Money Matters

28^th July 2006

The Malta Independent - Friday Wisdom

Throughout the nineteen eighties the main economic problem was one of obstinately high inflation caused by the two oil price shocks firstly in 1973/74 and then again following the Iranian revolution in 1979.

The main economic credo then was the need to iron out excessive inflation from the system at all costs and for this purpose the monetarist theory prevailed. This centred round the belief that there was a direct relationship between the quantity of money in the economy and inflation, so that if the quantity of money increased at a higher rate than the real growth of the economy the difference would be reflected in price rises and hence growing inflation.

This theory made some rather simplistic assumptions that it is quite possible to actually measure the quantity of money in the economy and that such money had a relatively constant velocity of circulation - as a two pound note that is involved in five separate transactions could make the same function as a ten pound note that changes hands only once.

The upshot of the monetarist theory was that interest rates had to be allowed to go as high as necessary in order to control the quantity of money which was allowed to grow only at a pre-set target reflecting the expected real growth of the economy. Inflation was truly ironed out of the system but with a considerable time lag and at the expense of severe economic recessions throughout most of the eighties and early nineties. Double-digit interest rates discouraged investment and consumption, killing off demand and forcing property prices to plummet.

I well remember the UK situation in 1992 when property prices went so low that they did not cover the mortgage that many borrowers were struggling to service merely to repay the interest, let alone the capital. Negative equity in mortgages was the rule of the day, defaults mounted and with a deteriorating loan book which was hitting Bank’s profits the appetite for new lending disappeared altogether, further stagnating the economy.

Given this background the obvious question that is asked is how is it that this time round, with oil prices reaching an all time nominal high just a whisker off seventy nine dollars per barrel and obstinately well above the seventy dollar mark, which in real terms is not far off the peak real price hit in 1979, high energy prices have not produced similar inflation problems.

One could write a thesis about this giving a myriad of reasons that in their own way contribute to this favourable state of affairs. The fact that economies have become much more energy efficient obviously helps.

Globalisation has meant that developed economies are now more based on service industries that are not as energy dependent as manufacturing, explaining why the impact has been less severe than previously. Manufacturing has been substantially outsourced to low cost countries, especially to China who compensate for increased energy inputs by lower labour costs making it possible for the final price to remain low in spite of higher energy costs.

Few central banks these days put much reliance on strict monetarism and on money supply statistics in determining their interest rates policies. Probably the ECB is the only important Central Bank in the world which makes reference to money supply growth in the decision making process for interest rate levels but there is no automatic link as hitherto between the money supply growth and interest rate levels. If there were such a strict link in the monetarist school of thought, interest rates would be much higher than they are, probably causing recession. Instead we have had one of the longest economic upswings since 2001/2002 and the interest rate cycle seems already to be peaking at rather historically low levels.

Strict monetarists would argue that Central Banks are inviting trouble by keeping interest rates so low. The fact that no undue retail price inflation has been caused by the abundant liquidity they pumped into the system as a direct result of their keeping interest rates at historically low levels, does not mean that another type of inflation has not been created. It is like pushing on a toothpaste tube with the cap closed; the pressure is simply transferred.

Should Central Banks be mindful of the asset price inflation they have created, particularly in the real estate market? Are Central Banks only responsible to control retail inflation and they can neglect asset price inflation even if the formation of price bubbles in property prices could risk financial instability, as has been experienced in Japan?

The mission statement of our Central Bank states that its goal is “to maintain price stability and to ensure a sound financial system, thereby contributing to sustainable economic development”. The objective of retail price stability is obvious but the objective to achieve also asset price stability is implicit in the need to keep sustainable development and a sound financial system.

Our property market could have reached an inflection point. Rising interest rates and increased supply generally lead to reduced demand, stock building and eventual price curtailment. Developers should also bear in mind that in Malta property prices have yet to experience a truly rising interest rate scenario. In the interest hikes of the eighties and nineties, we were shielded by rigid exchange controls that kept local interest rates steady. This is no longer possible. If interest rates internationally go up, we will have to follow suit. Moderately rising rates could produce a healthy soft landing for our property market. Aggressive interest rate rises could render the landing hard and painful. However, moderate or aggressive, it is no longer our decision.