It has to. The extreme—unprecedented—moves that respective governments, policy makers and central bankers have taken in the past year are going to have an effect on the long-term health of the economy.

Let us take a brief look at what happened and what is still taking place in Australia.

In response to the crisis the RBA followed the lead of the central banks of the US and UK and increased base money considerably—from approximately $47 billion to over $72 billion, an increase of over $25 billion in just four months, something that has never been done before in Australia.

Although we don’t know exactly where the money went (the RBA does not comment on particular counterparties), based on the data it is safe to say that it went into the banking sector, either to encourage banks to keep lending to each other or simply as a direct subsidy by taking securities off the bank’s balance sheets and giving them cash in return.

The thing is, unlike the US and UK where the massive increase in base money is still sitting in reserves at their central banks (they receive a ‘safe’ level of interest and are keeping the reserves on hand for future asset write-downs), the Australian banks have already decided to use the new money. I’ll touch on where it has gone in a moment, but for now this means that at least some of the new money has already entered the wider economy and will have to have an inflationary effect at some point in the future. Historically it can take up to two years for an increase in the money base to end up in the CPI (a horrible, heavily manipulated figure)…but who knows this time. What it has done though, in the short term, is keep assets inflated, preventing prices in financial markets, housing, credit markets and so on from adjusting downwards.

So where has the money gone? A quick glance at the data for long-term securities reveals that a lot of the new money has probably entered that market with the amount invested, both public and private, increasing significantly since the money was injected. So the banks are monetising at least part of the government’s deficit with RBA-created money. This is important to note, because fiscal spending is not inflationary under one condition: when you as an individual buy a government bond. When you do this you are making a loan to the government; you are putting part of your cash holdings into the hands of the treasury. There is then no increase in the total quantity of currency or credits available and hence no inflation.

Now, when the banks buy government securities from their new reserves, as I suspect they have been, it is just as inflationary as effects of issuing more paper money. It is under this scenario that the government’s fiscal spending will create future inflation as the loans funding it are not sourced from real, productive savings: there are now more dollars chasing the same amount of goods.

Loans are still relatively stagnant, reinforcing the view that the banks are choosing to invest the new cash in relatively safe long-term securities instead of issuing new loans (although there’s hardly been a ‘crash’ in loans – loan growth is still close to 10% YoY and appears to be turning upwards).

So what does this all mean? For one thing, it appears the banks received a good ol’ fashioned bail out, although the RBA was much more covert in its efforts than the Fed. While this will probably prop up the financial sector in the short term, it can’t be good for the wider economy as prices, production and consumption have failed to coordinate…I have no doubt one of the reasons the market hit records recently is because a lot of the new money was being channelled into the stock market (it often is).

In the short-term the RBA is going to be under pressure to raise rates – I wonder if they can hold out until the election next year (Rudd and Swan will be putting a lot of pressure on them to hold off till then). I’m not sure if the RBA will fight the upwards pressure on interest rates by issuing more money (the only way they can keep it down) or if they will let rates rise…if they keep rates down until next year then inflation will be guaranteed in the medium-long term.

On the subject of inflation/deflation, the best indicator for future inflation has to be M3—coincidently, it is a figure that has been rising at near record levels over the past couple of years (34.8% from July 2007 – July 2009[1]).

Gold is also a good leading indicator for inflation; the AUD gold price (indexed) historically trends close to M3.

The above seems to indicate that inflation rather than deflation will be on the cards for Australia in the near future. Yes, there are plenty of bad debts that need to be written down but I don’t think we have to worry about deflation: the RBA will monetise most of the toxic assets and prevent the money supply and prices from falling too far. It is politically suicidal—for both Glen Stevens and the government—to allow deflation to occur on their watch.

This leads me to the fiscal issue. The reckless “stimulus” undertaken by the government has to have caused massive structural instabilities and further malinvestment in the economy. Rather than let the necessary restructuring occur, they have simply—at best—delayed it. At worst they have caused even more malinvestment and imbalances that will radiate throughout the economy for several years. It’s important to understand that the government can only create what it has first taken from someone else. All of the jobs the stimulus created are temporary in nature—they cannot be maintained unless the government keeps spending. They are not in areas demanded by the preferences of the consumers but by the fancies of Julia Gillard. Building roads to nowhere and new gymnasiums is wealth destruction plain and simple.

If the stimulus is wound down—a necessity to restore economic health—and the inflationary fears forecast above both take hold, stagflation is a distinct possibility. Especially considering that once rates start to rise again the glaring bubble that is the property market will come under stress and put further pressure on both the mortgage industry and jobs related to it (housing, construction and so on).

"There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved," -- Ludwig von Mises, Human Action

However, we do have more room to move than the US and UK (we actually export stuff and so have a larger pool of real savings to exhaust through government waste and bank subsidies), so it might be possible for the powers that be to keep this fiat regime going and avoid the necessary deflation (or hyperinflation and a collapse of the currency).

The beauty of monetary inflation is that it is never the same and does not necessarily affect the same industries. Loose-money policies at home and overseas could very easily create another asset bubble in our economy. Only time will tell.

[1] M3 growth has only matched this rate twice in Australia over the past 40 years. Those years were 1973 and 1989 and were followed with two recessions.