published in NZ Herald on 2 March as Approach is orthodox but so was burning witches

 Monetary Policy

Keith Rankin, 27 February 2000


Mistaken monetary policy - in particular the upward manipulation of interest rates - has been arguably the major single reason for the much slower rates of productivity growth in New Zealand from 1985.

Whenever the Reserve Bank is criticised in the Herald or elsewhere, the Bank almost always defends itself (eg Adrian Orr on 24 February). We are told that the Reserve Bank's approach is orthodox, and that inflation (or easy monetary policy, which as US observers will have noted, is not the same thing) cannot raise the long-run growth rate.

It is true that monetarism became orthodox in the USA and in Britain in the 1970s, and in much of the rest of the world in the 1980s. This orthodoxy is self-perpetuating because economists with a monetarist bent seek employment within nations' central banks.

Being orthodox is not the same as being correct. Indeed it was once orthodox to burn witches.

Monetarism's origins go back to a pamphlet published in 1567 by the French political philosopher Jean Bodin ("Reply to the Paradoxes of Malestroit concerning the Dearness of all things and the Remedy Therefore"). In addition to his arguments about the causes of inflation, Bodin, in his bestseller Demonomania, advocated the burning of witches. (Of course we cannot reject monetarism simply because its founder believed in such persecution.)

The stated goal of monetary policy is to allow economies to grow at their maximum sustainable rates. The modern monetarist approach assumes that price instability, economic fluctuations (ie upturns and downturns) and uncertainty diminish economic growth. A second key assumption behind this orthodoxy is that central bank intervention to raise or lower short-term interest rates can reduce price instability, fluctuations and uncertainty without long-term costs.

There is no hard evidence that either assumption is valid. Further, there is no evidence that this once-fashionable orthodoxy in macroeconomic management has been more successful in its goals than have previous orthodoxies.

In the USA through most of the 1990s, Alan Greenspan, an orthodox monetarist, resisted orthodox advice to raise interest rates to counter the Clinton growth boom. He feared that the costs of the monetarist medicine would exceed the expected costs of an inflationary boom.

Our own Don Brash had no such qualms in 1994. We will never know what would have happened if Dr Brash had adopted Greenspan-like restraint.

It turned out that, in the USA, the inflation did not materialise. Instead, all the risk-factors that were expected to produce inflation - eg wage growth and employment growth - turned out to be catalysts for a return to high productivity growth.

The second claim by the Reserve Bank is that inflation is of no benefit to an economy. This is rhetorical sleight-of-hand. The fact that inflation or a pro-inflation policy may not benefit an economy tells us nothing about the harm that an anti-inflation policy may create.

The orthodoxy that the Reserve Bank claims to be following is a hybrid of two incompatible versions of monetarism. One version suggests that the Brash approach has huge downside risks.

Classical monetarism, which dates back to Bodin but is most commonly linked to the 18th century Scottish philosopher David Hume, states that money is a veil and that therefore monetary policy in the long run impacts only on prices, never on the growth rate. That remains a central tenet of the Reserve Bank.

The alternative version of monetarism is that of Milton Friedman, the scourge of mid-20th century Keynesian orthodoxy. The US Federal Reserve Bank (the "Fed") is more in tune with Friedman's monetarism, and knows the downside of firm monetary policies. To illustrate that, there was a huge difference between the Fed's response to the 1987 sharemarket crash and that of our own central bank.

In the Friedman version, inappropriate tight monetary policies inflict sustained harm on the whole of the macroeconomy (prices, production and employment). Friedman co-authored a major historical study which concluded that most of the depressions and recessions in American history were caused by inappropriate monetary conditions.

Friedman also believed that policy fine-tuning - which is what our Reserve Bank does to try to smooth economic fluctuations - was counterproductive. Instead he suggested that central banks should simply expand the money supply by three percent per annum, enough he believed to finance maximum sustainable growth.

Friedman's policy programme was simplistic in the extreme. Nevertheless, in his hands, monetarist dogma changed. Following Friedman, we understood that poorly executed monetary policy could severely harm a nation's economy.

The orthodoxy that Alan Greenspan follows urges extreme caution in the use of high interest rates. In New Zealand, we have seen no such caution in the last 15 years. The result has been the obvious decline in our economic capacity relative to that of the countries we compare ourselves with.


Monetary Policy Still in Step with the World, NZRB's Adrian Orr, chief manager of the Reserve Bank's economics department, NZ Herald 24 Feb 2000.

Narrow focus of monetarism has had destructive economic effect, Tim Hazledine NZ Herald 15 Feb 2000.

© 2000  Keith Rankin

Rankin File | 2000 titles