The Mischief of Keynes’ Legacy Strikes Again

Deputy governor of the Reserve Bank (RBA) Michele Bullock came in for some criticism from some quarters (e.g., from the unlikely pairing of Andrew Bolt and Bill Kelty) for indicating that curing inflation means unemployment would need to rise from its current level of 3½ per cent to 4½ per cent. That’s about 140,000 people in work now who will be out of work by next year.

Not very pleasant for those 140,000 people, many of whom will have families to support. Hence the criticism. But, of course, Ms Bullock is just the messenger. Surely not, you might say! She and the governor and others in the RBA have their hands on the tiller. Not really, John Maynard Keynes and his downstream acolytes are calling the shots. She and others are simply dupes in the game.

I read all of the deputy governor’s speech (“Achieving Full Employment”) delivered to an Australian Industry Group forum in Newcastle on 20 June. It’s good standard RBA fare. Misguided of course; yet, at the same time, not the least insensitive to the plight of those who will be thrown out of work. In fact, Bullock goes out of her way to stress the short and long term damage that unemployment can cause to people’s lives. So criticisms of her speech on that score are entirely misconceived.

My criticism, on the other hand, and Bill Kelty’s for that matter, is entirely soundly conceived. I would say that, wouldn’t I? There it is, what else can I say. Bullock pins her analysis to something called the ‘non-accelerating inflation rate of unemployment’ (NAIRU). This is the rate of unemployment below which inflation will begin to rise. However, as she explains, no one at any tick of the clock knows what this rate is. It’s a “moving target” which “changes over time.” Thus it’s an entirely useless concept; a later development of a theory published in 1958 by New Zealand economist, William Phillips. He found an inverse relationship between unemployment and inflation (the so-called Phillips Curve). Like a lot of theoretically unanchored empirical results, it has no general application.

The indeterminacy of NAIRU is one reason why it is useless as a guide to monetary policy. There is a more important reason. It is steeped in demand-side Keynesian claptrap. According to Bullock, “One of the channels through which higher interest rates work to bring down inflation is by reducing the demand for goods and service and hence the overall demand for labour.” Au contraire, deputy governor, there is no logical leap from the demand for goods and services to the demand for labour. The economy doesn’t work in that Keynesian direction. It works the other way around. You have the cart before the horse.

Let me turn to John Stuart Mill, the GOAT economist, who well preceded the ‘crackpot’ Keynes, and whose Principles of Political Economy was the go-to economics text throughout the whole of the second half of the nineteenth century. Mill is the best choice not only because he is peerless among economists, dead or alive, but because of his quintessential and prescient anti-Keynesian stance. He understood that economic progress stems from the supply side. Mill rightly railed against those who attributed unemployment to insufficient demand. “Demand for commodities is not demand for labour,” he wrote. What employs labour “is the capital expended setting it to work.”

It’s question of focus. The RBA is all about quieting demand to cure inflation, as it is equally about stimulating demand to cure unemployment. This is totally, abjectly, and destructively misconceived. It’s product of Keynesian misinformation. Google should ban it?

Inflation is tackled by gradually lowering the rate of growth in the money supply, the extravagant growth of which led to inflation in the first place. We know that because inflation, as Milton Friedman expertly demonstrated, is always and everywhere a monetary phenomenon. Two things should be done to achieve a slowdown in monetary growth.

First the RBA should increase interest rates to gradually bring down the growth in bank lending – which is the largest driver of monetary growth. Note, however, the target variable is bank lending not interest rates.

Second the (independent) RBA should publicly pressure the government to reduce its deficit spending – which adds to the money supply. And also to the monetary base – which provides fuel to the banks to lend. For example, instead of the governor saying in a recent speech that fiscal policy was neutral in combatting inflation, he should properly have said that the government wasn’t helping. Brave call in the circumstances perhaps. Then again, if you are going to get the boot anyway?

What can the RBA do about its second mandate to maintain full employment? That, after all, is the topic of the deputy governor’s speech. Not much directly is the answer. It needs to concentrate on price stability which, as the deputy governor rightly says, creates a beneficial environment for economic growth. Indirectly, it can make life difficult for the government of the day by continually drawing attention to the supply-side benefits of lowering business taxes and reducing regulations in boosting economic growth and employment. Echoes of Arthur Laffer and Reagan, and Larry Kudlow and Trump.

Combine a measured and gradual tightening of monetary growth with fewer and less onerous regulations and lower business taxes, and there is no reason why reducing inflation can’t be paired with lower unemployment; not higher. As it is, yes, a policy of willy-nilly increasing interest rates is likely to lead to an overly sharp contraction in monetary growth and push up unemployment. But not as a fact of life; but, instead, as a consequence of poor economic policy.