The RBA is Broken and This Won’t Fix It

All of the goings-on with the Reserve Bank (RBA) yet not a mention that I could see in the press about the money supply. A new expert panel – the Monetary Policy Board (MPB) – will apparently govern monetary policy, having equal regard to inflation and employment. That’s stupid. Not because employment isn’t important but because there is no trade-off.

Yes, I know William Phillips, a New Zealand economist, found an inverse relationship between unemployment and inflation (the Phillips Curve). But, like a lot of empirical results, it was a time-and-place study with no general application and certainly no application at all over long periods.

Price stability and low unemployment go together. The latter depends upon achieving the former. Thinking that price stability must be forsaken to lower unemployment is trade-union-like economic thinking. And, as with most such thinking, distinctly misguided. You know the kind of thing the unions come up with: wage rises will help the economy by increasing demand for goods and services. Really? Then lets double, triple or quadruple wages to achieve economic nirvana. Unions have a role in protecting workers’ safety and in collective negotiations around the terms and conditions of employment. Best to keep them away, far away, from any kind of economic policy-making and certainly away from the MPB. They are economic ignoramuses. Listen to Sally McManus & Co. Their views, if ever translated into economic-cum-monetary policy, would vandalise the economy.

Of course the whole exercise of revamping the Reserve Bank is misconceived. There is no reason for it. Philip Lowe (and the RBA Board as a whole) made an error of judgement in giving voice to an internal view near to the end of 2021 that interest rates would probably not rise until after the end of 2023. Foot in mouth. A lapse. Not a sacking offence, when that kind of view, as expressed, was hardly novel among market participants here and abroad. To be transparent, I have in the past had an indirect working relationship with Lowe when he was no so exalted as being governor. He’s a sound, very competent chap. Exactly made for central banking. Couldn’t find anyone better. It’s not his fault that his economics and those of his colleagues, on and off the RBA’s board, is wanting. It’s a pandemic of bad economics which has infested the whole profession. Any new governor, any new board, is bound to be similarly infected.

On the substance of policymaking, central banks abroad did no better than the RBA. Some worse. They all kept interest rates too low for too long. They all responded to the unforeseen outbreak of inflation by successively hiking rates without the guiding benefit of a sound theory. Having a separate monetary policy board/committee, as some overseas central banks already do, didn’t help. Why would it? Only those with economic knowledge forged in Keynesian error held sway. To wit, the aforementioned pandemic of bad economics had its way.

Milton Friedman is long gone and those “monetarists” who understand his economics are thin on the ground. You only have to read the monetary policy pronouncements of central banks to understand that the perversion of economic thought wrought by Keynes is the ruling paradigm. In the depths of the self-inflicted economic misery, orchestrated by governments to combat what was a relatively mild virus for all but the aged and infirm, central bankers looked around. What did they see? The saw subdued demand and subdued economy activity, as expected when people and businesses are locked down. That, in their Keynesian worldview, meant that inflation was very unlikely to break out.

What they didn’t see, or at least bring into their calculations in any properly informed way, was that the money supply was growing rapidly. Friedman would have known, as monetarists still know, that if the money grows faster than real economic activity then inflation will result. From December 2019 to December 2021, the money supply defined as M3 (roughly, cash plus demand and term deposits in all deposit-taking institutions) grew by 23 per cent. Narrow money (cash plus demand deposits) grew faster still. From the December quarter 2019 to the December quarter 2021, real GDP grew by less than 5 per cent. Any guesses as to how the excess money growth would find expression? Obviously central banks were oblivious.

On the other side, when monetary policy is being tightened, as now, attention must equally be paid to how the money supply is doing. Once inflation has been set loose by poor policy, Friedman advocated orchestrating a gradual reduction in the rate of growth of the money supply to avoid disrupting the economy too much. What you don’t do is adjust interest rates willy-nilly according to the latest inflation figure. Be assured, central bankers are not focusing on the money supply. They are Keynesians. The new MPB will no doubt pour over the state of the economy to no avail. The best central bank would be few staff and a monetary rule. Keep the growth in the money supply broadly in line with real economic growth. Fat chance.

A panel established to look at the RBA was bound to suggest some meddlesome restructuring to justify their existence. An additional board, why not; a chief operating officer, a communications guru. More cleaning staff perhaps. Tea ladies, there used to be tea ladies. All of that is bound to improve setting interest rates, isn’t it? No, it isn’t. But forget that, look at the shiny new version of the RBA.

9 thoughts on “The RBA is Broken and This Won’t Fix It

  • Daffy says:

    Some many months ago, me, with a humble MBA, wrote to one of the papers that sometimes publishes my letters to say something like: “Inflation following an explosion in money supply on top of production crushed by government edict. Who’d have thought?”
    Looks like PS and I are of a mind on this.

    • Watchman Williams says:

      And I, with an even humbler Intermediate Certificate, can assure you that, when a majority of citizens are dependent on Government support of one sort or another, without actually producing anything, then the country is on the way to irrelevance and, ultimately, oblivion.

  • Stephen Ireland says:

    Thanks Daffy. Even humble ex-mine managers could foresee the brick wall. I recall discussing with one of my family, also a mine manager but now running our rural retail business, how best to take advantage of the low interest rate regime, productively, while avoiding the looming crash.

  • pgang says:

    Call me Cynical, but this new board probably has nothing to do with improving monetary policy, but a lot to do with Treasury getting its foot in the door.

  • Geoff Sherrington says:

    Peter, similar song sheet, thank you. Here is a Geoffrey lecture.
    Why? Why does Australia have to have a Bureaucracy for Everything? It is not logical.
    Some bureaucracies are logical, like for Defence, International Relations, Customs & Quarantine. These involve working with people from other countries.
    Do we need a Bank Bureaucracy? Possibly, but it should be limited to procedural management functions, with no command powers.
    At the end of 2022 I sent a couple of letters to Dr Lowe. Some of his senior staff had expressed admiration for the net zero carbon concept. This was not only based on models, it was reliant on models. Noting that the RBA management also relied on models, I suggested it prudent for the RBA to examine validation tests of the net zero model as well as their own. It seems that validation of models is either absent or not considered important. (It was noted that the RBA model on interest rates had failed, as in it could hardly be more wrong).
    We do not need control-heavy bureaucracies that depend on unvalidated computer models. Australia’s framework has shifted over my lifetime from rewarding personal and corporate free enterprise to denigrating it by words and actions that favour socialism moving towards communism. Why? Geoff S

  • bomber49 says:

    Murdoch Press journo Terry McCrann had been preaching interest rates increase 12 months before the RBA admitted it was too slow to react to inflation. Put Terry on the Board.

  • BalancedObservation says:

    Though unlike Peter Smith I don’t know Philip Lowe I think he’s done a pretty competent job personally.
    I also agree that fragmenting monetary policy further with another unelected independent interest rate setting body is hardly going to help matters.
    In fact the RBA review makes very few significantly helpful points in over 250 pages. Overall it lacks coherence. On balance it will certainly not significantly improve the overall performance of the RBA.
    Implementation of its findings is more likely to weaken the joint efforts of the RBA and the government to enhance the stability and performance of Australia’s economy.
    When it comes to the critical need to coordinate fiscal and monetary policy its recommendations are arguably contradictory.
    The report rightly calls for greater cooperation between the government and the RBA . And there’s certainly a real need for that. Yet its recommendations don’t enhance that. They’re highly likely to do the opposite.
    Recently there’s been virtually no real cooperation by Labor with the RBA to tackle the immediate inflation threat with fiscal action. If effective fiscal action had been taken by Labor interest rates would probably not have had to rise so fast or as high as they have without it.
    Despite the inflation threat Labor has left billions of dollars of new expenditure intact – including middle class welfare handouts on childcare and housing. And Labor has actually talked up wages growth.
    So there’s certainly a need for greater cooperation in tackling the immediate inflation threat.
    Labor has arguably hidden behind the RBA in avoiding making difficult fiscal decisions. Labor has effectively put the onus of any fallout from anti inflation measures onto the RBA, while it’s virtually sat on its fiscal hands. The recommendations will make it even easier for future governments to do that.
    The recommendations say there needs to be more cooperation and sharing of data between government and the RBA. Good luck with that when at the same time the recommendations move to separate the role of government and the RBA more. They fragment cooperation even further by setting up another separate unelected independent interest rate setting body and take away the elected government’s right of veto over RBA interest rate decisions.
    The changes are so urgent that they will not be implemented till July 2024. And they’re so necessary despite the fact the report claims the RBA is held in high esteem internationally and in Australia and has generally done a good job.

  • mrsfarley2001 says:

    Labor + fiscal action always = handing out other people’s money. That’s the only “fiscal” thing they understand. Your fifth-last para sez it all.

  • BalancedObservation says:

    The authors of this report have seemingly failed to effectively consider how a direct clash between an unelected RBA and an elected government would be resolved.
    In some extreme economic circumstances not resolving such a dispute quickly could lead to very dangerous economic instability and a complete lack of confidence in the Australian economy in financial markets here and internationally.
    What happens if the unelected bureaucrats on the new interest-rate-setting body are totally at odds with the elected government’s economic policy? There’s plenty of evidence that’s not an impossible scenario by any means.
    It’s become a very serious issue now that the report recommends taking away the right of an elected government to veto policy of the unelected RBA . Labor intends to follow the recommendation.
    Currently the government is legally able to intervene in such a situation and veto RBA policy to manage such a crisis. It hasn’t so far, publicly at least, but the very existence of the veto power can ensure resolution of such a crisis and arguably has in the past.
    In such a crisis it may not just be a case of who is right or who is wrong. The real crisis could be caused by both arms of vital economic policy being at odds with each other leading to stagnation and/or conflict in economic policy execution.
    It seems to me that the only way such a crisis can be resolved under the new arrangements is for a government to sack the RBA board and reappoint members more amenable to its policy. That would be messy and delayed. And could possibly be challenged legally given the newly proposed legislation strengthening the independence of the RBA.
    This report, commissioned by Jim Chalmers, is all the more dangerous because it is likely to be implemented because it has a modicum of intellectual respectability unlike the recent Chalmers’ economic waffle paper.
    The relatively benign response to the report is a reflection of the poor level of economic debate in this country, particularly in the mainstream media.

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