Peter Lyons: Monetary policy only hides economic bruises

It is becoming evident that staunch monetarism is not a magic bullet for economic management, writes Peter Lyons. Photo / Supplied

I was at the bank the other day making a rare deposit. The teller asked if I wanted insurance then laughed when she recognised me from a previous visit.

I thanked her and restated that I preferred to minimise my dealings with banks in New Zealand. She showed commendable persistence and asked if I wanted a mortgage at their new extra low rates. I could even take a loan to make extensions or renovations.

I asked if that included cosmetic surgery. She pressed a pamphlet on me. I suspect she may have confused a few of the digits on my account balance.

We are lucky to live in this age of ultra cheap money. It is strange that previous generations failed to understand that setting interest rates low is the magic bullet of economic management.

I assured the teller I would consider borrowing some money to buy one of the local weatherboard shacks on the slopes of Mt Albert. She smiled uneasily.

The origins of this period of cheap money go back to a weekend in 1971 when US President Richard Nixon announced the US dollar was no longer backed by gold. The international monetary system that had been in place since World War II moved into uncharted territory.

The link between a bank teller offering me easy loans in Mt Albert in 2015 and a decision by the US Government in 1971 seems long and tenuous. But the connection is fascinating.

After World War II, most Western currencies were fixed against the US dollar which was fixed against gold. This provided a degree of certainty about the value of different currencies.

This arrangement fell apart after 1971. The 1970s were a decade of unprecedented inflation. Many governments printed money to pay their bills. They were no longer tied to an international system of fixed exchange rates that had restricted their ability to fiddle their currencies.

In the 1980s, an economic doctrine called monetarism gained power in many Western countries. This was based on the belief that inflation was public enemy number one. In 1989, New Zealand made the Reserve Bank politically independent and gave it an explicit inflation target. That target is currently 1 to 3 per cent. This was designed to foster confidence about the value of our currency. It was brutal but it worked.

Reserve banks raise interest rates to stifle demand if inflation is creeping up. It lowers interest rates if inflation is low to try to pump up demand and increase employment and growth. It uses interest rates as a blunt instrument to bludgeon the economy into shape.

Inflation right now is virtually non-existent. The Reserve Bank is worried about rising unemployment and falling economic growth as well as the possibility of deflation. It is trying to pump adrenalin into our economy.

But this policy has major flaws that have become evident since the global financial crisis. Lower interest rates during downturns are meant to encourage consumers to borrow and spend and businesses to borrow and expand. But lower interest rates in New Zealand generally stoke housing inflation. This creates few new jobs and little additional output. Unfortunately, banks prefer lending on residential property rather than for business expansion.

What has also become evident over the past 30 years is that monetarism has contributed to a huge build-up of private sector debt in many Western economies.

The deregulated banking sector has happily facilitated this process and made huge profits as a result. But when things turned ugly in 2007 and 2008 they hid behind government bailouts and guarantees. They were too big to fail.

Monetarism has contributed to large- scale inflation in asset prices such as housing and shares. But the well-being factor is largely illusionary for the broader economy. Few new jobs are created, there is little new industry, output or income growth.

It is becoming evident that staunch monetarism is not a magic bullet for economic management. An economy can resemble a battered boxer whose face has become badly swollen and distorted.

• Peter Lyons teaches economics at St Peters College in Epsom and has written several economics texts.