Download Inquiry into the future monetary policy framework

Submission by Leigh Harkness to the
Inquiry into the future monetary policy framework
by the Finance and Expenditure Committee
Causes of inflationary pressure
While inflation can be imported through foreign prices and the exchange rate, the bulk
of inflation can be traced to the growth of bank credit relative to the growth of the real
economy. The following graph of the CPI uses RBNZ data for money and the NZ
Statistics data for the GDP to calculate inflation. The model uses 1995 as the base
year to link the modelled CPI to the actual CPI.
New Zealand: Modelled CPI
1,150
Official CPI
1,100
Model CPI
1,050
Average Modelled CPI
CPI
1,000
950
900
850
800
750
Mar. 2009
Mar. 2008
Mar. 2007
Mar. 2006
Mar. 2005
Mar. 2004
Mar. 2003
Mar. 2002
Mar. 2001
Mar. 2000
Mar. 1999
Mar. 1998
Mar. 1997
Mar. 1996
Mar. 1995
Mar. 1994
700
This graph, together with the worksheet used to calculate it is available at:
http://www.buoyanteconomies.com/NZCADM3R.htm
Inflation is modelled here as the square root of all of the following: the change in the
money supply (M3R) over the change in the change in the real GDP.
The same formula can be applied to Australian and USA data and the graphs and data
for these economies are available from:
http://www.buoyanteconomies.com/AustInflation.htm and
http://www.buoyanteconomies.com/USACAD.htm respectively.
Not all sources of money cause inflation. In the case of the USA in particular, it is
difficult to isolate the inflationary money from the non-inflationary money. The USA
Federal Reserve does not provide a statistic comparable with the M3R money supply
that the RBNZ publishes.
Members of the Finance and Expenditure committee would be aware that if forged
money were to enter the economy, it would be inflationary. It would be entitling the
forgers to goods and services that they had not earned any entitlement. It would
generate demand without any supply. Forgery can be considered as theft from the
economy.
Similarly, if the government were to print money to finance its expenditure, it could
have a similar effect. It would be entitling the government to goods and services to
which it was not entitled. We only need to look to Zimbabwe to see the consequences
of such excesses.
There is another source of money that can have a similar effect. This is the growth of
bank credit. If bank lending were equal to loan repayments, lending would equal loan
repayments and the money supply from this source would not increase. However, if
lending were greater than loan repayments, then the banks would be creating more
money and entitling people to goods and services in much the same way as a forger or
government financed by printing money.
Of course, there is a difference in that the borrower from a bank would eventually
repay the loan. But while bank were lending more than loan repayments, banks
would be entitling people to goods that that the economy has not saved to make
available to these borrowers.
The effect of bank lending is obvious when one compares the growth of bank credit to
the current account deficit as shown in the following graph. The creation of
additional bank credit is entitling the economy to more goods than it has produced,
and this causes current account deficits.
NZ: M3R and Current Account Deficit
160
140
M 3R
CAD
NZ$ Billion .
120
100
80
60
40
20
Mar-08
Mar-06
Mar-04
Mar-02
Mar-00
Mar-98
Mar-96
Mar-94
Mar-92
Mar-90
-20
Mar-88
0
The committee is welcome to verify the data for this graph. It is available in the same
workbook as above for New Zealand. Similar graphs between the current account
deficit and the money supply are available for Australia and the USA. The money
that causes current account deficits also causes inflation.
The usual reaction to this information is to discredit the data and the person who
provided it. Information that confirms what we already know is readily acceptable.
But it is not very valuable as it does not tell us anything new. New information is
valuable. But, it is an unfortunate human trait that the greater the impact of new
information on what we are doing, the more rigorously we will oppose it.1
I first discovered this relationship while working as the economist for the tiny
economy of the Kingdom of Tonga. We used the relationship to manage the growth
of bank credit in the 1980’s so as to control the balance of payments. While that
policy was in place, Tonga was one of the fastest growing economies in the Pacific.
When later I joined the Australian Treasury, the Treasury considered the information
threatening and tried to discredit it and discredit me. Eventually, I was told to leave
the Treasury.
Yet the validity of the relationship remains. Norman Dixon2 describes how General
Percival in Singapore rejected the information that the Japanese were advancing down
the Malay Peninsula. Rejection of that information led to the greatest defeat in
military history. While the committee is free to reject this data, rejecting it could
leave New Zealand in the same monetary situation that it currently finds unacceptable
and which the committee is expected to overcome.
1
2
Norman Dixon., On the Psychology of Military Incompetence
Op. cit.
While the above monetary information seems to raise more questions than it answers,
it is necessary to accept the validity of that information before measures can be
developed that would enhance monetary policy in New Zealand.
The RBNZ is aware of this information. It has responded saying that:
The Bank does not currently use monetary aggregate measures to predict future inflation.
Internal work at the Bank has shown that the relationship between changes in monetary
aggregates and inflation is not particularly close, with changes in inflation appearing to lead
changes in money over some periods - suggesting that people respond to higher prices by
demanding more money, rather than increases in monetary aggregates causing increases in
inflation.3
In attempting to discredit the information that I had provided to the RBNZ, it
discredits its own monetary policy. It is tantamount to saying that the RBNZ does not
believe that monetary policy is of any use in the control of inflation. It suggests the
RBNZ is making a General Percival type of response to uncomfortable information.
The effectiveness of current monetary policy in controlling inflation
The RBNZ faces a dilemma in that if it allows the money supply to increase to
provide employment and growth, it also causes inflation and raises the current
account deficit. Using interest rates to control the growth of bank credit has
implications for the exchange rate, also. Raising interest rates attracts foreign
investment which inflates the exchange rate, reducing the incomes of exporters and
making imports more attractive. When faced with multiple objectives but only one
policy instrument to achieve them, monetary policy is doomed to fail.
The interaction of monetary policy
The graphs of the current account deficit for Australia and the USA show no clear
relationship between the fiscal deficit and the current account deficit. The fiscal
surplus/deficit is relevant to the current account deficit and inflation only in as far as it
raises or reduces the growth of bank credit.
Additional measures that could enhance monetary policy in New Zealand
Monetary policy could be enhanced in New Zealand if it were to adopt a more open
exchange rate system: that is, one that allowed exports to generate additional money
and income for the economy. That is not to say that New Zealand should return to a
fixed exchange rate. However, there is no need for New Zealand to quarantine money
3
Taken from an email from the RBNZ, a copy of which is available at:
http://www.buoyanteconomies.com/RBNZ120308.htm
from export growth: a source that raises foreign reserves and national saving. This
source of money is not inflationary in the way that money from bank credit is.
One approach to attaining such an outcome is to link the growth of bank credit to the
foreign reserve holdings of each of the banks. For examples, banks could increase
their lending by say NZ$10 for every US$1 increase in their foreign reserves. The
provision for banks to hold foreign reserves would enable them to create money from
a source other than bank credit.
With such a monetary regime, it would not be possible for the banks to lend the
country into balance of payments difficulties. Bank lending could rise only as foreign
reserves increased. To manage inflation and employment, the RBNZ would need to
regulate that for, say, every 1% that inflation exceeds 3% or unemployment exceeds
2%, the amount that banks could lend for every US$1 increase in foreign reserves
would be reduced by NZ$1. This if inflation were 4% and unemployment 4%, the
banks would be allowed to lend only NZ$7 for every US$1 increase in foreign
reserves.
Banks make money from lending, not from holding foreign reserves. To maximise
their lending, banks would drive the exchange rate to a level that would achieve full
employment and move it at a speed that would not breech the inflationary caps.
If they needed more foreign reserves to enable them to increase their lending, banks
could choose to: lower the exchange rate to raise exports and reduce imports; or, raise
interest rates to attract foreign capital.
In such an environment, the New Zealand economy could attain balance of payment
stability, full employment and low inflation. Instead of just interest rates being the
only instrument to attain its economies objectives, the economy would have the
exchange rate, interest rates, the growth of bank credit and the growth of foreign
reserves available as instrument to attain its objectives.
A more thorough discussion of these policy options is considered in papers available
at: http://www.buoyanteconomies.com/papers.htm .
Leigh Harkness
(Graphs updated September 2009)