I recently watched the movie “Margin Call”, a movie set in a similar vein as the Wall Street movies but one that (better) deals with the recent financial crisis from the point of view of the people (investment banks) directly involved. This quote by one of the leading characters near the end of the movie, John Tuld, resonated with me the most:

“We just react. And we make a lot money if we get it right. And we get left by the side of the road if we get it wrong. And there have always been and there always will be the same percentage of winners and losers. Happy foxes and sad sacks. Fat cats and starving dogs in this world. Yeah, there may be more of us today than there's ever been. But the percentages-they stay exactly the same.”

How very Schumpeterian of him! After all, “Capitalist reality is first and last a process of change”; if you fail, i.e., if you do not consistently make other people happy by providing them with goods or services at acceptable prices then you will quickly be “left by the side of the road”, replaced by a “happy fox” who is better equipped to solve the endless coordination problems in the economy – someone for whom you will likely have to work in exchange for a consistent, less-risky wage according to your marginal productivity.

To get to the point of this article, let us compare John Tuld to Gordon Gecko’s speech in “Wall Street”:

“The point is, ladies and gentleman, that greed, for lack of a better word, is good. Greed is right, greed works. Greed clarifies, cuts through, and captures the essence of the evolutionary spirit. Greed, in all of its forms; greed for life, for money, for love, knowledge has marked the upward surge of mankind.”

To the contrary, greed for greed’s sake alone is not good; greed has been indirectly responsible for most of the worst atrocities that have been committed throughout the history of mankind. But we are all greedy; it is hardwired into our nature. The question then becomes not “how do we stop greed” (sadly trying to change human nature is something people in the political system seem determined to keep attempting) but “how can we control greed”? And the answer is the same as it has always been: we can control greed only by allowing Adam Smith’s self-interested individuals to operate within the correct institutional setting; that is, within an institutional setting of private property, freedom to contract and voluntary consent that encourages social cooperation rather than predation. Milton Friedman succinctly summarised how this process works within the correct institutional setting:

“The key insight of Adam Smith's Wealth of Nations is misleadingly simple: if an exchange between two parties is voluntary, it will not take place unless both believe they will benefit from it. Most economic fallacies derive from the neglect of this simple insight, from the tendency to assume that there is a fixed pie, that one party can gain only at the expense of another.”

It is when you remove these constraints – as we have done with certain industries (hint: the financial sector) – that that very greed and self-interest that can be so beneficial to society is instead channelled towards unproductive, zero-sum uses such as political rent-seeking. As Max Weber said, there is “…orientation to the profit possibilities in continuous buying and selling on the market with free exchange”, as well as orientation to profit opportunities that are the result of “…domination by force…by political authorities”.

There is nothing wrong with greedy, self-interested individuals seeking a profit. But there is a problem when this profit is not created by satisfying the needs of fellow human beings through non-coercive means but is instead achieved through rent-seeking in the political sphere. Profit derived from rent-seeking, transfer payments, coercion or fraud are not what capitalism is about; they come about when the returns for greedy individuals is greater in seeking regulation, lobbying and buying politicians than the returns that they could earn by (unintentionally) satisfying their fellow man through the market process. The rewards to individuals in sectors of the economy where the profits are privatised while losses are largely socialised and where their very existence is owed almost entirely to artificial means created through state intervention are not examples of “market failure” but are examples of “government failure”. What is not needed is more government to solve a problem created by the government; what is needed is more capitalism to channel individual self-interest into socially cooperative and productive activities – profit that expands the pie, not profit (rent-seeking) that takes from it. Differentiating between the two is a critical distinction to make, less tragic policy errors be committed.

On the 25-26th of November, a watershed moment in the history of Australian liberty will be occurring in Sydney: the Australian Mises Seminar. Over the past year we have collaborated with the best and brightest representatives of Austrian economics and libertarianism in Australia to bring you this incredible weekend. I invite you to register asap: http://www.mises.org.au

 

 

Speakers include:

Hans-Hermann Hoppe is Professor Emeritus of Economics at the University of Nevada, Las Vegas. A world-renowed Austrian School economist and anarchocapitalist philosopher, he is also a distinguished fellow with the Ludwig von Mises Institute and founder of The Property and Freedom Society.

Ben O'Neill is a Lecturer in Statistics at the University of New South Wales (ADFA campus) and an Adjunct Scholar at the Ludwig von Mises Institute (USA). He was the winner of the Templeton Fellowship Essay Contest for 2009 at The Independent Institute (USA). He has published work in statistics, economics and political philosophy. He has formerly practiced as a solicitor and as a political advisor.

Chris Leithner received First Class Honours at McGill University. He holds Masters degrees from Queens University and The Australian National University, and completed his PhD at the University of Strathclyde (Glasgow, Scotland). His most recent book is The Evil Princes of Martin Place: The Reserve Bank of Australia, the Global Financial Crisis and the Threat to Australians' Liberty and Prosperity.

Steven Kates is a Senior Lecturer in Economics at RMIT University. He has previously spoken at the Austrian Scholars Conference and is a specialist in the history of economic thought, with particular emphasis on John Maynard Keynes and Says Law. A recent book of his is titled Free Market Economics: An Introduction for the General Reader.

Andrew Dahdal is a lecturer in the Faculty of Business and Economics at Macquarie University. He is presenting a paper on the constitutionality of paper money under the Australian Constitution, arguing that the founders envisioned only private issuance of money and did not wish for governments to get involved.

David Hart is the Director of Liberty Fund’s Online Library of Liberty Project. He has a Ph.D. in history from King’s College, Cambridge and taught for 15 years in the Department of History at the University of Adelaide before joining Liberty Fund.

Mark Tier is an Australian writer and businessman who lives in Hong Kong “partly because paying taxes is against my religion.” A graduate in economics from the Australian National University, he began a PhD program in economics at UCLA. Founder of the investment newsletter World Money Analyst, which he published and edited until 1991, he is also the author of Understanding Inflation, which became a bestseller in Australia in 1974, and The Nature of Market Cycles.

Ron Manners is an Australian businessman with over 50 years experience in the mining industry and is founder and Executive Director of the Mannkal Economic Education Foundation, an Australian free-market think tank.

Neville Kennard is a veteran Australian preaching and practising capitalist. Kennard has had success in the real world. In fact, his name is more recognisable and respected in Australia than words like "free-market", "libertarian" and "classical liberal". Maybe one day Kennard's self-ownership will become half as popular as Kennards Self Storage. Kennard was the first chairman and the first donor of The Centre for Independent Studies (CIS). He is also a CIS distinguished fellow. Kennard has been endorsed by the Godfather/Ron Paul of Australian classical liberalism, Bert Kelly, as "splendid ... speaks my language ... brave."

Viv Forbes is Chairman of The Carbon Sense Coalition. He is Australia's most productive libertarian, for each of the last 36 years, since he started the Workers Party in Queensland. He is a grandfather, sheep and cattle grazier, soil scientist and mining consultant.

Sarah Correa served as a liaison with aid relief in Afghanistan.

I recently listened to a presentation by Michael Pettis where he expressed his views and outlook for the Chinese economy over the next few years. Pettis made several interesting points that, if correct, would have large implications for Australia.

The Chinese growth model is not a new model (think mercantilist) and as it currently exists it is not sustainable. Capital has not been allocated correctly (i.e. according to market forces) and as a result there is massive malinvestment in things like infrastructure, state-owned and export-focused industries. A huge amount of wealth has been channelled into these areas at the expense of the Chinese consumer through direct state investment or, worse still, camouflaged subsides to state-owned enterprises (SOE’s).

This was fine 20 years ago – China lacked infrastructure and it was easy for the government to find things to invest in. Roads and railways actually represented economically viable investments that had previously been neglected. A problem arises when these ‘easy’ investment opportunities no longer exist (China today) in that any further investment into this kind of infrastructure provides very little net return to the Chinese economy – and because price signals and market forces have been so distorted or suppressed, the capital allocation problem becomes increasingly difficult and capital is increasingly likely to be squandered on wasteful projects.

Amplifying this issue is the old concentrated benefits and dispersed costs problem that we have discussed before and exists in any modern democracy let alone ‘managed’ economy. That is, incentives faced by bureaucrats and politicians necessitate that they will misallocate investment decisions on a massive scale because there are short-term gains for people in power (GDP growth, higher local employment, kickbacks) while the costs are paid for by a large, disorganised group of people in the long-term. This is particularly bad in China because the banking system is centralised and loans for local officials are artificially cheap and will often never be repaid. Pettis notes that “…probably beginning in the late 1990’s we [China] began misallocating capital; we began investing in a way that subtracts growth rather than adds to it but we don’t recognise that it subtracts growth for many many years”.

He goes to pains to stress that infrastructure is not a nominal issue but a relative issue – infrastructure is there to boost labour productivity and for China’s level of development (wage levels, productivity), it makes no sense for them to have the same level of infrastructure as, say, Japan, who's labour productivity and wages are ten times greater. The Chinese government has ignored this and as a result has massively misallocated resources in infrastructure investment; capital that could have been better used elsewhere.

Pettis also notes that while SOE’s may be profitable on paper, when you include all of their subsidies then almost all the so-called profit is accounted for by implicit debt guarantees, monopoly or direct subsidies from the state. Give that SOE’s account for about 50% of all loans in China, this is a big deal – if they are not in fact profitable then they are failing the most fundamental of market tests – they are not providing a net social gain. Pettis estimates that SOE’s are in fact making a loss somewhere between 6-8 times their stated profitability – a huge number that does not show up on their books because of these massive, hidden subsidies (much like how a lot of China's debt is hidden). Needless to say, capital is being misallocated on a grand scale.

Australian Implications

Pettis provides some ways out for China that they will have to take if they want to rebalance – both of which involve boosting household consumption, which has been suppressed by the Chinese government through control of the exchange rate (good for GDP and exporters; bad for household wealth), wages (again, if you keep wage growth below productivity growth then it is a subsidy for business and boosts GDP figures at the expense of households) and direct transfers (subsidies).

The first is for China to restructure towards a removal of subsidies to exporters, infrastructure, SOE’s etc., all of which presently comes at the expense of households. This will be a boon for the Chinese people as their purchasing power (real wealth) will increase substantially over time. This does not have to come at the expense of savings – I should note that trying to boost consumption at the expense of savings is a difficult if not impossible task (and downright foolish from an economic growth/wealth accumulation perspective) – it will instead have to come at the expense of state infrastructure spending, SOE’s, removal of growth obstacles and so forth. This is the ‘unproductive’ sector in China at the moment which, due to the way GDP is measured, most people think is the ‘productive’ sector (as it drives GDP ‘growth’).

In this scenario, consumption growth can increase as a % of GDP only when the growth in GDP falls as a result of a restructuring away from centrally planned big GDP boosters such as infrastructure, SOE and other subsidies (along with more rapid reversals of the current household to state transfers, i.e. privatisations). This economic empowerment of the Chinese people would be a good thing for China and the world (excl. Australia, Brazil, and Canada – commodity exporters).

The second scenario is if China tries to manufacture a shift towards consumption with more centrally-planned policies aimed at destroying savings while maintaining infrastructure, SOE and other subsidies and thus GDP growth: the Keynesian way. This method of trying to artificially boost consumption as a share of GDP is doomed to fail and is more likely to end in a hard landing for China as it has for every other mercantile-growth-theory economy in history. But, it can probably keep the “China miracle” (or rather, GDP growth) going for longer.

To conclude, China has a debt problem. China has a banking problem. China has an inflation problem. China has serious structural problems (misallocated investment). Whatever happens in China, all roads would appear to lead to bust for commodity exporting countries like Australia (assuming the European banking crisis doesn’t bring Australia down by restricting funding to our over-leveraged banking sector first). The difference between the two above scenarios, for Australia, is in the extent and in the timing.

Disclaimer: my summary is no doubt lacking, so please listen to the actual presentation – it is well worth the 40 odd minutes of your time.

 

David Koch - Kochie - is a household name, respected and beloved for his cheerful character and financial advice. I like Kochie, as most people do. But Kochie's latest article makes him an enemy of the Aussie battler.

The Article

Kochie makes the case in this article that times are tough for the Aussie homeowner and small businesses. The RBA, by giving no indication that it will cut interest rates, is causing a 'crisis in confidence' that is destabilizing to the Australian economy:

The problem is that businesses large and small need to be able to plan ahead, and Stevens’ appearance on Friday gave little reassurance. All Stevens said is that it is a good thing to “sit still and do nothing” in such rocky times, but that is of little comfort to our struggling business owners. It has arguably got to the point that the RBA’s secrecy is causing a serious crisis of confidence in the broader economy, and this can lead to a destructive cycle in which fear feeds on itself, causing employers to shed jobs and cut back on investment. Indeed, the 9,000 jobs that have been lost in the past month suggest this is already happening.

Kochie, as indicated by the title of his article 'Why the RBA needs to cut interest rates', wants to run the printing presses to save the Australian economy. He disregards the real economists naysayers crying 'inflation' in the night with a quite amazing statement:

A cut in interest rates now would have no effect on the factors which are causing inflationary pressures, such as utility bills, food and fuel. Most of the inflation in our system is beyond the control of both the RBA and consumer spending.

This statement reflects a sad truth that Kochie doesn't really understand what inflation is and how it works. Because of this, he does not understand the consequences of printing money and it's role in stimulating the business cycle within the economy.

He continues:

Mervyn King, the former head of the Bank of England, once famously said that 'good central banking is boring.' What he meant is that it is better for everybody if the central bank is predictable, and does not have surprises hidden up its sleeve.

Predictability, it seems, means that the RBA should print money and misdirect the Australian economy on demand.

Governor Stevens should pay attention. While the RBA has done a pretty good job over the past couple of years, it went too far in the run up the the GFC in 2008 when raising the cash rate to 7.25%, pushing typical mortgage rates to 9.6%. It resulted in a glut of repossessions and unnecessary job losses. That took the market by surprise. We don’t need another surprise like that. Give us some transparency and let our small businesses get planning with some peace of mind.

The conclusions that Kochie makes in this paragraph again represent a lack of understanding as to the causes of the financial crisis. Moreover, transparency doesn't mean printing money and keeping the inflation party going ad infinitum.

Why Kochie is wrong: Inflation

Inflation is typically understood as a rise in the price of goods and commodities. It is more accurate to call this phenomenon 'price inflation'. It is the job of the economist to understand WHY things take place in the economy... to ask questions regarding market processes that everyone takes for granted. In this case, why is there a general rise in the prices of commodities, goods and services in the economy, especially when there is a strong tendency within the free market to lower prices?

The answer is: monetary inflation, which leads to price inflation.

Let's imagine that there is a shortage of coconuts. We can understand that the 'marginal utility' of coconuts has increased - or in other words, the number of coconuts available for individuals to satisfy their wants has decreased. This means that individuals will value coconuts higher than before as there are fewer coconuts available to satisfy 'lower order' wants.

For example, imagine that Robinson Crusoe is living on a deserted island where the only food available is coconuts. His uses for coconuts may look something like this (in order of priority):

1. Eat for survival and health
2. Use the shells to make shelter
3. Use the shells to make shoes
4. Throw them into the ocean for fun

If the island is super-abundant in fresh coconuts, so that Crusoe can collect 2000 coconuts a year. Crusoe eats about 1000 coconuts a year. Because of his productivity and the availability of coconuts, Crusoe doesn't have to ever worry about starving or being malnourished. This leaves him with 1000 extra coconuts to satisfy less important uses. Crusoe can use 500 coconuts to make himself some himself a nice hut. This still leaves with 500 extra coconuts to the 2 remaining uses. To make shoes for walking around the island, he needs 300 coconuts a year to make a new pair every 2 weeks (the approximate durability of coconut shoes). Crusoe is left with 200 coconuts to throw into the ocean for fun.

If a cyclone comes and causes significant damage on the island, so that Crusoe can only collect 1700 coconuts a year. If he wants to survive, this will force Crusoe to give up some of the uses for coconuts that he has. He can't throw 200 coconuts into the ocean that year otherwise he want have shoes to walk around the island in. Coconuts now are more valuable to Crusoe; he can't just waste a few here and there as he did before.

As I said, this simple thought experiment is used to explain the concept of 'marginal utility'. Now imagine that Crusoe wasn't alone on this island, that he had a neighbor called Ug the Ogre on the other side of the island. Crusoe trades 100 coconuts for chickens with Ug. This means that Crusoe’s uses for coconuts are (in order of priority):

1. Eat for survival and health
2. Use the shells to make shelter
3. Use the shells to make shoes
4. Trade for chickens (5 coconuts/chicken)
5. Throw them into the ocean for fun

This means that Crusoe only has 100 coconuts left to throw into the ocean for fun. One day, a storm comes and wipes out 200 coconuts from his stock. This means that Crusoe doesn’t have any coconuts to trade with Ug or use for leisure. Ug is upset; he really wants coconuts from Crusoe.

At the current exchange ratio, 5 coconuts will get Crusoe 1 chicken. So in other words, the price of a chicken is 5 coconuts. Ug tries to trade with Crusoe in vain. Ug realises that he needs to reorder Crusoe’s priority list for using coconuts. Ug changes the price of chickens to 1 coconut/chicken.

This makes all the difference in the world for Crusoe. The value, from his perspective, of having 300 chickens a year is greater than the value of using coconuts to make shoes. Crusoe’s use of coconuts now changes (in order of priority):

1. Eat for survival and health
2. Use the shells to make shelter
3. Trade for chickens (1 coconut/chicken)
4. Use the shells to make shoes
5. Throw them into the ocean for fun

Let’s imagine now that the opposite happened. Crusoe finds a long rod of bamboo that increases the number of coconuts he can harvest to 4000/year. Now Crusoe has more coconuts than he knows what to do with. Crusoe decides that since he has more coconuts to trade, he wants more chickens. Ug still has the same number of chickens and is only willing to part with 300 in a year. Crusoe tries to get the chickens at a price of 1 coconut/chicken, but Ug is no fool. He knows that Crusoe has many coconuts. He refuses and only accepts a price above 5 coconuts/chicken. Crusoe accepts, knowing that he can afford to pay a premium on coconuts without any consequence to the other more important uses he has for coconuts. Or maybe Ug doesn’t know about Crusoe’s ‘coconut inflation’ and is just plain unhappy with parting with 300 chickens for 300 coconuts because he has a higher value for chickens in that place and time. The price of chickens must go higher (i.e. inflates) in order for him to trade. In either case, Crusoe can afford the trade because of the inflation in the number of coconuts. The coconut inflation led to chicken price inflation.

So in this example we have seen that changes in the abundance of goods alters their marginal utility and value in the eyes of individuals. What these individuals are willing to trade for other goods (i.e. prices) will also change. Replace chickens for everyday items that you purchase like food, petrol, cars and homes. Now replace coconuts with money, or dollars in your wallet. If you have a greater supply of dollars in your wallet, you can afford to pay more for goods and services. In other words, monetary inflation leads to price inflation.

Monetary inflation is an increase in the supply of dollars in your wallet, or credit on your card. Monetary inflation is significantly controlled by the actions of the RBA through interest rate policy and open-market activities. When the RBA lowers interest rates, it lowers the price at which banks can borrow money from them. How does a bank borrow money from the RBA? The RBA creates the money out of thin air (i.e. synonymous with printing money) by crediting the bank’s account. It’s like me logging onto the computer records of your bank and changing the balance from $1,000 to $10,000; this would be $9,000 worth of monetary inflation. The bank does the same thing to you when lending money for a home, car or credit card loan. It will create the money out of thin air, an accounting entry essentially. You can read about how this happens routinely and lawfully in Professor Jesus Huerta de Soto’s book ‘Money, Banking and Economic Cycles’.

So if the interest rate is lowered, banks can borrow more money from the RBA to cover more loans to entrepreneurs and other individuals within the economy. This artificial increase in the money supply inevitably causes widespread malinvestment within the economy, the same way a travelling circus can do to a local town it stops in. The circus brings fresh new money into the town, which may cause a restaurant owner to mistakenly believe that there is a permanent increase in business. The restaurant owner buys the property next door and builds an extension to accommodate the growth in customers. He can afford these additional costs so long as these new additional customers keep coming. Eventually the circus leaves town and the restaurant owner faces the harsh reality that the monetary inflation brought by the clowns is now over, and all he is left with is debt he can no longer afford.

The clowns at the RBA have indeed been shopping at every business, printing and lending money to more and more people through the fractional reserve banking system. This has tricked entrepreneurs and individuals around Australia to invest in various bubbles, namely the housing and building sector, thinking that the party will never be over. Well it is over, and not because the circus has left town, but because the debt-servicing burden has exceeded the consumption and savings capacity of the economy. The solution to this problem is not to increase the levels of debt in the economy to stimulate more debt-fuelled consumption. This can only make the problem far worse than it is, threatening the stability of our currency and decreasing the affordability in the cost of living for Aussie battlers. An increase in the money supply without real growth within the economy only raises the prices of goods and services faster than wages can adjust. The RBA can and is trying as hard as they can to hide this in their official inflation numbers, through the voodoo of hedonics etc. The average Australian family already know that their heads are just below the water of rising prices.

So Kochie, the trusted financial advisor of Australia, thinks that this is all a good thing. More money printing, more debt, higher prices and further economic ruin… for predictability’s sake at least. As long as Kochie advocates the policies of economic suicide, he will remain an enemy of the Aussie battler.

To understand the finer details of my analysis and opinion, I recommend the following reading list:

1. Money, Banking and Economic Cycles – Jesus Huerta de Soto
2. The Ethics of Money Production – Guido Hülsmann
3. The Evil Princes of Martin Place: the Reserve Bank of Australia, the Global Financial Crisis, and the Threat to Australian’s Liberty and Prosperity – Chris Leithner

 

God bless,

Washo

I recently watched a National Press Club debate between British climate sceptic Christopher Monckton and Australian economist Richard Denniss. The point I would like to address is the claim that Denniss made repeatedly during the debate, that [sic]:

"...the main point is that this conspiracy runs far deeper than the communist takeover of Greenpeace because Malcolm Turnbull and John Howard are in on it and Marius Kloppers and Ralph Hillman the head of the coal association, are in on it...we just really need an explanation here of what is it that is driving the head of BHP to accept this and why is Woodside using climate science to predict how much stronger its gas rigs will need to be to resist the climate change that their gas is going to cause."

I can provide the answer the Denniss is [not] looking for: large, established businesses are not necessarily friends of - and are in fact almost certainly against - the market and are instead in favour of anything the government can do to prevent competition by raising the barriers to entry for their industry. It is entirely within the scope of rational self-interest for someone like Marius Kloppers get on board and support a carbon tax regardless of the science that may or may not be behind it. As Matt Ridley pointed out in his recent book The Rational Optimist:

"I hold no brief for large corporations, whose inefficiencies, complacencies, and anti-competitive tendencies often drive me as crazy as the next man.  Like Milton Friedman, I notice that ‘business corporations in general are not defenders of free enterprise.  On the contrary, they are one of the chief sources of danger.’  They are addicted to corporate welfare, they love regulations that erect barriers to entry to their small competitors, they yearn for monopoly and they grow flabby and inefficient with age."

We live in a crony-capitalist world and thus should expect the likes of BHP to jump at the opportunity to get in bed with government (no doubt BHP's team of lawyers have cut private deals with the government for their support resulting in them coming out on top of any carbon tax, whether through exemptions, compensation or simply through the increased barriers to entry insulating them from competition). As Mises said:

"In the interventionist state it is no longer of crucial importance for the success of an enterprise that operations be run in such a way that the needs of the consumer are satisfied in the best and least expensive way; it is much more important that one has "good relations" with the controlling political factions, that the interventions redound to the advantage and not the disadvantage of the enterprise...An enterprise may be well run, but it will go under if it does not know how to protect its interests in the arrangement of tariff rates, in the wage negotiations before arbitration boards, and in governing bodies of cartels. It is much more important to have "connections" than to produce well and cheaply. Consequently the men who reach the top of such enterprises are not those who know how to organize operations and give production a direction which the market situation de mands, but rather men who are in good standing both "above" and "below," men who know how to get along with the press and with all political parties, especially with the radicals, such that their dealings cause no offense."

I hope that answers Denniss's question. As for the carbon tax itself, no self-respecting economist should support it regardless of what the science shows. Indeed, Australia is lining up as a perfect case study for why it is impossible for any government to implement a theoretically, economically "efficient" carbon tax. It is yet another example of the problems repeatedly highlighted by the public choice school; that even if we assume the best intentions, the incentives and institutions that self-interested political and bureaucratic actors operate within will always result in an outcome that will be worse than if nothing was done at all.

The interest rate debate has once again entered the mainstream in Australia with Westpac becoming the first major bank to forecast that the next move the Reserve Bank of Australia (RBA) makes will be a 25 basis point cut in December of this year, followed by another three 25 basis point cuts next year (bringing the cash rate down from the present 4.75 per cent to 3.75 per cent). This is in line with what the bond market has been showing for a while and was followed by comments from bloggers and financial / economic pundits all providing their two cents on the issue, with opinions varying on whether rates should increase (actually, I have yet to find anyone supporting an increase – while the ‘experts’ are forecasting a rise, most think it is unwarranted) or decrease.

While there is nothing wrong with trying to predict the RBA’s moves – in fact, in today’s world of fiat currencies and a centrally-planned cash rate, it can be incredibly profitable for the savvy investor to correctly predict the moves of their favourite central bankers – it is wrong for people to make claims that the RBA “must” either increase or decrease rates when these claims are based on fallacious reasoning. Most of this reasoning proceeds like this:

1)      Analyst ‘sees’ X industry or industries suffering

2)      Concludes rates are too high for non-miners

3)      Insists that RBA must cut rates

But to suggest policy recommendations on this reasoning is extremely dangerous. For one, who says that the current state (or some past state) of X industry is the proper state? Perhaps it is rife with malinvestment and the marginal businesses within X industry are finally starting to liquidate, allowing for the necessary restructuring and capital reallocation process to begin? Lowering rates would simply delay this process and squander even more capital with the piper still to be paid down the road.

Imports, not exports…

Another classic fallacy that is tossed around as if it is fact is that a cut in the cash rate and the subsequently weaker dollar it will create as capital inflows reverse is that it “…will be a boost to manufacturers and exporters.” But this is the oldest trick in the mercantilist book and can only be believed if you ignore the wider effects this policy has on the economy rather than the visible gains of a few select industries and the balance of trade; it is the zero-sum idea that all that matters for economic wellbeing is that the balance of trade remains positive. However, the “boost” received by exporters and manufacturers is largely illusory; while some industries will undoubtedly gain, domestic prices will rise faster than any gains those industries receive from increased sales. Given that everyone is also a consumer, they and everyone else in the economy now have to pay more for everything they consume. With a weaker dollar, the entire country has to export more and work harder to pay for the same amount of imports received before the devaluation of the currency. When you have to trade (export) more ‘stuff’ for the same amount of ‘stuff’ as you could buy before (import) then it is a net loss, not a gain.

Back to interest rates…

There are only two ways to avoid a boom-bust cycle induced by exogenous factors (e.g., monetary expansion in the US/China): maintain a cash rate that is perfectly aligned with the natural rate of interest – that is the rate that Knut Wicksell initially defined as the equilibrium interest rate that balances saving and investment in an economy over time – or with sound money such as a true gold standard (this is of course assuming government control over money; if money was privatised, true free banking – under the institutional setting of private property, contract and consent – would be the ideal method).

We know for a fact that all central planners, even the ‘elite’ planners who sit at the top of currency boards known as central banks, suffer from the same knowledge and rational calculation limits as all central planners do and can never equal or better a private competitive market in the allocation of scarce resources. They suffer from what Hayek, in his Nobel Laureate acceptance speech, called the “Pretence of Knowledge”; a belief that they can “manage” something that is impossible to manage. Thus, the only option available under fiat currency – that of keeping the cash rate perfectly aligned with the natural rate – is impossible beyond the occasional fluke. This means that unless the central bank raised rates to a level that stifled all economic growth, it is almost a certainty – especially when the insights of the public choice school are factored in – that the cash rate will be held below the natural rate more often than not. When this happens, there is only one outcome: relative price distortions, an unsustainable boom and the subsequent malinvestment that goes with it.

The reality is that any policy that cuts the cash rate below the natural rate of interest will cause inflation and even though it will be touted as an attempt to “fix” the economy it will not in fact “fix” the economy but will instead be nothing more than a transfer of wealth to debt holders (banks, government, corporations, mortgagees) at the expense of everyone with savings (anyone holding bonds, bank deposits, insurance policies or super, i.e. most people). Likewise, if the cash rate is held above the natural rate of interest a reverse transfer will occur. As Bob Murphy noted,

“In truth, there's no obvious right or wrong answer to this question [what interest rates should be]. It would be akin to asking, "How many cars should the Soviet planners have produced in 1983?" One is tempted to say, "Ideally, the number of cars that would have been produced if there had been a capitalist economy," but not only is that impossible to know; it's not correct. The very existence of a centrally planned apparatus changes the real economic data, and so changes what the "correct" number of cars should have been, even if we could agree on the criteria for correctness.”

Structural issues

One of the reasons people believe they can achieve economic prosperity through price manipulation (interest rates) is that they have no concept of capital; it is simply this homogenous blob of putty which can be moulded in any shape or form. In reality, capital can do no such thing; once it is ‘formed’ it differs in how easy it is to reallocate to other uses, from virtually impossible (say a bridge to nowhere) to relatively easy (human capital).

“The more elastic is the currency system the longer can a more or less constant difference persist between the two interest rates [actual and natural] and the greater, therefore, will be the influence of this discrepancy on prices,” Cf. K. Wicksell in Geldzins und Giiterpretse.

Australia has had over 20 years of relative prosperity, in part financed through unprecedented levels of personal and now government debt. There are now massive structural imbalances in the economy (housing for one!) that have accumulated over these years as a result of interest rate targeting and a floating fiat currency. Another rather unfortunate aspect of interest rate manipulation is that it covers up the distortions the government itself has – the burden it inflicts is allowed to grow without the effects being felt for a significant amount of time. To paraphrase Milton Friedman, the “Iron Triangle” of politicians, special interests (e.g. banks) and bureaucrats (e.g. the RBA) is able to grow significantly larger than it would under a free market and the most effective way it does this – by stealth – is through its control of the interest rate.

Conclusion

In summary, by maintaining relatively stable interest rates, a flexible exchange rate and growth in the (aggregate) price level consistent with its stated goals over the course of the past decade – in other words, by doing its job – the RBA allowed relative prices in Australia to be slowly but surely distorted and malinvestment to ensue. Cutting the interest rate in an attempt to distort the correct functioning of the price system and prevent the appropriate feedback mechanisms from reaching actors in the economy will at best delay the inevitable (and cause further resource misallocations) and at worst fail completely, resulting in a prolonged downturn as restructuring is made virtually impossible.

While cutting the interest rate may spare many marginal firms and individuals in the short-run, in the long-run there will be significantly less wealth (not false wealth i.e., as recorded by GDP, but a smaller pie - a smaller quantity of goods per capita) for all Australians. Marginal and unsound firms – the ones most affected by the false signals sent by the RBA’s price manipulation – have to be allowed to restructure or liquidate, correcting Australia’s structure of production, allowing sound businesses to grow and letting economic recovery occur as quickly as possible. This can only happen if the natural rate of interest is allowed to reveal itself through the market system.