Stock Market, Interest Rates and the Business Cycle

By: Gerard_Jackson

The turbulence in America's subprime market is being blamed for the current international financial crises, proving once again that our economic commentators are largely clueless on such matters. This is made particularly clear by their approach to rising interest rates that are going to cause a lot of pain. (For example, the ANZ bank has raised its standard variable home loan rate to 8.32 per cent).

Treasurer Peter Costello finds himself at a complete loss. Were we not told that eliminating government debt and accumulating surpluses would lower interest rates? Yet our interest rates have been about 30 per cent above the US level — and she's been running a deficit. And what does Costello do? He blames America's subprime market for the rise in our interest rates. Never mind, Alan Wood, economics editor of The Australian , is going to run interference for him. His response to the present financial turmoil is to claim that “Costello may yet owe a big debt of gratitude to a greedy bunch of loan sharks in the US subprime mortgage market” ( Shaky market may halt rate rise , 11 August 2007).

This is a vicious accusation from someone who is at a complete loss to explain the present monetary disturbance. As far as Wood and Costello are concerned, money has nothing to do with it. This is why Wood could say that “the Reserve Bank's decision to pump up market liquidity was more of a precaution than a necessity, although there's no way to be sure”. Of course he cannot be sure — that's because he is as hopeless on monetary and capital theory as is Costello.

How about these figures? When Howard first became Prime Minister in March 1996 the amount of Australian currency was 18.7, bank deposits were 65.3 and M1 was 84. The respective figures are now 37.4, 170 and 2007. In per centage terms currency has increased by 116 per cent, bank deposits by 160 per cent and M1 by 146 per cent. And Alan Wood and the rest of Australia's economic commentariat cannot find a damn thing wrong with these monetary aggregates. Yet he has the bloody gall to refer to “loan sharks”. Even Bernie Frazer, a former governor of the Reserve Bank of Australia, unequivocally stated that

If demand runs ahead of capacity, it will spill over into imports and widen the current account deficit (CAD). This is what happened in 1989-90 when the deficit reached 6 per cent of GDP. On this occasion the CAD is not expected to increase to the very high levels reached during the lat 1980s. (Reserve Bank Annual Report, 1994).

What does it take for the likes of Wood to connect the dots between our current account deficit, foreign debt and interest rates to these monetary figures? I just do not know. But I do know that anyone who praises the Reserve Bank of Australia's handling of the business cycle must be completely ignorant of economic history and capital theory. I figure that takes in the whole of our navel-gazing economic commentators.

So how did we get here? I am reminded of a paper delivered to the Melbourne Institute conference in late 1997 by Peter Downes, an RBA staffer. He made the point that there can be no business cycle because there is no statistical regularity in these economic fluctuations. He went on to criticize demand-side explanations for booms and busts. His view being that if we can foresee demand-driven movements in GDP in which the economic aggregates move in the same direction this leads to the question: why can't these forces be controlled? It seems that he thinks that the continual changes that influence these forces are too complicated to be controlled. Downes revealed the Keynesian influence on his thinking when he stated that

The leakage into imports of these latter items [producer goods] attenuates the impact of the investment accelerator and the inventory cycle, which consequently seem to play a lesser role here in propagating shocks over time than in other countries. This makes the movements in GDP more subject in the short term to movements in exogenous factors.

There are no leakages. The economy is not an incredible complex piece of plumbing. Exchanges take place on a voluntary basis. If “demand runs ahead of capacity”, as Bernie Fraser put it, then the demand for imports will rise. But this is just another way of saying that the Reserve is inflating the currency. Following the usual economic template Downes said that Australia is especially influenced by commodity price movements and mining booms, wage pushes and droughts. Well, price movements and mining booms can be directly linked to credit expansion elsewhere on the planet. In the present situation it is China's credit-driven boom that is raising the prices of our commodities. As for wage pushes, these can, if big enough, force an economy into recession. But this situation cannot be compared with the so-called boom-bust cycle. The same goes for droughts.

He argued that there is also the problem of short-term demand leaking into imports. Once again, this is a monetary phenomenon. But in this country money does not matter, at least from most of our economists' point of view. Then there is the impact of rising labour costs as activity intensifies. Again, if wages rise because of rising productivity there is no problem. But if wages are driven by an inflationary policy (loose money) then the problem is not labour costs but the Reserve Bank. The same goes for higher prices emerging as economic activity intensifies. Higher interest rates in this kind of monetary environment will inevitably rise. The answer is sound money. As a rule, an inflationary policy drives down the exchange rate. However, Australia can avoid this for a time if there is an increased demand for her commodities. This is precisely what has happened.

It seems to me that the only thing that Downes got right is that there really is no such thing as the business cycle, which is supposed to be an inherent part of capitalism: the product of the “anarchy of social production”. (Karl Marx and Friedrich Engels The Communist Manifesto , Blackfriars Press LTD, Leicester, 1948, p. 76). Whatever he thinks, there is no inventory or building cycle; the accelerator is a Keynesian myth, and the sooner it is buried the better; as already explained, ‘demand' — meaning an expanded money supply — does not leak into imports. What happens is that the rate of interest is forced below the market rate which sends a false investment signal to businesses by expanding credit. The newly created credit is then employed in projects for which all the factors necessary for their completion are not available. Sooner or later the necessary readjustments will have to be made. We call it a recession.

This forcing of interest rates down below their market rates requires further attention. What used to be called a ‘cheap money' policy fuels speculation in shares and real estate; prices begin to rise as does the demand for imports in response to the increase in monetary demand which also misdirects production. As prices rise the price premium also rises causing nominal and eventually real interest rates to rise. Moreover, artificially lowering the rate of interest therefore expands demand for producer goods without increasing their supply. In the case of Australia a disproportionate amount of the newly-created bank credit will be directed to foreign producers of capital goods. The so-called accelerator has nothing to do with it.

For fear of sound repetitive, the accelerator does not exist. Therefore any economic analysis based on this economic fiction is guaranteed to give lousy results. For a full refutation of the accelerator principle readers should turn to Professor W. H. Hutt's The Keynesian Episode: A Reassessment , Liberty Press, 1979, chapter 17). So rather than attenuate any cycle we find that the rise in imported capital goods is just another aspect of credit-generated boom.

Unfortunately, even if our politicians were wise enough implement sound monetary policies the inflationary policies of other countries would still destabilise us. (This is not an argument against such policies. Their absence has caused much damage to the economy and continues to do so). As other countries inflate they increase their demand for our products thereby causing us to direct investment into those lines of production; when they finally call a halt to their inflationary policies demand for our exports fall and this reverberates throughout the economy. The extent of the immediate damage is really determined by the degree to which resources were shifted to those export sectors.

I was inclined to the view that our economic commentators, despite certain individual protestations to the contrary, are still stuck in a Keynesian rut but Terry McCrann and Alan Wood have started me wondering whether most of Australia's economic commentariat has largely abandoned even Keynesianism in order to embrace institutional economics, an approach that denies the very existence of economic laws.

Gerard Jackson
BrookesNews.Com

Gerard Jackson is Brookes economics editor.

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