Debt and monetary policy — is there a link?
Gerard Jackson
It is a pretty sorry state of affairs when economic commentators can write of consumer spending and debt driving the economy without once referring to monetary policy. It is even worse when the same commentators write about monetary policy without even alluding to the money supply. This is akin to writing about botany without referring to plants.
A typical approach used by our commentators has "a consumer spending boom" operating in two ways. First, money is borrowed to buy a house or a car, for example. The seller then spends the money, the expenditure of which ripples through the economy as each recipient spends in turn.
Second, one can borrow against one's collateral, a house for instance. The borrowed money then ripples through economy as it is spent. Judging the situation from this angle commentators then write of a debt-driven boom. Sometimes even praising it as helping to sustain a strong economy and stimulate jobs growth. Eventually the spectre of higher interest rates appears to threaten this process, as is happening now.
However, these Pollyannas have a simple (I should say simpleminded) response. The Reserve won't raise rates to the point where they would burst the debt bubble and cause a severe downturn. The other argument is that so long as inflation appears confined to the 2-3 per cent range there is no need to raise rates. What is that even if the CPI is within the 2-3 per cent range a point will be reached when the Reserve won't have a choice. Whether we have reached that stage is for the Reserve to determine.
Let us now take a look at these commentators' economic logic, according to which borrowing — particularly by consumers — has been driving economic growth. If, for example, I borrow $1000 dollars from my neighbour how can this act help expand demand? A classical economist would be quick to point out that borrowing is a process whereby purchasing power is temporarily transferred from one person to another, thus leaving total spending unchanged.
Yet current crop of commentators seriously argue that borrowing in itself expands demand. How can this be? The answer is that these borrowed funds are not coming out of savings but out of a rapidly expanding money supply. This is something classical economists, at least the early ones, would have pinpointed. Central banks believe that can use interest rate policy to control inflation and economic growth by forcing down the "cost of capital". This is sheer mercantilism and always ends in tears.
The immediate result of forcing down rates is to expand the money supply which in turn stimulates output. From March 1996 to January 2008 currency grew by 110.7 per cent, bank deposits by 186 per cent and M1 by 169.2 per cent. This reckless expansion borders on the criminal. Any old time economist would have had no difficulty in relating our housing boom, current account deficit and foreign debt to the Reserve's reckless monetary policy.
The massive increase in bank deposits created a massive borrowing boom. Therefore it is not debt that has been driving the boom but an unsustainable monetary policy for which we can than Keynesianism.
The results of this irresponsible monetary policy has been documented, though barely understood. By March 2004, for example, debt levels had set a record with household debt being more than 400 per cent its 1991 level. Furthermore, real estate values nearly doubled in the four years to 2003. April 2003 to April 2004 experienced the highest annual growth in household debt ever recorded. Up to June 2004 year household debt was rising by 17 per cent a year. These figures are a symptom of racing inflation and make a mockery of the claim that the CPI was under control.
No wonder Reserve Bank governor Ian Macfarlane expressed concern about the situation. Well, notwithstanding the former governor's concern, the situation has only worsened. Unfortunately, Glenn Stevens, the Reserve's current governor, performance is on par with Macfarlane's sorry record. Ignoring the Reserve's reckless monetary policy some commentators blame deregulation for the boom in borrowing and real estate values, suggesting that the 1980s banking reforms are the principal reason for the debt explosion. This is very bad economics. There would be no debt problem if the debt had been funded by genuine savings instead of monetary growth. (I should point out that this stage that savings diverted to consumption become dissavings).
It has also been argued that the debt problem cannot be completely laid at the banks' doors because since 1990 a great deal of debt comes from outside the banking system. So what? If borrowing comes from individual savers then it is not part of the problem. Nevertheless, when rates are raised these borrowers would also feel financial pain: A fact that many borrowers have recently become aware of.
In any case, this argument overlooks the reality that currency has more than doubled during the last 14 years, which in itself is sufficient enough to expand the lending capacity of non-banking financial institutions. Be that as it may, there should be no escaping the fact the real problem is a dangerous lack of understanding of the nature of money and the microeconomic consequences of monetary expansion. Until greater monetary understanding is acquired, we can still expect the Reserve to repeatedly issue vain warnings about the growth of household debt and the need to curb it.
Gerard Jackson is Brookes' economics editor
BrookesNews.Com
Monday 5 May 2008