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RBA has a bubble battle on its hands

By Henry Thornton - posted Tuesday, 1 March 2011

Now it is (almost) official. Retiring (one assumes) Reserve Bank director Warwick McKibbin says there is a bigger bubble building than that of 2003-07.

Thanks for the support, Warwick, as this has been a theme of this column for at least a year. We refer in particular to Henry's article in this series dated February 2, 2010: "It would be hard for Ben Bernanke to begin raising rates while 20 per cent of US workers are unemployed or underemployed, but failure to do this will recreate the asset bubbles of 2003-2007.

"Bubbles create busts, and the next bust will come from a far higher base of wasted labour market resource. Ben Bernanke presumably spent any holiday break pondering this major dilemma."


Bernanke's dilemma is severe but so too is that facing RBA chief Glenn Stevens. Australia's goods and services inflation is rising, though when it will break through the RBA's "target zone" is a matter of legitimate debate.

"Sooner than you think, Mr Stevens," is my view, but I do not expect you to take that view seriously. But goods and services inflation is well above that modest level in Australia's rapidly growing major trading partners, including China. And asset inflation is a far larger problem just about everywhere, as this column has been saying, along with other dissidents.

Fortunately, dissidents merely get ignored in this nation (which, in Professor McKibbin's case, means not being reappointed to the RBA's board), not locked away or worse as when despots rule. Chancing my arm further, it seems timely to explain how the modern global monetary economy can generate such paradoxical results.

Milton Friedman popularised a very simple one good, one asset (money) model of a closed economy. This can be summarised in the famous "quantity theory" equation relating the supply of money, its "velocity of circulation" (how often each unit of money is turned over), the price of the single good and its quantity.

This equation is best understood as a statement of long-term equilibrium. Allowing for variations in velocity of circulation and in the production of the single good during the adjustment process, the statements in the preceding paragraph hold in the long run when velocity and production have returned to their assumed steady state levels (or rates of growth).

In the late 1990s and early 2000s, a major change to the structure of global capitalism began to be important. The emerging economic superstates of China and India began to influence the Western nations by their provision of cheap goods. This requires an obvious application of a two-good, one asset (money) model. In the world of "dominant China", expanding the global money supply might not raise the prices of manufactured goods charged by China at all, or the relevant adjustment might take many years. With manufactured prices fixed, presumably the prices of other goods would be the main item to adjust, meaning goods not imported from China. In countries other than China, non-traded goods would experience inflation until a new equilibrium was established.


If we introduce a second asset, call it "bonds", or "shares", or "non-monetary capital", its price will also rise in a world where the manufacturing goods price is fixed and money expands. Now we have the possibility of non-monetary asset inflation. In a world of loose monetary policy there will be both asset and non-traded product inflation.

In the real world there are many countries, almost all producing their own money, many, many products and assets other than money for each country, and there are degrees of flexibility between the currencies of each nation. If the money supply of the dominant economy (still that of the US) whose money serves as a global currency is expanded, this will make the prices of non-money assets and non-traded good rise. Ultimately, of course, China's manufacturing prices need to rise also, or China's currency has to rise, but at a time of great structural development of China this development may take years if not decades.

Whether, with manufacturing prices fixed, non-traded goods inflation or non-money asset inflation rises more in response to increasing US money is an empirical matter. Suppose, however, that the US suffers a recession so that non-traded goods inflation is low or zero. Then rising money supply may only increase non-money asset prices.

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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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