What's Wrong with the Reserve Bank

It’s boom time, and the Reserve Bank of Australia (RBA) last week duly delivered on media predictions that it would push up the cost of borrowing to dampen the boom.

The new cash or interest rate is 6.5 per cent, after the ninth successive rise (all at 0.25 per cent) since May 2002.

This rise will not please the Howard Government and it certainly won’t please those with variable rate housing mortgages, many of whom are already struggling to make their monthly payments.

The theology underpinning monetary policy in Australia is simple. If inflation is tending upwards (3 per cent is the upper limit of acceptability), interest rates rise. When inflation eases off, interest rates are held stable or reduced marginally.

Thanks to Sean Leahy

The RBA’s predecessor, established after World War II, was given a rounded policy brief that included full employment as well as inflation. The new improved central bank has only a single brief: to control inflation.

The RBA’s mentality and tools are as narrow as its policy brief is constrained. Reserve Bank Governors preside over the economic pot on the stove and turn the heat up or down. They have to ensure that it’s cooking and not boiling over, but that’s it. They aren’t responsible for what goes into the pot, and they don’t know the recipes.

This pot-watching framework is the product of a crass amalgamation of crude versions of competing macroeconomic theories a ‘hydraulic’ Keynesianism, for which aggregate domestic expenditure can be readily manipulated, and Monetarism, for which money and prices are analytically separate from the ‘real’ economy. Individuals within monetary authorities may have a more nuanced understanding of how things operate, but this bastard approach to economic management has been institutionalised.

The macroeconomic orientation is compounded by the pretense that the structure of the economy is outside the Government’s purview. There is a pervasive ideology (at least in the English-speaking world), entrenched in the academic economics syllabus, that governments get the ‘big picture’ right, and the private sector looks after the details, generating public benefit through the pursuit of private interest courtesy of the market mechanism. The Government’s role at the microeconomic level is merely to dismantle all the impediments to the ‘free market.’

This clean lines scenario has been repeated by the Treasurer only recently, but a model official version was produced by Treasury for the 1999-2000 Budget Papers.

The real world does not operate to order, with socially desirable goals left wanting in the anarchic pursuit of self interest. The development of a skilled workforce, for example, is a perennial casualty of market forces and central bankers, by training and socialisation, have no idea of what goes into what economists crudely call ‘the supply side.’

The macroeconomic bluntness of the RBA’s brief has other obvious problems. It discounts sectoral (and regional) differences in tempo. Do we shut down the whole country because two States are going gang-busters on resources? Some sectors may need dampening, while others may not.

It also discounts variable dependence on debt (the family farmer was a traditional dependent) and variable dependence on domestic capital markets for that debt.

Beyond the macroeconomic bluntness lies a more fundamental question of causal influence. The RBA’s sole instrument seeks to influence the price of credit. Its effectiveness depends on the presumption that credit markets (and ultimately expenditure) are sensitive to price, which in turn relies on the presumption that markets clear readily (given no external impediments), and that they clear through price variation.

Both demand and supply are assumed to be sensitive to price. Pushing up the base price of credit is supposed to reduce the demand for credit and push up the supply of savings, and, through a pincer movement, depress aggregate expenditure. In turn, depressed expenditure is supposed to depress the inflation rate.

Again, in the real world, there are a few slips between the cup and the lip. The authorities have given up trying to understand how inflation is generated. The loss of faith during the 1980s in the previously virulently fashionable Monetarism (which argued that inflation was simply a product of excess money supply) has left a void. In the old days, economists used to fight over what causes inflation; now nobody bothers. These days, to admit differences of opinion only makes a profession buoyed on the cult of expertise look hollow.

Dissonant detail is confronted pragmatically, rather than being analysed for lessons. A rise in the cash rate is going to do nothing for the price of food, driven higher by petrol prices or climatic adversity. It’s going to do nothing for the pressure on earnings of skilled workers in high demand and in short supply. It’s going to do nothing for the price of health insurance.

A rise in the cash rate may help to dampen house price rises, as it did in 2005. House prices are more closely linked to the price of credit than other prices. But the last two years has seen a dramatically uneven effect across the housing spectrum.

Housing supply is inelastic, and housing prices are not a dominant determinant of increased supply. Moreover, the housing market is dramatically differentiated by perceived quality. Quality housing supply is essentially fixed, with insatiable demand impervious to interest rates. Rate rises hit hardest those who most need support. An undiscriminating macroeconomic instrument is blind to such considerations.

Furthermore, following financial deregulation, access to global capital markets by large financial institutions made domestic market conditions (such as interest rates) of marginal significance.

The weakness of macroeconomic measures has been enhanced with the destruction of a range of monetary policy instruments after decades of lobbying from the banks and capital markets. Quantitative controls and discriminatory interventions have been removed from the policy basket.

All that is left is manipulation of the cash rate, which can be brutal in some domains and ineffective in others. Financial deregulation may have rendered many previous instruments inoperative, but a changed environment doesn’t invalidate the need for the authorities to rethink how a weak regulatory regimen can be reinforced.

Monetary policy has been further weakened by the 1998 creation of the Australian Prudential Regulatory Authority (APRA) as a separate entity. APRA has a formal wide brief for intervention into the operation of financial institutions, but it has consistently declined to use its charter to advantage, preferring to concentrate on the narrow issue of banks’ balance sheets.

The separation of regulators and APRA’s narrow focus have both contributed to passivity in the face of the myriad finance sector innovations and policy changes that have facilitated a massive rise in credit in the last decade in particular, residential mortgage securitisation, margin lending for share market speculation, home equity withdrawals, and deposit deferral instruments for residential investors, backed up by the lessening of capital gains tax in 1999.

The profit-oriented private sector performs essentially public functions with public outcomes. But regulatory authorities are now allowed to influence this process only on the narrowest of terms and by the most indirect of means. Vested interests and ideology appear to be more important than functionality.

The monetary authorities themselves seem to have been trained out of conceiving the big picture and have succumbed to an ideologically driven role dressed up as technical expertise. The much repeated aphorism attributed to the American psychologist Abraham Maslow is apt: ‘if the only tool you have is a hammer, you tend to treat everything as if it is a nail.’

Behind the ideological confinement of policy instruments is the ideological prioritisation of policy agendas, and the ideological delimitation of theoretical causal influences. An incisive 2003 article by University of Massachusetts Amherst economist Richard Wolff exposes the discretionary character of the policy environment, most strikingly embodied in the now heavily blinkered arena of monetary policy:

Policies ‘work’ by selecting particular causes of any targeted problem, focusing exclusively upon them, and thereby moving other causes to the edges or altogether out of consideration The great practical importance of policy is to shape events by restricting the public discourse about what steps are appropriate to deal with problems. That is why, despite the fact that particular policies eg reducing interest rates to reverse economic declines ‘fail’ as often as they ‘succeed,’ they remain dominant policies across repeated economic declines. Policies police the public understanding and response to social problems.

Monetary authorities now speak in signs rather than substance, and their status is determined by the cult of recognition rather than reason. Governance is by technobabble; the new secular religion. The priesthood raises the interest rate as ritual blood-letting to the gods in the hope of rain and a bountiful harvest.

Our market analysts imagine that they have risen beyond the primitives but they are still examining the entrails of the beast for clues to unfathomable mechanisms of the processes that dictate our lives.