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  • PD Jonson

Reflections on Central Banking

Updated: May 2, 2020

1. Introduction. “The essence of central banking is discretionary control of the monetary system.” So said Sir Richard Sayers in his Central Banking After Bagehot. This statement is at the core of my topic. It is one which some find obvious, but that others would dispute. At the very least, it should cause the citizen of a democracy to stop and think. For the monetary system is at the heart of the developed economy.

I am one of those who believe that discretionary control over that system is necessary. I also believe that a degree of independence - certainly independence of thought and opinion - from normal political processes is also desirable, perhaps essential. But control is partly exercised by central bankers who are not elected by the populace. In a democracy, the question of accountability becomes crucial.

I shall start with some general, somewhat philosophical, thoughts. Then I shall discuss what monetary policy is about and what a central bank can realistically expect to achieve. Many aspects of this discussion are well-known, of course, but there are some interesting connections to the questions of independence and accountability that I would like to draw out. I will then give some reflections upon the Australian experience and on the way ahead. My focus will largely be on the monetary policy role of central banks, with issues such as supervision, the provision of banking services and so on covered only lightly. This is not to say that these other topics are unimportant, nor to deny that they have connections with monetary policy. It is simply to make the topic manageable. Also in the interest of manageability I shall not on this occasion discuss technical questions for monetary policy concerning appropriate exchange rate regimes, precise use of various monetary indicators and so on. Rather my focus is on important principles and on recent practice in the Australian economy.

2. Some General Issues In a complex socio-political and economic system, there is an intuitive appeal in the notions of separation of powers, on the one hand, and checks and balances on the other. The notion of independence between arms of government has antecedents in the ideas advanced by the 18th century French philosopher Montesquieu. Montesquieu's idea was that 'when legislative and executive powers are united in the same person, there can be no liberty'.(1) He also said that 'to prevent the abuse of power it is necessary that by the very disposition of things power should be a check to power.'(2)

Modern democracies operate with a range of arrangements. At one end of the spectrum, the public service can be seen as the technical instrument of the government of the day - the implementers of policy. Statutory authorities have greater, although still limited, independence. In practice, the degree of independence depends partly on the nature of the work for which the authority is responsible and partly on the personalities of the politicians and statutory officers concerned. In societies such as ours the separation of powers is most complete in the case of the judiciary. In all democracies, the power to make laws is held separate from the power to judge on the basis of them.

In Australia's case, the ultimate arbiter, the High Court, is made up of Justices appointed by the Governor General (on advice from his Ministers). Once appointed, they may only be removed by the Governor-General on an address from both houses of Parliament seeking removal 'on the ground of proved misbehaviour or incapacity' (Sec. 72 of Constitution). I would like to suggest that this idea of separation of powers naturally extends to central banks in a particular way. This is partly because central banking is a technical matter requiring a high degree of specialist attention.

There is also a more fundamental matter - concern for the longer-term health of the economy. The medieval practice of 'clipping the coinage' - removal of part of the currency's precious metal content, and thus its real value - was an insidious form of taxation, that was levied on citizens by unscrupulous sovereigns. The modern economy has its parallel, with the possibility of government activities being funded by turning the printing press. The resulting inflation effectively takes away the real wealth of all who hold fixed value assets and contracts. Equivalents have occurred in the 20th century. There have been periods of hyper-inflation in some countries as well as a more persistent erosion of currency values in the past 40 years. One of the most dramatic examples of abuse was in Nazi Germany. Following the Reichsbank Act of 1939, the amount of credit extended to the German government by the central bank was a matter purely for the political and military leaders to decide(3). Inflationary finance rendered the Reichsmark worthless by the end of World War 11. The final result was currency reform and a central bank whose independence has been jealously preserved ever since.

This example establishes the case for there to be a separation of the power to spend money (vested in the Government) from the power to create it (the Central Bank). But it is worth nothing that so eminent an authority as Milton Friedman has explicity rejected the analogy between the central bank and the judiciary(4).

There are two arguments against separation of powers in the field of economics. The first is Friedman's - the elected government must ultimately be responsible. The second is more technical - policies must be coordinated. If central banks typically acted to thwart the sensible aims of overall economic policy, the case for even limited independence would quickly be overturned. Serious debate on this subject in Australia was joined at the time of the Great Depression of the 1930s and the subsequent Royal Commission into Banking.

The formal position in Australia is clear and reasonably well known. The Reserve Bank Act requires the Board of the Bank to make decisions about monetary policy. But the government of the day has the final say. After due process (including the tabling of all relevant arguments in Parliament) the government can direct the Bank to act in a way different to that decided by the Board.

This provision has never been used, suggesting that one partner has been dominant or (more likely) that accommodations have been achieved. In practice, in Australia as elsewhere, the issue becomes one of degree. In most countries there is a noticeable difference of perspective - with the central bank more concerned for longer-term economic stability and political government more alive to economic problems in the shorter-term. Good monetary policy requires inputs from both political government and a strong central bank. It is appropriate in a democracy that government have the final say. But citizens are entitled to know if the central bank has a view which differs from that of the government.

3. What Can Monetary Policy Do?

Monetary policy has two main objectives:

  • - first, to keep the financial system in good order;

  • - second, to provide a stabilising force in the economy.

(i) Financial stability There are many dimensions to the first objective. The rules by which financial business is transacted must be fair, well-understood and as simple as possible - 'the playing field must be level'. Financial institutions must have well-based rules by which to play. Market operations must be conducted so as to underpin order and continuity, even (to an exent) predictability. But if a financial panic develops, the central bank must do what it can to calm the situation, without flooding the market with excess liquidity. The classic prescription is Bagehot's - 'lend freely but -at a penal rate'.(5)

It is worth noting that in recent years central banks around the world have considerably increased the resources devoted to supervision of b anks, and in some cases of other financial institutions. This is an inevitable and desirable development as the global financial system becomes more integrated and sophisticated. There are of course many difficult questions such as where to draw the line between banks and nonbanks, how best to ensure an appropriate degree of international coordination and, perhaps most importantly, how to choose the best trade-off between safety and the freedom to innovate (i.e. between risk and reward). To my way of thinking, questions such as these can only be determined on a case-by-case basis. (

ii) Stabilising the economy The second objective - providing a general stabilising force for the economy - is often defined in terms of minimising inflation. Sometimes in technical discussions it is asserted that monetary policy has a “comparative advantage” in fighting inflation and should therefore be 'assigned' to this objective. To my mind this is an over-simplification. Many forces impact on inflation (and on economic performance generally). Good monetary policy works with (and sometimes against!) those other forces to produce the best possible economic outcome - to 'best contribute to... the economic prosperity and welfare of the people' - as the Reserve Bank Act puts it.

Both 'stability of the currency' and 'maintenance of full employment' (other statutory objectives for Australian monetary policy) are important but essentially subsidiary components of 'economic well-being'. Successful economic policy will harness all of the instruments of economic policy to achieve the objectives outlined above. Of course outside forces - world depression, adverse seasonal conditions, some major problem of industrial relations - can overwhelm even the most well-coordinated set of policies. But if policies are well-coordinated the role of monetary policy will usually be clear, if impossible to specify for all circumstances in advance.

Some of the most difficult dilemmas for monetary policy come when policies are not coordinated. If, for example, fiscal policy is too expansionary, monetary policy may have to be tighter than it would otherwise be - with adverse but unavoidable implications for economic growth. If, to take another difficult case, growth of labour costs is excessive, monetary policy will need to choose between validating inflation or (by tightening to offset inflation) raising unemployment, at least for a time.

Dilemmas can be created by market forces too. Australia has seen strong swings in sentiment about its likely economic performance. This has been reflected in swings of the exchange rate and it has been impossible to prevent related fluctuations in interest rates. One of the natural advantages of monetary policy is that it can be adjusted more quickly and flexibly than other policies. So often it falls to monetary policy to act quickly and to 'hold the line' until other policies can be changed.

When an economy is tending to overheat, for example, or if the exchange rate is falling very rapidly, monetary policy may be tightened. But usually this will not be the end of the story - other policies will need to be brought into play to produce a more enduring improvement. The evidence from modern experience is that monetary policy, if used boldly, can have powerful effects on the economy. Changes in monetary policy will change interest rates and the exchange rate. These key financial prices then impact on a myriad of decisions in a way which produces changes in economic activity generally, and, with some lag, inflation and the balance of payments.

It is worth noting that decisions frequently need to be made in an atmosphere of considerable uncertainty. Often it will be impossible to judge the correctness of policy action until well after the decision needs to be made. This point may seem obvious, but it is frequently overlooked by commentators. I have drawn a picture in which monetary polic y is a flexible and powerful arm of economic policy. It will be varied in ways that depend on the circumstances of the time - but what to do will not always be obvious. Considerable discretion is needed, and there can be no simple 'rules of the game'. This picture may seem to be self-evidently correct, but it has not always been accepted in all quarters. There have been times in the past when monetary policy was conducted according to simple (or apparently simple) rules.

Previous approaches There was the time of the so-called 'gold standard'. Monetary policy was then concerned mainly with maintaining fixed rates of exchange between currencies. When policy was too expansionary, the country concerned would lose reserves. Monetary policy would tighten almost automatically so that interest rates were raised, activity slowed and reserves were re-built.

In a later stage, there was considerable interest in so-called 'monetary targeting'. In this approach, monetary policy would respond to growth in some particular monetary aggregate. If actual monetary growth exceeded some targeted rate, monetary policy would be tightened. Interest rates would rise, slowing economic activity and demands for credit and money. Exchange rates were flexible and the theory had it that monetary policy could be used to choose an optimal rate of inflation for any particular country which might well be different to that chosen by other countries, with the exchange rate moving to reflect the difference.

Both systems were useful at times in the past but each proved less than satisfactory in the long haul. The 'gold standard' enforced costs that were eventually seen as unacceptable on the real economy. Monetary targeting helped to tame inflation in the early 1980s but then came into question as deregulation and financial innovation changed the meaning and nature of the monetary aggregates and their relationship to economic activity.

Current practice Experience has not been identical in all countries, but in the face of recent developments major central banks have all tended to respond pragmatically to developments in a wide range of economic data. The former Chairman of the US Federal Reserve Board, Paul Volcker, has recently said that 'we cannot avoid relying upon a large element of judgement in deciding what, considering all the prevailing circumstances, money growth is appropriate'. The British Chancellor has said that 'the reality, with or without any particular target, is that policy is directed pragmatically, on the evidence from a whole range of ... indicators'.

In the case of Australia, the Governor of the Reserve Bank has talked of a 'check list' of economic and monetary indicators, and of the need for “considerable pragmatism” in its use. As is well-known, the 'check list' contains all the important economic and financial variables - the money supply, interest rates, exchange rates, the balance of payments, the level of international debt, economic activity and inflation.

To my mind, use of such a checklist is a way of formally recognising the many complex and interrelated elements of economic development. The framers of monetary policy need to reach a settled view of flow everything fits together, encompassing prospective developments as well as those in the immediate past. (Incidentally, it is worth observing that the immense difficulty of knowing where the economy is likely to be headed is often ignored, or downplayed, by critics of those with a role in formulating economic policy). So in practice a central banker will find himself asking questions like: what is the state of the world economy? Will domestic demand grow quickly enough to provide good growth of employment and to underpin business fixed investment? Or (on the other hand) will demand be so strong that excessive levels of imports are drawn in and inflationary forces generated? Will levels of competitiveness be satisfactory? What is needed of economic policy generally (and will the government be able to do what is needed)? and, finally, what is required of monetary policy -should it be eased or tightened and if so by how much?

All this is a far cry from the workings of the gold standard or from the textbook description of monetary targeting. There is simply no escaping the need for 'on balance' judgements taking into account all relevant factors.

Accountability All this again raises the question of accountability. This question was more easily dealt with in earlier times. Under the gold standard, central banks were accountable for maintaining the value of the currency and it was obvious when they failed to do so. Under monetary targeting, deviations between actual and targeted growth rates for 'money' were also obvious to all. But now that the simplest versions of these systems have been abandoned, the question arises of how to judge the performance of central banks.

Obviously, long-run economic performance will provide the ultimate test - 'actions speak louder than words'. If the economy performs well it will usually be reasonable to conclude that monetary policy was broadly appropriate. If economic performance is poor, expert evaluation can judge the contribution of external factors and that of domestic economic policy, including monetary policy. Expert evaluation will, however, take time and experts can differ. Evaluation of policy will be greatly enhanced by the fullest disclosure of why policies are as they are. It seems to me that there is no satisfactory alternative to full and frank discussion of monetary policy within a relatively short period of decisions being taken.

4. The Record in Australia The attachment to this paper (section 7) examines the record of monetary policy over the past 20 years in three phases:

  • - the 'Keynesian' period in the early 1970s;

  • - the 'Monetarist' phase from the middle 1970s to the early 1980s; and,

  • - the ' Post- Monetarist' or 'pragmatic' phase since then.

In the latter phase monetary 'projections' were abandoned (for good reason) and the 'Accord' was given an important role in reducing inflation while maintaining growth. The record on both growth and inflation has been good. Excessive fiscal expansion early in the period, and a general tendency for the Australian economy to overheat, produced rapid growth of Australia's international debt, and contributed (with the fall in the terms of trade) to a sizeable fall in the value of the Australian dollar. So obviously the record is not perfect. Both the external environment and all aspects of policy need to be examined, and it is impossible to be definitive. My judgements are discussed at greater length in Section 7: 'Australian Experience with Monetary Policy', the attachment to this paper. In summary, my judgments are that, in the recent 'post-monetarist' era in Australia:

  • - monetary policy has been noticeably more successful than in the earlier eras examined

  • - monetary policy would (with the benefit of hindsight) have been even more successful if it had been both steadier in its application and somewhat firmer overall.

5. The Way Ahead Can we do even better? My tentative answer is 'yes'.' I shall discuss 'the way ahead' Under four headings -assessment of the economy- aspects of decision making; staffing the Bank; and accountability.

Economic assessment I do not seek to assert that it would have been easy to do better. Perfect foresight would have helped, but it was not of course available. Nor do I believe that 'political' biases were important in the period reviewed. To the extent that performance fell short of the ideal, I believe this can partly be explained by errors of judgement about where the economy was headed, rather than by the imposition of 'political'judgement. The most persistent tendency has been to underestimate the strength of demand in the Australian economy. The process of structural reform on which the government is now embarked is likely to intensify this tendency. The problem of how to cope with it needs more attention from the Bank, the Government and outside commentators.

My conjecture is that the Australian economy is likely to show a continued tendency to grow too strongly for comfort. Fiscal policy is now in good shape and there are reasonable prospects of continued wage restraint. Reform of the tax system, improvements to work practices and the orderly reduction of protectionism is likely to give a further impetus to growth. Of course commodity prices will again turn down, there could be outbreaks of old-fashioned industrial strife, and so on. If adverse developments were sufficiently important to risk serious recession in the Australian economy then monetary policy might need to be eased. But in the circumstances most likely to be facing Australia the main question for monetary policy is likely to be the appropriate degree of firmness.

A second reason for not doing better is that monetary policy has at times not resisted certain market forces sufficiently stoutly. For most of the 'post-monetarist' period Australia's monetary policy has in fact been easing. For much of the period the international investment community has been optimistic about Australia and this had led to a rising exchange rate and falling domestic interest rates. Then when investor sentiment swings the other way, as it has done dramatically on occasion, monetary policy finds itself scrambling to recover lost ground.

My prescription is clear. Australian monetary policy should be more self-confident in its application. As a nation we must be prepared to steer the appropriate course on domestic monetary policy more independently of international forces. This will almost certainly require greater flexibility in the value of the Australian dollar - particularly upward flexibility at times of bullish sentiment - and this will not always be comfortable. But the challenge for general economic policy is to find ways to cope with this. There is also the more technical question of whether the 'check list' will remain the best way to reach decisions about monetary policy. One can readily accept two somewhat opposing views:

  • - the first is that the traditional 'monetarist' indicators - growth of monetary aggregates - are internally flawed in current circumstances as a guide to action, so that no simple monetary 'rule' can safely be used;

  • - the second is that the 'check list' is rather vague as a guide to action and may produce a rather passive approach with excessive numbers of 'no change' recommendations.

My resolution of the conflict is to conclude that there is no viable alternative to use of a 'check list'. But its use must be subjected to the highest degree of critical scrutiny both within and from outside the Bank. If this scrutiny produces a monetary policy that is both firmer and less variable than we have had in recent years the Australian economy will perform better.

Other aspects of decision making I have no major recommendations about the formal independence of the Reserve Bank or other aspects of the Reserve Bank Act. Current principles are appropriate. It is of course obvious that views of successive Governments and of the Bank cannot always be identical. One could observe that in some appropriate circumstances use of Section 11 of the Reserve Bank Act to formally register a difference of view could be a healthy development. But if it occurs it will also be appropriate that the Government's view prevails. It is, after all, directly responsible to the electorate.

I would however suggest that provisions for membership of the Board be examined - the current disqualification of people in the finance industry excludes many who would have a valuable contribution to make. (Incidentally, this is a view I have held for some years.) Of course there are difficult issues to resolve. The chief executive of a major bank may find the potential conflicts of interest involved in membership of the Board of the Reserve Bank impossible to handle. But others in the financial sector may be able to distance themselves appropriately from the 'Treasury' function in their companies, as can Board members from major non-financial enterprises.

I would also urge that thought be given to the appointment of executive directors from the staff of the Bank. The system of executive directors works well in the Bundesbank and the Bank of England and would be one way to bring greater professionalism to bear on decision making procedures. The classic objection to this suggestion is that the Board might become a captive of the relevant professionals. But politicians and non-executive director of private corporations often avoid the problem, so why should it be different for a central bank? I do not urge that all directors be full-time - there is much to be obtained from an 'outside' perspective.

Staffing the Bank There will also need to be careful thought given to staffing the Bank in the years ahead. There has been a considerable 'brain drain' for some time - as from the public service more generally. If not checked, this must eventually begin to affect standards of analysis and of performance. (I do not assert that it has yet.) Improved salaries will be needed but even more important (in my view) will be improvements to management practices.

Creation of the conditions which allow good people to enter the service at senior levels will be crucial if the Bank is to keep pace with developments in our rapidly changing economic and financial system. I also believe that abolition of tenure for the nonstatutory officers of the Bank would be one way to improve performance. Dismissal must never be arbitary but, unless there is a tradition in which the very best can be rewarded handsomely and the worst can be freed to find a more effective role, performance cannot be maximised. For the statutory officers – the Governor, Deputy-Governor and any executives directors who may be appointed – tenure should be guaranteed, except in appropriately defined circumstances, for the term of relevant appointment. There is no other way of ensuring the conditions in which advice shall be frank and fearless.

Accountability My final point is that there should be greater public accountability by the Bank in explaining and justifying its decisions and views. In arguing this I readily - and happily - note that performance has been lifted in recent years. Speeches by governors have become more frequent and informative. Relations with the media have become more professional. The Bank's monthly Bulletin and its Annual Reports have been much improved.

But the Bank still does not publicly present regular and fully articulated commentary on tile evolving economic situation and on the needs of policy. Performance on this front falls well short of that achieved by both the German Bundesbank and the US Federal Reserve Board.

There are two reasons for seeking to do more. The first is that unelected officials have a responsibility to explain their views and decisions, and current Australian practice in the area of monetary policy falls short of the ideal. If this point is accepted then there are a variety of models to choose from. The Bundesbank is perhaps the most independent of central banks as well as the most frank in its publications. The US Federal Open Market Committee releases its minutes with a short lag, while the chairman of the Board of Governors testifies regularly before Congress. The Bank of England has high literary standards in its publications and, like the Reserve Bank of Australia, is gradually becoming more open in revealing its views.

The second reason for greater accountability is both more pragmatic and closer to my central theme. The discipline of having to explain itself more thoroughly is likely to lead in various ways to better standards of analysis within the Bank. Like the possibility of being hanged, having to put one's views on the line for public scrutiny is a great way to concentrate the mind. In my view, the improvements already seen in the Bank's public profile are an important direct reason for the better performance of monetary policy in recent years. The point, of course, is that still better Communications, and even greater public accountability, are likely to improve that performance even further.

6. Concluding Comments I have written this paper because of my belief in the value of accountability. One cannot cover all aspects of a career spanning 16 years in a single talk - and in any case I have spoken and written on many of the more technical aspects of monetary policy in the past. But I felt a duty to give my views on those matters on which serving officers are not normally encouraged to speak.

Overall, I give reasonably high marks to the monetary authorities - the Treasurer and the Bank - for their performance in recent years. Indeed, I am proud to have played a part in the formulation of monetary policy in this period. My suggestions, such as they are, are aimed at improving an already good performance. As the Governor urged upon me on more than one occasion during my time at the Bank, the motto must be like that of the old-time water carters - 'Good, Better, Best'.

7. Australian Experience with Monetary Policy Australian monetary experience in the past 20 years can be broken into three phases - which I shall describe respectively as 'Keynesian', 'Monetarist' and 'Post- Monetarist' or 'pragmatic'. The first phase runs from 1969 to 1976. The second begins with the adoption of monetary 'projections' and ends in 1983 - one could argue about whether the election of the Hawke government or the float of the exchange rate marked the divide. We are still in the 'post-monetarist' phase. The attached graphs remind us of major features of monetary experience over the period.

(i) The 'Keynesian ' phase During the late 1960s the Australian economy was importing inflation from abroad. The exchange rate was held down and rates of interest were controlled at low levels. Monetary growth accelerated rapidly - this expansion was followed in a classic way by excess demand for commodities, and a major inflation of wages and prices. Not all of the forces making for inflation were monetary in a narrow sense - there was the sharp rise in the price of oil internationally and in Australia an unsustainable surge in government outlays and a wage explosion. All of these developments had causes which were at least partly independent of monetary developments. (Of course, developments on all fronts at this time were influenced by an earlier period of monetary laxness world-wide.) The inflation of the early 1970s was eventually checked. Internationally. monetary policy was tightened and in Australia there was a high exchange rate (the $A briefly reached $US1.49) combined with an old fashioned credit squeeze.


Substantial monetary and general economic instability was generated during the early 1970s. The episode kindled an interest in achieving greater monetary stability in most countries. It is fair to say that in Australia the Reserve Bank had been well aware of the technical weakness in the 'Keynesian' methods of monetary control prevalent in the early 1970s, although it could perhaps be criticised for not pressing more vigorously the case for sensible policies. When proposals emerged in late 1975 for putting emphasis on stability of monetary growth, the Bank was cautiously supportive.

(ii) The “Monetarist” phase Australia never embraced th e so-called 'Monetarist counter-revolution' with the same enthusiasm as did some other countries. Instead of monetary 'targets' there were 'conditional projections'. With an exchange rate still fixed, and then moving in small and reasonably predictable steps, and interest rates still held down by traditional 'political' forces, the Reserve Bank was well aware that an all out commitment to monetary targets would fail. The 'projections' were always chosen cautiously, and monetary 'overruns' were more frequent than “underruns”. These results demonstrate that Australia's commitment to monetarism was less than whole-hearted. But the record is one of greater stability in monetary growth, and a better performance with inflation, at least by comparison with results in the latter part of the 'Keynesian' phase. Gradually it came to be accepted (not least by politicians) that successful monetary policy, as part of a successful economic policy generally, required greater variability in both the exchange rate and interest rates. By the time that the Hawke government was elected a wide spectrum of opinion saw the need for rates of interest and exchange to be determined in the market place. But Treasurer Keating, and the Labor government generally, was far from holding a 'Monetarist' position on control of inflation. Indeed, the centre-piece of the economic strategy was the 'Accord' with the ACTU.

(iii) The 'Post-monetarist 'phase Australia entered the 'post-monetarist' phase earlier than major countries. After a period of transition during 1983, the basic condition for an effective monetary policy was laid with the floating of the Australian dollar at the end of the year. It is a considerable irony that, just as the means were available to achieve monetary targets, doubts began to be felt about the appropriateness of so doing. There were two reasons for doubt. From the political side was the view that an effective incomes policy would 'lead the way' in reducing inflation - a view too glibly questioned by conventional economists (especially, by the way, those in the business world!). From the technical side was the argument that big changes in the monetary framework were in train. Although no-one could be confident about their effects, what seemed likely was that changes such as the abolition of exchange control, the admission of new banks and the changes to regulations (which would substantially increase competition in the financial system) would together have the potential to disrupt established relationships - for example the relationship between monetary growth and inflation. After a period of agonising reappraisal, the Government (with the Reserve Bank's clear support) “suspended” the monetary projection. This occurred just before the sharp increase in monetary growth due largely to the wave of 'reintermediation' (as the banks and other financial intermediaries gained market share). Although the wisdom of the decision was questioned at the time it became accepted reasonably quickly, although not before the change was seen by some as one factor causing the first big drop in the value of the floating $A.

Subsequent experience has included a couple of sharp tightenings of monetary policy, partly in response to further big drops in the value of the dollar and partly in response to judgements that the economy was overheating (or that there was a risk of this). Indeed, there has been one episode (in mid - 1986) when short-term interest rates reached levels roughly equal to those in 1974 (and much higher in 'real' - or inflation adjusted - terms). At the time, some commentators predicted highly adverse effects on real activity from this policy. But the economy proved more robust than expected by the pessimists. The periods of tightening monetary policy have been very visible. But it is worth noting that, for most of the post-monetarist period, Australia's monetary policy has been easi ng. To a considerable extent this has been led by market forces, during periods of bullish sentiment about the economy in general, and the value of the $A in particular. The tendency for interest rates to fall at times of optimistic sentiment shows that achieving an independent monetary policy is more difficult than the textbooks suggest.

What is the record? A first point to note is that the economy has been growing strongly throughout the period. Overheating, not underheating, has been the problem. Even in 1986, in the wake of what seemed to some to be a risky degree of monetary tightness, domestic demand was merely flat, and production and employment continued to grow. This evidence might be read either way - monetary policy did not stifle growth; but did it allow growth to be excessive? A first answer to this question is that inflation has been lower on average (and at the peak) than in either of the two previous episodes. The average rate of inflation was: 10.21% in the Keynesian phase-, 10.5 1 % in the Monetarist phase; and 7.25% so far in the Post-Monetarist phase. This result was achieved despite the big net drop in the value of the $A during the third phase.

So, by this traditional criterion, monetary policy seems to have performed well. Not all of the credit for strong growth and lower inflation can be taken by monetary policy. The success of the Accord (and other policies) has also contributed, and to a considerable extent. It is worth expanding on this point. The Fraser government imparted a strong fiscal stimulus in its final budget. The Hawke government inherited both a large budget deficit and an economy which recovered strongly from the recession of 1982. Fiscal policy was too expansionary for several years, and this contributed to excessive growth of domestic demand. (It is worth noting in passing that the past two years have seen a substantial, wholly appropriate, tightening of fiscal policy.)

By boosting Australia's competitiveness, the success of the Accord in reducing labour costs helped stave off the consequences of the excessive demand, while ensuring strong growth of employment. But when the major drop in the terms of trade occurred in 1985 and 1986, the inherent weakness of Australia's external position was fully exposed. The big drop in the value of the Australian dollar which occurred at the time was, of course, appropriate to the situation. That it was allowed to occur (despite some vigorous 'testing and smoothing' and a substantial tightening of monetary policy) is an example of successful discretionary monetary policy.

So macroeconomic policy gets good marks for generating strong growth and inflation lower than in the past, but loses points for allowing the development of an unsustainable external deficit. Whether (or to what extent) the precarious external situation is due to an excessively easy monetary policy is open to debate. A tighter monetary policy would have meant slower growth of demand, which would have meant lower imports. But tighter monetary policy would also have meant an exchange rate higher than it would otherwise have been, encouraging imports and discouraging exports.

On balance I believe a somewhat tighter monetary policy would have made for a stronger external position, and that this would have been preferable. The argument against a tighter monetary policy is (and has been) that economic growth would be lower. This too is a matter for judgement. Interest rates which were higher on average would have dampened consumption (which has been excessive). Higher interest rates may also have dampened business fixed investment (which has been too low). But if slower overall growth of demand had produced a lower external deficit business confidence would almost certainly have been higher, and this might have produced more investment. This is especially likely to have been the case if a tighter monetary policy had also been a steadier one.

Of course, it can also be observed that even better results would have been produced by a better overall policy mix, with a budgetary policy which was generally tighter. There have been genuine dilemmas involved in this experience, but to my mind monetary policy should at times have resisted more stoutly the temptation to ease. With the benefit of hindsight, it is clear that there have been periods of premature easing with subsequent scrambling to recover ground.

Notes 1. The Spirit of the Laws X 1, 6(5) 2. ibid, 4 (2) 3. The Deutsche Bundesbank - Its monetary policy instruments and functions, 1982. 4. M. Friedman, A Monetary and Fiscal Framework for Econmic Stability, 1953. 5. The words in quotation marks are my free translation – the source was not available to me.

This article first published in Quadrant, 1988.

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