Open season on the RBA
It must be open season on the Reserve Bank of Australia (RBA), because the central bank was recently savaged by both Deloitte Access Economics and business journalist Alan Kohler, for very similar reasons. First Deloitte:
“Our view remains unchanged – the additional 50 basis points of increases earlier this year were unnecessary, and have prompted a further downgrade in Australia’s growth outlook. That downgrade is centred on our households, and a ‘consumer recession’ is now forecast in 2023, with household spending expected to finish the year below where it started.”
That’s a strong criticism, given that the RBA has been one of the most dovish advanced economy central banks despite currently having one of the highest rates of inflation in the anglosphere:
Australia’s cash rate is currently 3.6%, meaning it’s below NZ, Canada, the UK and the US.
The authors of the Deloitte report are making the mistake of underestimating the costs of a prolonged inflation. Yes, it’s possible to juice the economy for a bit longer by keeping monetary policy even more accommodative than it already is. But that comes at the cost of higher inflation, lower employment (in the long run), and due to the efficiency losses (more on that later), slower overall growth. Which leads me to Kohler:
“But with unemployment now down to 3.5 per cent and holding, and chronic labour shortages throughout the economy, workers’ power looks to be on the way back.
Well, that’s the way the Reserve Bank sees it anyway, so it has hiked the cash rate 10 times in a row to get the unemployment rate back above 4 per cent and head off a wage-price spiral.”
Not once in his essay does Kohler mention the trade-off to excessive monetary easing: inflation. And he really should have, because economists have been writing about the real effects of inflation for a long time. For example, Kessel and Alchian (1962) observed that a bout of unanticipated inflation – i.e. not dissimilar to what we recently experienced – will cause real wages to decline despite “increases in the quantity of labor demanded and increases in output and employment”.
Workers' power, and according to Kohler “business owners and executives [who] got out of the habit of giving pay rises”, are not the issue here. If Kohler wants to improve the bargaining power of workers relative to employers, he should advocate for reforms to achieve that end. But calling for the RBA to allow inflation to run amok to reduce unemployment is a recipe for disaster, and in the long run will actually undermine workers' power.
That’s because if unanticipated inflation becomes anticipated – that is, if the RBA fails to regain credibility around its 2-3% inflation target and instead lets it rip for longer – it will cause “a decrease in the efficiency with which a community utilizes its resources and of course a loss to money-holders”. In other words, people will become less willing to hold cash and substitute it for inferior methods of wealth preservation, such as real assets (e.g. land), and engage in fewer market-based transactions. The cost of transacting will increase and economic growth will slow.
But here’s the real kicker:
“Since money, like inventory, plant and equipment, and labor, is an agent of production, a rise in the costs of using money is a change in the relative prices of inputs. Just as production techniques vary in their mixes of capital and labor, so also do they differ in the extent to which they use money. For industries that employ relatively money-intensive methods of production, anticipated inflation implies that their product costs rise and their profitability falls relative to industry generally. In the long run, this difference in profitability implies a reallocation of resources toward less money-intensive products and techniques.”
The businesses that are most affected by anticipated inflation are labour-intensive, so “the demand for labor falls and real wages decline”, while the demand for capital and rents increase. This is the world Kohler wants for us. We’ve been there before, and it wasn’t pretty. Inflation is no substitute for reform.
Treasurer Chalmers will release the 294-page review on the RBA sometime in the next couple of weeks, and has already flagged “significant” changes to how the central bank operates. Let’s just hope his advisors are a bit more aware of the trade-offs than Deloitte or Kohler.