he may be too concerned about something that will not happen. Y2K was a real threat; inflation is not.

Friedman's first edition of the monetarist rule book said that central banks must control the money supply so that the quantity of money in any nation grows at a steady rate of three percent each year. It didn't work because most instances of rising prices are not caused by the growth of a nation's internal money supply, and because central banks cannot control the supply of bank credit from which most money is created.

The second edition of the rulebook emphasises the manipulation of interest rates, through in particular the announcement of an "Official Cash Rate" (OCR). Higher interest rates are supposed to lead to lower inflation rates.

The problem with this interest rate rule is that the direct effect of rising interest rates is to increase rather than decrease inflation. Interest is simply the "wages of capital". Like the wages of labour, interest is a production cost. As an economic cost (ie an "opportunity cost") interest is much more than debt-servicing. Profit is a form of interest. Companies must pay higher dividends when interest rates for bank deposits are raised.

Monetarist policies reduce inflation only when indirect effects outweigh the direct effects of higher capital costs. Raising interest rates and hence business costs causes marginal businesses to fail. Unemployment rises. Surviving firms take on fewer new workers or cut wages in order to service their debts, placate shareholders and pay for the financial and business services that they need when in trouble. Because workers have less to spend in such a deflationary environment, firms producing wage goods - ie goods and services that workers buy - make heroic attempts to keep their output prices down despite rises in costs.

Another indirect effect only applies to nations with floating exchange rates. A rise in interest rates in New Zealand relative to other countries leads to a net inflow of foreign capital and a higher exchange rate. The result is that New Zealand exports some of its increased input inflation, while "benefiting" from the rising unemployment that inhibits the growth of output inflation.

If we consider the global economy as one, rising world interest rates lead to rising rather than falling world inflation. The irony is that the countries leading a rise in interest rates may themselves experience reduced inflation. They export their inflation as their exchange rates rise.

There are times when central banks should raise interest rates. In a genuinely overheated economy, interest rates rise of their own accord as overconfident firms compete for credit. A policy that anticipates such a rise in market interest rates can benefit an economy by discouraging too many firms from expanding at the same time. Indeed, Alan Greenspan is more worried about unsustainable growth in the USA than about inflation. He does not have a rigid contract that overemphasises inflation, as Brash's does. New Zealand has not been through a decade of sustained growth, so the need to dampen growth is not a valid reason for raising interest rates in New Zealand.

In the 1950s and 1960s, tight monetary policy was used as a response to a balance of payments difficulty. Indeed Tuesday's scary balance of trade data does, on the surface, offer a much better reason for tightening monetary policy than does any concern about demand inflation.

In the 1950s and 1960s, firm monetary policy could reduce a balance of payments deficit because we had a fixed exchange rate and exchange controls. A credit squeeze (as we called it then) led to reductions in the demand for goods and services. That would lead to fewer imports. There would be no reductions of exports so long as other countries were not simultaneously tightening their monetary policies.

The problem here is that high interest rates have exactly the opposite effect when exchange controls are absent. Now, a rise in interest rates generates an increased net capital inflow. The balance of payments deficit must be equal to the net capital inflow.

New Zealand had a huge net capital inflow in 1999. Hence its huge balance of payments deficit.

Higher interest rates in 2000 will cause (i) the balance of payments deficit to increase, (ii) costs to rise, (iii) unemployment to be higher than it would otherwise have been, (iv) growth to slow down in the export and import-competing sectors, and (v) profits to rise in industries that are able to pass on cost increases. In New Zealand, when monetary policy tightens, inflation rises markedly in the non-tradeable sectors.

Higher interest rates bring gains to the richest 5-10% of the New Zealand population. Losses that outweigh the gains are borne by the remaining 90-95%. Indeed, that is the real story of a monetarist experiment that is not over yet. The Reserve Bank perseveres with Plan A because it cannot admit to the grief that that game plan has caused to the people of New Zealand.

© 2000   Keith Rankin

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