Well, where to begin. The CPI has to be one of the worst, most heavily manipulated and misleading indices in history. This latest example is just another reason as to why it is money and not an arbitrary basket of prices that we need to watch if we want to gauge how much the RBA is debasing the currency:

Australia's monthly inflation rate has jumped, with prices rising at the fastest pace since October 2008, spurred in large part by the federal government's 25 per cent tax slug on cigarettes.

"While there is a spike in the headline measure due to the 25 per cent lift in the tobacco excise, excluding this outcome still sees headline inflation breaching the upper limit of the RBA's two to three per cent inflation target band," said TD Securities senior strategist Annette Beacher. Source

I am constantly reminded of this advice when I hear the government speak about anything to do with economics:

"If you tell a lie long enough, loud enough and often enough, the people will believe it" - Adolf Hitler

Such is the case with the CPI and the so-called cause of inflation. We are constantly told that higher inflation and, consequently, higher interest rates are the result of higher prices – a nice little semantic trick, a renaming of terms which leads people to believe exactly what the government wants them to. Claiming that a cigarette tax caused a rise in inflation is akin to putting the carriage in front of the horse: a general increase in the price level occurs because of inflation, not the other way around. Prices do not just rise for no reason; they rise and fall based on supply and demand. On the supply side, things such as an unforeseen event, e.g. a natural disaster or drought causing a supply shortage or certain government intervention can increase prices. However, more often than not the culprit is the deliberate debasement of the currency by the central bank - otherwise known as monetary inflation. If any politician honestly believed in the fight "against inflation" and the "increasing cost of living," they could quite easily cease debasing the currency and end inflation in its tracks.

Now let us examine this so-called inflationary cigarette tax again. We are told that because of this tax, which increased the price of cigarettes, upwards pressure is placed on inflation - but surely if the price of cigarettes rise and as a result people are spending more of their incomes on cigarettes, they will then have less to spend on other things and therefore prices for other goods in the economy should fall? To clarify, imagine an unchanged stock of goods and an unchanged money supply - if more of that money supply is dedicated to cigarettes but the quantity of money stays the same then there is less money to go around and consequently prices will have to fall in other areas[1].

On the other hand, real inflation is caused by an increase in the money supply. If there is more money chasing an unchanged stock of goods there will be an increase in the average price of goods as well as in cigarettes. In other words, it is not possible for a tax-induced price rise in one good - cigarettes - to set in motion a general increase in the price of goods and services without the money supply also increasing. Then again, defining inflation in the carriage-before-the-horse way allows politicians to prey on the ignorance of the general population and spout rhetoric about how they are going to "fight" inflation, castigate speculators or some foreign enemy, something which is priceless for them in their quest to win votes. Fooling the general population into believing that inflation is a price phenomenon rather than a monetary phenomenon has allowed them to expand the size and scope of government immensely. Until people wake up to this fact, I do not see the system changing any time soon.

---

[1] It is not quite as clear cut as this. The amount collected by the tax which would usually be spent by the smokers on goods and services aligned with their preferences is instead arbitrarily allocated by the government, likely leading to malinvestment and wasted resources. The price level will therefore remain the same in aggregate, although prices will be distorted in certain areas (i.e. say every smoker goes without a carton of beer every month to maintain their level of smoking at the higher price. Beer prices will fall while the industry where the government spends the new revenue, say insulation schemes, will be artificially stimulated and price will rise. This price rise sends a signal that people are demanding this service, thereby encouraging labour and capital away from the beer industry. Once the spending ends, and it will, those people lured in by the higher wages will be unemployed and will likely find themselves with skills not required in the marketplace, something Hayek would call a malinvestment in human capital. Please remember that this is a very simplistic example with just two industries but I hope it clarifies the issue).

The banks don’t have to lend to inflate

Contrary to popular belief, banks do not need to lend to expand the money supply and eventually create price inflation. Yes, the Australian banks are still lending at an impressive rate but since the bust this has been predominantly to the housing, individual and public sectors, with commercial lending actually declining year-on-year (although it is already on the way back up from July lows).

Just because the demand for loans by businesses fell off does not mean that the monetary pumping undertaken by the RBA will have no effect on price inflation. Banks never have to be passive and, indeed, they usually waste no time in spending their new cash reserves. All they have to do to expand the money supply is buy existing securities, whether from each other or other corporations, thereby increasing deposits. They do not have to depend upon business firms to request commercial loans, or to float new bond issues.

…But it doesn’t matter anyway

Saying that, in a speech today the RBA's head of domestic markets department, John Broadbent, revealed that “…listed corporates have raised a record amount of equity this year, totalling some $60 billion, with issues broadly based across all sectors.” So not only are banks buying existing securities but they are buying up new bonds at record levels. This will be inflationary.

Mr Broadbent continued to say that most of these equity raisings had been used to pay down debt, with some companies explicitly saying the funds raised were to repay bank loans. While this may sound deflationary, it is not.  When someone pays back debt, the money used to pay that debt with does not suddenly disappear but simply goes to the creditor, in the case the bank. The bank then spends on additional security purchases, shares, or issues more loans which increase deposits. In other words, most if not all of the ‘repaid debt’ flows straight back into the economy.

The seeds have been sown

“The first sign of a hyperinflation is a rally in the stock market,” Jens O. Parrson, Dying of Money: A History of the Great German and American Inflations.

The new money and all-time low interest rates from the RBA coupled with a record fiscal deficit and added public debt obligations has created a new wave of malinvestments (investment in areas not aligned with consumer preferences but that which appears profitable thanks to the artificially low cost of credit and rising prices) in Australia that will eventually need to be liquidated. As an example of the rising confidence, the latest Dun & Bradstreet business expectations survey of 1200 business owners and executives shows expectations for investing in capital are at the highest level in 10 quarters, registering an index level of eight points. It is only a matter of time before the distortions created by all of the new cash created by the banks – and enabled by the RBA – will be revealed. While it may take a few years thanks to factors such as China’s demand for Australian resources, foreign accumulation of the Australian dollar (as bad as it was, every other nation appears to be inflating more) and so on, those same factors will mean the eventual bust will be worse in Australia than elsewhere.

The Australian recovery is not sustainable and rapid price inflation is a very distinct possibility.

In a "better late than never" move, the RBA raised the cash rate by 25 basis points to 3.25 per cent earlier today based on stronger than expected "economic conditions" and "measures of confidence". This was not entirely unexpected, as we reported last month the only way rates would remain at 3 per cent was if the incumbent Labor party had enough sway to 'persuade' the RBA to hold rates.

The only way to artificially keep interest rates down is to increase the money supply – whether through the purchase of government securities, increasing the amount of cash in the economy or lowering the discount rate (encouraging banks to borrow more).

Record growth in M3 thanks to the loose money policies around the world following the last 'bust' (2001ish) saw the pressure on interest rates soar considerably leading up to the crash and instead of further raising rates[1] – a move that was necessary to allow the prior malinvestment to liquidate and for prices to coordinate downwards – the RBA simply flooded the financial sector with additional money thereby preventing any restructuring from occurring.

The structural flaws in the economy – a capital structure still swarming with malinvestments that are not aligned with the intertemporal (time) preferences of the consumers – have resulted in inflated prices in several industries such as housing, construction, banking and finance.

"As soon as deflation makes itself felt, there will be immediate attempts to combat it—often when it is only a local and necessary process that should not be prevented," Friedrich August von Hayek.

Inflating the money supply is a short-term solution that cannot create any additional long-term wealth. Real savings are the barometer for investments that can be successfully carried through to completion: by inflating the money supply the RBA merely deceives investors into thinking the pool of real savings is larger than it actually is. It gives them the impression that consumers have forgone current consumption thereby freeing up more capital for longer-term projects aimed at increasing the productive capacity of the economy.

Think of inflation as you would drug taking: it is disastrous for long-term health, but it can work wonders and make you feel great in the short-term. Likewise, deflation is akin to a drug taker going through withdrawals – it can be quite painful in the short-term but will result in improved long-term health. Unfortunately, the nature of politics is that only one option, inflation, is viable.

Following the outbreak of the 'credit crunch', the governments fearmongering strategy was put into good effect to gain short-term popularity and, more importantly, push for favoured policies that have turned a necessary market correction in a few selected industries into a much more severe, economy-wide problem.

To offset the inflation set in motion by the reckless monetary pumping of the past year, the RBA is raising interest rates. This will attract foreigners seeking a higher yield and should therefore strengthen the dollar relative to other currencies in the short-term. It can only be expected that the RBA will to continue to breach their policy of abstaining from currency manipulation to keep the $AUD below one $USD under the guidance of their mercantilist think bots in an attempt to avoid a slowdown in export growth. This directly contradicts their attempt at keeping inflation at bay and will instead lead to further increases in the money supply and, consequently, price inflation.

Despite relatively small 'inflation' – the CPI figure is up 1.5% YoY, the record amount of pumping undertaken by the RBA cannot be swept under the rug; it will have a serious effect on the wider economy in the future. While businesses are reducing their risk by reducing leverage, banks are still increasing their loans year-on-year (we never came close to having a 'credit crunch') within the banking sector, to consumers and into mortgages.

Unfortunately for the economy, the seeds of the next fiduciary inflationary bubble have been well and truly sown.

"The market rate of interest cannot be lowered by a credit expansion except for a short time, and even then it brings about all those effects which the theory of the trade cycle describes," Ludwig von Mises.

The Australian economy has been flooded with a fresh batch of cheap money. The level of savings is below 5% of disposable income. Private debt is still over 150% of disposable income. Housing is as expensive as ever. The 'stimulus' simply, at best, kept people employed where they happened to be (hint: areas of malinvestment), at worst further distorted the distribution of labour and capital structure of the economy. Public debt is at record highs. Unemployment will continue to get worse as the stimulus wears off and the jobs that were 'saved' are once again, necessarily, 'lost'. Price inflation will rear its head (of course with a mighty lag thanks to the heavily manipulated CPI) and interest rates will have to rise further.

The above are hardly what you would call solid pillars of growth. The economy is anything but healthy and any recovery will not be sustainable.

Unless the free market is given permission to work and the necessary liquidation and restructuring allowed to occur, problems will continue to appear and will be addressed, again and again, by policies that only deal with the immediate, visible effects; effects caused by the very policies designed to combat them! The result will be bigger government, higher inflation and our very own 'lost decade'.

---

[1] Of course the best way would be to leave interest rates - effectively the price of borrowing money - for the free market to determine. Government price controls never, ever end well.

Building on what Drwasho wrote back in June, I have to say, I’m really not sure. There’s a good reason to believe both could happen but as always timing is the hardest part to predict.

The case for deflation is a strong one – commercial bank credit is in freefall as banks look to let their commercial loans run down and don’t seem to be replacing them with new investments. This has to have a strong deflationary effect on the economy and it’s unlikely any amount of prime-pumping on behalf of the Fed can counteract it. In fact, a lot of the new money is simply sitting in excess reserves, likely going into treasuries or simply collecting interest from the Fed (a new ‘tool’ in the Fed’s arsenal – paying interest on excess reserves) rather than funding new loans.

The deflationary theory is hardly new; it’s exactly what happened during the great depression. Rothbard, in America’s Great Depression, highlighted a few key reasons as to why deflation occurred despite the low interest rate, cheap money inflationary policy pursued by the government of the day. They are:

1)     Lower interest rates further discouraged the banks from making loans or investments. Just when risk was increasing, the incentive to bear risk—the prospective interest-return—was being lowered by governmental manipulation.

2)     The enormous increase in bank failures. With over 1,000 banks failing every year, bankers knew in their hearts that no bank (outside of the nonexistent ideal 100 percent bank) could ever withstand a determined run.

3)     Foreigners lost confidence in the dollar, partly as a result of the program, and drew out gold;

4)     American citizens lost confidence in the banks and changed their deposits into Federal Reserve notes;

5)     Bankers refused to endanger themselves any further, and either used the increased resources to repay debt to the Federal Reserve or allowed them to pile up in the vaults.

Today a lot of the conditions that prevented the politically ‘desired’ inflation from occurring back in the 1930s don’t exist. For one, we have a fiat money regime rather than a gold standard making it harder for foreigners to convert their US dollars to gold or other assets without losing value. Another big difference is that government’s around the world enacted a policy of deposit insurance, thereby preventing mass bank failures (creating ‘zombie banks’ instead) through bank runs. But aside from those two differences, the other points still hold true.

It’s important to remember that Bernanke is well schooled in the great depression. His problem is not that he doesn’t understand why inflation didn’t occur; it’s that he still believes inflation is the correct solution and is therefore looking to prevent the above from causing deflation this time around. He’s going to go all-out in an attempt to reinflate the bubble rather than let the necessary deflation and restructuring work its magic.

So can he do it?

This is what I’m not sure about. It’s going to be very difficult to get people to leverage up this time around. What we do know is that Bernanke will stop at nothing in his attempts to reinflate the bubble, an effort which may amount to nothing more than blowing air into a broken balloon. Excess reserves have increased astronomically, as they did in the great depression, but the question is whether they will make it into the money supply or not. At this stage every attempt has been fleeting with banks quite happy to buy up treasuries or simply take the small, but safe, return that the Fed pays them.

Will the new powers the Fed is after allow Bernanke to charge a negative interest rate on excess reserves, forcing banks to buy existing securities or create new loans, thereby increasing the true money supply? Will the growth in the public sector, public works, ‘stimulus’ and so on create enough spending to drive inflation faster than the private sector is deflating? These are all very curious questions and unfortunately, at this stage, no one knows. We’re stuck in limbo and all I can say is that the next several months are going to be very, very interesting.

Concerning Australia, this time around we have China. While in the great depression we were one of the hardest hit due to our export dependence and protectionist policies pursued by our major trading partners, this time we have a centrally-planned major trading partner in China instructing their factories to keep production up and, therefore, demanding our commodities. The export-focused, mercantilist policies of the Chinese government, while depriving their own citizens of deserved wealth, are in effect a subsidy for the Australian economy. By artificially keeping their currency low and subsidising their export industries they’re not only increasing demand for our raw materials but are supplying us with goods that are cheaper than they would be if China was a more free market orientated country. Yes, this is a bad thing for the Chinese people, but it’s good for Australians.

This leads me to believe that it won’t be as bad here as it will be in Europe and the US, despite our government rolling out the third largest stimulus package behind only the US and Korea (on a per-capita basis). The biggest threat to Australia is the growing size of the public sector, of increased regulation and the massive debt that we, and future generations, have been laden with for no good reason.

It seems, as with the US, Australian banks are finding it difficult to (likely voluntarily) create new loans to replace the ones that are running down. I’m more concerned, at this stage, about inflation in Australia than in the US. The RBA has been a bit reckless with their monetary policy – for example, they just increased the currency stock by $4 billion – an increase of almost 10% on the existing supply. This is money that won’t be sitting idle; it’s being spent and will have an impact on prices, perhaps not immediately due to the winding down of credit, but it will in the future. What happens when the banks start expanding credit and the RBA’s cash injection is already flowing?  This, together with the irresponsible spending by the government will have to force interest rates to rise if we’re to have any chance of avoiding price inflation.

When the government’s stimulus proves to be ineffectual at providing long-term jobs we’re probably going to be faced with rising inflation, rising interest rates and rising unemployment. But with an election looming, we probably won’t hear anything about that until Rudd is sworn in for a second, and probably final, term. The Keynesian solution adopted by this government requires endless doses of government spending, deficits and new money which will only lead to a growth in the welfare state, inflation and wealth destruction. The real solution is simple: get the government out of the way and let the necessary coordination between prices, costs and wages take effect.

Every high school or university student who studies economics and even the average layman who reads or listens to the media and the politicians is of the belief that inflation is a price phenomenon. They’re told that higher inflation and, consequently, higher interest rates are the result of higher prices – a nice little semantic trick, a renaming of terms which leads people to believe exactly what the government wants them to.

The “official” definition of inflation is akin to putting the carriage in front of the horse: a general increase in the price level occurs because of inflation, not the other way around. Prices don’t just rise for no reason; they rise because of unforeseen events (e.g. a natural disaster or drought causing a supply shortage or government regulation/price controls) or through the debasement of the currency – otherwise known as monetary inflation.

What I want to know is why so many smart people never ask the question: where do higher prices come from? To put it more succinctly, how is it that, with technology and productivity improving on a daily basis, prices go up rather than down?

The answer is in fact quite simple: prices rise year after year because the government (through their agency the Reserve Bank) increases the quantity of money in circulation. Let’s have a quick look at the data and see how much the money supply (M3) has increased since 1982 relative to Total Average Weekly Wages and the Price Level.

Quite staggering indeed. Over almost thirty years the government has increased the money supply by a whopping 1,363%. Wages, on the other hand, have only increased by 276% - but does that mean we’re 276% wealthier today than in 1982? Hardly. If you take a look at the increase in prices, they’ve risen by 193%. Yes, we are all wealthier today than we were in 1982, 78% wealthier in fact [1], and I should hope so too!

The issue I have is the endless improvements in technology and productivity are not being transferred entirely to the consumer, to the average Australian. The government, through the constant debasement of the dollar, takes a large percentage of the said gains for their excessive existence, wasteful ventures and to fund the welfare nanny state. This is effectively a hidden tax on everyone who is paid in Australian Dollars.

Not only that, but there are countless other problems caused by debasing the money supply aside from just theft, it: encourages malinvestment by suppressing interest rates and thus unemployment and wasted resources; keeps the poor poor (more on that in a bit); creates dependency on the state by eroding savings; encourages improvidence; and many, many more, including the eventual collapse of the monetary system itself (e.g. Germany, Zimbabwe). As Ludwig von Mises said,

“With regard to these endeavours we must emphasize three points. First: Inflationary or expansionist policy must result in overconsumption on the one hand and in mal-investment on the other. It thus squanders capital and impairs the future state of want-satisfaction. Second: The inflationary process does not remove the necessity of adjusting production and reallocating resources. It merely postpones it and thereby makes it more troublesome. Third: Inflation cannot be employed as a permanent policy because it must, when continued, finally result in a breakdown of the monetary system.”

So how do they do it? When the Reserve Bank increases reserves the new money has to flow somewhere. That ‘new money’ usually enters through the financial services industry through favourable credit conditions allowing them to lend to households, or invest on the stock market, real estate, and so on. If that doesn’t work, the government can always increase its deficit and oblige banks to monetise government debt (like they just did). The increased spending through “stimulus” and “infrastructure investment” enables the newly created money stock to enter the economy and therefore drive up prices [2].

As the first recipients of the new money, the banks and government are still buying at ‘normal’ prices – prices that haven’t yet adjusted to account for the recent increase in supply. This is how they secretly tax anyone earning or holding Australian Dollars – the increase in prices caused by the new money filters its way through the economy and the people who receive wage increases last – usually the poor – are the ones who are taxed the most. The financial sector, as early recipients – and usually the rich – benefits the most (after the government).

“To cover the fact that a central bank is merely a cartel which has been legalized, its proponents had to lay down a thick smoke screen of technical jargon focusing always on how it would supposedly benefit commerce, the public, and the nation... there was not the slightest glimmer that underneath it all, was a master plan which was designed from top to bottom to serve private interests at the expense of the public... the system is merely a cartel with a government facade,” G. Edward Griffin

Next time you hear a politician spouting off about how they’ll “fight inflation”, remember that they’re the ones who are causing it. All they would have to do if they honestly cared about lower prices and helping the 'battlers' would be to stop creating money, to cease deficit spending and to return to sound money. Unfortunately most, if not all politicians in Australia, don’t actually care about the 'battlers' so long as their own taxpayer-funded trough is kept full. So what’s the solution going forward? There are lots of ideas out there, from a return to a gold standard to free banking (i.e. banks being allowed to issue their own currencies) among others – but at the end of day the only thing that really matters is that ability to manipulate the money supply is taken away from the government as soon as possible.

“A private central bank issuing the public currency is a greater menace to the liberties of the people than a standing army...We must not let our rulers load us with perpetual debt,” Thomas Jefferson

We can always dream.

---

[1] Issues with the wage and CPI data aside (e.g. average wage may be higher but there may also be more unemployment. Likewise the CPI excludes a lot of 'everyday' items that may have risen significantly more than the figure suggests).

[2] There are other ways too – e.g. the Reserve Bank could always simply buy up assets for itself.

Hey everyone,

So Justin is going to be away for a little while and I've been staring at the home page of aussienomics for the past few days blankly, waiting for some sort of inspiration to descend or arise upon me... sadly nought.  I do have several small thoughts that I guess I can post as regularly as I can until I come up with something long and profound to post.  In any case, feedback and interaction makes the experience better for all of us.

Recently I watched the movie 1984, based off the novel written by George Orwell.  I don't recommend people watch the film, unless you want to see the fantastic acting performance by Richard Burton.  The book is sensational, I'm about 10% of my way through the book myself.  What hit home to me today is that governments around the world are heading for that dystopian destination.  I once thought that it was virtually impossible for that level of tyranny to occur within my life time... I now believe differently.  Sadly, the level of apathy and disengagement of the population has me worried about the future.  My beef is not with the politicians, as they are just men and women with the same power complex that average individuals possess.  My discontent is with you, the person reading this article and the persons who are not reading this article.  My disappointment is with all of us, past and present, who have allowed, either actively or passively, this monstrosity to occur.

What am I talking about, it's simple: legalized tyranny.  In this country you cannot defend yourself with a weapon without fear of imprisonment, they restrict the ability to defend yourself by making it virtually impractical to have a gun in your home and use it for self defense.  The crazy thing about it is, people actually think this is a great idea.  My response is this, if a murderer breaks into your home, which scenario would you prefer:  1) Call the cops and wait 10-20 minutes before they arrive OR  2) Have the means and ability to personally defend yourself without fear of imprisonment for manslaughter?  How about economic tyranny... an income tax, a GST, a corporate tax, property tax, capital gains tax and now, the upcoming carbon tax.  I've said it before, one day the government will find a way to tax you for every breath of CO2 you exhale.

Last in this tirade, but not least, the inflation tax... the debasement of the value of the money you keep in the bank.  I've discussed this previously, but did you know that the money you keep in the bank depreciates in value despite the interest you earn in the bank?  The central bank of Australia (i.e. the RBA) continues to print and print money, perpetuating a fraudulent banking that loans money into existence.  Now as I wrote this sentence I know that people's brains have 'glazed over', they don't know what I'm referring to.  The term 'fractional reserve banking' is a foreign term, much like 'magna carta' or 'habeus corpus'... concepts and principles too difficult to invest time for learning.  And what is the price for this ignorance, this intellectual slavery to our overlords... it is not the suffering that we are enduring now, no that would be too obvious.  The penalty for our unconsciousness is the fact that people LOVE to be enslaved and will defend tooth and nail to 'return to Egypt, for it was better for us there...'.

This is an angry post, and I am angry at all of us... we must wake up before it is too late and we all end up distracted by 'Dancing with the Stars', 'Master Chef' or 'Gossip Girl' and surrender our brain, wallet and soul into the hands of a Beast.

Dr Washo

 

PS    Love mercy, truth, freedom, knowledge, wisdom, understanding and love itself rather than entertainment, lust and greed.

There's an excellent piece in today's Mises Daily by Chris Brown which highlights a lot of what I've been saying over the past several months: fiscal 'stimulus' is nothing more than a colossal waste of resources. Here's an excerpt:

"It turns out that Australia's Prime Minister Kevin Rudd is going around town breaking windows by, well, demanding they be built. There are over 35,000 construction and maintenance projects planned across Australia over the next 12 months. This includes AU$49 (US$39.4) billion dedicated to "nation building infrastructure," or crudely AU$2,200 in taxes for every man, woman, and child residing in Australia."

As long as people continue to believe that jobs are all that matter, we're doomed to repeat the mistakes of the past over and over again. Even if the 'stimulus' increased GDP in monetary terms and allowed us to stave off a technical recession, it will not create any additional real wealth or production in the economy; at best it will merely divert it.

Elsewhere, the RBA released their latest financial aggregates. Nothing too surprising in there, with monetary growth (M1, M3, broad money, money base, currency etc) all remaining about 15% YoY. Two noticeable changes were the increase in term and other non-government deposits by almost 30% YoY indicating that people are increasing their savings which is a good thing. A more worrying sign is that lending to the government by all financial intermediaries (AFI's) was up 273% YoY, a perfect example of the government squeezing the lending industry. At some stage the banks are going to have to increase the interest rates on their loans at which point the RBA will need to decide whether they a) sit back and watch (possibly raise rates too); or b) start printing money to keep rates down, thereby causing inflation.

Interesting times indeed...

The prevailing opinion on the streets is that capitalism has failed and the government is a necessary evil required to "fix it". This opinion is so well ingrained it's almost impossible to sway with logic and reasoning; indeed, people seem to be passionate in their hatred towards the "greedy banks" and support of "job creation". This all follows the media storm around the banks raising interest rates despite the RBA keeping rates on hold, with a follow-up RBA study indicating that, contrary to what the Commonwealth bank was claiming, funding costs have not increased.

The issue of the whole central banking system aside[1], why is everyone so worried about the banks charging an interest rate (which is the price of borrowing capital) higher than it costs them to acquire? That's like saying because it only costs a bookstore owner $5 to produce a book, they shouldn't be allowed to sell it for above $6, as that's a "fair price" and anything above that would be "exploitative" (as determined by some all-knowledgeable bureaucrat). Let's not lose sight of the fact that every exchange is voluntary and no one was or is coerced into borrowing money (government "incentives" to take on debt aside!). The real issue, of course, is the government intervention that prevents competitors from entering the banking business. As long as the government doesn't restrict competition, no one is able to either exploit labour or remain in a "monopolistic" or "cartel" position for long.

In other news, I also noticed that today's Financial Review (Australian Edition) contained an article showing that of the OECD nations, Australia has the most progressive tax system - we outstrip even the quasi-socialist European countries as far as wealth redistribution and welfare 'nanny' state goes[2].

Finally, I've updated the Recommended Reading section with some great books and essays which anyone is free to read or download. One in particular is "The Myth of the Failure of Capitalism" by Ludwig von Mises, a short essay addressing the fallacious views that the market and not the government is to blame for this crisis. Here's an excerpt:

The crisis under which the world is presently suffering is the crisis of interventionism and of state and municipal socialism, in short the crisis of anticapitalist policies. Capitalist society is guided by the play of the market mechanism. On that issue there is no difference of opinion. The market prices bring supply and demand into congruence and determine the direction and extent of production. It is from the market that the capitalist economy receives its sense. If the function of the market as regulator of production is always thwarted by economic policies in so far as the latter try to determine prices, wages, and interest rates instead of letting the market determine them, then a crisis will surely develop.

Click here if you would like to read the full essay.

---

[1] I personally think we need a return to sound money and free banking to avoid political manipulation of the money supply -- which, by the way, has been increasing by almost 20% YoY for the past decade. I'll provide a nice chart showing this growth within the next week.

[2] As with the above, I plan to write about this sometime in the next two weeks.

What's that, the first home buyers grant doesn't do anything except subsidise the real estate/construction industries? I never would have guessed...

The Reserve Bank's deputy governor says the boosted first home owner grant may have pushed up house prices at the lower end of the market.

The Federal Government has in some cases tripled the value of the grant, in a bid to stimulate the housing market.

But the RBA's Ric Battellino has warned it could lose its incentive value.

"The benefits of that policy can get eroded very quickly by being capitalised into house prices," he said.

"From all accounts the bottom end of the housing market has picked up a lot in recent times, and it doesn't take long for the average house price to rise by $20,000 and leave the home buyers no better off than they were before."-- Source

The government never cared about homebuyers. If they did, they would have allowed the housing industry to suffer the necessary downturn making houses more affordable for low income families. That aside, since when was it a 'right' to own a house? In most cases renting is a far more economical, flexible way to go. The incentives behind home ownership are usually non-financial and instead psychological in nature (if we want to get more cynical -- the government loves it because it makes it that much harder for people to leave).

The first homebuyers grant was(is) nothing more than another prop-up for the real estate and construction unions along with various other interest groups. Good riddance.

The Reserve Bank of Australia (RBA), a group of government-sponsored bankers given the task of keeping the banking, finance and currency cartel going on behalf of various interest groups, decided to leave rates on hold at 3.25pc during their last meeting. Their decision was received with mixed results: the politicians were slapping themselves on the back, citing their 'stimulus packages' as having cushioned the economy while the homeowners and other debtors were moderately critical.

The minutes of that meeting which were released today have revealed that they believe "...the domestic financial system remained strong and the monetary policy transmission process was working to deliver large reductions in interest rates to end borrowers, particularly households."

Well that's true enough. The artificial reduction of interest rates below what the market rate would be will distort the capital structure of the economy and encourage malinvestment in areas such as housing. Why shouldn't people be able to buy houses that they can't afford, right?

"Early indications were that the monetary and fiscal stimulus that had been applied to the economy was having an expansionary effect, but the size of this remained unclear and it would take some time for the full impact to come through."

"The question for policy was whether further stimulus should be added at this meeting, or whether, having reduced rates at each meeting since September, the Board should pause for a further evaluation of the situation. Members could see reasonable cases for both courses of action. On balance, they judged that, having made a major change to monetary policy over the preceding several meetings in anticipation of weak economic conditions, the best course for this meeting was to leave the cash rate unchanged. Members believed this would leave adequate flexibility for policy at future meetings."

The real reason behind the RBA's decision to leave rates unchanged is the dreaded "liquidity trap" that they all fear. The theory behind this stems back to Keynes, where he said that if the rate of interest falls to a level where people prefer to hold cash rather than debt (due to the low level of interest), then central banks have lost "...effective control over the interest rate". This view is supported by central bankers around the world, including the RBA. Here's a good argument outlining the flaws in this theory.

Interest rates need to rise, not fall. Monetary and Fiscal policy will only cause long-term misery. Eventually -- I don't know when -- the stop-go inflationary policy of the central banks will have to end. Each time we have a recession (a necessary restructuring process) and it's 'cured' by said policy, the capital structure of the economy is further distorted. The Austrian's tried to let their government sort out their woes in the 20s and 30s with spectacular results,

“Austria was successful in pushing through policies which are popular all over the world. Austria has most impressive records in five lines: she increased public expenditures, she increased wages, she increased social benefits, she increased bank credits, she increased consumption. After all those achievements she was on the verge of ruin.” -- Fritz Machlup, The Consumption of Capital in Austria, Review of Economic Statistics, II, 1935, p. 19.

We can't turn stones into bread as Keynes suggested. Printing money doesn't create any wealth. If we continue down this path, unrestrained government spending will result in the "eating of the seed corn", or capital consumption, as Mises noted after witnessing the Austrian demise. There's a point at which the interventionist welfare state will have exhausted "the reserve fund" of accumulated wealth, after which the consumption of capital becomes the only basis upon which to continue to feed the fiscal demands of the state.

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.

I know it's old but I just had to bring this up. The words in the title are ones spoken by Glen Stevens, the Reserve Bank Governor of Australia in a speech on December 9, 2008.

I do not know anyone who predicted this course of events. This should give us cause to reflect on how hard a job it is to make genuinely useful forecasts. What we have seen is truly a ‘tail’ outcome – the kind of outcome that the routine forecasting process never predicts. But it has occurred, it has implications, and so we must reflect on it.

I find it odd that the Reserve Bank Governor doesn't know anyone who predicted the recent world events. Off the top of my head I can think of a few - hell the entire Austrian School of economics has been calling this thing since 2006(ish). Perhaps it's because the Reserve Bank relies on their Computerised General Equilibrium (CGE) models of the economy, based on the flawed neoclassical fundamentals in which their staff are trained to provide them with these 'forecasts'.

Unfortunately, CGE models have all but conquered the world of policy analysis today; use of the general equilibrium framework appears to be taken as the mark of good science. I personally favour an Austrian approach of qualitative case-by-case analysis. To quote Henry Hazlitt (I forget the exact date -- sometime around the 1930s/40s):

The art of economics consists in looking not merely at the immediate but at the long effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups.

Perhaps the Governor aught to broaden his horizons a bit and start reading literature from all trains of thought rather than just neoclassical/keynesian rhetoric that they've been blindly following their entire lives.