Every month I publish a report on my own blog to coincide with the meeting of the Reserve Bank of Australia (RBA). I will now cross post this entry to Asia EconoMonitor, as well as writing special pieces from time to time.
This month’s Debtwatch is focused on Australian economic policy, but it has global relevance because the issue is a Bill that would enhance the independence of the RBA. This belief that independence of Central Banks is a “good thing” is prevalent around the globe; I argue that this confidence in Central Banks is not justified by the data.
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 (c) 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:
- The Governor-General has to suspend the RBA Governor or Deputy, on one of the three grounds;
- Within 7 days of that, the Treasurer has to give both Houses a statement justifying the suspension;
- Within 15 days of that, each House has to vote to approve terminating the appointment; and
- 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.
Fortunately, the sky won’t fall in if the Amendment is passed. It leaves intact the provisions of Section 11, which allow the government to compel the RBA to undertake a different policy than the one it wants to follow. So monetary policy could still be taken out of the hands of the RBA, if a serious disagreement developed over what to do in an equally serious economic crisis–and the politicians were courageous enough to call the experts to heel.
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.