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Learning the lessons

By Alan Moran - posted Tuesday, 2 December 2008

Anna Schwartz co-authored with Milton Friedman the signature piece of work on money and economic stability. Now 92 and still working, she recalls that in 2002, US Federal Reserve Chairman, Mr Bernanke, said in a speech in honour of Friedman's 90th birthday, "I would like to say to Milton and Anna: regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again."

In fact the hubris of those in charge of policy intervention is never having to say sorry - at least for their own actions. Federal Reserve Chairman Bernanke and before him Alan Greenspan, as well as Australia’s Reserve Bank chiefs Glenn Stevens and Ian MacFarlane, thought they knew the solutions to avoiding a re-run of the Great Depression.

And yet, and yet!


The prologue to the current crisis was the same effervescent money supply expansion we saw in the 1920s. Easy and cheap money caused the same asset price inflation. Uncertainty over how long this could last and belated attempts by the authorities to rein it in led to the Great Depression. Central bankers then and now, wanting to be nice guys, oversaw a shoveling out of money into the economy. In doing so they were sowing the seeds of disaster.

The recent period of debt accumulation fuelling asset inflation is instructive. For Australian households, debt to disposable income increased from under 40 per cent in the period to the mid 1980s to over 150 per cent by the mid 2000s. Although asset values also increased, this still left a massive rise in debt net of assets. And the value of assets (especially houses and shares) that underpinned most of that debt is now heading south.

Interest rates were held too low for too long and a level of housing stock that zoning regulations have kept in tight supply was the obvious outlet for the Reserve Bank’s monetary excesses. Households’ interest payments on homes, historically at less than 4 per cent of disposable income, ballooned out to double this by 2004 and, with the interest rate increases since then, in June of this year approached 12 per cent.

As with the Great Depression, governments are now “reflating”. In doing so, they are taking the advice of the very Reserve Banks and Treasury Departments that pulled the levers which caused the problem. Governments and Reserve Banks are lowering interest rates, handing out cash and supporting financial businesses with suspect assets.

This time last year, the Reserve Bank was forecasting growth a tad lower than the previous year’s 4 per cent. It now sees growth in June 2009 at only 1 per cent.

Notwithstanding last week’s forecasts by the OECD of positive growth for Australia, even this looks optimistic. Worldwide, reductions of 20 per cent are now being built into many firms’ production schedules.


For Australia, the world financial collapse has shown we were over-reliant on foreign capital that was indirectly financing consumers’ spending. We now need to save more.

But the government’s knee-jerk reaction to the economic downturn, in addition to slashing interest rates has been to give consumers money to increase their spending.

Canberra has already handed out $10.4 billion to promote more consumer spending. As ever, the problem is not a shortage of demand. It is that people have become over-extended and with assets overvalued they have to repair their real levels of savings. Disposing of the budget surplus in a spending spree means releasing funds that previously were locked up in forced savings by taxpayers. But those forced savings were, serendipitously, partly compensating for the savings diverted into speculative activity.

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Alan Moran is the principle of Regulatory Economics.

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