The Mysteries of the Floating Dollar
As the great bard put it, “There is a tide in the affairs of men, which, taken at the flood, leads on to fortune …” The tide was taken in 1983 and the floating of the Australian dollar was a reform that helped make Australia one of the most successful nations.
(Article first published in Quadrant, April 2012)
Another wise saying reminds us that success has many fathers and failure is a bastard. This is indeed the situation with respect to the floating of the Australian dollar. The principal candidates are Prime Minister Bob Hawke and Treasurer Paul Keating, both of whom played the roles appropriate to their position in an elected, reformist government. Advising the two leading politicians were their private advisers, among whom Professor Ross Garnaut is said to have been especially influential, the Treasury and its mercurial secretary John Stone, and the Reserve Bank of Australia and its governor Bob Johnston.
In my opinion, all of these people and the two great public institutions involved played their part. Bob Hawke had studied economics at Oxford University, had served on the board of the Reserve Bank and organised a successful National Economic Summit early in his prime ministership. Paul Keating had his own qualifications from the school of hard knocks, a description he offered at the time of our first meeting, and great political courage. Bob Johnston had co-ordinated the Reserve Bank’s contributions to the work of the Campbell committee and was keenly interested in better communication between the Reserve Bank and the Australian public. The intellectually formidable Secretary of Treasury, John Stone, had for many years worked at senior levels in Treasury, promoting good sense in economic policy and favouring deregulation over regulation in Treasury’s policy advice and public utterances.
Floating the Australian dollar was a team effort, but there are various mysteries, including the mystery of the missing cabinet papers. My aim is to tell the story of the float from an RBA perspective and to address several greater and lesser mysteries.
I should state at the outset that I am relying on what I regard as a sharp memory as an adviser to the governor of the Reserve Bank, as a participant in what was a major research effort within the Reserve Bank, and first-hand experience of exchange rate management including the virtual floating of the forward rate. I have also where possible checked my memory of events against those of key Reserve Bank and Treasury players. I benefited from reading the transcript of an interview of John Phillips, former deputy governor of the Reserve Bank, recorded by Frank Heimans and held in the National Library of Australia.
The Reserve Bank was uniquely placed to understand the market dynamics that effectively demanded the adoption of a floating exchange rate, and the theoretical points that argued for the same outcome. The Reserve Bank contained within its senior ranks men with a strong respect for the lessons of history and the damage done by inappropriate policy settings, including the major error of a fixed but variable exchange rate when global inflation took off in the late 1960s.
I arrived at the Reserve Bank in early 1972 on the bottom rank of graduate entry. It quickly became clear that people in the Research Department almost to a man and woman believed that the financial system needed to be deregulated, with credit for this going mostly to the then Head of Research (equivalent to the current title of Assistant Governor, Economic), Austin Holmes, who was strongly supported by his then Deputy, Don Sanders, later deputy governor and then CEO of the Commonwealth Bank. John Phillips, who was also to play a vital role as the master of the markets in 1983, was about to return from Secretary’s department to PNG department to hand it over to the newly created Bank of PNG.
Austin Holmes was a larger-than-life and much loved figure who received his economics training at Cambridge University, where he formed a strong friendship with Harry Johnson, then a young lecturer. Harry went on to be one of the world’s top monetary economists, with joint professorial appointments at the University of Chicago and the London School of Economics.
Holmes was a free thinker with a sound knowledge of modern monetary economics. He worried about the damage wrought by inflation and argued for the orthodox position that avoiding inflation in an inflationary world, as it was becoming in the early 1970s, required a disciplined monetary policy including a floating exchange rate. As a young newcomer, I had the opportunity to ask the then deputy governor Harry (later governor Sir Harold) Knight whether he believed Australia should have a floating exchange rate. Harry replied that, like Saint Augustine, he wished to be made pure, but not yet. He gave this same reply when asked years later by the Campbell committee. This committee eventually recommended an exchange rate “determined in the market”, demonstrating that the case for such a reform was well accepted outside official circles.
When the Campbell committee was deliberating there was a certain amount of internal tension in the Reserve Bank about this matter. I was selected as part of a group of officers headed by Bob Johnston, then the Bank’s secretary and in charge of dealing with the Campbell committee, to answer questions asked by that committee. The night before this group was to appear before the committee we were told by Bob Johnston that we had to stick to the (Augustinian) party line on the currency regime. I objected and was robustly ticked off, but then next morning was told that I was free to express my personal view.
As part of my early research I analysed the effects of the global upsurge of inflation on Australia’s inflation using a modified version of the Bank’s RBI (econometric) model of the economy. The results of this exercise showed that the rise in Australia’s inflation was largely due to global inflation, that it was imported, although reinforced by the Whitlam government’s fiscal and wage policies. This was controversial at the time, but I was allowed to present this result at academic conferences and seminars despite bureaucratic discomfort due to the fact that Treasury argued at the time that Australia’s inflation was largely due to wage pressure. Three years later I was told by Treasury’s Chris Higgins that Treasury had come to believe that I had got this matter right.
I later developed a more sophisticated model (called RBII) of the Australian economy and used it to demonstrate in refereed journals the sort of conclusions that Austin Holmes, Don Sanders and other senior officers believed to be true, based on their knowledge of monetary economics. A version of this model was later used to convince Treasurer Keating to change course at the time of his “banana republic” outburst in 1986. Projections for five years ahead showed a jump in Australia’s international debt (relative to GDP) and a large currency devaluation. This projected debt explosion would only be stabilised, the model and my advice suggested, if fiscal policy was tightened substantially, real wages were cut and monetary policy was tightened. This of course is a different story, except to demonstrate that the Reserve Bank took seriously its economic theory and research based on that theory. This is an example of a case in which the Reserve Bank led a debate that could have been, arguably should have been, led by Treasury. It also earned me the Treasurer’s enmity and led fairly directly to the end of my hitherto promising career as a central banker.
There was a strong tradition at the Reserve Bank, created by Austin Holmes and maintained by Bill Norton and then myself when each of us ran the research department, of bringing distinguished economists to work in the Bank. Visitors included Harry Johnson, Anne Kreuger, John Helliwell, David Laidler, Mike Parkin and Chris Pissarides, who recently shared a Nobel Prize in Economics. Promising young economists were sent to the world’s leading universities for postgraduate study. We did not lack inspiration from, or the benefit of access to, the world’s best economists.
In the late 1970s the Bank’s international department had as visitors for substantial periods of time John Hewson, Victoria Chick and later Michael Porter. All of these internationally oriented economists believed in and promulgated the standard view about the relationship between an effective monetary policy and a floating exchange rate. By the time the debate became live with the election of the Hawke government, there was no dissenting view that I could discern within the Reserve Bank. I can attest from direct experience and subsequent discussion that this applied to virtually all the younger men in Treasury, and staff in the Treasurer’s office and the Prime Minister’s office.
I come now to the first of the mysteries in the “evolutionary” process that led to the float of the dollar itself. Before I replaced Austin Holmes as head of the research department in June 1981, I spent some time in the international department. There I saw at close quarters the weaknesses of the then “crawling peg” exchange rate managed by a “troika” of politicians and their senior officials and advised by younger officials like myself. But I was also asked to figure out how to smooth out the then wide fluctuations in the forward book, which after some hard thinking and hard talking was achieved with aggressive movements in forward rates that amounted to implementing a floating forward rate. This (of course) put more pressure on the spot rate. This reform took place in late 1980 or early 1981 (RBA records available to me lack precision). The mystery is this. John Stone quotes a decision in October 1983 to “float the forward rate”, using his support for this to illustrate his belief in an “evolutionary” approach to a floating spot rate.
While I was advising on daily movements of the spot and forward rates, I once suggested to Harry Knight that we should try to give the speculators a black eye by changing the rate in an unexpected way. His response was simple and direct: “We need to behave predictably and without trying to out-think market participants.” This tradition of stable policy rules was well embedded within the Reserve Bank, and it is a position that with age and experience I now better appreciate.
Formal submissions, careful research, well-tested economic theory and intimate knowledge of markets were all necessary inputs to what was by any standard a momentous policy decision. But there is also a point of political economy. Before my time at the Reserve Bank I had been a young activist in the North Carlton branch of the Labor Party. Even before studying economics I used to give talks on economics at other local branches of the Labor Party, and I believed that I knew a bit about the mindset of senior Labor politicians. (By the time I began to be involved in economic policy at the Reserve Bank, I had left the Labor Party, whose wild economic experiments under Whitlam I objected to, but also to avoid any suggestion of political bias.) In fact during the first meeting of the Bank’s top management group after the election of the Hawke government, governor Bob Johnston specifically asked if I felt comfortable, as a well-known “dry” economist, advising a Labor government. Given my history, and hopes for the Hawke government, I had no trouble answering that question in the affirmative.
The election in 1983 of a new Labor government had coincided with a standard currency crisis. Then the convention was that once an election was called interest rates under official control and the exchange rate could not be altered. Towards the end of the election campaign it became likely that Labor would win, and in the week before the election approximately $3 billion left the country. Over the weekend the choices were to implement a credit squeeze (we may have called it “tight money”) or devalue the dollar. The sensible decision was taken to devalue the dollar by 10 per cent, which happened on the following Monday, after which almost $3 billion flowed back into the country, netting the currency speculators a cool $300 million. As the debate about money management heated up, I used ask Treasurer Keating at every opportunity whether a Labor government wanted speculators to make such profits at the expense of taxpayers.
I submit that a point of political economy of that kind is likely to have had a material impact on the eventual decision to float the Australian dollar. Such thinking was unlikely to occur to very senior officials, which is why one ideally has a mixture of high officials, senior politicians, political staffers and even business leaders involved in any major policy decision. Yes, Minister provides a classic if fictional picture of how it works in practice.
From the time of the election of the Hawke government, the currency devaluation and the associated instability of foreign exchange flows, there were many discussions between senior officers of the Reserve Bank, the Treasurer and his advisers, sometimes involving the Prime Minister. As John Phillips puts it in his interview:
'We … set out to explain to the government … the relationship between domestic interest rates, exchange rates, capital flows internal, capital flows external … And why you couldn’t just control one bit of the system and let the other bits run free.'
John Phillips and his team in the international department, including the visiting economists, prepared “an exercise to look at the options for a more market oriented exchange rate system. When we’d finished this we got all the papers together in what subsequently became known as the ‘War Book’.” When the time came for papers to be written for cabinet immediately before the decision to float, this material was the basis for two papers written by the Reserve Bank. In the event, these papers and at least one written by Treasury were not formalised as cabinet papers and the cabinet minutes record only the decision to float. This is another of the mysteries surrounding the decision itself, one perhaps worthy of an Agatha Christie.
When I was head of the research department from mid-1981 I saw John Stone at regular meetings of the Reserve Bank board, a group to which it was my task to present on the economy and general issues for monetary policy. I agreed strongly with most of Mr Stone’s views about the economy, including the damaging impact of global inflation in the early 1970s, the inability of the then prevailing currency and monetary arrangements to insulate Australia, the potential role of exchange controls in modifying currency flows in any system of currency management, and Treasury’s passionate belief in sensible fiscal policies. We also agreed on the vital need to banish inflation to maximise employment. The only real argument we had was on one occasion with cash rates at 22 per cent when I told the board at one meeting in 1981 that enough was enough with tightening cash rates, and John Stone differed, quite strongly as I recall.
Stone’s argument against floating the dollar in December 1983 is that the time was not right, that the proper case had not been made and he believed that more “evolution” was needed. But one can observe that excessive caution or excessive demand for more research or better explanation is a great enemy of economic reform. John Stone is not by nature an excessively cautious man. Why might such a man oppose, or give the appearance of opposing, such a major reform, supported by almost all respectable economists at the time? He should surely have realised that opposition would at best delay the decision and at worst, as knowledge of his opposition leaked out, might cause international investors to doubt Australia’s commitment to sensible economic policies. So why did the secretary of Treasury not cut his losses and support the float in December 1983? This is another of the mysteries facing any Agatha Christie of economic policy reform.
Such opposition in December 1983 might (I speculate) have been the response of an institution overly conditioned to oppose the government of the day. Treasury was used to fighting economic nonsense—witness the Khemlani affair during the Whitlam government. Treasury then rightly objected to the policy agenda being hijacked by enthusiastic and incompetent amateurs. And assuming Treasury was the reforming institution Stone says it was, how do we explain the Fraser years, which are famous for their lack of economic reform? Perhaps by the time a competent Labor government arrived, Treasury’s senior men were unused to proposing specific reforms, or even locked into opposition to reform proposals suggested by the government or its prime minister.
(After writing this paragraph I came across David Kemp’s 2006 paper, “Advisors and Decisions 1976”. Dr Kemp says, “At the core of the [Fraser] government there was an epic battle between the Prime Minister and the government’s senior advisors in the Treasury, the Department of Foreign Affairs, and the Department of the Prime Minister and Cabinet.” In discussing economic policy and the devaluation of 1976, Kemp says: “This refusal [to draft a statement on the economy] was essentially a strike that threatened to remove the government’s capacity to defend its position.” It is also interesting to learn from Dr Kemp that in mid-October 1976, Friedrich Hayek visited the Prime Minister and “opened the conversation with the suggestion that the exchange rate should be allowed to float”.)
In my book Great Crises of Capitalism I suggest that opposition to the float by the Secretary of the Treasury in 1983 may have been based on the analytic point that, with a floating exchange rate, monetary policy is relatively more important than fiscal policy, whereas with a fixed rate it is the other way round. Perhaps (I speculated) Stone believed that loss of international reserves provided a far bigger stick with which to beat a profligate government than a falling exchange rate.
In fact, another mystery is that following the float it took the best part of a decade for monetary policy to be used strongly enough to beat inflation, and then it came in the form of the “recession we had to have” to quote Paul Keating’s typically memorable description. At the time of the earlier “banana republic” crisis, legend has it that Keating achieved serious cuts to government spending by counting out the score for the Expenditure Review Committee as the currency sank inexorably.
I should add that the interest rate cuts in 1987 and 1988, which were attributed to me as “principal architect” by Paul Keating, were in fact against my advice at the time. I was one of few on the official team who did not see the 1987 share market crash as likely to cause an economic slump, and I was concerned at the inflationary pressures. At each meeting of the board I recommended rate hikes, messages apparently agreed to by the board, before stepping down as head of research in early 1988. Given that the easing of monetary policy at that time, against my advice, is now seen as a major mistake, this is yet another mystery surrounding the floating of the dollar, in this case concerning the delayed achievement of low inflation.
Almost thirty years on, we have come to see a floating exchange rate as more than a necessary policy to beat inflation (but not sufficient unless accompanied by disciplined monetary policy). Now that the debate has been won by solid and painful experience, a floating currency is also seen as an automatic stabiliser, depreciation supporting activity when the economy is struggling and appreciation helping constrain inflation when the economy is doing well. The current mining boom with strong commodity prices is testing this view due to the pressure from a high exchange rate on non-mining industries, but the general point remains valid.
In summary, there was at least a decade of research and careful analysis behind the Reserve Bank’s position in early 1983. Equally, close interaction with markets provided direct evidence of the futility of fixed exchange rates (always forced to flex when external or domestic economic conditions change sufficiently) or gradual “crawls” to what politicians or officials thought was a better position. More generally, I recall the decision to float the Australian dollar as: (a) way overdue; (b) solidly backed by economic theory and research specifically applied to the Australian economy and its markets; and (c) reinforced by a number of points of “political economy”. I certainly agree with John Stone’s May 1984 judgment that the float decision was “the most important single step in economic policy to be taken by any Australian government in the post-war period”. Maybe a marginally better time and circumstance could have been found, but often a missed tide never returns.
P.D. Jonson adds:
In preparing this paper I have consulted several former colleagues, including retired senior Reserve Bank officials, but also former Treasury officials and political staffers. I have benefited in many ways from John Stone, “Floating the Dollar: Fact and Fiction”, Quadrant, January-February 2012. My essay “On the Edge of Chaos” contains a more personal account of my involvement in various matters, including the float of the dollar, during my career at the Reserve Bank (available here…).