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  • PD Jonson

Preface to Confessions of a Monetary Policy Tragic

Updated: May 2, 2020

My new red peddle car was stolen on my first day at kindergarten. I was an average performer at school, below average after a severe viral illness suffered in year ten. The effects of this illness however made me a far better footballer, a reasonable net outcome I thought at the time. Much to my family's surprise, I trained for two years with Carlton's senior team, being paid 6 pounds a week for the privilege. Sadly I was sent back each year to play for Nunawading.

The drive and aggression gained during the illness eventually was applied to academic pursuits. I went late to university and started as a part-timer at Melbourne U. My honours essay applied Friedman and Schwarz's Monetary History of the United States to Australia, and I concluded that as a small open economy with a largely fixed exchange rate inflation was imported and the money stock was demand determined. I later learned this was the effect predicted in Bob Mundell's work. There is nothing truly original under the sun.

This work earned me a phone call from the legendary Austin Holmes and then a scholarship from the Reserve Bank of Australia (RBA) to undertake a PhD degree at the university of my choice. I chose the London School of Economics, mainly because that institution did not require me to do any more coursework. There I was supervised by another legendary economist Harry Johnson. I caught Harry's eye with a simulation analysis, using the RBA's first generation economic model (RBI), to demonstrate that Australia's inflation in the early 1970s was largely imported.

At the LSE, I was particular pals with two other graduate students. Chris Pissarides, recently a Nobel Laureate, helped with mathematical problems and later visited the RBA. Henryk Kierzkowski introduced me to the work of Archibald and Lipsey and together we applied the concept of 'monetary disequilibrium' to a two-sector model with traded goods and non-traded goods. Harry Johnson immediately grasped this concept and ran hard with it, while Henryk and I had our article using the idea rejected by the leading British journal (despite one very positive review) but subsequently published by The Manchester School. David Laidler and Michael Parkin were both inspirational colleagues both while we were in the UK and during later visits to the RBA.

My PhD applied this approach to a long-term (1880 to 1970) model of the British Economy, with technical assistance from Clifford Wymer. Clifford became a lifetime friend who came to the RBA to help build his style of 'minimal' economic model for Australia, which became RBII. This work survived rigorous scrutiny at a conference involving 13 eminent economists and was later useful in creating the predictions that led to the Banana Republic debate. Sadly, the conference volume is out-of-print and the RBA refused my request for the galley proofs (which were probably long ago sent to the tip) so that I could have the volume reprinted.

Far more sadly, after moving to Washington to work at the International Monetary Fund (IMF), Clifford contracted a severe illness after a minor medical procedure and had to retire to the family farm in New Zealand. Clifford continued to work when he could and in late 2012 a mutual friend in Rome provided the good news that Clifford had returned to London where he was again working. He was involved with research projects underway in the USA at Cornell and the University of Rome in Italy. We started a joint project in Australia that has resulted in the much fun and some clear results.

Our recent modelling confirms the role of 'monetary disequilibrium' in long-term models of the USA and the UK, first demonstrated in my PhD thesis in 1975. These models seek to explain share prices, a task that eminent Nobel laureates George Akerlof and Robert Shiller say in their book Animal Spirits is impossible. Our attempt to model share prices uses simple hypotheses about the roots of animal spirits and the role of post-gold-standard banking practices that will eventually be reported in the final chapters of this book.

The beginning

This book begins with a biographical account of the author's career at the RBA and its unhappy ending. It includes an essay on the float of the Aussie dollar, written in response to an article on the subject by John Stone, former Secretary of the Treasurer and then Senator. It also has two essays written more or less immediately after my exit from the RBA. The first argues that the RBA should be more independent (but not completely independent) and more open in sharing its views, but otherwise endorses the then status quo. The second makes the case for a central bank independent from political government with a mandate to contain (goods and services) inflation.

The return of Henry Thornton

The middle section is called The Henry Thornton Papers. As the CEO of Norwich Union’s Australian business, I was encouraged to participate in public debate on economic policy. When I moved to ANZ bank to run its underperforming funds management business I was not prepared to ask permission to continue this practice (which I expected would have been denied). I was explaining this dilemma to then editor of Quadrant, PP (Paddy) McGuinness, and he suggested adoption of a nom de plume. Paddy nominated Henry Thornton. He explained that Henry was a fine monetary economist who was recognised as such only after his death. I took this as a compliment and continued to write on policy matters, mainly for Quadrant.

I then had the idea of writing for a wider audience as Henry Thornton and was pleased that Michael Stutchbury welcomed Henry to the pages of The Australian. The idea was to write for publication on the first Tuesday of the month, providing advice for members of the board of the RBA with their breakfast. I began in partnership with Alex Erskine, and our first article was in June 2002, with a ‘Taylor rule’ for Australia. Alex eventually tired of the game of telling readers what the RBA would do and why, which quickly developed into reasons for what the RBA should do. A new editor at the Oz eventually told me he needed help with his costs and Henry retired from its pages in August 2013 with an article on ‘The Recession we did not need to have’.

The logic was the end of the mining boom combined with an excessive value of the exchange rate that had been strangling non-mining industries in our very own version of the so-called ‘Dutch disease’, sometimes know as the ‘Gregory thesis’. Henry had earlier (January 2013) called for a ‘Monetary Policy Revamp’ involving a tax on capital inflow to tame the excessive dollar, an idea greeted with the usual lofty silence from Martin Place. Later I attended a seminar at Melbourne U in which a bright young visiting economist outlined a theoretical case for taxes or subsidies on capital flows to help manage a floating exchange rate. There is truly nothing new under the sun. The lofty silence was maintained in Martin Place.

In between the Taylor Rule and the Dutch Disease there were two other themes in Henry Thornton’s commentary. The first was monetary policy tightening ‘too little, too late’, which was a regular critique during Ian Macfarlane’s time in charge of the RBA. Ian’s reputation was saved by the deflationary impact of China’s emergence (which to be fair Ian might have recognised) and then the global crisis of 2007-08.

The second theme was how to deal with asset inflation. The US Fed’s classic view, espoused most explicitly by Alan Greenspan, was that no-one could tell when there was a bubble in asset prices, so it was best to let it burst and clean up afterwards. Libertarians are inclined to agree with this, presumably trusting their ability to sell before the bust, but the costs of a really big bust, as in New York beginning in 1929 make the opposite case. Ben ('Bene') Bernanke mostly followed Alan Greenspan’s approach, although toward the end of this time as Head of the Fed he began talking about what has become known as ‘Prudential Policy’.

The great global credit boom that began in the early 1970s after President Nixon finally killed the gold standard certainly needed some controls, as the global crash of 2007-08 illustrated with extraordinary clarity. Policy makers, including Ben Bernanke, claim that near zero interest rates, printing money (aka ‘quantitative easing’), bank bailouts and fiscal expansion saved the world from a great catastrophe. That might well be correct but it may have merely postponed inevitable nemesis. To his credit, Glenn Stevens at the RBA has been more cautious in his commentary, although his term ended with an ongoing housing boom in Australia (and many other global cities) and a global share boom.

Avoiding such a situation in future (and near-term nemesis) is the real issue. I suspect that active ‘Prudential Policy’ with higher liquid reserves for banks and pro-cyclical reserve ratios may be needed. And also some use of higher interest rates (higher than needed to contain goods and services inflation) if the boom looks like reaching bubble proportions.

I more or less got to this position in my 2011 book Great Crises of Capitalism. I was delighted when Bene’s successor Janet Yellen adopted the idea of assigning ‘Prudential Policy’ to asset inflation and Monetary Policy to goods and services inflation, though she wisely provided the caveat about using interest rates to curb asset prices in extreme circumstances.

Back to hard research

Views on the relevance of asset inflation and its control are developed in the articles in the final part of this book. The first in this series was clarified when I produced a post-modern painting to illustrate effects of a monetary expansion when goods markets inflation is constrained. This was the case in the USA by stringent price controls in the second half of WWII, when share prices boomed, and again in the build up to 2007, partly due to the strength of the China boom.

My return, with two co-authors, to the work of Friedman and Schwartz, follows. We re-analyze US economic history, using the approach of the two great American economists, but adding asset prices (specifically share prices) plus 52 years additional data.

We find that asset inflation and goods inflation normally respond in a similar way to monetary policy as measured by money growth. However, there are several clearly aberrant episodes – during major wars but also in vital decades of peace. In US history there are three key peacetime examples - the share boom of the 1920s, the period from 1948 to the middle 1960s, especially 1949 to 1956, and the two decades from 1980 to 2000, and especially 1994 to 2000. In the first and third of these cases, monetary policy, as represented by growth of the stock of money, was moderate but not tight. In the middle case, money growth was below the bottom of the range we call 'moderate', but in all three cases commodity inflation was subdued while share prices rose powerfully.

The final article (to be provided) summarises rigorous econometric testing of various hypotheses about asset inflation in a well-established modelling framework developed by Clifford Wymer and myself, and others mentioned in this essay. To help explain share prices (and business fixed investment) we introduce an embedded hypothesis about the formation of 'Animal Spirits'. This is a challenge to mainstream economists, who believe Animal Spirits is unmanagable and unmeasurable. Such unbelievers are therefore forced to throw away the possibility of understanding an important cause of the big booms and busts of capitalism.

Why 'tragic' in the book's title?

This is a simple matter. All my adult life I have thought about or written about monetary policy. For over 16 years I was a central banker with the job of first being a change agent, then providing input to policy discussions and then leading the policy debate as 'Head of Research'. After a fight with the nation's treasurer this career reached an inevitable roadblock.

Like Bob Menzies and his much loved football team and John Howard and cricket, I am clearly a monetary policy tragic, with unfinished business. Hard research may provide an acceptable full stop.

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