Leithner & Co Pty Ltd - Is Australia Really a Low-Inflation Country?

IS AUSTRALIA
REALLY A LOW-INFLATION COUNTRY?

15 March 2000

On 2 February the Reserve Bank of Australia increased the official cash rate, the rate on funds lent between banks and other institutions, from 5.0% to 5.5%. The RBA did so, according to the statement which accompanied its decision, partly because it detected incipient signs of inflation. A vociferous band of critics, however, has discounted both actual and incipient inflation and contended that higher interest rates will harm businesses and consumers. Despite their differences, three key assumptions unite these disputants: Australia is a low-inflation country; disinflation and low interest rates underpin the robust growth achieved in recent years; and the lower the inflation and interest rates, the longer the current prosperity will prevail. Similar debates, conducted by similar coalitions of support and opposition, are being conducted in Britain, Canada and the U.S.

I dissent from both groups and their three shared assumptions. Not only is inflation much higher than is usually recognised: its cause – subsidised market rates of interest – is encouraging “malinvestments” in capital goods. The monetary expansion of recent years, in other words, has sown the seeds of economic difficulties in the future. Australians have no particular reason to seek price stability or to be concerned about changes (whether upwards or downwards) in the general level of prices. They have every reason, however, to demand that the inflation of the money supply be quelled. The word “inflation” is almost invariably used by economists, politicians and market commentators and participants to refer to increases in the prices of raw materials, finished products and wages. Using this definition, the “headline” rate of inflation in Australia averaged approximately 2% per annum between January 1990 and December 1999, and has remained below or within the Reserve Bank’s target range of 2-3% since early 1996.

The conventional wisdom thus defines inflation in terms of its several possible consequences rather than its single and definitive cause. Inflation, in other words, rarely if ever refers to an increase in the supply of money. Attention is thereby distracted from monetary expansion – and from central banks’ sole responsibility for this expansion. Depending upon one’s definition of the money supply, inflation in Australia averaged closer to 6-7% during the 1990s. None other than the Reserve Bank Governor, Mr Ian McFarlane, told the Victorian branch of the Economic Society of Australia on 10 February that few (apart, presumably, from those eager to borrow) have recognised just how expansionary Australian monetary policy was during 1999.

As a result, the Reserve Bank’s quarterly economic statement released on 16 February stated that “inexpensive and freely available credit” was driving Australia’s rapid growth. The RBA’s statement, in the words of the Australian Financial Review, “portrayed an economy reaching its speed limit, fuelled by loose credit and rising asset prices.”

In this respect Australia is not alone: according to figures compiled by Gerry van Wyngen, inflation of the money supply in OECD countries has proceeded at an average rate of 7% per annum since 1988, and has increased dramatically from a low of 3% in the mid-1990s to 11% in 1999. Indeed, in an interview with Forbes published on 27 December 1999, James Grant, editor of Grant’s Interest Rate Observer, stated that “the [U.S.] Federal Reserve is expanding its balance sheet at year-on-year rates of about 13%. Fannie Mae and Freddie Mac [financial intermediaries backed indirectly by the U.S. government] are expanding balance sheets in excess of 20%. One can observe extremely brisk rates of overall growth in debt. If inflation were a stock, you’d want to own it. It’s selling below book value.”

Similarly, on 22 December 1999, Gerry van Wyngen reported to the Australian Financial Review: “the Fed has pumped the system full of money. The U.S. monetary base has jumped an incredible 20% annualised in the past three months. These are not just huge cash injections, they are so large that they are completely unprecedented. Banks are awash with money, and not just in the U.S., but also in Europe and the Asia-Pacific region.” On this latter point, Bridgewater Associates, the economic research firm based at Westport, Connecticut, reported in January 2000 that the Bank of Japan “has been adding yen to the banking system at rates which are magnitudes above the largest that have ever been seen in the past.” Clearly, then, when inflation is properly seen as an increase in the money supply, then inflation in Australia and elsewhere is currently much more pronounced than central bankers, politicians, economists and investors have recognised.

This view of inflation has two important consequences. First, it helps us to reconcile something which is otherwise difficult to comprehend: the co-existence in recent years of growth and virtually stable prices. Inflation often causes the general level of prices to increase. But it need not always do so: if technological improvements or organisational efficiencies exert a downward influence upon prices, but an increase in the money supply exerts an upward influence, then no visible change in the price level may occur. During times of high inflation, in other words, wages and prices may increase modestly or not at all. According to economists Friedrich Hayek, Wilhelm Röpke and Murray Rothbard, precisely such a situation occurred in Europe and the U.S. during the Roaring Twenties. And if contemporary proponents of the “New Economy” are correct, it is recurring today.Second, this perspective indicates how inflation produces demand for goods and services which is not supported by the current structure of production – and which thereby exacerbates the business cycle. Interest reflects individuals’ valuation of time; and the “natural” rate of interest indicates how much they are willing to forego consumption today in the expectation of greater consumption tomorrow. The greater (less) their willingness, the lower (higher) the natural rate of interest.

Yet the natural rate seldom prevails; and that which does (the “money” rate) is typically distorted by commercial and central banks. If the money rate is set lower than the natural rate, then the pace of credit creation quickens: seeing that it pays to borrow (i.e., the cost of credit is less than what can be earned on a new investment) businesses will demand loans. Hence inflation often makes its presence felt in the market for loans. If inflation encourages investment, then the structure of production will tilt towards more sophisticated (“lengthier”) processes and seemingly decrease the natural rate of interest.

The structure at any particular time tends to be just long enough to exhaust the fund of savings generated by the natural rate. But the future is unknowable, entrepreneurial error is inevitable and a perfect correspondence between the rate and the structure is unlikely. If the structure is too short relative to the rate, then there will exist unused capital available for deployment on more marginal projects; and if the structure is too long, then the fund will be expended before production is completed.The situation under these latter circumstances resembles that of a builder who has oversized a set of foundations and discovers, once much of the structure has been raised, that there are insufficient bricks to complete it. To complete their capital projects, and reassured by the apparent boom, entrepreneurs will seek to borrow more at subsidised market rates of interest. Sooner or later, however, either commercial banks (worried about the increasing pace and declining quality of credit) or the central bank (fearful of incipient or actual price increases) will halt the boom by intervening in the various markets for loans.

In this context it is significant that in the past several months central banks have expressed greater concern about price increases. It is also significant that, according to the January 2000 issue of Standard and Poor’s CreditFocus, the quality of credit in Australia and New Zealand has declined for five consecutive half-year periods.

Looking at inflation and interest rates from this perspective has two implications for investors. First, the relevant question to ask about prices and credit relates not so much to their stability but to their integrity. Stability can mask distortions introduced by easy money. Investors would therefore do well to ask themselves: given government intervention, do prices and interest rates convey accurate information? Acting on them, would individuals make reasonable choices? Or would they undertake malinvestments which must be liquidated when the boom ends?

Second, what is needed for a sound expansion of production is additional capital goods – not more money and credit. The boom conditions apparent today in some parts of Australia, Britain and Canada and many parts of the U.S. are therefore partly illusory. And to some extent Australians, Americans, Britons and Canadians are living on both borrowed time and borrowed money. Investment encouraged by subsidised rates of interest can be continued only so long as central and commercial banks make credit available at sub-natural rates. It is this margin between the subsidised and the natural rate which misleads entrepreneurs and gives their investments the false appearance of profitability. It also misleads consumers and gives their shopping sprees the false appearance of sustainability. When the boom ends, it does not cause difficulties: it merely makes apparent difficulties which inhered all along in inflation. The defining feature of booms, it seems to me, is not that they are periods of good business – rather, they are times when capital is squandered on bad investments.