Australian monetary policy is set with two objectives in mind – prospective inflation and the state of economic activity. It is more than sixteen years since the current approach of an independent central bank with a mandate to contain inflation was implemented. This approach has worked well, supported for most of the time by international conditions of low inflation and moderate growth.
The Global Financial Crisis has changed the international economic conditions in ways that require a changed approach by the Reserve, ironically as an unexpected consequence of Australia's generally superior performance. Important nations are deeply indebted, with highly inflationary monetary policies whose effects are masked by the deep recession induced by the global crisis. Investors elsewhere are seeking safe havens for their money, and Australia is one such haven.
This article aims to convince the board of the Reserve Bank and the government to introduce a variable tax on capital inflow to enable the Reserve to continue to control inflation without an exchange rate that is severely handicapping many Australian industries. If this is not done, either inflation will be ignited here by further cuts of interest rates or great sections of industry will be wiped out by a high dollar that with a high cost base makes businesses globally uncompetitive.
This matter is urgent as the RBA's current approach – which is seeking a safe path between two conflicting objectives - has already damaged Australia's industrial base and further damage will be far greater if the advice offered here is not followed.
There is a vital historical precedent for the problem now facing the RBA. The US Federal Reserve in the 1920s faced a booming economy and rising share prices. US monetary policy could not both restrain the boom and prevent what became a massive share price bubble whose eventual bursting was an important reason for the onset and severity of the economic downturn we all call the Great Depression. Milton Friedman and Anna J. Schwartz say in their monumental book A Monetary History of the United States 1867 to 1960: '... there is no doubt that the desire to curb the stock market boom was a major if not dominating factor in Reserve actions during 1928 and 1929. ... But they did exert steady deflationary pressure on the economy. ... that episode ... exemplifies the difficulties raised by seeking to make monetary policy serve two masters'. (pp 290 – 291).
Friedman and Schwartz say, curiously given Friedman's general support of steady, non-inflationary monetary policy, that the US Fed could have broken the market boom with a short sharp shock and then eased monetary policy before it damaged economic conditions generally. But an alternative would have been for the Fed to increase margin requirements on borrowing to buy equities until the market boom was punctured. Two objectives – economic conditions generally, and avoidance of a market bubble – and two instruments – monetary policy and margin policy.
Australia's floating exchange rate is in a real sense equivalent to America's stock market. In the late 1980s I was part of the group of officials grappling with a mild version of the current dilemma. My repeated advice to the board of the Reserve was to keep monetary policy firm – indeed I was recommending tighter monetary policy (defined then as now by higher official cash rates). Month after month the board seemed to agree with my recommendations, but each month interest rates generally fell, and it became clear that my policy was not the policy of higher authority.
Higher authority, it seemed, was concerned at the damage likely to be done by the high exchange rate.
This debate was never made explicit at executive meetings within the bank or meetings of the board. The closest we came to this issue was that higher authority sometimes opined that a rising exchange rate was the equivalent of a tightening of monetary policy, a point that was impossible easily to refute. The net effect was a single policy attempting to do two things – suppress the currency hikes and contain inflation. Like the policy of the US Fed in 1928 and 1929, this approach failed, and produced an overall monetary policy that was inflationary. The consequence was a later sharp hike of interest rates, the 'recession we had to have' and great, unnecessary misery for many Australians.
Current management of the RBA is grappling with the same dilemma, I would hope and expect with more explicit discussion of the options. Current management is leaning more heavily on the anti-inflation option, with less concern for the state of the domestic economy, than two decades ago. But now, as in late-1980s Australia, or in the late stages of the American boom of the roaring twenties, monetary policy cannot serve two masters.
The only sensible answer is for the Reserve Bank to introduce a higher cost for international investors seeking to buy Australian assets. This will be achieved with implementation of a tax on capital inflow. I do not wish this to be in the form of the old exchange control department, abolished with great determination when the Australian dollar was floated in 1983. What is needed is all capital inflow be taxed once as it comes in, not after deep diligence by officials with politically imposed ideas about which inflow is good and which is bad.
Prime Minister John Howard famously said that 'we will decide who comes to this country and the circumstances in which they come,' and this is now a clear and politically bipartisan policy. It is equally clear that we have the right to discourage the excess capital that is creating a high exchange rate and consequent excess pressure on many Australian industries. This is the best way to resolve the current dilemma for monetary policy. The problem of uncompetitive industry cannot be solved by monetary policy in its current setting.
Our floating exchange rate with an independent, inflation fighting central bank has generally served Australia well, supported by helpful international conditions. The policy now needs the support of a direct, non-discriminatory control over capital inflow. If not resolved, this problem with cause great damage to Australian industry, as it did in the late eighties, when the correct conclusions were not drawn. A similar problem helped lead America, and then the world, into a Great Depression.
The lesson of history is clear; and we ignore it at our peril.