There was a strong tradition at the Reserve Bank, created by Austin Holmes and maintained by Bill Norton and then myself when we ran the research department, of bringing distinguished economists to work in the Bank. Visitors included Harry Johnson, Anne Kreuger, John Helliwell, David Laidler, Mike Parkin and Chris Pissarides, who recently shared a Nobel Prize in Economics. Promising young economists were sent to the world's leading universities for postgraduate study. We did not lack inspiration from, or the benefit of access to, the world's best economists.
In the late 1970s the Bank's international department had as visitors for substantial periods of time John Hewson and later Michael Porter. Both these internationally oriented economists believed in and promulgated the standard view about the relationship between an effective monetary policy and a floating exchange rate. By the time the debate became live with the election of the Hawke government, there was no dissenting view that I could discern within the Reserve Bank. I can attest from direct experience and subsequent discussion that this applied to virtually all the younger men in Treasury, and staff in the Treasurer's office and the Prime Minister's office.
I come now to the first of the mysteries in the "evolutionary" process that led to the float of the dollar itself. Before I replaced Austin Holmes as head of the research department in June 1981, I spent some time in the international department. There I saw at close quarters the weaknesses of the then "crawling peg" exchange rate managed by a "troika" of politicians and their senior officials and advised by younger officials like myself. But I was also asked to figure out how to smooth out the then wide fluctuations in the forward book, which after some hard thinking and hard talking was achieved with aggressive movements in forward rates that amounted to implementing a floating forward rate. This (of course) put more pressure on the spot rate. This reform took place in late 1980 or early 1981 (RBA records available to me lack precision). The mystery is this. John Stone quotes a decision in October 1983 to "float the forward rate", using his support for this to illustrate his belief in an "evolutionary" approach to a floating spot rate.
While I was advising on daily movements of the spot and forward rates, I once suggested to Harry Knight that we should try to give the speculators a black eye by changing the rate in an unexpected way. His response was simple and direct: "We need to behave predictably and without trying to out-think market participants." This tradition of stable policy rules was well embedded within the Reserve Bank, and it is a position that with age and experience I now better appreciate.
Formal submissions, careful research, well-tested economic theory and intimate knowledge of markets were all necessary inputs to what was by any standard a momentous policy decision. But there is also a point of political economy. Before my time at the Reserve Bank I had been a young activist in the North Carlton branch of the Labor Party. Even before studying economics I used to give talks on economics at other local branches of the Labor Party, and I believed that I knew a bit about the mindset of senior Labor politicians. (By the time I began to be involved in economic policy at the Reserve Bank, I had left the Labor Party, whose wild economic experiments under Whitlam I objected to, but also to avoid any suggestion of political bias.) In fact during the first meeting of the Bank's top management group after the election of the Hawke government, governor Bob Johnston specifically asked if I felt comfortable, as a well-known "dry" economist, advising a Labor government. Given my history, and hopes for the Hawke government, I had no trouble answering that question in the affirmative.
The election in 1983 of a new Labor government had coincided with a standard currency crisis. Then the convention was that once an election was called interest rates under official control and the exchange rate could not be altered. Towards the end of the election campaign it became likely that Labor would win, and in the week before the election approximately $3 billion left the country. Over the weekend the choices were to implement a credit squeeze (we may have called it "tight money") or devalue the dollar. The sensible decision was taken to devalue the dollar by 10 per cent, which happened on the following Monday, after which almost $3 billion flowed back into the country, netting the currency speculators a cool $300 million. As the debate about money management heated up, I used ask Treasurer Keating at every opportunity whether a Labor government wanted speculators to make such profits at the expense of taxpayers.
I submit that a point of political economy of that kind is likely to have had a material impact on the eventual decision to float the Australian dollar. Such thinking was unlikely to occur to very senior officials, which is why one ideally has a mixture of high officials, senior politicians, political staffers and even business leaders involved in any major policy decision. Yes, Minister provides a classic if fictional picture of how it works in practice.
From the time of the election of the Hawke government, the currency devaluation and the associated instability of foreign exchange flows, there were many discussions between senior officers of the Reserve Bank, the Treasurer and his advisers, sometimes involving the Prime Minister. As John Phillips puts it in his interview:
We ... set out to explain to the government ... the relationship between domestic interest rates, exchange rates, capital flows internal, capital flows external ... And why you couldn't just control one bit of the system and let the other bits run free.
John Phillips and his team in the international department, including the visiting economists, prepared "an exercise to look at the options for a more market oriented exchange rate system. When we'd finished this we got all the papers together in what subsequently became known as the 'War Book'." When the time came for papers to be written for cabinet immediately before the decision to float, this material was the basis for two papers written by the Reserve Bank. In the event, these papers and at least one written by Treasury were not formalised as cabinet papers and the cabinet minutes record only the decision to float. This is another of the mysteries surrounding the decision itself, one perhaps worthy of an Agatha Christie.
When I was head of the research department from mid-1981 I saw John Stone at regular meetings of the Reserve Bank board, a group to which it was my task to present on the economy and general issues for monetary policy. I agreed strongly with most of Mr Stone's views about the economy, including the damaging impact of global inflation in the early 1970s, the inability of the then prevailing currency and monetary arrangements to insulate Australia, the potential role of exchange controls in modifying currency flows in any system of currency management, and Treasury's passionate belief in sensible fiscal policies. We also agreed on the vital need to banish inflation to maximise employment. The only real argument we had was on one occasion with cash rates at 22 per cent when I told the board at one meeting in 1981 that enough was enough with tightening cash rates, and John Stone differed, quite strongly as I recall.
Stone's argument against floating the dollar in December 1983 is that the time was not right, that the proper case had not been made and he believed that more "evolution" was needed. But one can observe that excessive caution or excessive demand for more research or better explanation is a great enemy of economic reform. John Stone is not by nature an excessively cautious man. Why might such a man oppose, or give the appearance of opposing, such a major reform, supported by almost all respectable economists at the time? He should surely have realised that opposition would at best delay the decision and at worst, as knowledge of his opposition leaked out, might cause international investors to doubt Australia's commitment to sensible economic policies. So why did the secretary of Treasury not cut his losses and support the float in December 1983? This is another of the mysteries facing any Agatha Christie of economic policy reform.
In preparing this paper I have consulted several former colleagues, including retired senior Reserve Bank officials, but also former Treasury officials and political staffers. I have benefited in many ways from John Stone, "Floating the Dollar: Fact and Fiction",Quadrant, January-February 2012. My essay "On the Edge of Chaos" contains a more personal account of my involvement in various matters, including the float of the dollar, during my career at the Reserve Bank (available here...).
This article was first publishedin Quadrant.