Monetary Policy Needs More Than A Rates Lever
Newcastle Herald
Thursday May 8, 2008
THE KISS principle keep it simple, stupid is something everyone knows. Why make something more complicated than it needs to be?
But Einstein, who coined the phrase, actually said: "Keep things as simple as possible, but no simpler."There lies the dilemma. Just as you can err by making something too complicated, you can also err by believing that something is simpler than it really is.Like, for example, monetary policy. The Reserve Bank of Australia appears to have reduced it to the simple objective of controlling inflation, using the equally simple mechanism of interest rates.Although the bank left rates on hold this week, that has been the strategy. If inflation goes up, move "the interest rate lever" up, and inflation will come back down.A growing number of people believe that the Reserve Bank has made the "too simple" mistake. There is more to monetary policy than simply controlling the rate of inflation. And controlling inflation itself isn't just a simple matter of tweaking the interest rate.The view that there's more to monetary policy than controlling inflation can be heard everywhere from the backyards of Blacktown to the boardroom of America's Federal Reserve. The backyard conversations focus on whether they can pay the mortgage; the boardroom conversations, on whether household bankruptcies will cause the financial system to collapse.That, in the end, is the real objective of central banks: to guarantee that borrowers, in general, don't go broke, and that banks, in general, remain solvent. Fighting inflation is a lower priority than making sure the financial system functions.That's how the RBA's American cousin is behaving now. America faces many of the same inflationary pressures that we do except that rents are falling. Yet US Federal Reserve Governor Ben Bernanke is ignoring inflation, and instead reducing interest rates to keep the system solvent.Why is the RBA sticking to its anti-inflation guns? Partly, because it has made the judgement call that Australia doesn't have the same financial problems as the US. Subprime loans are a much smaller part of the overall lending mix here than in the US, the bankruptcy rate is low, and so on.That judgement call could be wrong.Even though there are fewer subprime loans here than in the US, our household debt burden is just as high as America's and household debt has risen three times faster in Australia over the past decade than it has in America.Bankruptcy data also understates how many households are in difficulty. Many home owners are forced to sell by lenders before bankruptcy, because a mortgagee sale would reduce the same price too much. America's system doesn't give lenders that option, so the comparison of bankruptcy rates paints a falsely rosy picture of Australia.The main reason though, is that the RBA has a simple rule called the Taylor Rule that argues that inflation can be controlled by fiddling with the interest rate. It seems to be sticking to that rule, even as signs abound that the economy isn't that simple. Inflation is being caused by factors that we've never experienced before global warming, peak oil and China hitting capacity constraints. Those factors can't be fine-tuned by the Australian interest rate.Just as important, the interest rate bang depends on how big private debt is, and right now it's so big that every 0.1 per cent rise in interest rates slugs indebted households by a billion dollars. The RBA's simple rule ignores the impact of debt, so its interest rate hikes can hurt a lot more than its models imply.Applying a simple rule can mean that harm is done, even by those whose intention is to do good.Steve Keen is an associate professor of economics at the University of Western Sydney and author of the Debtwatch Report (debtdeflation.com/blogs).
© 2008 Newcastle Herald