ECONOMIC AFFAIRS: by Colin TeeseNews Weekly
Australia facing external economic pressures
, September 27, 2008
One-time federal Liberal leader Dr John Hewson has had second thoughts about whether the Reserve Bank of Australia is capable of exercising its traditional role in economic management. Colin Teese reports.One-time federal Liberal leader Dr John Hewson has had second thoughts about the best way to fight inflation, according to a recent article of his ("Little choice for the RBA", Australian Financial Review, August 29).
A couple of decades ago, Hewson was in the vanguard of those calling for an independent Reserve Bank of Australia. Inflation in the economy, he and others of like mind insisted, was best managed if central banks were given independent control over monetary policy (that is to say setting official interest rates to control the flow of money going into the economy).
A central bank without independence, it was feared, would always be susceptible to government pressure to adjust interest rates to serve political rather than economic purposes.
The central bank would set an annual inflation target (of, say, 2 to 3 per cent). Whenever inflation in the economy threatened to move above the target, interest rates would be increased, making money dearer and thereby slowing the growth in total spending and reigning in any potential breakout of inflation.Stagflation
Hewson and others recalled the nasty history of the 1970s. Runaway inflation had ushered in a worldwide recession, bringing with it a new economic phenomenon somewhat inelegantly entitled "stagflation" - i.e., stagnant or declining output and employment, combined with galloping inflation of a kind usually associated with excessive growth.
All of these inflationary troubles, and their consequences, so the thinking went, could be traced back to permissive monetary policy wilfully tolerated by governments, primarily in the United States but also elsewhere in the West. The solution was to wrest control of monetary policy from the hands of politicians, with their short-term political horizons, and pass it to the safer hands and more sober minds of central bankers.
It all made wonderful sense - providing, of course, that the reasoning was sound and that stagflation could be attributed entirely, or certainly largely, to malevolent politicians rather than to some other still-to-be-identified cause.
Many were not convinced that the causes of stagflation all those years ago could be put down to mere mismanagement of the money supply. Their view was that monetary policy was, of itself, an inadequate instrument to manage inflation - no matter who had control over it. Importantly, what could not be disputed was that however well monetary policy might help manage goods-price inflation, it could have no impact on asset-price inflation - notably, on share and house prices.
Orthodox economists dismissed contemptuously any concern for asset-price inflation. Some, indeed, saw it as a virtue. The economics writer of the Australian Financial Review
is on record as asserting that inflating house prices actually made people richer.
The eternal merit of Dr Hewson's recent article is that he is now prepared to re-visit once firmly held positions. He may even be the first of the orthodox economists in this country to show such flexibility.
And let no-one attempt to criticise him for inconsistency. What he is really suggesting is that the underlying assumptions of some economic policy positions of 25 years ago no longer hold. Good on him!
Certainly, central banks seem to have come to believe their own publicity. However, central banks management of interest rates may not
have been the decisive influence in controlling inflation in the last 25 years, Hewson now believes.
He concludes, again correctly, that downward pressures on inflation over that period have been externally generated. We were importing deflation
in the form of cheaper goods from the newly emerging economies, notably China, in the same way that we are now importing inflation from external sources.
The reality facing us is that the era of cheap imports from China and other emerging economies is coming to an end. Rising global energy and oil prices are feeding further cost pressures into all economies. At the same time, the cost of money (i.e., interest rates) is rising and its supply becoming more restricted.
If goods-price deflation over the last quarter century was, in large part, externally generated (by, for example, cheap goods from China), it follows that the central bank's manipulation of interest rates was a sideshow to that main game.
And since the inflationary pressures we now face are also being generated externally, it follows, as before, that those external pressures will be the decisive influence on future levels of inflation in Australia. What our Reserve Bank does or does not do about interest rates will have, at best, small impact on the future development of these inflationary pressures.
Hewson goes on from here to draw further obvious, but hitherto widely ignored, conclusions about the problems in our economy caused by our excessive dependence on minerals exports.
Australia's is, in fact, a dual economy. Prosperity, even excessive growth - and certainly inflation - in one part of the economy and specifically benefiting certain states, is being driven by the boom in mineral commodity exports. This boom also pushes up the exchange rate of the Australian dollar, making our exports dearer and imports cheaper.
Meanwhile, other critical parts of the economy, notably manufacturing in the two most populous states, Victoria and New South Wales, which end up carrying the full burden of these consequences, drift into recession.
Coping with all of this is beyond the capacity of our Reserve Bank. The single element of the present inflationary pressures that the bank is capable of influencing is that created by the mining boom. To deal with that the RBA should be raising interest rates. Instead, it has recently cut them by 0.25 per cent.
Why? Because taking firm action to tame the inflationary pressures of the mining boom in the minerals-exporting states by pushing up interest rates would have pushed the other parts of our economy in the rest of Australia more deeply into recession.
A number of important points emerge from all of this. First, central banks, whether or not independent - in Australia or elsewhere - cannot deal with internationally-generated inflationary pressures. Second, in Australia's case, the "dual economy" phenomenon creates a special problem.
Clearly, the RBA's hands are tied. Controlling domestically driven inflation in one part of the economy will impact adversely on the economic health of the other part. And that is precisely the scenario we have witnessed being played out recently. Whichever way the RBA moved on interest rates, it was open to criticism.
Central banks in other parts of the Western world, most notably in the United States, face a similar dilemma, though for different reasons.
The US Federal Reserve has, correctly, ignored inflationary concerns in order to tackle an internally generated financial crisis, which, if left unchecked, was threatening to undermine Western capitalism. What was done to prop up the famous US bank, Lehman Brothers, was of questionable legality and may have cost US taxpayers US$5 billion. In the circumstances, the government probably felt it had no alternative.
Of course, the US Federal Reserve was, and is, confronting much the same externally generated inflationary pressures as Australia, and, like our own Reserve Bank, could do nothing about them. No wonder the US Federal Reserve chairman, Ben Bernanke, decided to ignore them.
Against this background we may reasonably conclude that central banks are no longer capable of exercising their traditional role in economic management.
How could this have come about? At the very least, we can say that the financial crisis which began in the US some time after the middle of last year is a major contributing factor. The US financial system was, after all, fuelling the asset-price boom. Nobody seems to have any idea about the likely duration of the present crisis, or even what might be its lasting impact.
What we can say is that its impact has spread quickly to infect much of Europe, Japan and even China, although, so far, to a small extent. New Zealand has also been badly affected.
Thus far, we in Australia have managed to avoid most of its worst aspects, though, like the rest of the world, we are suffering from the resurgence of serious inflation which is being drawn along in its wake.
Why have we been so lucky so far? Mostly because of our trading relationship with China. And China has not yet seen its own economic growth slow significantly - thankfully.
Our huge exports of iron ore and coal depend heavily on continuing Chinese economic growth. While China keeps growing we can expect to avoid the worst of the fall-out from the US financial crisis.
Still, the future remains uncertain, and, at the very least, we can anticipate some slowing of Chinese exports. But we also know that, in recent years, an ever-increasing proportion of China's economic growth has been internally generated.
Let us hope that continues. Any slow-down in the sales of energy resources and iron ore to China will have serious adverse consequences for us. Our future prosperity rests heavily upon those sales.
On the other hand, having China as our biggest customer also brings problems. China is becoming so rich and so powerful that it is capable of, and wants to, buy significant interests in our biggest mining companies.Chinese investment
Even if this were only ordinary foreign investment, there would be cause for concern. But this is so-called "sovereign wealth fund" investment, which, in the case of China means, effectively, direct investment by the Chinese government.
The question for Australia is how much of our sovereignty is threatened by Chinese government holdings in our biggest mining companies?
The way events are shaping up means that, in the coming years, China seems poised to exercise an ever-increasing influence over our politics and economics - maybe, a bigger and more troubling influence than we would like.
Can we be certain that either side of politics in Australia will be up to dealing with the problem?- Colin Teese is a former deputy secretary of the Department of Trade.