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April 18th 2014 print

Peter Smith

The RBA’s Guiding Misconception

The minutes from the latest board meeting demonstrate that it gets the big picture, but the analysis of what it all means is addled. Consumer spending and private-sector investment in plant and equipment are not the same thing, but this simple fact is ignored

rbaI had time on my hands and, lacking more diverting options, I thought what better way to use it than to read the recently published minutes of the Reserve Bank of Australia’s most recent board meeting, held at the beginning of this month? While these minutes tend to be on the dry side, they do provide the best snapshot of the state of the global and domestic economy.

Having paid the RBA a compliment I don’t intend dwell. In fact, I want to focus on a couple of extracts from the minutes which go a long way towards explaining why economics as wielded by public sector economists has become unhelpful in solving economic problems. They are as follows:

  • “Public demand [Dec. Qtr. 2013] had made a surprisingly strong contribution to growth, but planned fiscal consolidation at state and federal levels was likely to weigh on public demand for some time.”
  • “Members noted that while falling mining investment and weak public demand were set to constrain growth for some time, there were early promising signs in other parts of the economy. In particular, a strong pick-up in dwelling investment was in prospect and there was some evidence that consumer demand had strengthened a little…many businesses appeared to be waiting for an increase in current demand to occur before they were willing to increase investment spending.”

The first extract attributes part of growth to public demand and goes on to foreshadow that planned fiscal consolidation will lead to less public demand. Ergo, as a matter of transitive logic, according to the RBA, fiscal consolidation will reduce economic growth. There are two problems with this: one definitional; the other substantive.

Fiscal consolidation (FC) — reducing the budget deficit — can be achieved by reducing transfer payments (e.g., welfare expenditure), by increasing taxation, or by reducing government expenditure on public servants’ wages, or on goods and services, or on infrastructure. Reducing transfer payments has no effect on public demand. Increasing taxes has no effect on public demand. So exactly what kind of fiscal consolidation is being referred to by the RBA? And the plot thickens when Tony Abbott is all-out to increase government infrastructure spending. It would be instructive if the RBA were to spell out what they’re including in FC.

On the substantive problem, let’s assume by FC that the RBA is referring to cuts in Tony Jones’ wages at the ABC; in public sector wages more generally; and in expenditure on things like hiring consultants, research grants to discover the effect of global warming on stickleback fish, and on building yet more superfluous school halls. Now this would represent a reduction in public demand and it might have a transitory negative impact on economic growth. But it takes a thoroughgoing socialist mindset to assume that resources (real and financial) freed from the public sector will not be taken up quickly by the private sector and, moreover, used much more effectively to create value. It takes an unreconstructed Keynesian; in other words, an economist prepared to ignore all economics prior to 1936, and also the microeconomic foundations of macroeconomics, to conclude that a reduction in the budget deficit – however it is put together — will reduce growth.

I am sure that not all RBA economists are unreconstructed Keynesians. But let’s try to show it guys when the next set of minutes comes out. Unfortunately, can we be confident when the second bullet-pointed extract (above) is abysmally and despondently Keynesian in its orientation?

Notice that the second extract conflates public demand, consumer demand, dwelling investment and mining and other business investment as contributors to growth. John Stuart Mill wept. We are to conclude, presumably, that government spending on public sector wages and consumers buying goods at Kmart are equivalent to businesses building houses, purchasing plant and equipment and digging out iron ore. It is astonishingly puerile economics.

I would doubt that spending a dollar on the average public servant’s wages contributes more that 20 cents to value creation (and that’s generous), and consumer spending uses up value. It doesn’t create value. On the other, hand businesses survive only if they create more value than they use up. Economic growth is another way of describing the continuing process of creating more value than is used up. Is that so hard to understand?

I would give the RBA an A-plus for succinctly describing the current state of economic affairs, but only a generous C-minus (can do better etc…) for its economic analysis, with an accompanying admonishment for badly informing the public debate.


Peter Smith, a frequent Quadrant Online contributor, is the author of Bad Economics