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October 19, 2008

Why Rudds $10.4 billion Hit will Not Prevent a Recession
by Gerard Jackson

Prime Minister Rudd's move to inject $10.4 billion (about half of the surplus) had the laudable effect of revealing the sorry state of economic commentary in this country. Take those commentators who fear that the injection will spur inflation and aggravate the current account deficit. Whatever one might think of the injection it is certainly not inflationary. The surplus is held on deposit with the Reserve bank and is therefore still part of the money supply. In that sense we are not talking about a monetary injection but a reduction in cash balances, usually and mistakenly called idle balances.

Any effect on the CPI would be minimal and a one-off event. This does not mean, however, that there could not be a significant increase in the prices of certain items. But the distinction between the whole array of prices and a few individual prices must be maintained, just as it should never be forgotten that a continuing increase in general prices can only be brought about by a sustained increase in the money supply*.

The fallacy behind the injection is that consumption is the engine of economic growth. As I have stressed innumerable times it is total business spending that drives the economy, not consumer spending. The fallacy has led to our commentariat assuming that a decline in consumer spending is slowing the economy. Yet if this assumption were correct then a down turn in business spending in the higher stages of production would follow a reduction in consumer spending.

When we examine the date we find that the opposite has happened. The The AIG's (Australian Industry Group) October report states that in September "Manufacturing activity fell for a fourth successive month". To those who understand the link between monetary policy, interest rates and manufacturing the PMI is signalling that the economy is sliding into recession. I have spent sometime warning readers that Australia faced an impending recession. Back in 1999 I warned that the US had entered the first phase of a recession. I said the same thing about Australia, stressing that total business spending was falling and this indicates recession regardless of increasing consumer spending, falling unemployment and a positive GDP. The chart below illustrates why I was right.

The Australian situation was reversed when in 2001 the Reserve slapped on the monetary accelerator and sent M1 zooming by 22 per cent. Rudd's $10 billion response to the present slowdown could accelerate the manufacturing contraction. Increasing demand at the lower stages of production can only come at the expense of the higher stages by bidding away resources. I say could because the process of manufacturing contraction may be moving so fast that the sudden $10 billion increase in consumer spending might very well have no effect on it. This, however, is really a post-mortem question. Real forces are now in motion and Rudd's fiscal counter attack cannot stop them.

Let us now take a detour through the world of economic commentary. Michael Stutchbury, economics editor of The Australian, introduced his article with the statement that "the 1930s Depression economist John Maynard Keynes said that in the long run we're all dead". And so he did. But he was not referring to the 1930s or depression -- or any depression for that matter -- but to the quantity theory of money and the level of prices in the long run. (John Maynard Keynes A Tract on Monetary Reform, London:Macmillan, 1924, p. 80). From his error on Keynes it was only a small step to making a much larger one. In his opinion Rudd's fiscal tactic

might be enough to keep the economy out of recession until next year's July 1 tax cuts and monetary stimulus kicking. (Staying alive in the short run, The Australian, 15 October 2008).

As I have already pointed out -- this ain't going to happen. Paul Kelly, Stutchbury's colleague, fatuously announced that this "is the recession we don't have to have, and won't". (The Australian online, 18 October 2008). Peter Jonson -- aka Henry Thornton -- thinks Rudd is a real "recession buster". He then praised the grossly incompetent Gordon Brown for turning "adversity into hope by being seen to have led the world's financial system out of complete stasis by proposing partial re-nationalisation of failing banks". (Henry Thornton, The Australian 15 October 2008). This is typical rubbish from a man who thinks putting the cretinous Pelosi in charge of the US economy until Obama and his lefty cronies are ready to implement their destructive tax policy is a bloody good idea. (Henry Thornton -- the real one, that is -- must be turning in his grave).

Terry McCrann -- regarded by the economic illiterates who fill our corporate boardrooms -- as a sound man on economics came down on the side of the Rudd package, arguing that a "direct fiscal stimulus is both necessary and appropriate -- and effectively pre-emptive". (Rudd and ANZ moves likely to crimp future rate cuts, 18 October 2008). As if on cue came the clueless Andrew Bolt who has got it into what passes for a brain that he is sufficiently knowledgeable about economics to give an informed opinion on fiscal policy. He therefore portentously declared -- no doubt hoping it would impress his readers as well as his boss -- that

some stimulus may indeed be needed, to keep people in work by getting the rest of us to keep spending. But was quite this much stimulus -- Rudd spending half the Budget surplus in one surprise hit -- really necessary? (Queries for PM amid crisis, Herald Sun, 15 October 2008).

Brimming with the sort of self-confidence that one finds in the kind of person who after reading an article or two on a subject becomes an instant expert and boor who then earnestly attempts to impress all and sundry with his newly acquired knowledge, Malcolm Turnbull sternly addressed the nation and explained that

The financial crisis started when banks in America made trillions of dollars of housing loans to people far too many of whom could not afford to repay them. This reckless lending fuelled a housing bubble and of course, so long as house prices kept going up, everyone was happy.

Complete bilge. The world faced a financial crises because it has spent years on a monetary binge. All those so-called "surplus savings" that were sloshing around the world's banking systems were in reality masses of excess bank deposits the responsibility for the creation of which has to be laid at the doors of the central banks.

During the Howard years Australia experienced an extraordinary monetary expansion. Allow me to once again draw readers' attention to the monetary aggregates. From March 1996 to December 2007 currency rose by 110 per cent, bank deposits by 178 per cent and M1 by 163 per cent. These are terrible figures that could only end in tears. Yet they have yet to register with our commentariat. Recent monetary figures have been particularly interesting.

Last December M1 peaked at 231.3 after which it dropped to 216.3 in May, a 6.5 per cent deflation in five months. I pointed out at the time that the June figure of 224.7 suggested that the Reserve was trying to reflate. I was right. The monetary aggregates for June were revised upward to 233.3, the figure for July fell slightly to 232.6 while the August figure stands at 231.9.

The following chart provides a vivid picture of monetary conditions, showing that they have been extremely tight since last December, being, as we have seen, even deflationary for the period of January to May.(The green line represents M1, [currency plus bank deposits] the red line represents bank deposits and the blue line represents currency).

There is absolutely no way that any increase in consumer spending can possibly offset the monetary squeeze the Reserve created. It's time our commentators learned that the Keynesian multiplier really is a myth and that the accelerator concept was demolished decades ago. (William H. Hutt, The Keynesian Episode, LibertyPress, 1979, chap. 17). As Fritz Machlup observed:

... monetary factors cause the [business] cycle but real phenomena constitute it, Essays on Hayek, Routledge, Kegan Paul 1977, p. 23).

To slightly paraphrase Margo Channing: "Fasten your seatbelts, it's going to be a bumpy ride."

Gerard Jackson
BrookesNews.Com

Gerard Jackson is Brookes economics editor.

Copyright © 2005-2009 Gerard Jackson

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