Here is a link for an interview with Friedman when he came to Australia in 1998 which is interesting.

http://www.abc.net.au/money/vault/extras/extra5.htm

following is a chart on US Household debt and debt service from Nouriel Roubini’s Global EconoMonitor website.
http://www.rgemonitor.com/blog/roubini/archive/2008-02/

Can you tell me if Australia household debt and debt servicing

is in better or worse shape the the US.

Thank you

Keith MacLennan

It’s like I am an individual imaginary number trying to understand the Mandelbrot set, only with far more dimensions.

You are unusual!

Firstly, let me say that your financial prudence is probably in no practical danger. I do advocate that deliberately engineered inflation is a solution for a debt-induced recession (in the same way that chemotherapy is a solution for cancer–it may work, it’s dreadful, but better than the alternative). But I have complete confidence that the rest of my profession will fight tooth and nail to avoid inflation–and they will win the initial policy battle, and I will lose.

Secondly, once they realise (in about 4-6 years) that inflation is needed–certainly if deflation takes hold, as it did in Japan–the method they use to try to cause it will fail.

So I think that, practically speaking, you have nothing to worry about.

More likely, a combination of a debt-induced recession, falling asset prices, and possible deflation, will put you in a better situation than the one you already occupy.

On the theoretical points, there’s much to discuss. The bubble we’ve been through has primarily driven up asset prices, with a spillover as well into additional commodity spending; but if the bubble hadn’t occurred, it’s quite possible that economic growth would have been as high or higher. If our institutional framework had encouraged actual investment rather than speculation, we could well have seen the benefits of real innovations–low cost solar panels for example, or a low cost maglev transportation system–rather than simply inflated asset values.

So I don’t think the depression that a collapse in asset prices will cause will simply balance out an excessively high period of growth caused by the borrowing. The borrowing binge quite possibly reduced growth over what it could have been without it, while the negative impact of a debt-driven slump will be substantial.

As noted, you are a true exception: most people who are in your cash-rich situation got there via asset speculation–and getting out early before the bubble burst. Those who rode that route to riches and then found it eaten away (via a successful program of deliberately caused inflation) would not get my sympathy. You would–but as noted, in practice I doubt that you’ll need it.

The real long term solution that I’m angling for is to relate loans to the income stream the asset purchased by the loan will generate. That would stop these bubbles in their tracks–indeed the only avenue for large gains for lenders would come from backing truly innovative investment, rather than speculation on the prices of existing assets. But in the meantime, once a crisis caused by excessive debt comes along, I also have a responsibility to suggest a short-term palliative as well–hence noting the beneficial role of commodity price inflation in such a setting.

There is also one aspect of today that will quite possibly cause inflation, independent of any policy: global warming and peak oil will drive up commodity prices, without any policy input. China’s boom is also doing the same thing–though that may prove fragile for ecological as much as economic reasons at some stage in the near future.

On interest rates, I would have less of a problem with the RBA’s hawkishness on this if it were actually directed at spiking the property market bubble. It’s a blunt, dangerous way to do that, but yes a rate rise now–or sharper ones earlier–could have stopped the debt bubble earlier.

My concern instead is that the RBA is focusing simply on keeping commodity price inflation low.

Now if they did the right thing for the wrong reason, that in itself would be a lesser evil. But there is a possibility that they will do a right thing and a wrong one: stop the bubble, ultimately, years after it should have been pricked; but also set off deflationary forces.

I hasten to add that I expect inflation courtesy of global warming (GW) and peak oil (PO), no matter what the rate rises independently do to inflationary pressures. But even then there is a chance that a sudden debt-induced recession here, and in the rest of the OECD, could lead to deflation even with GW & PO.

Then we’d be in the worst of all worlds.

Finally, while I’m advocating inflation as a policy, it’s as much a “hold the line” advocacy as anything else. Inflation of the order of 2-4% has been a commonplace over the last two centuries–most of the episodes of falling prices have been in conjunction with bursting debt bubbles, while higher inflations have been associated mainly with wars. People like yourself have prospered despite that inflation.

So the RBA being paranoid about a level of 4% now is, to my mind, a bit like obsessing about a cracked nail when you’re on the verge of getting pneumonia. Ignore the nail for a while, and do something about your chest would be apt medical advice.

Thanks for your work.

I’m just a non economist out here with a family and a pretty high income. What’s quite unusual about me is that I have no housing assets but do have large savings. I can see that the speculative housing mania has made it so much cheaper for me to rent than to own a house that I am far better off without even one house let alone the usual three or six of most people with my income.

I’m just trying to think through the implications to the individual of the idea that we should allow a little bit of inflation to avoid the ‘disaster’ of asset price falls and the economic contraction that will go with the reduction in credit growth that the asset price falls cause.

So if we imagine that rather than raising rates above 7%, rates had been left back at 6 or 5% and inflation allowed to rise to 5% or so. What would that do to the incentives placed on me? What would it do to the incentives placed on the geared housing (or other) speculator? What about the person with a home loan line of credit looking at a nice new car or lounge?

For those who earn more than they spend like me, if it became clear that the value of our savings were going to be systematically eroded as a matter of policy and thus slowly transferred to the people we lend them to, then it would not seem rational to continue to save. It seems that it’s almost impossible to convince people to save as it is, let alone if we intentionally make real (before tax) interest rates tiny or negative. I might not buy a house at more than three times the cost of renting one, but I might consider buying antiques, or something (anything?) else tangible that amused me and that government cannot decide to steadily nick from me to transfer to other people. Even extra concert tickets now would seem more rational than saving the money only to find that in a few years the same money plus interest will not buy the same concert tickets. Maybe I should even borrow to buy the concert tickets under those circumstances – as long as I never paid my loan back it would disappear eventually. How would my and a zillion other people’s behavior feed back into inflation?

A realisation that we will intentionally allow some inflation will surely show geared price speculators that they were right all along and reinforce their irrational behavior (well, in fact make it rational), so lead to more of it.

I can’t see how the economic contraction that may go along with a reversal of the credit expansion and asset price bubble can be a disaster. Sure, lots of people will realise that they are broke, but hiding it from them for longer does not change it.

If there was a lot more employment up to and including now because of unsustainable credit growth in a great house price bubble ponzi scheme, then that employment maybe was a kind of a “goodness” over and above normal, rather than the inevitable return to sustainable economic behavior being seen as a “badness” beneath normal.

There is an issue of both moral fairness and operant learning here as well. Should those people who recognised that house prices were irrational be penalised for having thought about what they do and decided to save instead? Should those people who use the investment technique of ‘look for something that somebody recently paid more than guy before him for and pay even more’ not suffer the expected consequences at the expense of those who behaved rationally? What future behaviors would this constellation of penalties for rational behavior and and non-penalties for irrational behavior induce?

I guess in short I’m asking, won’t keeping interest rates low and allowing “a bit more” inflation just hide the problem of household speculation and insolvency from us for a bit longer, allowing or even inducing more new players to join the ponzi scheme, and making it worse in the long run?

I had a quick look, but as soon as I saw “Do the Math.. Calculate the inherent multiplication of debt to systemic collapse yourself!”, I lost interest–if you’ll pardon the pun!

The basic argument the site makes is the same one that some of my non-neoclassical colleagues made when they attempted to model endogenous money creation, working from the propositions of the European Circuitist School. Effectively, they argue that if you borrow a Loan, all that it can do is finance an equivalent amount of expenditure–and since interest is charged on the loan, there is no possibility of paying it back.

Certainly, they felt, it wasn’t possible to borrow money, repay it plus interest, and make a profit. As one of my good friends in this field put it:

““The existence of monetary profits at the macroeconomic level has always been a conundrum for theoreticians of the monetary circuit… not only are firms unable to create profits, they also cannot raise sufficient funds to cover the payment of interest. In other words, how can M become M`?” (Rochon 2005: 125)”

I set out to solve that problem, and developed a simple model of a pure credit economy that showed it was quite possible to borrow money, make a profit, and repay the loan over time–with positive profits to capitalists, positive wages to workers, and positive interest income to bankers.

I’ve avoided posting this to my blog for quite a while, because it requires delving into some moderately difficult logic; but given the extent to which posters here bring this topic up, it looks like I’m going to have to make a post on it.

The argument is too complex to make in a reply like this, but the essence is that the proposition that interest necessarily causes debt to accumulate to unsustainable levels involves a confusion of stocks with flows. An initial loan is a stock; it enables a flow of income to be generated (assuming the existence of a productive economy which generates a physical surplus of outputs over inputs) that enables the flow of interest payments to be met; and so long as the physical productivity of the economy substantially exceeds the rate of interest, there is a sufficient surplus flow of profits over interest payments that can be used to pay debt down to zero over time, if desired.

Clearly in the real world, debt has accumulated close to exponentially; but this phenomenon requires a more sophisticated explanation than that proferred by perfecteconomy and the like.

So for the moment, take it from me that perfecteconomy’s arguments are flawed. Then give me a few weeks to develop a post on this–I have another Debtwatch to get ready for March, and a ton of formal academic writing commitments to reach.

Dave, throwing Friedman’s thoughts into the rubbish bin is kind treatment. At a glib level–”inflation is caused by too much money chasing too few goods”–it seems to be folk common sense, and most people assume there is good economic logic backing up that folk conclusion.

It’s not. In my opinion, the model from which Friedman derived his conclusions about money supply growth and inflation is an insult to logic. But you have to read the original article to know that.

This is why, in my teaching, I insist that my students “read the originals” rather than relying on second or third hand accounts in textbooks and the like.

Friedman’s case was made in a paper entitled “The Optimum Quantity of Money”. His model of money creation in that paper was that a helicopter magically appears over an economy and drops dollar bills at random out of the sky.

You think I’m joking?:

“Let us suppose now that one day a helicopter flies over this community and drops an additional $1,000 in bills from the sky, which is, of course, hastily collected by members of the community…”

“When the helicopter starts dropping money in a steady stream-or, more generally, when the quantity of money starts unexpectedly to rise more rapidly-it takes time for people to catch on to what is happening…”

This is where the jibe at Bernanke as being “helicopter Ben” came from, when he argued in 2003 that, if deflation occurred, it could be countered by “the simple expedient of the printing press”.

Hello Milton, where does credit figure in this? And debt?

It gets worse when it comes to practical recommendations. Whereas the simple summary of Milton argues for increasing the money supply at, say, 5%, to get a 2% rate of inflation, his preferred recommendation was for continuous deflation:

“These practical considerations, I believe, make it unwise to recommend as a policy objective a policy of deflation of final-product prices sufficient to yield a full optimum in the sense of this paper. The rough estimates of the preceding section indicate that that would require for the U.S. a decline in prices at the rate of at least 5 per cent per year, and perhaps decidedly more…”

He followed this with an observation that the transition to this regime would be costly, and ended up recommending 2 percent increase p.a. to keep prices constant. But the entire discussion did not once consider the impact of deflation on outstanding debt levels–because, in his model, THERE IS NO DEBT. Money is simply an asset to the holder but a liability to no-one.

That is not the credit world in which we actually live. His model is both laughable and irrelevant to our actual economy.

It is also a very serious mistake in modelling to reverse the direction of causation. If price rises cause growth in the money supply, rather than vice versa, then trying to limit growth in the money supply (a) will not work to control iflation and (b) will probably have unexpected and unintended consequences.

This was the experience of Central Banks when they followed Milton’s creed and tried to control the rate of growth of the money supply. Firstly they missed monetary targets by huge margins–they’d set a target of, say, 10% increase in the money supply for one year, and actually get a 22% increase.

Secondly, whereas Milton argued that the economy would very rapidly adjust to the change in money supply predominantly by changes in the rate of inflation, the main impact of the attempt to limit money supply growth was borne by output rather than prices–and the ensuing long-lasting recession was the ultimate cause of inflation falling, rather than the simple expedient of trying (normally unsuccessfully) to limit money supply growth.

The only instances where anything like monetarism had success was where the economy was experiencing runaway inflation–like Zimbabwe’s 100,000% annual rate now–caused by literally profligate money printing by the government. But when the economy was a more conventional OECD nation experiencing 5-20% inflation, the policies were impossible to achieve (the failure to reach targets) and had dramatically different results to those he predicted (recession rather than price adjustment).

We need a much more sophisticated appreciation of the dynamics of credit money, and Friedman’s simplistic non-credit model of money is detracts from that ultimate goal.

>To Aac I would say i am not a fan of Elliot
>Wave. The wave guys have been predicting a
>global financial melt since the mid eighties!!

Irrespective of where the article was published I think it makes sense. For example, why would people lend money to a bank at 7% return when they could buy government debt at 7.81% (the 90 bank bill at present) or corporate bonds with spreads ~2% higher.

Thus interest rates in Australia, like in the US, are governed by the cost of debt and primarily government debt; where the latter is typically sold at auction.

Bank lending rates also depend on how much money banks can lend due to bank capital reserve requirements and fractional banking, the risk involved, and the rate at which people are willing to lend money to banks.

Typically mortgage rates in the US from the government sponsored enterprises are coupled to their 10 and 30 bond yields. At present even this is decoupled to a certain extent as mortgage rates in the US are now 6.5% which is ~0.75% high than it was six months ago when interest rates were much higher. Personal loans from commercial banks are now at 8.9% (see BOA calculator). Thus lending rates in the US is not directly related to their interbank lending rate.

The same could happen in Australia with rates sky rocketing due to banks unable to obtain money cheaply from depositors, risk repricing or foreigners unwilling to buy Australian government debt.

Are you familiar with “PEOPLE For Mathematically Perfected Economy” at

http://perfecteconomy.com/

There are series of spread sheets available on the right hand side of the web page which are trivial to understand. It seems to prove that the debt based monetary system collapses when the amount of money in circulation becomes less than the amount of debt owing to the banks.

The proof seems correct under the assumption that all interest payments to the banks are used to generate more debt. In my opinion however this assumption is not strictly correct as some interest payments end up as bank profits which are then paid to banks depositors (people that lend money to banks) and share holders of the banks in the form of bank dividends. These dividends and deposit interest can then be used to redeem debt. Now if everyone in society owned bank shares, proportionally given at birth say, then the system would be fair. Of course debt can still increase as people seek more material wealth, bigger houses etc….

My observation therefore is that it seems we may have a system that is prone to collapse depending on how banks are allowed to operate.

Foundation – M3 money supply

Banks has spawned a shadow banking system which initially removes assets from their balance sheets. This virtual money world is collapsing and a lot of this stuff is coming back onto their banks balance sheets. This I believe is what is spiking the M3 money supply.

Contrarian – on price inflation

Psychology plays a big part as in for example the 400% increase in oil in the 70s due to a 5% decline in supply. Or, gold at present being bid up to high levels based on inflation fears. Thus the exact price of an item is really based on whether it is deemed an essential item. If an item is deemed essential (food or the latest shoe craze even) then small supply fluctuations would lead to large price fluctuations – my guess is that programming fear, greed, fashion into a computer program is difficult.