From instrument to actor: the changing role of the RBA

Matthew Smith, University of Sydney

Stephen Bell Australia’s Money Mandarins: The Reserve Bank and the Politics of Money, Melbourne, Cambridge University Press, 2004 (ix, 248 pp). ISBN 0-52183-990-4 (hard cover) RRP $59.95.

During the 2004 federal election campaign a major, perhaps decisive, issue was the implications of a change in government for the level of interest rates. Unfortunately, the controversy failed to generate a debate that would better enlighten the public on just how interest rates are actually determined and how Australian governments might influence them. A valuable contribution to a better understanding of this issue is provided in Stephen Bell’s book.

Historical Background

Australia’s Money Mandarins examines the emergence of the Reserve Bank of Australia (RBA) in the last twenty years as a powerful, independent, policy-making institution. Stephen Bell’s sources include ‘frank’ interviews with former governors of the RBA, Bob Johnston (1982–89) and Bernie Fraser (1989–96), the current governor, Ian Macfarlane (1996–) and former Labor government treasurer (1983–91) and prime minister (1991–96), Paul Keating. They are all key figures in this institutional development of the RBA.

Bell sets the scene with a brief history of central banking in Australia. He begins with the establishment of the Commonwealth Bank of Australia (CBA) in 1911, taking the reader through political controversies over its role and management in the 1930s and 40s to the Chifley government’s 1945 banking legislation. This legislation effectively defined the RBA’s central banking role in the post-war period. (As Bell shows, the Reserve Bank Act of 1959, which established the RBA, incorporated the substance of the 1945 legislation.) In accordance with the Keynesian approach to macroeconomic management, with its commitment to full-employment, Chifley’s legislation gave the CBA, then the RBA, an auxiliary role to Treasury in the formulation of macroeconomic policy. Its main task was to keep interest rates low and to minimise the cost of servicing public debt in support of an expansionary fiscal policy.

By the late 1980s senior managers in the RBA began to push for a more independent role for the central bank.

Bell argues that under this ‘Keynesian-inspired’ regime the RBA had no independence in the formulation of monetary policy because all major decisions required the approval of the treasurer. By contrast, the RBA had considerable power over a highly regulated financial system. Bell shows that the RBA began to acquire a more important ‘advisory’ role in 1970s, mainly because the federal government gave priority to stemming high inflation that arose early in the decade after a steep hike in world oil prices. During this time, the deregulation of international financial markets also caused a reconsideration of the RBA’s role. In particular, the floating of major foreign currencies, following the breakdown of the Bretton Woods system in 1971, posed challenges for the management of the Australian monetary system. However, Bell shows that the turning point for the RBA’s emergence was the deregulation of the Australian financial system, especially the floating of the Australian dollar, in 1983.

The RBA Emerges as an Independent Policy Maker

The heart of Bell’s book tells the story of the RBA’s emergence from the early 1980s and its evolution into an independent policy maker in the 1990s. Following financial deregulation, the RBA had to feel its way in the new environment. It began to conduct monetary policy through open market operations in the short-term money market, targeting the ‘cash’ rate and gauging how its actions affected economic activity.

From the outset the RBA was tested by financial instability. First, there was a large depreciation in the newly floated Australian exchange rate. Second, a current account crisis in the mid-1980s brought both interest rate and exchange rate instability. To deal with the latter problem, the RBA raised short-term interest rates, both to slow the economy and to resist the downward pressure on the exchange rate and its inflationary consequences. Then, in 1987 and 1988 the RBA had to deal with an economic ‘boom’ characterised by an enormous expansion in credit that fuelled asset inflation, initially in the equity market until its collapse in late 1987 and then subsequently in the property market.

Bell shows that a major problem for the RBA during the 1980s was that its role in the macroeconomic policy framework of the Hawke Labour government was unclear. Uncertainty about the RBA’s role was reflected in the ‘checklist’ approach to policy-making it adopted after abandoning monetary targeting in 1985. Under the Hawke Labour government, reducing inflation was not a primary goal of policy even though inflation remained higher than in Australia’s trading partners throughout the 1980s. Moreover, government policymakers saw the Accord as playing the major role in tackling inflation and, indeed, despite strong growth in the economy, from 1986 onwards it appeared to be effective in getting a downward trend in the inflation rate.

Bell shows that the RBA attained independence without any legislation.

However, as Bell tells it, by the late 1980s senior managers in the RBA began to push for a more independent role focused on targeting inflation. This change in attitude coincided with politico-economic events. First, the RBA was given the task of slowing down a ‘boom’ economy because fiscal policy was hamstrung: the government needed to offer tax cuts under the Accord to negotiate both wage restraint and industrial relations reform and other structural changes affecting industry. Although Treasurer Keating, at least publicly, indicated that monetary policy was designed to resolve the current account problem, those within the RBA saw it as an opportunity to focus on reducing inflation as their rightful goal. Second, with the evolution toward a more decentralised wages system, policy makers, especially in the RBA, believed that the capacity of the Accord to tackle inflation was fading. Third, Keating’s appointment of Bernie Fraser as governor in 1989 marked a change in the outlook of the RBA. According to Bell, despite occasional tensions, Bob Johnston built a close relationship with Keating, ensuring the RBA had a prominent part in macroeconomic policy. But Fraser brought a new determination to establish the RBA’s ‘credibility’ on fighting inflation. No doubt an important motive for Fraser was overturning a perception that he was an appointed ‘dove’ who would sing the government’s tune.

Central bank independence from government gained worldwide popularity from the late-1980s until well into the 1990s, when numerous countries—notably New Zealand, France, and Britain—legislated to grant policy-making independence to their central banks. The most independent central bank in the world, the European Central Bank was established with European monetary union in 1998. Legislators believed that by giving them power to conduct monetary policy free of government interference, central banks would attain ‘credibility’ in the goal of suppressing inflation and could ensure that monetary policy influenced inflationary expectations more effectively. In support of this idea the academic literature was replete with studies claiming to show that a low inflation rate was a function of the legal independence of a country’s central bank (see, for example Alesina & Summers 1993).

Following this global trend, debate in Australia about legislating central bank independence began in the late 1980s, supported in the financial sector and by the conservative opposition but opposed by the Labor government. Bell shows that the RBA attained independence without any legislation. The RBA earned this de facto independence during the deep economic recession of 1990–1991, when Australia’s inflation rate was brought down from six to a low two per cent. Bell’s account of the roles played by the main figures in this episode is particularly interesting. In short, while there were some disagreements between Keating and the RBA over the timing of interest rate changes, once the recession occurred there was general agreement to take the opportunity of lowering the inflation rate for good. This new resolve was demonstrated by the slowness with which the RBA lowered rates from very high peak levels during the recession and by its pre-emptive raising of rates in 1994 and 1995 to restrain inflationary expectations during the economic recovery.

The RBA is ultimately an agent for the government.

Bell argues that the RBA made the running on this inflation-slaying stance and by the early 1990s it had gained independence over monetary policy. With the RBA having gained ‘credibility’, especially with the financial markets, the Keating Labor government was not inclined to challenge its newly won independence. Indeed, the government endorsed the inflation target of two to three per cent proposed by the RBA in 1993. After Ian Macfarlane became governor in 1996, the incoming Howard Coalition government more formally endorsed the bank’s independence and its inflation target in a document entitled Statement on the Conduct of Monetary Policy. Bell notes that, with the Statement, the RBA’s statutory goal of full-employment has now been submerged. It is ironic that at a time of high unemployment and low inflation this goal was at least publicly downgraded, especially when the RBA’s ‘credibility’ had been established at the terrible social cost of high rates of unemployment throughout the 1990s.

Bell’s interpretation of the RBA’s performance from the mid-1990s to the present is not entirely satisfactory. He claims that the RBA’s monetary stance has for the most part been expansionary during this time. Certainly the period has been marked by low inflation and sustained economic growth that has slowly wound down unemployment. However, I believe Bell does not give enough credit for this economic success to the structural reforms so painfully implemented by the Hawke and Keating Labor governments. These reforms improved the nation’s international competitiveness and its trading performance. Indeed, high labour productivity growth, especially during the 1990s when firms significantly rationalised their workforces and adopted new technologies, has been the key factor in keeping inflation low (Australian Bureau of Statistics 2004a; 2004b; Department of Treasury 2001). These structural changes and labour’s reduced bargaining strength have made the RBA’s task of keeping inflationary expectations in check much easier. Indeed, the low interest rate environment stems directly from low inflation. It is, if you like, a ‘dividend’ of that structural change.

The Howard Coalition government has been quite happy to ride on the back of this economic success, further pushing the edges of privatisation and market deregulation and reforming the indirect taxation system as well as maintaining a restrictive fiscal stance. Its overall policy position, though, has contributed to alarming growth in private household debt that, as Bell notes, makes monetary policy a more potent weapon. If anything, this development has thrown even more responsibility for macroeconomic policy onto the RBA.

Future Challenges for Policy Makers

Having explained the establishment and evolution of the RBA to date, Bell spends the remainder of the book discussing independence, accountability, and governance (chapters six to eight), and the problem of asset price inflation for monetary policy. Assessing the RBA’s current independence from government interference, Bell criticises studies that define independence simply by reference to legislation rather than the actual working relationship between the central bank and the government. He shows that the RBA has acquired independence without legislative changes, based instead on the convention that if it has ‘credibility’ it will keep inflation low and, thereby, interest rates lower.

Australia’s Money Mandarins provides valuable insight into the way key policy makers think.

There appears to be an ‘understanding’, at least among its senior management, that the RBA’s independence is ultimately subject to public support. Hence, Bell’s argument that under the new arrangements the public do not appear to understand that now the RBA is solely responsible for setting interest rates misses the point. Just as the Howard Coalition government has taken credit for low interest rates, the public will hold it or any other government responsible for high interest rates however much that government tries to distance itself from the RBA’s decisions. This is precisely what we should expect in a democracy. The RBA is ultimately an agent for the government. But under the current arrangements the accountability of the RBA for its decisions is all important. Bell details the measures the RBA has taken to improve its public accountability and suggests ways this process could be furthered.

Bell’s analysis of the challenge of asset inflation is inconclusive. He focuses on the recent housing boom in Australia, but the problem of asset inflation is not new. It has been debated since before Adam Smith’s time. As the Great Depression, the long Japanese recession of the 1990s, and Australia’s last recession have recently demonstrated, a boom in asset prices is dangerous because when it collapses the hangover of high ‘bad debt’ can seriously inhibit investment-led recovery. As Banking School economist, Thomas Tooke, concluded some 150 years ago, monetary policy is highly effective in tackling speculative-based asset inflation. Operating as much through the process of arbitrage as through squeezing the cash flow position of debt-laden investors (speculators), raising the level of interest rates will almost certainly always depress share and property prices. The problem for policy making is the timing of the restrictive stance and the duality of its impact on activity. On one hand, if the central bank delays action until after the ‘boom’ has taken place, it is likely to induce the ‘crash’ it wants to avoid. On the other, if the central bank acts pre-emptively, it may slow economic activity unnecessarily.

In the current low inflation environment, the RBA is hamstrung in tackling asset inflation because business interest groups and the government expect that the RBA’s policy should be primarily guided by the actual inflation rate, not by growing household debt and an unsustainable ‘boom’ in asset prices. This suggests that other policy instruments, such as adjustments in tax concessions on capital gains and on interest payment liabilities, and, even more importantly, prudential measures to discourage lending on the basis of inflated asset values, need to be employed to better contain asset inflation.

Australia’s Money Mandarins provides valuable insight into the way key policy makers think and the important role that the RBA has come to play in macroeconomic policy making. The RBA has currently the power to independently influence the general level of interest rates through operations in the short-term money market that set (or target) short-term rates. As already mentioned, its primary goal is to contain inflation within the target range. However, providing it can meet its primary goal of containing inflation, the RBA has also shown willingness to use monetary policy to achieve other goals, such as restricting growth in speculative-based lending, supporting the domestic economy against external shocks (such as the Asian crisis) and generally encouraging economic expansion.

Low inflation is important for long-term fiscal expansion because it ensures low interest rates.

However, we can’t assume that the current institutional arrangements giving the RBA its independence are permanent. These arrangements remain subject to government interest and, more importantly, to public support. And under current arrangements, inconsistency between the conduct of monetary policy and fiscal policy might become a problem. As yet, this has not arisen because the Howard government has, for the most part, been content with a restrictive fiscal policy while private sector growth has been robust. But if there were a significant recession in Australia, the need for an expansionary fiscal policy would test the consistency of purpose of monetary policy. Further, for those who believe that the next step in Australia’s economic development requires considerable public capital expenditure to modernise infrastructure in education, health, transport, and household services, the current arrangements pose the threat of an unsympathetic RBA, which would see such a spending program as inflationary. The RBA might also oppose expanding public capital expenditure on the grounds of the so-called ‘crowding-out’ argument (an argument that wrongly supposes that in response to increases in aggregate demand, output is inelastic in the long run).

Despite the greater possibility for policy conflict under the current institutional arrangements if governments were to adopt a ‘Keynesian’ orientated fiscal policy, we need to acknowledge that low inflation is important for long-term fiscal expansion because it ensures low interest rates and, therefore, low public debt-servicing costs. Hence, in principle, giving the RBA primary responsibility for suppressing inflation and keeping interest rates low would be consistent with a long-term expansionary macroeconomic stance providing there was a common purpose and these policies were complemented by longer-term measures to support strong productivity growth. Within this alternative policy regime, the RBA’s implicit policy goal would be to keep interest rates at the lowest levels possible over the medium to long run.

References

Alesina, A. & Summers, L.H. 1993, ‘Central bank independence and macroeconomic performance: some comparative evidence’, Journal of Money, Credit and Banking, no. 5, pp. 173–199.

Australian Bureau of Statistics 2004a, Australian System of National Accounts, 2003-04, Cat. no. 5204

Australian Bureau of Statistics 2004b, Measures of Australia’s Progress, Cat. no. 1370.

Department of Treasury 2001, Commonwealth Budget Paper 1, Statement 4, 2001–02.

Matthew Smith is lecturer in the Discipline of Economics in the School of Economics and Political Science at the University of Sydney. His research interests include monetary theory and monetary economics. He has published papers in the European Journal of the History of Economic Thought and in Contributions to Political Economy.