The parliament wisely gave a treasurer the power to reign in the Reserve Bank of Australia (RBA) when it was not acting in the best interests of the Australians. Jim Chalmers should use it.
Reserve Bank governors in Australia have never achieved the same mystique as Montague Norman, the Governor of the Bank of England from 1920 until 1944. Some, however, have exercised a level of power that rivalled Norman’s. As explained below, this is hard to justify in a democracy in which unelected officials are not supposed to exercise powers that should be the preserve of ministers. Treasury officials can’t do so. Nor should Reserve Bank governors.
The egalitarian instincts of the first governor of Australia’s Reserve Bank Nugget Coombs precluded his adopting Norman’s wardrobe of a large black hat and opera cape, let alone his habit of travelling under the pseudonym of Professor Skinner. Norman was also a Nazi sympathiser who helped transfer stolen Czech gold and sell it on behalf of Hitler.
Coombs was already a widely accomplished public servant, supporter of the arts and economist when he became the first governor of Australia’s Reserve Bank in 1949. He followed the then Keynesian consensus that a central bank should help stimulate a sluggish economy and restrain one that was becoming overheated. At the time, the new Bank was part of the wider Commonwealth Bank which also functioned as an ordinary bank. The new body was not put on a stand-alone basis until a 1959 Act of Parliament did so.
The Act set out a charter making the Reserve responsible for “the stability of the currency; the maintenance of full employment; and the economic prosperity and welfare of the people of Australia”.
The Act did not state that the Reserve’s primary job was to fight inflation. That interpretation has been adopted by some governors such as the current incumbent, Philip Lowe, but not all. The governor in 1991 Bernie Fraser resisted suggestions that he might be sacked by an incoming government by declaring, “I won’t go just to appease some dickhead minister who wants to put Attila the Hun in charge of monetary policy”.
Although little mentioned these days, a democratic safeguard was inserted in the Act to let a Treasurer overrule a governor and board from pursuing policies not considered to be to the greatest advantage of the Australian people. When a difference of opinion arises, the board should give the Treasurer a statement on the disputed matter. If not satisfied, the Treasurer can order the board to adopt the desired policy. The Treasurer then has 15 days sitting days to table in each House of Parliament a copy of the order determining the policy and statements from the board and the government.
This safeguard allows a treasurer to stop the RBA implementing a particular policy, for example, raising (or cutting) interest rates in an unjustified manner. With a single exception, treasurers have not exercised this option, presumably because they fear it would make them more unpopular than the Reserve Bank. In my view, Labor’s treasurer Jim Chalmers could safely have done so when Philip Lowe, as further explained below, lifted interest-rates without sufficient justification.
The sole exception occurred in 1960 when the then governor Nugget Coombs wanted to raise interest rates to help restrain inflation. The Coalition treasurer Harold Holt refused to let him. The Reserve considered using its Act’s provisions for resolving differences with the government but refrained. Later in the year, Holt accepted the proposed interest rate rise and tightened the budget to put downward pressure on inflation. Holt also supported ordering the banks to the cut the level of credit they issued. This process was widely described as leading to a “credit squeeze” that caused the Menzies government to nearly lose the 1961 election. The Reserve no longer has the power to directly limit credit.
Despite this episode, Australia did well during the post-war economic boom. Unemployment averaged less than 2% between 1945 and 1973, sometimes even falling below 1%. Inflation averaged less than 5%, despite the boom in wool prices during the Korean War which sent inflation past 25% in the early 1950s.
While RBA governor in 1997 Ian Macfarlane said that macroeconomic success in Australia and elsewhere during this period was due to use of “activist fiscal and monetary policies”. Before long, these policies were changed to more destructive path.
As inflation and unemployment rose around much of the globe in the 1970s following the sharp rise in oil prices caused by the producing countries, support grew for a solution based on Milton Friedman’s “monetarist” ideas for tackling inflation by controlling the money supply. Friedman was basically an ideologue, who wanted to cut government spending and taxes as well as deregulate just about everything in sight. His unemployment solution was to deregulate wages so they can drop sharply, supposedly making it easier for employers to employ more people. But this didn’t happen when Friedman’s attempts to control the money supply led to a recession in which employers have no incentive to employ more people because they can’t sell the extra output.
Friedman’s theory relied on a simple model that assumes a causal relationship between two variables – prices and the supply of money – leading to the conclusion that you will cut inflation by cutting the money supply. The problem is that causal relationships also extend to two other variables in model, so that the initial impact of cutting the money supply could be to cut growth in the economy.
This happened in Britain where Friedman was revered by Margret Thatcher’s government. Thatcher, an Oxford graduate in science, said monetarism is “as essential as the laws of gravity”. Just like Newton’s apple, prices were supposedly subject to the immutable laws of nature. Thatcher was greeted with wild applause at the 1980 Conservative party conference where she declared to wild applause, “The lady is not for turning” – a reference to her harsh program based on Friedman’s ideas.
But turn she did, after it became obvious that the target for the chosen money supply measure, called M3, could not be met. It was scrapped and a narrower measure substituted. It too failed. Monetary targeting was then dropped altogether. Prices, it transpired, did not obey the same laws as Newton’s apple.
In the meantime, interest rates rose sharply, bankrupting many of small business supporters who put their faith in Thatcherism. Despite this set back, Thatcher vigorously implemented other elements of Friedman’s agenda, such as slashing the welfare state and taking the sword to unions.
In 1974, the Reserve Bank adopted M3 as its preferred money supply measure. Urged on by the new Coalition treasurer, Philip Lynch, it begun the much more ambitious task in 1976 of trying to control its rate of growth. Although supported by champions such as the Financial Review’s Paddy McGuinness, it eventually had to be scrapped as a policy tool because the 1983 float of the dollar meant the money supply could no longer be measured accurately, let alone used to control inflation.
According to McFarlane, who took over as the Reserve’s governor in 1992, “There was not much debate” about how to conduct policy during the “high watermark” for monetarism in the late 1970s. He said the monetarist revival of the quantity theory of money focused attention on the monetary aggregates as the most important measuring standard of monetary policy”.
According to Macfarlane, the application of monetarist theory rests on the proposition that the money supply is somehow injected from outside the economy and that the monetary authorities can control the rate of injection. Thus, the money supply is an exogenous variable which can be controlled by central banks, if only they display the necessary resolve in the face of any ensuing rise in unemployment and bankruptcies. Macfarlane said the opposite is the case – the money supply is generated from within the economy and can’t be controlled by central banks. But this did not stop a demonstrably foolish idea being embraced by powerful people.
Friedman was responsible for promoting another disastrous theory – that financial speculation is always stabilising. Friedman and others adopted the Efficient Market Hypothesis that assumed markets are always rational and always correct any deviation from rationality. Faced with the reality that people sometimes make mistakes about what will happen in a radically, uncertain future, supporters of the official efficient market hypothesis made a soothing, but baseless, assumption that the mistakes will always cancel one another out. They don’t.
The floating of the exchange rate meant the Australian dollar was no longer bought and sold primarily to fund trade and other traditional transactions. It and other currencies became commodities to be traded in the currency markets. Sony’s Akio Morita said at the time this “imposed the irrationality of the speculators culture on the daily lives of business people and consumers”.
At a conference sponsored by the Reserve in July 1993, the main speaker Paul Krugman said the “efficient markets hypothesis” turned out to be a disastrous failure. But he saw some advantages in exchange rate flexibility in helping countries adjust to changing circumstances.
The Reserve was given another lesson in how hard it is to use interest-rates to fine tune the economy when it lifted interest rates to 17% in 1990-91, causing a harsh recession. At one stage, there were only three jobs available for every hundred people unemployed. The worst impact was as stubborn increase in long-term unemployment. The Reserve and the Treasurer, Paul Keating, were too slow to increase interest rates and squeeze down on credit creation, then too slow to release the brakes.
The back drop involved a financial boom, particularly in the real estate sector, where excessive borrowing prevailed in a deregulatory environment. Speculation was rife and certainly not stabilising. Financial institutions collapsed and debt laden businessmen like Allan Bond and Christopher Skase went under.
We are now entering another period where the Reserve is increasing interest rates recklessly.
Although the RBA’s May 23 statement on Monetary Policy said it expected the cash interest rate to peak at 3.75% in that month before declining, the Governor Philip Lowe took no notice. He announced on June 6 the cash rate would increase to 4.1%. and said inflation was 7%. A former RBA Governor, Bernie Fraser said the interest rate rise risked slowing economic activity more than it would slow inflation.
Lowe’s own Monetary Policy Statement said its preferred measure for inflation would be 6% for June 2023 and expected it to be 3.75 % for June 2024 and 3% in June 2025. The latter is in line with the RBA’s inflation target, so why did he lift the cash rate to 4.1%? It’s a question the Treasurer should put to him as a formal request under the bank’s act provision for resolving differences. Lowe has plenty to answer.
The Australia Institute recently released documents discovered under freedom of information which show Reserve Bank modelling in February of alternative interest-rate paths. One left the cash rate at 3.35%, the second lifted it to 4.8% by August and the toughest to 4.8 % by May. All three scenarios were projected to make little difference to inflation but have a significant adverse impact on unemployment and increase the risk of a recession.
Lowe drew attention to wages in his June 6 statement, but they were subdued. He failed to mention that profits rose more sharply than wages. In fact, real labour production costs were lower than in 2019. If labour productivity is a problem, it’s because firms fail to invest enough in new technology or processes to improve output per worker.
A report released at the same time as the interest rate rise said base salaries for managing directors across 200 listed companies increased by an average 14% this financial year, more than double the inflation rate. They received an average salary of $1.58 million before performance bonuses. Australians are receiving average wage rises of an annual 3.7% this year – not enough to keep up with inflation.
The parliament wisely gave a treasurer the power to reign in the RBA when it was not acting in the best interests of the Australians. Chalmers should use it.