A bit of good news out of the Reserve Bank today, with the board deciding to leave rates unchanged at 3.25%. Despite the heretics screaming that this will cause us to head into a deeper recession from the rooftops of the highest building they can find, this is relatively good news. I say relatively because the best news would have been a rate hike, but that's just not going to happen with the current incumbents.
You see, when there's a credit crisis people suddenly realise that they didn't save enough over the boom period -- many investments were undertaken, malinvestments, that never should have been started. Many businesses that were in fact not profitable, appeared profitable throughout the boom. The capital structure of the economy has been distorted. People start to realise they need more liquid funds and seek to borrow money to keep their businesses afloat. The logical response by the lenders of this liquid capital, as simple supply and demand dictates, would be to raise prices (interest) -- supply hasn't increased but demand has (this would also deter the marginal -- high risk -- borrowers from taking out loans). Only the most profitable enterprises would be able to afford these higher rates, allowing the most prudent and successful to acquire the much needed liquidity while leaving the unprofitable ones (where all of the malinvestment was) to die. This would no doubt be painful in the short run, but it's not nearly as bad as the current inflationary policy response will be.
...today credit expansion is exclusively a government practice. As far as private banks and bankers are instrumental in issuing fiduciary media, their role is merely ancillary and concerns only technicalities. The governments alone direct the course of affairs. They have attained full supremacy in all matters concerning the size of circulation credit. While the size of the credit expansion that private banks and bankers are able to engineer on an unhampered market is strictly limited, the governments aim at the greatest possible amount of credit expansion. -- Ludwig von Mises, Human Action
The response I speak of is of course a rate cut - lowering the rate of interest below the natural rate lenders would charge in a free market. Rather than let the rate of interest rise, the central bank begins watering down the potency of the currency, enabling them to supply everyone with much needed liquid funds. This fallacy arises from the belief that lower borrowing costs will revive the economy by stimulating investment and consumption, thereby adding to output and employment. The rate is lowered to whatever is deemed appropriate by the government, pressure groups, unions and so on -- people with a vested interest in seeing this rate fall. This is only a superficial solution as these new funds aren't backed by any commodity or anything of value. The areas of malinvestment will still exist; this will just prolong their survival at the expense of the entire economy, transferring wealth from creditors to debtors. This just the obvious issue though, there is something much more sinister about inflationary policy which I'll touch on below.
"In the opinion of the public, more inflation and more credit expansion are the only remedy against the evils inflation and credit expansion have brought about." -- Ludwig von Mises, Human Action
Hayek noted that inflation is much more than just a transfer of wealth from creditors to debtors, as inevitably some people receive the new money first. This causes a distortion in the price structure: some goods and services increase in price first (the first to get the 'new' money) with the rest to follow in succession. Investment will pour into these sectors as they appear to be more profitable thanks to the increase in price, creating further malinvestments, all of which are dependent on an ever-increasing rate of inflation. This distortion in the price system will only cease some time after the end of the inflationary policy. When that time comes, the jobs created in these industries -- the ones which had an inappropriate amount of resources allocated to them due to this new money hitting them first -- will be destroyed. The only way to keep this going is to keep inflation going at an ever increasing rate, one which eventually has to bust -- and the fall will be far more painful the longer this policy is continued.
There are two outcomes from continued monetary expansion: Firstly, if these policies are continued indefinitely, we'll get hyperinflation. That one is straightforward. The other option is what we've had over the past few decades -- a stop-start inflationary policy; a continuation of the boom-bust cycle, or as Hayek said, one "in which from time to time the authorities get alarmed and try to brake, but only with the result that even before the rise of prices has been brought to a stop, unemployment begins to assume threatening proportions and the authorities feel forced to resume expansion."
It's unlikely the central banks will allow the onset of hyperinflation. The latter, on the other hand, is subject to diminishing returns (each stop-start becomes less effective and the recessions will last longer) and unless there are fundamental changes to the way in which we operate -- changes to the way unions, fiat money, central banking and so on exist -- we're doomed to either hyperinflation (with inevitable bust) or larger, more frequent boom-bust cycles.
