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November 30, 2008

The Economy Slides into Recession While the Pollyannas Look the Other Way
by Gerard Jackson

When I complain about the lousy state of economic commentary I also include the Reserve Bank of Australia. In a recent speech he gave in Melbourne Glenn Stevens, the Reserve's governor, argued that "the biggest mistake we could make would be to talk ourselves into unnecessary economic weakness". This is plain ridiculous. There is no way in which an economy can be talked into recession. If Mr Stevens knows of such a case I would love to hear about it. The reason why so many in the business community are pessimistic is because they are feeling a very chill wind that in their view portends depression and not because of any "gloomy talk".

If Stevens did not share the misgivings of the business community why has he cut interest rates by 2 per centage points since September? We have RBA assistant governor Malcolm Edey telling anyone who will listen that even though GDP is falling there will be sufficient growth to cushion us from the effects of the global crisis. As if on cue, he wheeled out Rudd's $10.4 billion spending package, arguing that it and a depreciating dollar will see us through.

Moreover, to help things along "central banks have been adding liquidity to their financial systems, and they have been cutting official interest rates". This is central bank code for expanding the money supply. Then we had Terry "Happy Days are Here Again" McCrann, finance writer for the Herald Sun, who thinks everything is really going swimmingly because business investment is up even though spending on "plant and equipment levelled off in the September quarter". (The real numbers look better, 28 November 2008).

The Australian Industry Group's Performance Manufacturing Index for July is headed: Manufacturing activity falls for second consecutive month. Its Index for August Showed manufacturing activity falling for the third consecutive month in August while "manufacturing employment fell for the sixth consecutive month". September saw manufacturing contracting for the third month in a row. The Group's October report screamed: "Manufacturing records weakest result in 16 years". It also showed that manufacturing had been contracting for five months. My guess is that the situation is getting worse. The vital point here is that AIG's performance manufacturing index has been below 50 for some months -- and anything below 50 indicates contraction.

The AIG is not alone in reporting bad news. On 19 November Westpac released its Melbourne Institute index of economic activity showing that "the likely pace of growth three to nine months into the future, was 1.1 per cent in September". Furthermore, there is "a decent risk that the first two quarters of growth in 2009 could be negative."

Taking into account that consumption is about 66 per cent of GDP and that GDP is approximately one-third of aggregate spending with the remainder being spent on intermediate goods, we must conclude that the contraction in manufacturing means that total spending has fallen. In short, we are already in recession. For some indication of this fact take a gander at the following chart. It shows that manufacturers' expectations of increased investment for 2008 were zero. Given the situation, I think the expected increase for 2009 is a shade more than optimistic.

Expectations of Capital Expenditure

Source: Wespac Australian Economic Reports,
week beginning 1 December 2008

Lets us now look at some figures in which our economic commentariat see no value. Austrian trade cycle theory predicts that an inflationary boom will cause prices to rise at a faster rate in the higher stages of production than in the lower stages. In addition, it is in the higher stages that an impending recession will first appear. This will takes the form of a profits squeeze as the prices of inputs rise faster than the prices of these firms' products.

Comparing the following to charts we find that producer prices for manufacturing rose faster than consumer prices. From September 2000 to September 2008 the CPI rose by 28 per cent while input prices for manufacturing rose by 58 per cent. The situation was the same for the preliminary and intermediate stages, with their respective prices rising by 28 per cent and 36 per cent. (All figures have been rounded off and time lags have been ignored).

Producer Price Indicators for the Preliminary Stage, the Intermediate stage, and the Costs of Materials for Manufacturing*

Source: Reserve Bank of Australia. *Australian Bureau of Statistics divides production into three stages. "Under this framework, preliminary (Stage 1) commodities are used in the production of intermediate (Stage 2) commodities; in turn intermediate (Stage 2) commodities flow into the production of final (Stage 3) commodities". (6427.0 Producer Price Indexes, Australia).

CPI

Source: Reserve Bank of Australia

To examine prices without taking account of the money supply would be unforgivable. Yet this is exactly what our economic commentariat do. For this lot money really does not matter but for Austrians it is the key to the business cycle. We can see from the chart below that from September 2000 to September 2008 currency rose by 58 per cent, bank deposits by 100 per cent and M1 (currency and bank deposits) by 86 per cent.

Money Supply

Source: Reserve Bank of Australia

In 2001 there was a sudden and significant hump in M1 (the top line) and bank deposits (the middle line). This hump marked a 21 per cent surge in M1 while the rate of change in the supply of currency remained unaltered. From this we deduce that the entire expansion came out of the banking system. This monetary injection was in response to the slowdown in manufacturing that the previous monetary policy had brought about.

The next monetary chart is very interesting. We see that M1 peaked in December 2007 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 -- and I was right. The monetary aggregates for June were revised upward to 233.3, the figure for July fell slightly to 232.6. That the Reserve was desperate to reverse the deflation is indicated by the September figure for M1 which now stands at 243.1 while bank deposits are 202.3 as against 192.2 for July. TR>

Money Supply

Source: Reserve Bank of Australia

Reserve Bank Assets

Source: Reserve Bank of Australia

The chart above show a sudden and sizable change in the Reserve's assets. This certainly strengthens the view that the Reserve is desperate to expand the money supply. Its actions suggest that another significant cut in interest rates is on the cards. But will it be enough? When a central bank persists in pursuing this kind of monetary policy a point is eventually reached where greater amounts of monetary injections are required to stimulate output until the consequent effect on prices, the exchange rate and the current account deficit create a situation where further monetary expansion is no longer politically acceptable.

Gerard Jackson
BrookesNews.Com

Gerard Jackson is Brookes economics editor.

Copyright © 2005-2009 Gerard Jackson

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