Do we need a reserve bank?

SUKRIT SABHLOK on scandals concerning Australia’s primary financial institution.

The Reserve Bank of Australia has been in the news recently, thanks to a corruption scandal splashed across the front pages of newspapers throughout the country. According to reports, two currency firms overseen by the Reserve Bank funnelled bribes to government officials in Indonesia, Malaysia and Vietnam, to win banknote deals. Securency and Note Printing Australia are partly and wholly owned (respectively) by the RBA, and many prominent political figures sat on the boards of the two companies.

This scandal, however, is just the tip of the iceberg. Other aspects of the RBA are equally shady, but are rarely exposed to public scrutiny. A new book by investor Chris Leithner, The Evil Princes of Martin Place: The Reserve Bank of Australia, the Global Financial Crisis and the Threat to Australians’ Liberty and Prosperity, documents in detail the nefarious schemes of Australia’s central bank.

Leithner is an adherent of the Austrian School of Economics, which argues that central banks are behind the boom-bust cycle that characterises modern economies. They are, in other words, the culprit responsible for recessions and depressions. By controlling the overnight cash rate (the rate at which banks borrow from the central bank), the Reserve Bank is able to control the money supply and thereby influence interest rates. This sets in motion a process that influences the rate of interest on housing loans, deposits and business loans.

When interest rates are kept artificially low, distortions in the structure of production, excessive borrowing and speculation are the result. The central bank’s loose money policies mislead investors into starting projects that appear profitable, but in hindsight are not. The crash comes because investors foolishly think that the boom will last, and leverage themselves too highly, as they were not prudent in their accumulation of debt.

This, in a nutshell, is the Austrian theory of the business cycle. According to this view, economic downturns are the price paid for prior (artificial) credit expansion.

We find evidence of this in the United States, when the Chairman of the Federal Reserve – Alan Greenspan – kept the federal funds rate at an absurdly low 1% from June 2003 till June 2004. Many attribute the resulting housing bubble to Greenspan’s suppression of rates.

In Australia, Leithner shows that the RBA also started an artificial boom. Leithner shows that from 1991-2007, the money supply rose rapidly. By Leithner’s reckoning, inflation (the M1 measure) increased by 404%, at an annualised compound rate of 10.2%. As in the US, much of the credit created by the Reserve Bank was pumped into the housing market, creating an asset price bubble. Stock prices were inflated.

For Leithner, however, the bust has not yet arrived – hence the reason why the Australian recession was not as severe as its American counterpart. Australian house prices remain overvalued and have not dropped to more realistic levels.

The role played by central banks in fostering monetary instability leads Leithner to question whether we need a central bank at all. It’s not a crazy question! For much of Australia’s history, there was no central bank. Private banks issued currencies and there was little government regulation of the banking sector.

In an environment of global financial instability that many argue is caused by central banking, it is worth asking serious questions about these institutions. Most central banks are highly secretive about their activities. For instance, the Reserve Bank did not even publish minutes of board meetings until December 2007.

There is a fundamental democratic principle involved here. Why should central banks, which are staffed by unelected bureaucrats, wield such a high level of discretionary power? Shouldn’t there be more democratic oversight of these money mandarins who have so much influence over our living standards?

We have seen what happens when central banks are left unchecked. In Zimbabwe, for example, hyperinflation has crippled the purchasing power of the currency. Prices in the African country rise at an extremely rapid pace, over 50% per month. Nobody is suggesting that a catastrophe of that nature is likely to befall Australia. But Zimbabwe is a reminder of the awesome power that central bankers wield, and should prompt us to improve accountability and search for less discretionary ways to manage money and banking.

Originally published in Indian Link (September 2011).

3 thoughts on “Do we need a reserve bank?

  1. “The crash comes because investors foolishly think that the boom will last, and leverage them too highly, as they were not prudent in their accumulation of debt.”

    I think that investors are not foolish, but acting quite rationally. Artificially low interest rates turn credit into a rival (as there is only so much credit in real terms) but non-excludable common good, of which rational actors will overuse, tragedy of the commons style. Whoever can get the most artificially cheap credit gains the most advantage, both through the profits and the devaluation of their debt through inflation.

    Everyone loses out if the sea is over-fished, but the people that lose out the least are those who do the most over-fishing. This is the same as artificially low interest rates. I can’t believe that people can’t see whats coming, instead I think people see whats coming and do their best to make the best of that, which unfortunately makes the situation worse.

  2. This makes your point stronger, as government set interest rates I think make it rational to act irresponsibly. I don’t think we can fix the issues caused by central banking by having people act smarter. Indeed the smarter people are, the worse things get. More credit makes more monetary inflation which makes credit more attractive and so on. This positive feedback cycle results in rational smart people causing the boom and bust cycle.

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