Monetary Policy

Monetary policy is a powerful tool, but it is a very blunt instrument, so the central bankers who use it have almost no control over the direction it will hit. They have very little control of what sector of the economy it will it affect. This is a serious weakness with the tool.

Over the last decade, central banks have kept interest rates low to prevent the pandemic from doing too much harm to the world economy. Their policy may have helped, but most of the effect of this weak monetary policy fed into share markets and housing markets, producing serious house price inflation and booming equity prices. This mostly benefit people who are better off.

Now that inflation has become a problem, central bankers are tightening monetary policy by pushing up interest rates. The problem is that the tightening on the way down does not always go in the same direction as the loosening on the way up.

Tight money policy might bring down share prices and house prices causing pain for the relatively well off, but it might affect the productive economy far more than it did on the way up. In attempting to bring the inflation that they deliberately created back under control, central banks might do terrible harm to the productive capacity of the economy that the poorer people of the world depend on.

Central banks are serious about tightening money policy, but they done really know how it will feed through the economy and which sectors will be affected most.

Expansionary Economics

European politicians are advocating Keynesian economic policies that would enable struggling countries to grow their way out of trouble. The Keynesian approach has two strings.

1. Monetary Policy
   Many economists believe that expanding the supply of money will contribute to an increase in economic growth. The main transition mechanism is reducing interest rates and making borrowing cheaper. This will encourage businesses to increase investment.
   
   Nominal interest rates cannot go negative, so when they reach zero, other methods have to be used. Quantitative easing is one method. Dropping dollars bills from a helicopter is another (it has not been used yet).
   
   
2. Fiscal Policy
   When governments spend more than they take in tax revenues to expand the economy, this is called fiscal policy.
   
   The Keynesians argue that fiscal policy can support monetary policy, during times when confidence is lacking. When businesses and households are unwilling to borrow, despite low interest rates, the government should borrow from the banking system to support its fiscal deficit. This transforms the increasing money supply into an increase in aggregate demand, which is supposed to contribute to economic growth.

Many European politicians want to replace the existing austerity with expansive Keynesian policies. The problem is that the countries of southern Europe have not implanted austerity policies. Their governments have been spending far more than they get in taxes for the past tent to twenty years. They have had expansive fiscal policies forever. They have had expansive monetary policies for the last five years.

The balance sheet of the Federal Reserve and the European Central Bank have grown rapidly due to the expansive policies that were introduced to correct the Global Financial Crisis. Spain, Greece, Portugal and Italy have had expansive Keynesian policies operating for the last five years. (Even after most of their debt has been cancelled, the Greek government has been spending more than it collects in taxes. It needs loans from other countries to continue at the current level).

This is not austerity.

The countries of southern Europe have had Keynesian, expansive policies for several years, but they have not worked. It is hard to see how more government expansion will solve the problem, when it has not worked already, and is quite likely they cause of the problem.

Money Cartel

Gary North explains that central banking is a cartel.

Monetary theory should therefore reflect the presuppositions, logic, and evidence that undergird general economic theory. Any attempt to segregate monetary theory from general economic theory is an admission of the failure of the general economic theory. This general theory is not general, because it does not apply to monetary theory.....

Nowhere in introductory economics textbooks do we find an analysis of central banking that is consistent with the chapter on economic cartels. No textbook in money and banking begins with an analysis of the banking system in terms of the economic analysis that applies to a cartel. Yet modern banking is unquestionably a cartel.

When money is controlled by a cartel that uses political power to keep out entrants into the industry, we can be sure that the members of this cartel are acting in their own economic self-interest. They are not acting on the basis of concern for the general public. They are not public-spirited individuals; they are self-interested individuals, just like everybody else.

Here is an example. When members of the school of economic thought called "public choice theory" analyze any government- protected cartel except central banking, they begin by showing how government protection of the cartel leads to higher prices, reduced productivity, and actions in opposition to the public interest. Yet when public choice economists write a chapter on central banking, they abandon their entire system of economic analysis. They speak of central bankers as public-spirited individuals who must be protected from interference by self- interested politicians, because banking is too important to be left to politicians. What banks need is legal independence, they say. What they need is immunity from democracy.

They seem completely oblivious to the fact that they are totally schizophrenic, analytically speaking. This goes on, decade after decade, yet other economists do not point to this inconsistency, precisely because they hold the same position.

I deal with this topic at Deposits and Loans and Mistrust and Banks.

Schizophrenic Economists

Gary North is currently publishing a series on money in his fortnightly newsletter. His latest article, highlights one of the most serious problems with modern economic theory.

If monetary theory is accurate, it is a subset of general economic theory, which must also be accurate. Monetary theory is not an independent theory of human action that is divorced analytically from a general theory of human action.

Only the Austrian School of economics believes this and adheres to it in practice. All other systems of economic thought segregate monetary theory from general economic theory.

There is a reason for this. Bankers for five centuries have benefited from a grant of privilege from the state: a legal privilege. Banks are allowed to write contracts that are prohibited to all other profit-seeking agencies. They are allowed to promise depositors immediate payment, yet they lend the depositors' money to borrowers.

Non-Austrian School free market economists do not challenge this legal arrangement, either in the name of economics (counterfeiting) or law (special privilege). They accept it. They do more than accept it. The applaud it, but in a value- free, totally neutral academic way. They are apologists for this grant of privilege.

They pay an intellectual price for their cheerleading. They cannot conceptually integrate this grant of privilege into their general theory of economic causation, which rests on a concept of private ownership and enforceable contracts. They make no attempt to square the analytical circle. They remain silent about this anomaly.

They pretend that their various rival theories of economic causation are coherent. They aren't.

This disconnect between monetary theory and general economic theory is the major flaw with modern economics. It is also the main reason that mainstream economisst did not foresee the financial crisis.

Cleaning up their own Mess

The subprime crisis and the credit crunch are the result of the "easy money" policies of the Federal Reserve Board during the first half of the decade.

Now they are going to be given more power to resolve this problem.

This is like feeding a laxative to a boy who has fouled his bed.

Setting Interest Rates

The responsibility of governments to set interest rates is just taken for granted. All modern countries have a central bank that sets the base rate of interest. What most people do not realise is that this is a very modern practice. For most of history, central banks did not exist, so do we need them now? (During medieval times, the church tried to control interest rates by prohibiting usury, but that was a disaster).

The more important question (normative economics) is whether it is morally right for the government to set interest rates. The answer to this question is obvious, if we think about other things we own. If the government tried to make me sell my house for $70,000, I would be very upset. If they set the price at which I could sell my car at $1000, I would be sure that was wrong.

Most people would prefer to put their house or car on the market and see what they could get. By forcing me to sell at a set price, the government is robbing me of the difference between that price and what I could get on the market. By setting the price higher than I could get on the market, it is robbing the purchaser of the difference between the set price and what I would be prepared to sell it for.

The ability to set prices, allows the government to rob one person for the benefit of another. Setting prices is a form of theft.

By setting the price of money, the government is stealing from some people, for the benefit of others. By setting the price of the future, the government is robbing some people of part of their future to benefit others. Those who benefit are the bankers and financiers who get access to cheap money. Those who suffer are the people on fixed incomes who cannot adjust for the resulting inflation. Government controlled interest rates are just another form of theft.

The modern practice of authorising a central bank to set interests is morally wrong, so it should be opposed by Christians.

Don't cry Ben, but you are overseeing a sysstem of theft.

Bollard beats Bernanke Again

Well, New Zealand could not win the America's Cup for yachting, but we have managed to keep the record for having the highest interest rates in the world. Yesterday Reserve Bank Governor Bollard raised the OCR to 8.25 percent. Beat that Ben Bernanke!

The reason for the increase is concern about inflationary pressure. Bollard the banker is worried that the economy is growing too fast. His new worry is strong world commodity prices increasing value of dairy exports. However,
an increase in the international price of exported commodities does not cause inflation. The incomes of exporters may increase, but the economy will be able to import more goods and services to meet the resulting increase in demand.

Anyway, as I have said before, we do not need a banker to slow down the economy.

Furthermore, a quick look at where the price pressures are coming from shows that increased interest rates will have no affect.

Over the last year, electricity prices have been increasing. That is caused by two things: cross subsidies from businesses to households have been removed and growing demand for electricity requires increased generation capacity which is more expensive. Higher interest rates will not change that.

Local authority rates are skyrocketing as local government politicians chase their dreams and then raise property rates to pay for them. Bollards intervention will not stop that.

The government is spending like crazy to win the next election. The Reserve Bank action does nothing to stop that.

Our monetary policy is just a twisted masochism. It cannot solve the problem it pretends to solve, but it punishes the productive parts of the economy.

See also

Bollards Blunder

Ratchet Down

Bollard goes to the Dentist

Monetary Policy and Inflation (9) Banker Fraility

Central bankers who think they need to manage the speed of the economy face two major problems. The first is that the economy does not have a speedometer. The best statistical measures of economic activity are not sufficiently precise and are available to late to accurately measure the speed of the economy. So most of the time, the central bankers do not know whether the economy is growing too fast or too slow. They will often take the wrong action.

The other problem is that controlling the interest rate is a very blunt instrument. When using interest rates to slow the economy, central bankers hurt all businesses, not just those which are lest efficient. Higher interest rates prevent efficient businesses from expanding and may cause some to shift overseas. Exporters are often hurt by the consequential rise in the currency.

On the other hand, reducing interest rates to speed up the economy encourages all businesses to expand, when it would be better if only the more efficient ones grew. Worse still, the low interest rates can cause distortions in the economy, by encouraging speculation in fashionable assets.

Monetary Policy and Inflation (8) Cooling It

The current fallacy is that inflation is caused by an economy growing too fast. The governor of the central bank is worried that the New Zealand economy is overheating. He has announced that he may have to increase interest rates to cool the economy, so inflation does not get out of control.

This idea that someone has to slowdown the economy is absurd. For a start, economic growth does not cause inflation. More importantly, an economy cannot grow too fast.

There are natural limits on how fast an economy can grow. It is constrained by the size of its labour force. The availability of raw materials and capital equipment also act as a constraint on economic growth. If the economy is growing fast, the price of the types of raw material and capital equipment that are scarce might increase. However, these price increases are good, because they weed out the inefficient producers. The entrepreneur who bids up prices to obtain scarce resources must be able to use them more efficiently than those that miss out. Bidding productive resources will make the economy stronger; it does not cause inflation.

The wage rates for the skills that are scarce might also increase, as new businesses vie the skills they need. Those who are able to attract skilled staff by paying higher wages will need to use their skills more efficiently, so rising wages are also good for the economy. The rising wages shift some of the benefits of the economic growth to employees. Growing incomes provides buyers for the extra goods and services.

An economy cannot grow faster than the engine that propels it. As economic growth comes up against the constraint of scarce skills and resources, less efficient producers will be forced out of business because they cannot compete and the weaker parts of the economy will contract. This process will make the economy stronger as inefficient producers are replaced by those that are more efficient. Once all resources are in the hands of the most efficient businesses, a new business will have to extremely efficient just to get started, so the rate of growth will slow to match the growth in productive resources.

The economy can look after itself. It does not need a government appointed monetary policy expert to slow it down.

Monetary Policy and Inflation (7) - Managing the Future

Governments used to believe that they could control the supply of money. Now they realise that is impossible and the best that they can do is control interest rates. But even this is too much for them.


The interest rate represents the value that society puts on the future. It is the price we have to pay to bring purchases from the future into the present. From the other side, it is the price that people get for postponing their spending to the future.

Interest rates should reflect changing attitudes to the future. If people are full of faith and confidence, interest rates should fall. However, if people want to eat drink and be merry, because the future is dark, interest rates will be high. As attitudes to the future change, interest rates should reflect them.

Interest rates affect the level of investment in the economy. If they are low, entrepreneurs will be keen to borrow money and purchase equipment, because they expect a good rate of return. This investment will make the economy more productive. If interest rates are high, many potential projects will be unprofitable. Investment in machine slow and productivity will decline.

The interest rate is a really important price, as it influences many important economic decisions. If it is set at the wrong level, the economy will become distorted and less productive.

In medieval times, the church set the price of bread (the so-called just price). This caused enormous problems, as the price was generally set to low and bread shortages followed. Sometimes, they set the price to high and there was plenty of bread, but people could not afford it. One of the benefits of the Reformation was that the church got out of the price-setting business and let the market set the price of bread.

The communists in the Soviet Union missed the lesson and attempted to control the price of bread for most of the twentieth century. The result was enormous shortages and people queuing for hours to get a loaf of bread.

If bishops and presidents cannot set the price of bread without making mistakes, how can a banker, determine the price of the future. A truly wise man would leave the people of New Zealand to make their own guesses about the future and decide what price they are willing pay to bring things forward.

The Reserve Bank Act allows the governor of the bank to manipulate interests. This is an absurd authority to give to any man, no matter how clever. The chances of a political appointee getting the price of the future right are fairly slim, given that only God knows the future. Alan Bollard does not know the future, so how can he set its price?

Allowing the government to control interest rates is an enormous mistake. They will generally get it wrong.

Monetary Policy and Inflation (6) - Controlling Cash

A major fallacy is that someone has to control the money supply.

Inflation became a problem when government started printing bank notes to pay for wars and politicians dreams. Therefore the solution to the problem seems be to limiting the printing of banknotes. Governments decided that they would prevent inflation by controlling the amount of cash in circulation. Then someone realized that money on call in a check account at the bank was as easy to spend as a wad of notes, so governments added cash in the bank to their target.

What the politicians did not seem to realise is that the amount of cash in circulation is only indirectly related to the level of economic activity. The amount of cash that I need varies across the month. After I have just been paid, I have a lot of cash on call in my account. Once I have visited the bank, I may have less money in my account, but a stash of notes in my pocket. If can get a better price for something with cash, I may want and even bigger wad of notes. On the day before payday, I may have no cash in my wallet, and all the surplus money in my account may have been put into an investment fund. My cash holdings would be zero.

The need for cash can vary considerably from day to day, but this not something the government should worry about. In theory, everyone could draw all their cash out of the bank on the same day and stock up with groceries. The demand for cash would go up enormously.

On the other hand, it is theoretically possible, though unlikely in practice, that on a particular day, everyone might have spent all their cash and put all their money at the bank onto fixed deposit. Every retail store might have invested their takings, including the cash float. At the end of that day, the level of cash holdings in the economy could be close to zero, but economy would not have ground to a halt. People would go to work the next day and life would carry on as usual.

The demand for notes and coins mostly depends on how quickly people spend their income after earning it. This is not something that governments should be controlling. The volume of cash and notes in circulation is decided by the behaviour of people in the economy and not the government.

The real problem is politicians printing money to pay for their grandiose schemes without increasing taxation. This is what needs to be prevented.

Monetary policy is a fraud. If the government is behaving, controlling the volume of money is not a problem, People can decide how much they want, so monetary policy is not needed. If politicians are misbehaving, then monetary policy will facilitate their misbehaviour. Therefore monetary policy is either not needed or doing harm. We would all be better off without it.

Monetary Policy and Inflation (5) - Bollard and Boom

For most of the last two decades, the Reserve Bank of New Zealand has been fairly responsible and quite successful in controlling the money supply. However, the recent housing boom has shattered any complacency. The Reserve Bank has repeatly raised interest rates in an effort to reduce inflation, but the boom has carried on regardless.

The problem began at the end of the dotcom boom in the United States, when Alan Greenspan turned on the monetary taps to prevent the recessions spreading to the rest of the economy. The result has been a great flood of money sloshing round the world. I suspect the torrent of money is now being fed, by lax monetary policy in the European Union as well. Normally, this excess money would have resulted in runaway prices, but China has saved the day by producing an endless supply of clothing and durable goods at cheap prices. Most prices have been held in check, but inflationary pressure has flowed into asset markets.
This deluge of money caused the housing boom in the US and is now being now being sucked up private equity firms to finance the purchases of businesses all over the world. Some of that money has sloshed in the New Zealand housing market. The result is that New Zealanders have access to an infinite supply of money when purchasing a house.

The governor of the Reserve Bank has cranked up interest rates in order to quench the flow, but like King Canute, he is powerless, trying to stop the tide. Raising interest rates has just increased the flow of money by making New Zealand a very attractive place to lend money. One measure of money (M3) increased by 16.5 percent during 2007, so it is not surprising that house prices have continued to grow.

The problem is that is a small open economy like New Zealand cannot be insulated from the rest of the world. If the world is awash with money, we cannot avoid getting wet. Gumboots and raincoats make life uncomfortable, but they will keep us dry. Raising interest rates has not stopped the housing boom, but it has really harmed the productive part of the economy.

Monetary Policy and Inflation (4) - No Excuses

The following often get blamed, but they cannot cause inflation.

• Businesses cannot start inflation, because they do not control the money supply.

• An oil shock cannot cause inflation by itself. If the price of major commodity doubles, those who buy it will no longer be able to afford other things that they used to buy, so the prices of those are likely to fall. There will be a change in relative prices, not an increase in overall all prices.
• A housing boom cannot cause inflation. If people suddenly get obsessed with owning houses, the prices of houses will go up. However, if people are spending their money on houses, they will have to stop buying other things and the denand for those things will fall. A housing boom can only turn into inflation, if the government supports it by increasing the money supply. Alan Greenspan supported the Dotcom bubble in 2000 by reducing the discount rate.
• Tax cuts do not cause inflation. Money that was previously spent by the government will be spent by the taxpayer. They may spend their money differently, which would result in a change in relative prices, but no extra money should be spent. Tax cuts only become inflationary, if the government continues to spend the money that it no longer receives in taxes. In this case the money is spent twice, once by the tax payer and once by the politicians, who give tax cuts, but are not willing to give up any of their wonderful schemes.

Only governments have the power to cause inflation. I would not expect a Parliamentary committee to discover new and better ways of managing money. They are the cause of the problem, so they will be unlikely to find a solution. They are more like to come with more creative ways of avoiding the blame for the damage that governments do to our money.

Monetary Policy and Inflation (3) - The Culprit

A review of the history of money shows that all serious inflations have been caused by governments. If you go back far enough currency was issued by banks. Often the notes and coins issued by several different banks would be in circulation. However, people did not trust the bankers because they saw them getting rich. So gradually governments took over responsibility for issuing notes and coins. Now in most countries, the government has a legal monopoly over the issuing of currency.

However, this did not solve the problem. Sure banks could inflate their own currency, but this was dangerous, because they could eventually face a run and the bank would be forced out of business. For a bank, it paid to be honest.

Governments do not face this constraint, because they cannot be forced out of business. The history of banking is littered with stories of governments that have inflated the currency of their nation. Initially, the governments turned on the printing presses and printed more banknotes. More recently, they have become more sophisticated and set up a central bank to manage the process. They can then inflate the currency by borrowing issuing securities and selling them to the central bank.

In the modern world, rampant inflation is always caused by the government expanding the money supply. Politicians like inflation, because it allows them to increase their spending without increasing taxation. Big spending politicians are usually to blame.

The worst inflation of during last century was in Germany. During 1922, prices rose by 700 percent. The cause was obvious. 300 paper mills were working top speed and 150 printing companies had 2000 presses going day and night turning out currency order by the government bank. During the following year, prices increased by more than 7000 percent, before the currency collapsed and was replaced.

More recent examples of runaway inflation include Bolivia (1985), Nicaragua (1988), Poland (1989), Brazil (1989 – 90), Peru (1990), Zaire (1990 –94), Russia (1990), Georgia (1992–94) Angola (1994– 97), Argentina (2002), Zimbawe (2006-). In every case, the cause was the government.

Monetary Policy and Inflation (2) - Definition

A serious obstacle to understanding inflation is the fact that the meaning of word has changed. The word inflation is now commonly used as a description of the CPI. Whenever the CPI increases, the news media announce that inflation has increased. However, a little thought about the meaning the word “inflation” gives a hint that something is wrong with this view.

The word “inflate: means blow up, dilate, enlarge, swell or expand”. The word inflation was used in the economic context to describe what was happening to money. The amount of money in circulation was expanding rapidly or being blown up like a balloon. Inflation was a description of a situation where the volume of money was being increased excessively. The consequences of this inflation of the money supply was rapid increase in prices. Over time the word inflation has changed to mean a rapid increase in the general level of prices.

The meaning of words change all the time, but we need to understand what is going on here. The word inflation was once used to describe the cause of the problem, whereas now it is used to describe the result. People have started to think that the result is the problem and forgotten about the cause of the problem. That is nice for those who are the cause of the problem, because they go unnoticed, but it does not help us to resolve it.

The verb inflate always has a subject. Someone pumps up the tire. Someone blows up the balloon. It cannot inflate itself. Nor can the money supply increase itself. If the money in circulation has expanded rapidly, someone has inflated it. We must not respond to the change in the meaning of word inflation by drifting into a view that inflation just happens. A rapid increase in the price level is caused by inflation of the currency.

Inflation of the money supply does not just happen, but is caused by someone. The expansion of a balloon cannot be stopped by squeezing it. The person inflating it must stop blowing into it. To get rid of inflation, we must stop those who are doing the inflating.

Monetary Policy and Inflation (1)

A select committee of the New Zealand parliament is investigating new ways of managing the money supply. The reason for the renewed interest in monetary policy is that the Reserve Bank of NZ has increased the official cash rate (OCR) to 7.75%. The consumers price index (CPI) has crept above their target of one to three percent and the Reserve Bank is concerned that economic activity is getting too strong.

Adjusting interest rates is the only instrument available to the Reserve Bank. Home owners are becoming concerned as mortgage interest rates have increased to nearly 9 percent. People are claiming that the monetary policy is making housing unaffordable and causing problems for the economy. Exporters are complaining about the strong New Zealand dollar. Many pundits are suggesting that we need new ways of managing monetary policy.

There will be a lot of “huffing and puffing” about monetary policy, but the main truth will not emerge. What we will not be told is that monetary policy itself is a fraud.

The entire monetary policy edifice is built on several economic fallacies that need to be exposed. I will have a go at doing this in the next few posts.