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
Thursday Column Archive (2000): http://pl.net/~keithr/Thursday2000.html