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RBA's done well with inflation

By Henry Thornton - posted Tuesday, 3 August 2010

The Reserve Bank can congratulate itself on its timely tightening of monetary policy while continuing to monitor the global and domestic challenges Australia faces.

The short-term ("cyclical") news has two main themes: the US and euro-zone economies are recovering very slowly from the great finance freeze of 2008; and the "developing" nations of Asia are running so strongly that some are now battling inflation.

This disjunction cannot last forever. It is a tangible sign of the global "imbalances" that economists wring their hands about but have no real advice to offer governments of the major nations that stand on either side of the development divide.


And what about the major geopolitical challenges facing the global economy? One wishes that Australia's political combatants would tell us their views on these challenges and what they mean for Australia. Instead we have a daily diet of personality issues and minor policy announcements.

China and India are both growing very fast. Only a few nations have grown as quickly in the past but none were as populous as India and China now are. These two nations will soon become economic and political giants.

China's double-digit growth, massive current account surpluses, and enormous lending to the US make it a global power already. China has been quietly reducing its holding of US bonds and has the power to inflict great damage to the world economy, if it decided that this was in its long-term interests.

The US is a declining power. While still extraordinarily powerful, the US has massive budget deficits, deficits that are projected to remain for "as far as the eye can see". The Harvard historian Niall Ferguson visited Australia last week and warned of the "imperial decline" that afflicts great powers when they are no longer able to manage their finances. Increased spending in areas such as health and public sector pensions are locked in, but so too are rising debt service payments as deficits raise debt, an effect compounded if borrowing costs begin to rise.

Fiscal consolidation always involves squeezing spending on defence. In the case of the US, there is the relatively easy solution of a return to its historic isolationism. An isolationist US would provide great challenges for Australia and other small, remote capitalist democracies. What, we are entitled to ask, is Julia Gillard's and Tony Abbott's plan for the contingency of an isolationist US?

The US may lack the courage to fix its current fiscal malaise - indeed this is highly unlikely to occur through the "obvious" method of restraint in government spending and increases in taxation.


Then there is the likelihood of one of three outcomes, or some mix of them. Debt default, a surge of inflation and rapidly rising costs of borrowing are all outcomes facing empires in decline. Default on its borrowings by the world's leading capitalist nation would raise powerful questions about the capitalist system itself.

Rising real interest rates face a debtor that is having trouble meeting its creditors' demands, and this is a situation China can impose on the US if it chooses to do so. Rising borrowing costs accompanied by deflation (falling prices of goods and services and perhaps also assets) is Ferguson's "nightmare" scenario. Such an outcome has been seen before - in France in the inter-war years and Japan more recently. It is a normal market response to unstoppable growth of a nation's debt.

The third "solution" to a politically impossible fiscal situation is resort to the printing press. This, too, has plenty of historical precedents and is the most likely outcome. Inflation is an insidious form of theft and would do great damage to America's economic fabric. With inflation already a problem in China and other rapidly growing developing nations, global inflation would do great damage everywhere. But the costs of inflation are not well understood and use of the printing press may seem the easiest path for beleaguered politicians.

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First published in The Australian on August 3, 2010.

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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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