Eco-Economy: There is No Alternative

Column – Finlay Thompson

The Reserve Bank will want to raise interest rates yet again. Inflation is lurking everywhere and our over-heating economy will be in need of the wet blanket again. Governor Don Brash will stand at the podium and announce seven percent interest, …

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Eco-Economy: There is No Alternative

Dr Finlay Thompson

The Reserve Bank will want to raise interest rates yet again. Inflation is lurking everywhere and our over-heating economy will be in need of the wet blanket again. Governor Don Brash will stand at the podium and announce seven percent interest, the media will ask experts, and Michael Cullen will look helpless.

The Reserve Bank will maintain a healthy distance from the public debate. This is the desirable stance for an independent central bank. Our Reserve Bank is a model of independance and rationality. Our Reserve Bank acts according to the mathematical rules of economics: interest rates and inflation, exchange rates and current accounts.

When the Reserve Bank raises interest rates again, we are told, and most would agree, that There Is No Alternative.

It is clear where power lies in our political and economic system. The Reserve Bank controls the money supply and treasury puts strict controls on government spending. Our new Labour government has come under attack from “Business” in the media for even suggesting a few labour market reforms. Let’s remember that the government has not actually acted yet! We are locked into a left versus right debate, with workers and poor supporters of the Labour and Alliance versus employers and wealthy supporters of National and Act. But the political line in the sand is in the wrong place.

The real conflict of interest is between the productive sector and the financial sector. The interests of employers, small businesses, farmers and the self-employed are much closer to those of workers and our poor than to the banks’ and financial institutions’. The productive sector, involved in real wealth creation, is in direct competition with the financial sector for profits.

All political leaders in New Zealand should be demanding explanations from the Reserve Bank. We all know that the government has no impact on the direction of our financial system. It is about time we started getting some answers about why interest rates must go up.

Every time interest rates go up, people are forced to close small businesses and sell houses. We all know how interest rate hikes push out of business any profitable enterprise that earns less than 6.5 percent. We all know that as interest rates go up the rent we pay in the form of mortgages goes up. Unless we can find some more income we will sell the house.

But the question we should be asking is, how do interest rate increases hold back inflation? The key to understanding is in the amount of money (M3, or money supply) in the economy and how it grows and shrinks. Money is created when banks make loans, and destroyed when people pay back their loans. High interest rates discourage people from borrowing and slow down the money creation. Of course the money supply must grow to cover the interest owing. Deputy Governor Murray Sherwin recently replied to New Zealand Banking Reform member Deirdre Kent:

“Money creation is a function of the broader financial system. The loans made by one bank may become a deposit at another bank, and thus underpin a further loan. It is only in that sense that the process of lending creates new deposits which count as a part of our definition of ‘money’.”

Money creation should be the responsibility of the Reserve Bank. Almost all of our money is debt, and so earns interest. We are paying rent for our money. There is another way. The government can create debt-free money. In fact our government used to create debt-free money, but it stopped doing that in 1989 when we handed control of money creation to the commercial banks with the Reserve Bank Act.

Since then the money supply (M3) has more than doubled. That is a compounding annual rate of more than 6.5 percent over the last ten years. Has the real economy (GDP) had that much growth? No! So where is the inflation? Luckily for the Reserve Bank, the price index does not include interest rates. As most people have noticed, our property market has inflated dramatically over the last ten years. Rent and mortgage costs have increased considerably across the whole economy.

More money, higher prices. Bank-created money, higher rent.
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