How our monetary system has been either your best friend in the past, or currently your worst enemy

May 31, 2019

Welcome to Furious Friday – Today – Continue with the Lucky Country Australia – Today – want to run through how a lot of our luck – especially if you have owned property, comes from the design of Australia’s monetary system since the early 90s. But diminishing marginal returns are a real thing – especially when it comes to money. In this episode we break this down to set the stage for the next two episodes – on Australian property and share markets and their potential returns for next few years.  

 

The heart of every monetary system - money can only be created by a central authority – for guarantee of value – most of human history:

1. Genghis Khan - established paper money in Yuan Dynasty- currency fully backed by silk and precious metals
   1. behead those found guilty of counterfeiting – in Before in Song Dynasty just tattoo their faces
   2. But this is when the paper money was fully backed by valuable goods
2. When it comes to fiat currency (our current monetary system) – need to have one central Authority to make sure that the intrinsic value placed on it sticks – in the form of a Government guarantee
   1. Imagine if we all viewed monopoly money was worth the value of the note – if we all believe it and accept the backing of the value – we will use it – but why is monopoly money worthless? Because it can be made by almost anyone at will with a colour printer
3. A central authority is needed – to not only produce the currency (that cant be faked easily), but be protected by law as the country having one single currency – capping the supply to be controlled by one entity
   1. but it can’t be the Government – having Gov over supply of money is bad – they can enforce law – ATO, or laundering/counterfeiting
   2. Policy - Separate Central Banks – this central authority then grants the right to create money through fractional reserve banking to commercial banks  - the right to further create money through lending
      1. banks do not have to keep all of its deposits in the bank – they create money by lending out a certain proportion of its deposits to others - who of course had to deposit the loan into a commercial bank to use it – as it has Authority granted by the regulators
      2. Deposit $1,000 – Bank lends out $800 – someone uses it, give it to someone for service = $1,800 = creating more money.
   3. And this also means that commercial banks are generally profitable as the money supply grows –
      81. 1993 - $81.5k mortgage, 8% rates, $6,500 p.a. – 2018 - $388k national average, 3.9% rates, $15,136 p.a.
      82. except of course when they stretch too far - like in 2008–9 = which thanks to the Government having authority over the money – they got a bailout of freshly printed money

• First made them make risky loans, secondly guaranteeing the loans/deposits – incentive to gamble, thirdly printing more money to buy back defaulted debt so the banks losses will be covered by future debt obligations in tax over 30-50 years

4. The system has evolved with Central Banks no longer having currency backed by anything - Floating of the Dollar in western world – USA 1971, AUS early 80s –That is really what fiat means – authority by decree
   1. but the key principle of the system in creating money is the monopoly of the central bank – but Now the supply simply doesn’t need a backing asset to provide a reference point
   2. But the issue with this is that the traditional way of wealth creation has been hijacked – being artificially controlled
      1. Two ways - The supply of money is now based on a whim rather than market forces – control of bread prices in USSR
         1. And natural incentives are being artificially manipulated – Like putting quotas in production based on weight
            1. Again – like USSR – nails would be produced too big to be usable – to reach quotas with less work
         2. You are incentivised to deposit funds into the bank when interest rates are high – bank can then lends money out = more money is created – but limited to the overall wealth of the population – 1) what they can afford in interest payments, and 2) rates depends on the level of deposits which relies on more people having more money in the bank

• Look over Aus savings rates – 1950s – fairly constant band – had lows of 10%, high of 20%, but mostly 15% -

1. 1983 – 1998 – 15 years – slow decline from 15% to 0% or negative – stayed there until about 2008 – then spiked
   1. Went back to 10% for a bit - Economic collapses can scare people to save more – but declined to 2.5% since
2. When we reflect on this, I don’t think it is too much to say whoever controls the creation of money controls the world …
   1. Of course, being able to create money is a wonderful – we all need to be able to create our own wealth –but when we the incentive to save, and the incentive to borrow are controlled by a central authority-
   2. It creates a system of uncertainty and often not an optimal outcome – as there is no instant feedback loops – like in every other financial market – apply this principle to anything
   3. You have a company that sets the price of power – it has a complete monopoly on Australian power – even the mining side of things – from resource to the power point – how well do you think we would be serviced?
   4. Would we have higher prices with worse access to power if there was a monopoly on power?
   5. I don’t see how this is any different to what each Central Bank does of every nation on earth
   6. They set the cash rates – or interest costs – they produce the cash
   7. But they are only one piece of the Authority – in Australia: Council of Financial Regulators Working Group
   8. APRA, ASIC, RBA - Then - Treasury department - The department is focused on developing Australian taxation system, land and income tax and economic policies.

 

These Things are all related – and all over pretty incredible control over the economy

1. Treasury department – Do all the economic modelling, projections based around assumptions, come up with policy to help rectify projections that are off the set targets –GDP growth, government revenues, taxation policy
2. RBA – controls money supply –monetary policy -
   1. Bases their decisions around economic reports and their own modelling - determines the cost of accessing credit is – borrowing
   2. Commercial Banks also source deposits (from individuals), money overseas, lend this money out based around a ratio of how much you are putting down – but the money all has to be AUD, or other approved currency
3. APRA and ASIC – Regulate the flow of the process – at the banks and consumer level

 

Back to Central Banks - Have a lot of control - RBA has a lot of power – central bankers have a lot of power –

1. one word from a Chairman of a central bank makes markets spook and drop, or charge – if they say they are going to do something in 2 weeks, then the market responds today in anticipation – based around their monetary policy changes

 

Monetary policy creators have a lot of power – This is what the RBA is responsible for -

1. The Reserve Bank Board sets interest rates so as to achieve the objectives set out in the Reserve Bank Act 1959
   1. the stability of the currency of Australia;
   2. the maintenance of full employment in Australia; and
   3. the economic prosperity and welfare of the people of Australia.
2. Since 1992 - these objectives have have managed through a target for consumer price inflation, of 2–3% p.a.
   1. Monetary policy aims to achieve this over the medium term so as to encourage strong and sustainable growth in the economy.
   2. Controlling inflation preserves the value of money. In the long run, this is the principal way in which monetary policy can help to form a sound basis for long-term growth in the economy.
3. How is this done? RBA policy - objective of monetary policy is to control inflation -target is the centrepiece of the monetary policy framework
   1. The Governor and the Treasurer have agreed on the 2-3% inflation each year is best
   2. sufficiently low that it does not materially distort economic decisions in the community – or a free market
4. The inflation target is defined as a medium-term average rather than as a rate (or band of rates)
   1. Between 2 and 3 due to inevitable uncertainties involved in forecasting, and lags in the effects of monetary policy on the economy - inflation is difficult to fine-tune within a narrow band –
   2. The inflation target is also forward-looking – Guess what the inflation rate will be in response to current conditions and the increase in money supply
      1. Ever been cooking something and not following the recipe 100% - Pancakes - Add too much milk, now it is runny, so put flour in, but too much, so add more milk, and then need to add a bit more sugar and egg to fix up the ratios, but now it is too runny again, but you are out of flour -
   3. Decision making process –The Board meets eleven times each year - the first Tuesday of the month except January
      1. For each meeting - the Bank's staff prepare a detailed account of developments in the Australian and international economies, and in domestic and international financial markets.
      2. The papers contain a recommendation for the policy decision. Senior staff attend the meeting and give presentations.
      3. Then policy decision is either to drop rates, raise them, or keep them the same – Then public told

 

1. This approach to monetary policy in Australia since early 1990s - Policies that they have set are all about low inflation –
   1. Reason for change –1960s-70 – 5% - then USD 1971 – 1983 rates started going up 5-13% in 13 years – inflation on lots of currencies previously backed to USD, and by proxy gold – lead to higher cash rates which needed to curb
   2. with floating dollar – rates in 1983 went up over next 7 years to 17% - 1989 to 1990 – two years it was expensive
   3. By 1997 – 7% rates were back – 10% lower – so borrowings went up massively
2. What actually creates inflation – or CPI technically here – cost of living going up – is it from people spending money on goods when there is more money, and then businesses being able to increase their prices over time to keep up with more demand – but thing called menu prices – this occurs slowly – fairly natural process – bit of an effort for companies to go through increases in prices – restaurants as example – printing new menus –
   1. and if you set prices too high – people stop buying and therefore – prices don’t go up so no inflation beyond the market demand for a good and thus pushing the price up in the process.
   2. When this is trying to be set through demand side economics – thinks more money – more people spend – businesses get to increase prices? Well – not when the increase in the money they get gets diverted into a home – loans are small, no problem – as you still have money to spend – now – more money can leave with no actual increase in what you have to spend after the debts interest and repayments
   3. When credit can be controlled – and printed at will – the allocation of the funds becomes distorted compared to the overall demand for it –
   4. Increase in prices comes from demand versus supply – but with technology making things cheaper, to artificially keep CPI up on average, more money needed, but different with certain assets people demand more compared to the supply – especially things like property – so when there is high demand and increasing access to credit – prices go up -
      1. Debt growth averaged 15% per annum compounding (1998–2009). During the same period national economic growth was less than 3% with debt stripped out.
      2. Between 1998 and 2008 inflation was about 36% and property prices increased by more than 300% in all capital cities except Melbourne (up 280%) and Sydney (up 180%)
   5. No wonder we are experiencing low CPI – Existing businesses are in a price war – as disposable incomes go down after debt costs are paid for – people have less to spend – so as an existing business – compete by reducing your costs to lower prices –
      1. Nature of the modern company – focused on the profit margins more so than the revenues
      2. Why the small corner stores can’t compete anymore - not to the economies of scale that Woolworths, WES have to have the lowest prices – while still making a profit due to lowest costs
   6. Issues with cheap money – and the focus on low inflation being manipulated – with no guarantee that the move up or down in cash rates will have the desired effects on economy – especially in a global economy – where models work in isolation – but add millions of other factors and the probability that it will work get very, very low
      1. No incentive to save – reduces growth – as savings are typically used for investments – either others or your own
      2. As rates go lower – amount of money increases – needs to – so cheap credit – the result? Artificial allocation of resources
         1. Housing prices sky rocketing around the world since the 80s – Rates go lower, growth goes lower as well – people are spending less as they are trying to pay back massive loans
         2. Don’t think it is a massive coincidence that

 

Revisit the effects of this policy on the housing market and share markets over the next two Furious Friday Episodes –

1. Property market – bubble or not?
2. Share market – lower growth environments, and dividends – run through Telstra as an example
3. Run through how to still build wealth in this environment

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 Resources:

Global Trends Interest Rates - https://voxeu.org/article/global-trends-interest-rates