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Steve Keen’s DebtWatch No 22 May 2008

The Reserve Bank Amend­ment (Enhanced Inde­pen­dence) Bill 2008, which was tabled in Par­lia­ment in March, aims to give the RBA Gov­er­nor and Deputy Gov­er­nor “the same lev­el of statu­to­ry inde­pen­dence as the Com­mis­sion­er of Tax­a­tion and the Aus­tralian Sta­tis­ti­cian” (Wayne Swann, Hansard, Thurs­day, 20 March 2008, p. 2381).

Under the cur­rent Reserve Bank Act, the Gov­er­nor and Deputy are appoint­ed by the Trea­sur­er, and the Trea­sur­er must remove them from their posi­tions if either of them:

“(a) becomes per­ma­nent­ly inca­pable of per­form­ing his or her duties; or
(b) engages in any paid employ­ment out­side the duties of his or her office; or
© becomes bank­rupt, applies to take the ben­e­fit of any law for the relief of bank­rupt or insol­vent debtors, com­pounds with his or her cred­i­tors or makes an assign­ment of his or her salary for their ben­e­fit;”

Under the Amend­ment:

• The Gov­er­nor Gen­er­al replaces the Trea­sur­er as the appoint­er (and ter­mi­na­tor);
• their removal under those same three con­di­tions becomes option­al rather than compulsory–the word­ing changes from “the Trea­sur­er shall ter­mi­nate his appoint­ment” to “The Gov­er­nor-Gen­er­al may ter­mi­nate the appoint­ment”; and
• there is a pro­ce­dure that must be fol­lowed for that option to be exer­cised:

1. The Gov­er­nor-Gen­er­al has to sus­pend the RBA Gov­er­nor or Deputy, on one of the three grounds;
2. With­in 7 days of that, the Trea­sur­er has to give both Hous­es a state­ment jus­ti­fy­ing the sus­pen­sion;
3. With­in 15 days of that, each House has to vote to approve ter­mi­nat­ing the appoint­ment; and
4. If either House votes against ter­mi­na­tion, the sus­pen­sion is revoked and the appoint­ment con­tin­ues.

There are some “Gilbert and Sul­li­van” aspects to this Amendment–we could, for exam­ple, have a comatose and bank­rupt Gov­er­nor kept in office indef­i­nite­ly by a hung Par­lia­ment.

But leav­ing aside even that even­tu­al­i­ty, the prin­ci­ple under­ly­ing the Amend­ment is flawed. Though the aim to put mon­e­tary pol­i­cy above pol­i­tics is noble, the faith it puts in eco­nom­ics is mis­guid­ed. Economists–even those run­ning the Reserve Bank–do not deserve the sta­tus this Act gives them.

There are good rea­sons to put the Tax Com­mis­sion­er above pol­i­tics. We don’t want a Tax Com­mis­sion­er using the office to run polit­i­cal vendet­tas (and the tax laws the Com­mis­sion­er enforces are passed by Par­lia­ment any­way, so in that sense the office is under polit­i­cal con­trol).

Equal­ly, no-one wants a offi­cial sta­tis­ti­cian who is sub­ject to polit­i­cal pressure–a good look at Stal­in’s Rus­sia shows where that might lead. The process of col­lect­ing and inter­pret­ing sta­tis­ti­cal data is also a well-estab­lished sci­ence.

There­in lies the rub: eco­nom­ics is not a well-estab­lished sci­ence, but this Act treats eco­nom­ics as if it were one.

If it were, then the Act would make sense. Then, only econ­o­mists should con­trol the economy–just as only physi­cists should run a nuclear pow­er sta­tion. But econ­o­mists don’t under­stand the econ­o­my any­where near as well as physi­cists under­stand nuclear fis­sion. Far from pre­vent­ing eco­nom­ic melt­downs, econ­o­mists can cause them, by apply­ing the­o­ries about how the econ­o­my works that are, in fact, wrong.

Of course, physi­cists can make mis­takes, and the inher­ent safe­ty of nuclear pow­er is a mat­ter of debate. But even crit­ics of nuclear pow­er have to admit that nuclear acci­dents have been a lot rar­er than finan­cial crises.

Now look at the cur­rent state of world finan­cial mar­kets, and ask your­self whether they resem­ble a well-func­tion­ing reac­tor, or Cher­nobyl on a bad day. Since the mid-1990s–when Cen­tral Banks have been more inde­pen­dent of gov­ern­ment con­trol than at any time in history–asset mar­kets have reached stratos­pher­ic lev­els of over-val­u­a­tion. If Cen­tral Banks were sup­posed to be man­ag­ing the nuclear reac­tors of finance, then they have tak­en the con­trol rods out and let the sys­tem go gang­busters.

The fuel that has fed this nuclear fire is pri­vate debt, which has risen at a faster rate than ever, and to lev­els that are unprece­dent­ed in human his­to­ry. What was a fun ride on the way up promis­es to be any­thing but fun on the way down.

Obvi­ous­ly many par­ties share respon­si­bil­i­ty for this mess, but with­out doubt economists–including Cen­tral Bankers–shoulder a large part of the blame.

First­ly, the last two decades have been a peri­od of unprece­dent­ed inde­pen­dence for Cen­tral Banks. After the high infla­tion of the 1970s and 80s, when politi­cians were last in direct con­trol of mon­e­tary pol­i­cy, politi­cians will­ing­ly ced­ed con­trol to the Cen­tral Bankers–largely to avoid the polit­i­cal pain of being blamed for high inter­est rates.

Infla­tion has cer­tain­ly been low­er since the Cen­tral Bankers too over, but at the same time there have been more–and ever larger–financial crises than when politi­cians held the reins. We’ve had the Asian Finan­cial Cri­sis (1997), the Russ­ian Finan­cial Cri­sis (1998), the Long Term Cap­i­tal Man­age­ment Finan­cial Cri­sis (1998), the Inter­net Bub­ble and NASDAQ Finan­cial Cri­sis (2000), and now, the Sub­prime Finan­cial Crisis–all since Cen­tral Banks cast off the shack­les of polit­i­cal con­trol.

That’s not a track record that inspires the con­fi­dence in Cen­tral Bankers. I’d be inclined to give them less inde­pen­dence, rather than more, on that evi­dence alone.

Sec­ond­ly, eco­nom­ic the­o­ry itself has con­tributed to the finan­cial excess­es that caused these crises. Econ­o­mists devel­oped mod­els of how mar­kets were sup­posed to behave–such as the “Effi­cient Mar­kets Hypothesis”–that cham­pi­oned the explo­sive growth of finan­cial mar­kets. Yet these the­o­ries were wild­ly inac­cu­rate mod­els of how mar­kets actu­al­ly behave.

When put into prac­tice, these the­o­ries gave us products–such as derivatives–that were sup­posed to help investors hedge against uncer­tain­ty, but were instead used for lever­aged gam­bling. They gave us policies–such as deregulation–that were sup­posed to lead to greater effi­cien­cy, and instead caused spec­u­la­tive bub­bles.

The same will prove to be true of the RBA’s cur­rent empha­sis upon con­trol­ling the rate of infla­tion using inter­est rates. I expect this policy–which is based on an eco­nom­ic mod­el known as the Tay­lor Rule–to fail in sev­er­al impor­tant ways:

• It will, as hap­pened with high inter­est rates in the ’90s, make the approach­ing reces­sion worse;
• It will fail to con­trol infla­tion any­way, since many of the caus­es of infla­tion are immune to move­ments in Aus­trali­a’s inter­est rates; and
• It down­plays the impor­tance of the over-arch­ing need to ensure the sound­ness of the finan­cial sys­tem, at a time when the sys­tem is more frag­ile than it has been since the Great Depres­sion.

I am cer­tain­ly not say­ing that politi­cians would have done a bet­ter job of man­ag­ing mon­e­tary pol­i­cy than econ­o­mists in the last two decades. Polit­i­cal poli­cies like the Howard Gov­ern­men­t’s dou­bling of the First Home Buy­ers Grant, and halv­ing the rate of cap­i­tal gains tax, def­i­nite­ly stoked the spec­u­la­tive fire beneath Aus­tralian house prices ear­li­er this decade.

But at least politi­cians are ulti­mate­ly account­able. This Act would put econ­o­mists above account­abil­i­ty, not so much to politi­cians, but to the Aus­tralian peo­ple.

Of course, I could be wrong, and the Reserve could be right. Events could prove its focus on fight­ing infla­tion to be cor­rect, and expe­ri­ence could thus show that the RBA deserves more inde­pen­dence than it cur­rent­ly has. So let’s defer this Act until we know from expe­ri­ence that this is the best way to man­age mon­e­tary pol­i­cy.

END OF COMMENTARY

Com­ment on Data

There are signs that Aus­trali­a’s debt bub­ble is final­ly approach­ing burst­ing point. Though debt is still ris­ing faster than GDP, the rate of increase is slowing–and even on the aggre­gate debt to GDP chart below, there are signs of a turn towards what Michael McNa­ma­ra of Aus­tralian Prop­er­ty Mon­i­tors so apt­ly chris­tened “Peak Debt”.

If we are indeed approach­ing “Peak Debt”, then it will be the third such moun­tain in Aus­trali­a’s eco­nom­ic history–the oth­er two being 1892 and 1931 respec­tive­ly. This still-grow­ing Peak, how­ev­er, already dwarfs the oth­er two. The fact that debt has reached such tow­er­ing pro­por­tions dur­ing a peri­od when Cen­tral Banks (and oth­er reg­u­la­tors) are sup­posed to be exer­cis­ing pru­den­tial con­trol over the finan­cial sys­tem is one of the main rea­sons that I am opposed to grant­i­ng them any more inde­pen­dence:

Last month, aggre­gate pri­vate debt rose by 0.86 percent–still faster than the month­ly rate of growth of nom­i­nal GDP (run­ning at 0.59 per­cent), but not over­whelm­ing­ly so, as has been the rule for the pre­vi­ous fif­teen years.

Sig­nif­i­cant­ly, per­son­al debt fell for the third month run­ning (though busi­ness and mort­gage debt con­tin­ued to rise). It appears that Aus­tralian house­holds might be final­ly try­ing to bring debt under con­trol, start­ing with its most expen­sive com­po­nent.

If a slow­down is final­ly hap­pen­ing, then–though in a finan­cial sense that is a good thing–there may well be an “inex­plic­a­ble” decline in eco­nom­ic activ­i­ty in its wake.

Since aggre­gate spend­ing is the sum of income plus the change in debt, when that change in debt slows down, so does demand. Since the change in debt last year account­ed for 19.4 per­cent of aggre­gate spend­ing, any slow­down will hit spending–on asset mar­kets, or con­sump­tion, or both–like a brick.