A select committee of the New Zealan parliament investigated new ways of
managing monetary policy. Their
concern was prompted by the Reserve Bank raising the official cash rate
(OCR) to 8.0%.
Raising and lowering interest rates is the only policy instrument
available to the Reserve Bank for keeping the consumers price index
(CPI) within a target range of one to three percent. Recently, the
CPI has been above the target range for over a year. The Reserve Bank
now believes that economic activity is too strong and that inflationary
pressures are building.
The prospect of continuing high interest rates has raised concerns
that monetary policy is making housing unaffordable and causing problems
for the economy. Home owners are becoming concerned by floating mortgage
interest rates above 10 percent. High interest rates have strengthened
the New Zealand dollar to a level where exporters are feeling the pain.
Many pundits are suggesting that we need new ways of managing
No doubt there will be a lot of “huffing and puffing” about
monetary policy, but the economic fallacies on which the monetary policy
edifice is built will not be exposed. We will not be told that monetary
policy itself is a fraud.Changed Meanings
A serious obstacle to understanding inflation is the fact that the
meaning of word “inflation” has changed. It 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 of 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 originally
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. Excessive inflation of the money supply caused a
rapid increase in prices, so gradually meaning of the word inflation has
changed 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 its
cause. That is nice for those who are the cause of the problem, because
they go unnoticed, but it does not help us to resolve the problem.
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.
Governments are the Culprit
A review of the history of money shows that all serious inflations
have been caused by governments. Way back in time, currency was issued
by banks. Often the notes and coins issued by several different banks
would be in circulation together. However, people did not trust the
bankers, as they got rich, so gradually governments took over
responsibility for issuing notes and coins. Now in most countries, the
government has a legal monopoly over the issue of currency.
State control of the currency does not eliminate inflation, but
exacerbates the problem. Private banks could inflate the currency they
issued, but this was dangerous, because if people caught on, the bank
would face a run and be forced out of business. 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. Up till the
nineteenth century, they just turned on the printing presses and printed
more banknotes. They are now more sophisticated and set up a central
bank to manage the process. They inflate the currency by issuing
securities and selling them to the central bank.
In the modern world, rampant inflation is always caused by
governments inflating their currency. They 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 is 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 government
was the cause.Only Government
Governments are skilled at finding culprits to blame for their
actions. Many of the fallacies about inflation are actually scapegoats
that governments blame when they have caused inflation. The following
are often blamed, but they are not the cause of inflation.
- Businesses cannot start inflation, because they cannot create money.
Even banks cannot cause inflation while the government has a monopoly
over the issue of currency.
- An oil price shock cannot cause inflation by itself. If the price of
major commodity doubles, those who continue to buy it will no longer be
able to afford other things that they used to buy, so the price of these
is likely to fall. There will be a change in relative prices, not an
increase in overall prices.
- A housing boom cannot cause inflation. If people become obsessed with
owning houses, the price of houses will go up. However, those who are
spending their money on houses will have to stop buying other things, so
the demand for those things will fall. If the person buying the house
borrows the money, the person that they borrow from has stopped buying
something. A housing boom can only turn into inflation, if the
government supports it by increasing the money in circulation. For
example, 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. People may spend
their money differently than the government would spend it. This 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 taxpayer and once by the politicians,
who give tax cuts, but are not willing to give up any of their wonderful
- 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
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.
Bollard and Boom
For most of the last two decades, the Reserve Bank has been fairly
responsible and quite successful in maintaining control of the money
supply. However, the recent housing boom has shattered any complacency.
The Reserve Bank has repeated 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 recession
spreading to the rest of the economy. The result has been a great flood
of money sloshing round the world. Normally, this excess money would
have resulted in runaway prices, but China has saved the day by
producing an endless supply of cheap clothing and durable goods. Most
prices have been held in check, so the inflationary pressure has flowed
into asset markets.
The 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.
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
cannot keep us dry. Raising interest rates has not stopped the housing
boom, but it has really harmed the productive part of the economy.
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
could 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 real problem is politicians printing money to pay for their
grandiose schemes without increasing taxation. This is what needs to be
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.
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 price that a 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
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.
Cooling the Economy
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 slow down 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 raw materials 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 for
productive resources will make the economy stronger; it does not cause
The wage rates for the skilled employees might also increase, as new
businesses vie for 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 also shift some of the benefits of the economic growth to
employees and growing incomes provides buyers for the extra goods and
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 producers, 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.
Central Banker Frailty
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
arrive too late and are not sufficiently precise 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 least 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
An economy cannot grow too fast, but monetary policy can distort
growth by causing parts of the economy to grow too fast. The current
housing boom is a good example of economic distortion fostered by
monetary policy. Without loose monetary policy, the speculation in
housing would have died quickly as supply and demand responded to
The housing sector has grown too fast, but this distortion only
occurred because central bankers put their foot on the accelerator at
the wrong time. Now they want to take their foot of the accelerator, but
disrupting the entire economy does not make sense.
Monetary policy does distort the economy. Worse still, monetary
policy cannot eliminate the distortions it creates. The best that
central bankers can ever do is to create a different distortion, so
allowing them to “correct” an economy that has been distorted by
their mistakes is totally foolish. Punishing exporters to control a
housing boom is unwise.Economic growth does not cause inflation.
Inflation of the currency causes economic distortions that disrupt the
Housing and Inflation
Modern people live with an assumption that house prices will always
rise. This is a false view. The intrinsic value of a house declines over
time as it deteriorates and become old fashioned. What actually happens
is the money loses its value over time, as central banks and governments
manipulate their country’s currency. People confuse a decline in the
value of money with an increase in the value of their houses. That
latter is an illusion
Most of the time, central bankers are taking actions to fix up
problems caused by their own mistakes. Allowing them to slow the entire
the economy to eliminate a problem they have caused is like giving the
key of your house to the pickpocket who stole your watch.Houses and
Leverage and Inflation
The credit crunch left banks, hedge funds, private equity firms and
other businesses throughout the world with balance sheet problems. The
market value of the financial instruments on the asset side of their
balance sheets has plummeted. In many cases, their value cannot be
determined, because there is no longer any market for them. The purchase
of these assets was leveraged by borrowing some of the credit that used
to be so readily available.
The problem is that the value of the debt on the liabilities side of
the balance sheet does not decline in value. The debt still has to be
repaid in full when it fall due. This means that the decline in value on
the assets side is a hit on the owners equity. In many cases the value
of debt is greater than the value of the assets, so the owners equity
has gone negative and the business is inherently worthless.
The solution to this fiasco that is preferred by the clever people is
two or three years of inflation at a rate of 20% to 30%. During
inflation, the market value of the assets on the assets side of the
balance sheet increases, while the nominal value of the debt on the
liabilities side remains fixed. This increases the owner’s equity and
restores the viability of the business.This inflation should be opposed.
Inflation wipes out the value of the savings of the people who have been
responsible and rewards those who have used debt and leverage to
speculate on property and other financial assets. A better solution
would let those who have used debt and leverage reap what they have
sown, and protect those who have been prudent.