Most economists like myself have come to believe that monetary policy now carries so much punch because a reduction in interest rates has a compound impact on borrowing costs, on exchange rates and on asset prices that it is unthinkable that we will have a serious recession ever again. That is, the RBA will always come to the rescue.
Paul Samuelson, the famed textbook writer who first taught me economics and subsequent winner of the Nobel Prize for Economics, has now shaken my belief more than a little. He has written a piece in the Herald Tribune (November 19) which is surprisingly pessimistic about the role of monetary policy in the current sub-prime mortgage crisis. He writes (brackets are mine):
It used to be enough for a central bank to lean against the wind. That means lower interest rates when unemployment is too high.. Today central bankers cannot know whether current interest rates are too high or too low. The safest bond interest rates are indeed low (he means relative to inflation). But financial panic (engendered by the mortgage lending crisis) means that even a mammoth corporation like General Electric would find it expensive now to finance a loan needed to build a new and efficient factory.
If he is right, the present crisis could easily develop into a serious US recession. Samuelson reminds us that, while China, India, Russia etc. may partly make up for any US recession, US still accounts for 20 per cent of global output. And financial market contagion across the world can be deadly.
His policy prescription is radical. First, he wants quasi-public agencies, like Fannie May and Freddie Mac, to fill the vacuum in the lending market and secondly (perhaps at a later date?) he wants prudential regulations tightened to discourage predatory lending. Samuelson obviously does not believe that central banks can solve the problem on their own. I have no problems with his prescriptions as an ultimate resort but I am not so sure he is right about the impotence of the central bank. Still, it makes one think!
Back in Australia, the implications are twofold. Firstly, it is possible to argue that the RBA was a little rash to raise interest rates earlier this month. A wait and see policy might have been better. Secondly, fiscal policy may need to play a bigger role in preventing a recession here. If monetary policy does prove less effective, lets hope a Howard or Rudd government will not be afraid to go into deficit financing (net borrowing or drawing on Future Fund) to pay for badly needed social and economic infrastructure. Unfortunately, although both Howard and Rudd say that they will run surpluses over the business cycle, they seem at times to be promising cash surpluses come what may. Heaven help us if that proves correct!