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Rate cuts not the answer to high $A

By Henry Thornton - posted Tuesday, 7 May 2013

The Reserve Bank of Australia is likely to cut cash rates by another 25 basis points either this month or next month. It faces an acute dilemma, however, due to its failure to acknowledge (or perhaps failure to accept) that monetary policy cannot serve two masters.

The problem needs again to be spelled out. The many economists I have spoken to about this matter agree about the limitation of monetary policy, but there is no agreement about the remedy. Henry's proposed tax on capital inflow is not even mentioned by people who write about the problems of a high Australian dollar strangling industry, fearful, I suspect, of being labelled as sinning against the modern economist's religion of universal free trade.

This religion of course falls short of recommending absolute free trade, just as few practicing Christians consistently obey the Ten Commandments. In particular, few economists recommend free trade in labor, witness the near hysteria about people arriving in remote locations in small boats and alleged overuse of 457 visas.  Free flows of people across national borders is clearly a policy that would improve global efficiency while maximising opportunities for people in the poverty-stricken nations but, like practicing Christians, economists have their limits too


Virtually all developed nations are operating with near-zero interest rates and "quantitative easing" -- a euphemism for printing money. Global investors are seeking yield. Australia is politically stable with mostly sensible economic policies, and yields among the highest in the developed world. Despite the fall in commodity prices, which previously would have caused the Australian dollar to fall more or less in parallel, global investors are pouring money into the country.

The net result is a high dollar that is making Australian industry uncompetitive. The official view is that the lack of competitiveness will be solved by firms and individuals working harder or smarter. That view, propounded recently by Reserve Bank deputy governor Philip Lowe, is that what doesn't kill you makes you stronger.

One can agree with Mr Lowe and others that the pressure of a high dollar (on top of generally high costs) will make some enterprises stronger, but many others will be forced to downsize or give up. Recent news has included fruit growers bulldozing their trees as the big food retailers source cheaper product overseas. A government or a central bank that endorses such outcomes is simply irresponsible, especially as agriculture is one industry that is notoriously not practising global free trade.

The RBA has at times been tempted to cut interest rates when there is what is regarded as undue pressure on the currency. This writer, whose job in the 1980s was to advise the board of the RBA on monetary policy, consistently recommended tightening monetary policy as recovery from the mild recession of the mid-80s proceeded.

Every month the board seemed to agree with this advice but in fact interest rates were cut. The prevailing view of my senior officers (or the treasurer, as the RBA was not then "independent") apparently was that the rising dollar needed to be reined in with lower interest rates, but this was not a matter that was debated before the board.

The net result was that easy monetary policy allowed excess demand to get out of hand, leading ultimately to a massive monetary crunch, the "recession we had to have" and much misery.


If the RBA takes the line of least resistance now, it will cut rates and it will be forced to cut rates further, as virtually every other developed nation has cash rates at zero, meaning Australia will join the ranks of inflationary nations. The cost of reversing inflation will be great and will compound the very issue of an uncompetitive economy that rate cuts will seek to overcome.

Monetary policy cannot serve two masters. Monetary policy needs to focus on overall stability of the economy with low and stable goods and services inflation. If an excessive dollar is putting this objective at risk, the RBA or the government needs a sensible way to rein in the dollar. The simplest and least harmful way to do this is to impose a flexible but uniform tax on capital inflow.

At a time of newly recognised fiscal crisis, one imagines that the government would welcome the revenue it would generate, as global investors do not vote in Australia's elections. There is no doubt that the dollar will eventually fall, and possibly by a large amount. Doing nothing but allowing (with easier monetary policy) costs to keep rising will eventually weaken global investors' appetite for our assets.

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This article was first published in The Australian.

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About the Author

Henry Thornton (1760-1815) was a banker, M.P., Philanthropist, and a leading figure in the influential group of Evangelicals that was known as the Clapham set. His column is provided by the writers at

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