AUSTRALIAN MONETARY POLICY RECONSIDERED

AUSTRALIAN MONETARY POLICY RECONSIDERED

I. “raditional Monetary Policy in Australia. 11. Deliberate Banking Control and Economic Stability. 111. Does “Deliberate Policy” accentuate Fluctuations ? IV. Testing the Effects of “Deliberate PolicyJJ.

I In the November, 1931, number of The Economic Record,

Dr. Roland Wilson criticized at some length an article on Aus- tralian Monetary Policy, which I published in the May number. His criticism, which is confined to those sections of my article dealing with the nature of the traditional policy, falls into two parts: criticism fist of the statistical data, and second of the interpretation placed upon them. As regards the alterna- tive statistical data offered by Dr. Wilson, it is only necessary to mention that while no doubt they are, in the main, more accurate than mine, they lead to the same conclusion. Atten- tion may therefore be confined to the question of interpretation.

The object of that part of my article which Dr. Wilson criticizes n a s to ascertain on what principles the Australian banking system regulates the volume of its credit-the volume of bank money. Unfortunately my views on this subject do not appear to have been expressed clearly enough t o enable Dr. JVilson to comprehend them. In order to facilitate comment on his criticism, an attempt must therefore first be made to state the conclusions more clearly.

I t appears, then, that the readiness of the banking system to make credit available to secondary industry is too dependent -in so far as industrial stability is held to be important-on variations in (a) the volume and prices of primary esports, and (b) the volume of government external borrowing. This ar,gument is based on the following five propositions: fist, that the above two factors are the chief determinants of the balance of payments; second, that the balance of payments largely governs the size both of the Australian banks’ London balances and of the gold reserve in Australia; third, that there is a tendency for the volume of bank money in Australia to vary with the balance of p a p e n t s - o r , in other words, to vary with both the London liquid balances and the Australian gold reserve, both of which are manifestations in the banking system of the

191

192 THE ECONOMIC RECORD DEC.

state of the balance of payments; fourth, that the price level tends to vary with the volume of bank money; and fifth, that unemployment varies, t o a considerable estent, inversely with the price level.

The first proposition-namely, that the two principal factors determining the balance of payments are the value of primary exports and the volume of government external borrom- ing-need not detain us ,long. Australian exports are predominantly of primary produce. Now both the volume of primary exports (which is largely dependent on the bounty of nature) and also export prices (which are largely dependent on the conditions of the world supply and demand for the particu- lar primary export concerned) may be taken, in relation to the present problem, as independent variables. The same is true of government borrowing; for though the size of this might be made to depend somewhat on variations in the size of the other items on the credit side of the international account (i.e., on exports), it does not appear, as was shown in the article, to have been made to do so in the past.

Propositions I1 and I11 relate to the control of bank credit. It was explained in the article that, other things being equal, an increase in any of the credit items in Australia’s international account, or a decrease in any of the debit items (or, in other words, an improvement in her “balance of payments”) leads automatically to two results: first, t o an increase in either the Australian banks’ London funds or the Australian gold reserve, or both; and second, to an increase in the excess of deposits over advances in Australia. For the reasons given in my article, this statement is a mere truism. If short loans are escluded from the “balance of payments”, one would therefore expect a considerable degree of sympathy between movements in the “balance of payments” and the London banking funds on the one hand and movements in the excess of deposits over advances in Australia on the other. Indeed, this is little more than a tautology.

Dr. Wilson supposes that my article represents an “unwit- ing departure” from and a “misconception of” this proposition, and that it is therefore confused. M y proposition, I11 (viz., that there is a tendency for the volume of bank money in Australia to vary with the balance of payments-that is, with the London banking funds and Australian gold reserve) consists of two distinct parts. The first con- cerns the automatic reaction of changes in the balance of pay-

But that is not so.

1932 AUSTRALIAN MONETARY POLICY 193

ments on the excess of deposits over advances just discussed. This is what Dr. Wilson refers to as “Tocker’s exposition of the mechanism of the sterling exchange standard”, but which for convenience will here be called the automatic reaction. The second part of the proposition relates to the action which, as a result of the “automatic reaction”, the banking system takes deliberately. Let us now inquire into this matter.

I1 An alteration in the balance of payments, other things

being equal, would involve a change in the aggregate volume of the country’s real income, and hence a change in the real demand for industrial products. The resulting change in industrial activity mould be independent of the banking system ; being, in the circumstances assumed, neither initiated nor modified by its action. It is the change that would occur in a barter economy not hindered in its eschange transactions by the absence of money. For convenience it may be called the “natural” industrial fluctuation.

aS regards the effects of the “deliberate” or “voluntar”’, aa distinct from the “automatic”, reaction of the banking system in these circumstances, there are evidently three possibili- ties. For banking policy must necessarily be such that it causes the amplitude of the “natural fluctuation” to be either enlarged, diminished or left unaffected. My o m view is that it probably, as a rule, causes it t o be enlarged. But before discussing this view (which is based on general reasoning rather than on statistics) comment may be made on what Dr. Wilson regards as statistical proof of his opinion that banking policy causes the amplitude of the fluctuation to be diminished.

In order (in effect) to examine statistically the nature of the banking system’s “voluntary reaction”, Dr. Wilson has constructed two charts’ showing the annual rate of change in advances and securities in relation to the annual change in the excess of deposits over advances. In the first chart the comparison is direct, while in the second the advances are shown with a year’s lag. On these comparisons Dr. Wilson comments as follows1.: “While it is evident that ‘credit, in the form of advances’ does have some tendency t o vary with the excess of deposits over advances with a lag o f from one t o two years, the more s i g d c a n t point is that, without any lag, “credit, in the form of advances’ has a fairly close inverse correlation with the

1. Ecmomic Record. November, 1931. p. 210. IS. 09. d.. P. 210.


excess of deposits over advances. It follows that banking funds abroad and the balance of payments should display a similar inverse correlation with ‘credit, in the form of advances’.” Why the inverse correlation is to be regarded as the more significant is not explained. But we may infer that from it is deduced (and that it derives its importance from) the conclusion that “the expansion and contraction of credit, i.e., advances, has been the instrument used by the Australian b a n h to smooth out, t o some extent, the fluctuations in totaZ deposits originating in irregular fluctuations in the balance of payments. ”2

But this conclusion is over hasty: the foundation for it yielded by the inverse correlation of the two series of data used by Dr. Wilson is insecure. Indeed, it seems not inappropriate to quote, in this connexion, Dr. Wilson’s own words. That is t o say, “the confusion appears to be due to a misconception. . . of the mechanism of the sterling eschange standard. ”3 For firstly, inverse correlation between advances and the excess of deposits over advances is to be expected as a result of the banking system’s “automatic reaction”. The reason is that if, as a group, exporters and importers normally borrom from the banks on a considerable scale, most of the factors acting on the balance of payments in such wise as t o produce an increase (or decrease) in deposits mill also rcsult in a decrease (or increase) in advances. For, as was pointed out in my article (p. 3) , “exports lead to the creation of a deposit or to the elimination of an advance, and imports to the creation of an advance or to the elimination of a deposit.” Moreover, secondly, the figures of advances in- clude thosc of “investments.” Thus the effects of changes in the balance of payments on the volume of advances may be obscured, in the published figures, by associated changes in the proportion of advances to investments. One mould expect, a pr io t i , to find this proportion showing positive correlation with changes in the escess of deposits over advances-that is, to find that in good years the banks convert investments into advances, and that in bad years they convert advances into investments. Hence, for both these reasons, inverse correlation between the rate of change in advances and the change in the excess of deposits over advances cannot be accepted as evidence that the banking system, through its “deliberate” policy, either dimin- ishes the amplitude of the “natural industrial fluctuation” or that it increases it. I t is quite consistent with either policy. Dr.

2. Op. cit., p. 215. 3. 011. cit., P. 211.


milson’s opinion4 that “to some (varying) estent, therefore the automat.ic operation of the balance of payments on the excess of deposits over advances, and hence on the price level, is‘ offset by deliberate manipulation on the part of the banking system, which is thus able to some extent t o steady prices through the influence of ‘created’ deposits”, must therefore be set aside as not proven. Some method other than that used by him for discovering the nature of the effect on industrial stability of the banking system’s “voluntary reaction” must be sought.

III General reasoning would suggest that it causes the ampli-

tude of the “natural fluctuation” t o be increased. That is t o say, when there occurs an improvement (or worsening) of the balance of payments, with, other things being equal, a resulting increase (or decrease) in the London banking funds and Aus- tralian gold reserve, in the escess of deposits over advances, and in industrial activity, the banking system accentuates this fluctuation in industrial activity by lending more freely (or less freely) to domestic industry. In my a r t i ~ l e , ~ this expectation mas based on two assumptions: first, that the banks in determining their lending policy pay attention to the size of their Lon- don funds and gold reserves (attempting to keep roughly the same proportion betveen these and the volume of their loans) ; and second, that they are not impeded in this endeavour by a shortage of cash reserves for meeting the country’s requirements for the purposes of cash payments. It was suggested that while this second assumption is not legitimate in all circumstances- for example, it is not legitimate as regards the availability of Australian bank: notes in 1 9 2 6 i t probably is legitimate in the main.

Since mriting my original article, I have had the oppor- tunity of discussing the first assumption with certain bankers. According to them, the criterion to which as a rule bankers have in the past paid most regard in re-dating their lending policy, has been not the proportioli between their loans and the London funds and gold reserve, but the proportion of deposits t o advances. This proportion they endeavour t o keep fairly stable. Thus when as a result of the “automatic reaction” the excess of deposits over advances increases (or decreases), the proportion of deposits to advances will also increase (or decrease), and in consequence the banks will lend to industry more

4. Op. cit.. p. 214. 5. See pp. 2 and 4.


freeIy (or less freeIy). In this event the effect will be the same as if primary regard were paid to the London funds and gold reserve; the amplitude of the “natural industrial fluctuation” will be increased.

Unfortunately, it is impossible to verify this ar-anment statistically, since the statistics that would be required are not available. As an index of the “voluntary reaction” the published figures of “Advances” (the index used by Dr. Wilson for this purposee) are for several reasons unsatisfactory. They are unsatisfactory for both the reasons advanced against his interpretation of the inverse correlation between the rate of change in “advances” and the change in the escess of deposits over advances, Furthermore, it is necessary fo r our purpose to dis- tinguish between loans t o industry and the finance of the external trade; and the published statistics do not afford a means of doing this.

CHART I

I. Proportion of non-interest-bearing deposits to total deposits.

11. Excess of deposits over advances (and investments). (Table

Until the requisite statistics are made available, it is impossible to come to any definite conclusion regarding what has been called the banks’ “deliberate reaction”. But it is possible to apply a rough (and admittedly inadequate) indirect test. This is to see if increases in the excess of deposits over advances have been associated with heightened velocity of the circulation of money, and decreases in the excess with

(Appendix, Table I, Column 11).

I, Column I).

6. Oa. cit.. P. 210. Cf. above. PP. 193-4.


lowered velocity. In the accompanying chart (Chart I), changes in the excess of deposits over advances (Curve I) are related to changes in the proportion of non-interest-bearing deposits to total deposits (Curve 11), since this proportion may be taken as a rough index of the rapidity of the circulation of money. The izvo curves shorn a considerable amount of sympathy, that of the proportion of non-interest deposits tending to lag behind the other. The mere fact that these curves tend to move together does not in itself help to prove anything, since the changes in the excess of deposits over advances might be brought about predominantly through changes in non-interest- bearing deposits. But the tendency of changes in the proportion of non-interest deposits to lag behind changes in the excess of deposits over advances may be taken as presumptive evidence against this. On the whole, therefore, there appears reason to believe that the velocity of circulation does tend to vary with the excess of deposits over advances.

The significance of this must not be overestimated. As regards positive action by the banlring system, the only conclusion it warrants is that the existence of deliberate expansion of credit when the excess of deposits over advances is increasing, and of deliberate contraction when it is decreasing, mould not be inconsistent with the statistics presented. But neither would the absence of such action be inconsistent, since the observed relationship between changes in the excess of deposits over advances and changes in the velocity of the circulation of money might be the result of the automatic reactions on credit associated with changes in the balance of payments. Indeed, we are here beset by the same difficulty as before, that the influence on the figures of the “deliberate reaction”, whatever the nature of that reaction may be, is masked by the influence of the ‘automatic reaction”.

IV Dr. Wilson may feel that all this should have been stated

specifically in my original article; and no doubt greater care should have been taken t o safeguard readers against possible misunderstanding and error. But for the purposes of that article an elaborate discussion of the banking system’s “deliberate reaction’’ was unnecessary. I t was simply necessary to show the net effect of the two Ends of reaction-“automatic” and “deliberate”-taken together. For as regards this matter my view was that “it is economically undesirable to cause

D


avoidable fluctuations in the volume of production and employ- ment in secondary industry merely because there are occurring, or have occurred, unavoidable fluctuations in the volume of primary industry.”’ I postulated that monetary policy should be designed to prevent, as far as possible, these induced fluctuations in the activity of secondary industries from occurring. For the reasons explained above, it was suggested that “Aus- tralian monetary policy actually promotes them. ” But-also for reasons given a b o v e 1 had to content myself, for the mo- ment, with attempting to prove that, whatever the banking system’s “voluntary reaction” is in fact, it does not at any rate prevent the “natural industrial fluctuation” as far as is economically desirable. The proof of this consisted of two steps : first, that the fluctuation is not prevented completely, and second, that there are ways available in which the banking system could with advantage to the community counteract it more than it does.

In order to prove the first step in this argument: it was first necessary to show movements in the excess of deposits over advances in relation to those in the balance of payments and London banking funds.g Owing, presumably, to an obscure or too brief presentation of the argument, Dr. Wilson has apparently misunderstood the purpose of this comparison, assuming that I was trying to apply a statistical test solely of the “deliberate reaction”. It mas this misconception which led him to suggest that I “apparently regard the working of the mechanism [of the sterling eschange standard] as dependent on deliberate regulation of credit by the banking system. ’j10 What Dr. Wilson failed to perceive was that it was possible to test the “deliberate reaction” of the banking system to a certain extent by using an index of its “automatic reaction”-i.e., the excess of deposits over advances. While a comparison of this with the gold reserve and London funds cannot show what the banking system actually does, it can shorn what it fails to do. It cannot show whether it aggravates the “automatic reaction” or offsets it; but since there is a considerable degree of correlation between the series of data concerned, it does show that it fails t o offset that reaction completely.

But the primary aim is to discover whether the banking system deliberately offsets, not its own “automatic reaction”,

7. P. 7. 8 . The aecond atop waa axmined in W o n UX. and ulr oataid. tha KODO

9. Chart I of the original rrti.de. 10. Op. cit.. p. 211.

or thir discussion.


but the “natural industrial fluctuation”. A brief examination must therefore be made of propositions IV and V.11 In order t o verify proposition IV, it is necessary to see if the banking system, by failing to counteract its “automatic reaction”, per- mits fluctuations to occur in the price level. In attempting to do this in my article, I related together movements in the excess of deposits over advances inverted, with a year’s lag, and the rate of change in the price level. But that was a mistake. The correct procedure was to make a direct comparison between the rate of change in prices and movements in the excess of deposits over advances.12 For reasons pointed out both by Dr. Wilson and myself, it mould be unreasonable to expect a very high degree of correlation between these series. Nevertheless, it seems clear that the rate of change in the price level does tend to vary mith the excess of deposits over advances.

CHART I1

Three-quarterly moving averages of :- I. Unemployment percentage (inverted). Table 11, Column V.

11. Rate of change in wholesale prices. Table 11, Column IV.

The final step in the argument is to see if fluctuations in the price level result in fluctuations in industrial activity. Be- tween changes in the price level and changes in the percentage of unemployment one mould expect to find that there is inverse correlation. In my article, the existence of such correlation was taken for granted. Without entering here into a discussion of the reasons on which this expectation is based, it may be well that the assumed relationship should be verified statistically. For

11. Ses above, P. 191. 12. Dr. Wilaon Rnda it difacult to understand why I should we. in this annexion.

the excess of deposita over advances. I hope that I have now made the resaon ium- eiently clear.


this purpose it is best to use quarterly figures, which are available since 1913. Owing t o the considerable trend in the price level during this period, it is simpler to use not the price level itself, but the rate of change.13 Three-quarterly moving averages have been taken of both series of data. Thus Chart I1 shows three- quarterly moving averages of the percentage of unemployment (inverted) and of the rate of change in the index of wholesale prices. The curve of unemployment is given one quarter’s lag- that is, what happened to unemployment in each quarter is related to what happened t o the price level in the preceding quarter. The two curves move in considerable sympathy. It may therefore be accepted that even if the banking system, through its “deliberate reaction”, causes the “natural industrial fluctuation” to be in part offset-and, as we have seen, it is more likely that it causes it t o be enlarged-it does not entirely eliminate it. Various inexpensive devices were suggested in Section I11 of my article for enabling the banking system to offset this “natural fluctuation’’ more completely than it does; and it may be concluded again, puce Dr. Wilson, that some or all of these devices should be adopted.

K. S. ISLES. The University of Edinburgh.

::. Th: L. the price level of each year u n percenrnne of that of the precedinp Ten:.


TABLE I'

Ezcess of Deposits over Advances (and Invest. ments) . and Proportion of Non-Interest-Bearing Deposits t o Total

Deposits .

I.? II . Proportion of Non-Interest-Bearing

Depoaits to Tot31 Deposits . Excesa of Year . Depoaib over A R .. I

Indudins Excluding Commonwealth Commonwealth

Bank . Bank . Advances (and Inveatmenta) .

1901 . . . . . . 1902 . . . . . . 1903 . . . . . . 1904 . . . . . . 1905 . . . . . . 1906 . . . . . . 1907 . . . . . . 1908 . . . . . . 1909 . . . . . . 1910 . . . . . . 1911 . . . . . . 1912 . . . . . . 1913 . . . . . . 1914 . . . . . . 1915 . . . . . . 1916 . . . . . . 1917 . . . . . . 1918 . . . . . . 1919 . . . . . . 1920 . . . . . . 1921 . . . . . . 1922 . . . . . . 1923 . . . . . . 1924 . . . . . . 1925 . . . . . . 1926 . . . . . . 1927 . . . . . . 1928 . . . . . .

E m . 3.25 5.71 3.53 4.50

12.99 19 * 29 18.46 12.85 20.06 29.28 30 * 68 26 * 05 30.91 40.97 46.55 44.22 63.33 5ti. 33 44.29 67.80 40.74 56.32 56.28 46.31 60.25 52.44 21.87 21.20

% 40.85 40.26 40 * 39 38.90 37.55 38.53 41.51 40.48 39.75 42.52 43.38 43.66 41.39 42.84 43.08 48.11 50-39 49.95 47.77

%

47.59 45.97 52.65 50.47 47.03 45.23 44.39 43.32 42.08 40.74 38-54

'Finance Bulletin . Nos . 11 and 19 . ?Includes the "savinga deposits" of the Commonwealth Bank . Cf . Wilson . o p . c i f ..

P . 204 .


TABLE I1

Three-guarterly Noving Averages of the Rate of Change in Wholesale Prices and of the Unemployment Percentage.

I. XI. III. rv. V. Rate of Unemploy-

Ysar. Quarter. Wholesale Change in ment Moving Averages of Prices. Wholesale Percent- Col. 11. Col. 111.

Prices. age.

1913

1914

1915

1916

1917

1918

1919

1920

1921

1922

1923

1924

1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4

1,111 1,095 1,072 1,072 1,085 1,113 1,185 1,225 1,387 1,660 1,822 1,544 1,502 1,493 1,505 1,514 1,525 1,587 1,715 1,804 1,877 1,940 1,954 1,965 1,934 1,956 2,068 2,262 2,351 2,567 2,650 2,352 2,164 1,897

1,729 1,671 1,743 1,786 1,831 1,851 1,956 2,003 1,966 1,946 1,880 1,848 1.866

1,822

%

98.56 97.90 100.0 101.21 102.58 106.47 103.46 113.22 119.68 109.76 84.74 97.28 99 * 40 100.80 100 * 60 100.59 104.07 108.06 105.19 104.10 103.36 100.72 100.56 98.42 101.14 105.73 109.38 103.93 109.19 103.23 88.75 92.01 87.66 96.05 94.90 96.65 104.31 102.47 102.52 101.09 105.67 102.40 98.15 98.98 96.61 98.30 100.97

6.4 7-3 7.0 5.3 5.9 5.7 10.7 11.0 12.0 9.5 8.8 6.8 5.9 5.3 5.3 6.7 7.5 6.3 7.1 7.4 5.5 6.2 6.1 5.5 6.5 8.5 6.2 5.2 5.6 6 .2 6.2 7.8 11-4 12.5 11.4 9.5 9.2 9.6 9.6 8.6 7.2 7.1 7.4 6.6 7.6 8.3 9.5 10.3

98.82 99.70 101.30 103.42 104.17 107 * 72 112.12 114.22 104.73 97.26 93.81 99.16 100.27 100 * 66 101.75 104.24 105.77 105.78 104.22 102.73 101.55 99.90 100.17 101.76 105.42 106.35 107.50 105.45 100.39 94.66 89.47 91.91 92.87 95.87 98.62 101.14 103.10 102.03 103.09 103.05 102.07 99.84 97.91 97.96 98.63 99.44

6.9 6.6 6.1 5.6 7.4 9.1 11.2 10.8 10.1 8.4 7.2 6-0 5.5 5-8 6.5 6.8 7.0 6.9 6.7 6.4 5.9 5.9 6.0 6.8 7.1 6.6 5.7 5.7 6.0 6.7 8.5 10.6 11.8 11.1 10.0 9.4 9.5 9.3 8.5 7.6 7.2 7.0 7.1 7.5 8.5 9.4 9.7


TABLE I1 (Continued)

I. 11. 111. IV. V.

Prices. Wholesale Percent- &I. 11. Col. m. Rate of Unemploy-

Prices. age.

Year. Quarter. Wholesale Change in ment Moving Averages of

1925

1926

1927

1928

1929

1930

1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2

1,848 1,825 1,848 1,856 1,841 1,892 1,832 1,764 1,737 1,743 1,882 1,904 1,840 1,820 1,764 1,744 1,788 1,794 1,832 1,799 1,680 1,667

% 99.04 98.75 101.26 100.43 99.19 102.77 96.83 96.29 98.47 100.35 107.98 101.17 96.64 98.91 96.92 98.87 102.52 100.34 102.12 98.20 93.39 99.23

9.3 10.2 7.9 8.1 8.2 6.7 7.6 5.7 5.9 6.4 6.7 8.9 10.7 11.2 11.4 9.9 9.3 10.0 12.1 13.1 14.6 18.5

99.59 99.68 100.48 100.29 100.80 99.60 98.63 97.20 98.37 102.27 103.17 101.93 98.91 97.49 98.23 99.44 100.58 101.66 100.22 97.90 96.94 96.18

9.9 9.1 8.7 8.1 7 . 7 7.5 6.7 6.4 6.0 6.3 7.3 8.8 10.3 11.1 10.8 10.2 9.7 10.5 11.7 13.3 15.4 17.9

Columns I and I1 from Development and Migration Commis- sion's Report on Unemployment, and from the Quarterly Bulletins of Statistics.

Column 111-The rate of change in wholesale prices is computed by taking each year's price level as a percentage of that of the preceding year.

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