Keith Rankin's Thursday Column
Inquiry or Whitewash?
11 May 2000
The inquiry into the operation of monetary policy announced this week looks like being a fairly narrow affair. The inquiry will not investigate whether the Reserve Bank should target inflation, or whether the target should be revised. Rather, the inquiry will address issues relating to the Reserve Bank's interpretation of its contract, its management processes, and whether key decisions should be made by a committee rather than by just one autocrat.
The most important question remains taboo. Does raising interest rates curb inflation in any non-pythonesque way? Is monetary policy such a scared cow that we cannot analyse it scientifically, by evaluating the assumed cause-effect relationship from interest rates to prices.
It is my view that monetary policy as rigidly practised in New Zealand, and as nominally practised in the countries we compare ourselves with, is like a castle built on quicksand; a fortress without foundations. The Reserve Bank suppresses inflation in the same sense that cutting off people's heads prevents them from picking their noses.
We can address the issue both from a purely theoretical point of view, and from an historical (or empirical) view.
Orthodox economic theory suggests that when Don Brash raises interest rates, he is like the Grand Old Duke of York, marching prices up the hill and down the hill at the same time, using a lot of energy to get nowhere.
Interest represents the cost of capital in the same way that wages represent the cost of labour. As such, interest and wages are analogues. They are the two main cost items in a private market economy. Indeed, the term 'capitalism' implies that capital and payments to suppliers of capital are somehow important.
Interest and profit are essentially the same thing in economics. In an economy like New Zealand's, about half the nations income is paid out in wages/salaries, and nearly as much is paid out as interest/profit. So interest is not a trivial cost. It works like this.
When interest rates go up, firms must pay bigger dividends to their shareholders. If they don't, then shareholders exit to get better returns elsewhere, the share price falls, the asset value of the firm falls.
The direct effect of raised interest rates is exactly the same as the direct effect of raised wages. Business costs increase. All else being unchanged, an increase in business costs leads to an increase in consumer prices. It's very basic economics. We wouldn't argue that increased wages cause inflation to fall. So why do we argue that rising capital payments lead to falling inflation? Why do we assume that rises in some business costs (but not other business costs) have this effect?
It is true that increased business costs can create a recession or a depression, and recessions/depressions reduce consumers' spending, and therefore businesses may cut their prices despite higher costs. While the direct effect of rising interest rates is to aggravate cost inflation, the indirect effect of easing demand inflation is tacitly assumed by our policymakers to outweigh the direct effect.
New Zealand has had no demand-inflation since the early 1970s.
While monetarist policies have a minimal impact on overall prices, they cause a radical redistribution in the distribution of income. The owners of capital - the capitalists - get rich when interest rates are high, because interest represents their income. At the same time, workers are squeezed by employers having to pay higher interest costs while being prevented by depressed market conditions from selling at higher prices.
The logic of raising capital costs as a means of fighting inflation is absurd; for ordinary businesses and their workers, the pain is inevitably much greater than the gain. But for capitalists (who supply capital to businesses) advocating high interest policies is sound. They win. The rest of us lose. If they can get away with tossing furphies about interest rates as means to get gullible governments to create laws like the Reserve Bank Act, then we should at least applaud them for their gall. After all, we sort-of kind-of applauded the great train robbers and other folk heroes who profited big time from the stupidity of public officials.
There are times when central banks should raise interest rates. They should act to dampen an unsustainable boom, not so much to stem inflation (which may or may not be a symptom of an unsustainable boom), but so as to ensure that sharemarkets and property markets don't expand so quickly that they will crash. Thus it is sensible for the US Federal Reserve to raise interest rates in the United States this year, following eight years of strong economic growth.
What about New Zealand's historical record? The Reserve Bank regards all inflation as being caused by excessive consumer spending which in turn is caused by 'easy' monetary conditions. 'Easy monetary conditions' is code for low interest rates. Further, it regards all cases of high consumer demand as having inflation potential.
When in the 20th century have we had bouts of inflation? In the late 1970s and the 1980s we had stagflation; inflation coinciding with an extended period of weak consumer demand. We also had stagflation in 1968. Attempts to weaken demand when it was already weak would hardly have cured that kind of problem.
High foreign demand for our products stimulated inflation in the early 1970s, the early 1950s and the 1910s. Each bout of demand-inflation was linked in part to a foreign war. The cure for global demand inflation is usually peace, not high interest rates.
From 1958 to 1966, New Zealand had an extended growth boom. If Don Brash had been in power in 1961, he would have slammed on the interest rate breaks. He wasn't, so he didn't. So we continued to have low inflation until the breaks were slammed on in 1967, following a huge fall in demand for New Zealand wool.
New Zealand's greatest growth boom lasted for 10 years, from 1932 to 1942. In real terms, the economy grew at 8% per capita per annum for 10 years. In that time, wages were raised considerably, benefits were increased, state houses were built. There was some inflation as export price increases were reflected in domestic prices. But manufacturing costs did not rise at all. Instead, there were big increases in manufacturing productivity. In domestic conditions that had much more demand-inflation potential than we have in 2000, domestic inflation did not happen.
I have just completed a book review of "Global Transition; a General Theory of Economic Development", by Graeme Snooks, Coghlan Professor of Economic History at the Australian National University. Snooks regards "strategic inflation" as central to the growth process of capitalist economies. He is very scathing towards the monetarist policies that became very fashionable in the 1980s, policies which in effect became part of New Zealand's unwritten constitution in 1989. Not only does Snooks argue that interest rate hikes kill off a beneficial form of inflation by creating recession, he also sees these policies - especially when imposed on third world economies which depend on foreign demand - as creating other kinds of inflation which are symptomatic of structural problems.
We hear in the business press these days that Don Brash made a mistake in 1994, by tightening monetary policy too late. Finance Minister Michael Cullen is one who makes that claim. It is dead wrong, and is one of the reasons why monetary policy has been tightened this year.
The New Zealand economy in 1994 was in some respects like the NZ economy of 1959, or the US and Australian economies of 1994. In those cases, prosperity continued for many years because interest rates were not raised at all. The pressures of growing consumer demand caused improvements in labour productivity instead of causing inflation. The big mistake in New Zealand was that interest rates were raised and, as a result, a healthy nationwide recovery gave way to an Auckland property boom. The Asian crisis of 1997-98 triggered a recession because we did our best to create a recession in 1995 and 1996. The Asian crisis did not trigger a recession in Australia, America, or in Europe.
Monetary policy in New Zealand serves an agenda other than the agenda it is supposed to be serving. It is a pro-capitalist, anti-worker agenda; a means of transferring money that would otherwise go to workers into the bank accounts of property owners.
There is no simple cause-effect relationship from high interest rates to low inflation to high sustainable growth. If we get low inflation after another bout of high interest rates, it will be because we have made our economy into a low wage low demand low productivity economy.
We were always going to have a slowdown in 2000 after the America's Cup. There is already enough data out to suggest that monetary policy is aggravating that slowdown. Monetary policy at present is pro-cyclical rather than counter-cyclical; aggravating rather than stabilising.
The inquiry into monetary policy should take a good look at the monetary history of New Zealand, and should note that the most immediate effect of rising interest rates is to increase consumer prices. It should also note that the more enduring impacts of artificially raised interest rates are reduced fulltime employment, reduced wages, increased dividends, productivity stasis and slow unsustainable growth. A whitewash, on the other hand, will focus on a few minor technical issues as a means of avoiding an analysis of what really does happen when interest rates are raised.
published on Scoop at www.scoop.co.nz/stories/HL0005/S00053.htm
Monetary power question for review, Brian Fallow, Business Herald, 10 May
© 2000 Keith Rankin
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