David Koch - An Enemy of the Aussie Battler

David Koch (or "Kochie") is a household name. Respected and beloved for his cheerful character and financial advice, most people - including me - like Kochie. But Kochie's latest article makes him an enemy of the Australian working class.

The Article

Kochie makes the case in his article that times are tough for the Aussie homeowner and for small businesses. He argues that the Reserve Bank of Australia, by giving no indication that it will cut interest rates, is causing a "crisis in confidence" that is destabilizing the Australian economy:

The problem is that businesses large and small need to be able to plan ahead, and Stevens’ appearance on Friday gave little reassurance. All Stevens said is that it is a good thing to “sit still and do nothing” in such rocky times, but that is of little comfort to our struggling business owners. It has arguably got to the point that the RBA’s secrecy is causing a serious crisis of confidence in the broader economy, and this can lead to a destructive cycle in which fear feeds on itself, causing employers to shed jobs and cut back on investment. Indeed, the 9,000 jobs that have been lost in the past month suggest this is already happening.

Kochie, as indicated by the title of his article 'Why the RBA needs to cut interest rates', wants to run the printing presses to save the Australian economy. He disregards the real economists naysayers crying 'inflation' in the night with a quite amazing statement:

A cut in interest rates now would have no effect on the factors which are causing inflationary pressures, such as utility bills, food and fuel. Most of the inflation in our system is beyond the control of both the RBA and consumer spending.

This statement indicates that Kochie doesn't really understand what inflation is and how it works. Because of this, he does not understand the consequences of printing money and its role in causing the business cycle.

He continues:

Mervyn King, the former head of the Bank of England, once famously said that 'good central banking is boring.' What he meant is that it is better for everybody if the central bank is predictable, and does not have surprises hidden up its sleeve.

Predictability apparently means that the RBA should print money and create malinvestments throughout the Australian economy:

Governor Stevens should pay attention. While the RBA has done a pretty good job over the past couple of years, it went too far in the run up the the GFC in 2008 when raising the cash rate to 7.25%, pushing typical mortgage rates to 9.6%. It resulted in a glut of repossessions and unnecessary job losses. That took the market by surprise. We don’t need another surprise like that. Give us some transparency and let our small businesses get planning with some peace of mind.

The conclusions that Kochie makes in this paragraph again represent a lack of understanding as to the causes of the financial crisis. Moreover, transparency doesn't mean printing money and keeping the inflation party going forever.

Why Kochie is wrong: Inflation

Inflation is typically understood as a rise in the price of goods and commodities. However, it's more accurate to call this phenomenon "price inflation". So why is there a general rise in the prices of commodities, goods and services in the economy, especially when there is a strong tendency within the free market to lower prices?

The answer is: monetary inflation (or an increase in the money supply), which leads to price inflation.

Let's imagine that there is a shortage of coconuts. In technical jargon, the "marginal utility" of coconuts has increased - or in other words, the number of coconuts available for individuals to satisfy their wants has decreased. This means that individuals will value coconuts more highly than before as there are fewer coconuts available to satisfy "lower order" wants.

For example, imagine that Robinson Crusoe is living on a deserted island where the only food available is coconuts. His uses for coconuts may look something like this (in order of priority):

1. Eat for survival and health
2. Use the shells to make shelter
3. Use the shells to make shoes
4. Throw them into the ocean for fun

If the island is abundant in fresh coconuts, then Crusoe can collect 2000 coconuts a year. Crusoe only eats about 1000 coconuts a year. Because of his productivity and the availability of coconuts, Crusoe doesn't have to ever worry about starving or being malnourished. This leaves him with 1000 extra coconuts to satisfy less important uses. Crusoe can use 500 coconuts to make himself some himself a nice hut. This still leaves with 500 extra coconuts to the 2 remaining uses. To make shoes for walking around the island, he needs 300 coconuts a year to make a new pair every 2 weeks (the approximate durability of coconut shoes). Crusoe is left with 200 coconuts to throw into the ocean for fun.

Suppose a cyclone hits and causes significant damage on the island, so that Crusoe can only collect 1700 coconuts in a particular year. If he wants to survive, this will force Crusoe to give up some of the uses for coconuts mentioned above. He can't throw 200 coconuts into the ocean for fun because otherwise he won't have shoes to walk around the island with. Coconuts now are more valuable to Crusoe; he can't just waste a few here and there as he did before.

This simple thought experiment is used to explain the concept of 'marginal utility". Now imagine that Crusoe wasn't alone on this island, that he had a neighbor called Ug the Ogre on the other side of the island. Crusoe trades 100 coconuts for chickens with Ug. This means that Crusoe’s uses for coconuts are (in order of priority):

1. Eat for survival and health
2. Use the shells to make shelter
3. Use the shells to make shoes
4. Trade for chickens (5 coconuts per chicken)
5. Throw them into the ocean for fun

Now Crusoe only has 100 coconuts left to throw into the ocean for fun. One day, a storm comes and wipes out 200 coconuts from his stock. This means that Crusoe doesn’t have any coconuts to trade with Ug or use for leisure. Ug is upset; he really wants coconuts from Crusoe. Ug tries to trade with Crusoe in vain.

At the current exchange ratio, 5 coconuts will get Crusoe 1 chicken. Ug realises that he needs to reorder Crusoe’s priority list for using coconuts. Ug changes the price of chickens to 1 coconut/chicken.

This makes all the difference in the world for Crusoe. The value, from his perspective, of having 300 chickens a year is greater than the value of using coconuts to make shoes. Crusoe’s use of coconuts now changes (in order of priority):

1. Eat for survival and health
2. Use the shells to make shelter
3. Trade for chickens (1 coconut per chicken)
4. Use the shells to make shoes
5. Throw them into the ocean for fun

Let’s imagine now that the opposite happened. Crusoe finds a long rod of bamboo that increases the number of coconuts he can harvest to 4000 per year. Now Crusoe has more coconuts than he knows what to do with. Crusoe decides that since he has more coconuts to trade, he wants more chickens. Ug still has the same number of chickens and is only willing to part with 300 in a year. Crusoe tries to get the chickens at a price of 1 coconut per chicken, but Ug is no fool. He knows that Crusoe has many coconuts. He refuses and only accepts a price above 5 coconuts per chicken. Crusoe accepts, knowing that he can afford to pay a premium on coconuts without any consequence to the other more important uses he has for coconuts. Or maybe Ug doesn’t know about Crusoe’s ‘coconut inflation’ and is just plain unhappy with parting with 300 chickens for 300 coconuts because he has a higher value for chickens in that place and time. The price of chickens must go higher (i.e. inflate) in order for him to trade. In either case, Crusoe can afford the trade because of the inflation in the number of coconuts. The coconut inflation led to chicken price inflation.

So in this example we have seen that changes in the abundance of goods alters their marginal utility and value in the eyes of individuals. What these individuals are willing to trade for other goods (i.e. prices) will also change. Replace chickens for everyday items that you purchase like food, petrol, cars and homes. Now replace coconuts with money, or dollars in your wallet. If you have a greater supply of dollars in your wallet, you can afford to pay more for goods and services. In other words, monetary inflation leads to price inflation.

Monetary inflation is an increase in the supply of dollars in your wallet, or credit on your card. Monetary inflation is significantly controlled by the actions of the RBA through interest rate policy and open-market activities. When the RBA lowers interest rates, it lowers the price at which banks can borrow money from them. The RBA creates the money out of thin air (i.e. synonymous with printing money) by crediting the bank’s account. It’s like logging onto the computer records of your bank and changing the balance from $1,000 to $10,000; this would be $9,000 worth of monetary inflation. The bank does the same thing to you when lending money for a home, car or credit card loan; it's in effect an accounting entry. This happens routinely and lawfully.

So if the interest rate is lowered, banks can borrow more money from the RBA to cover more loans to entrepreneurs and other individuals within the economy. This artificial increase in the money supply inevitably causes widespread malinvestment within the economy, the same way a travelling circus can do to a local town it stops in. The circus brings fresh new money into the town, which may cause a restaurant owner to mistakenly believe that there is a permanent increase in business. The restaurant owner buys the property next door and builds an extension to accommodate the growth in customers. He can afford these additional costs so long as these new additional customers keep coming. Eventually the circus leaves town and the restaurant owner faces the harsh reality that the monetary inflation brought by the clowns is now over, and all he is left with is debt he can no longer afford.

The clowns at the RBA have indeed been shopping at every business, printing and lending money to more and more people through the fractional reserve banking system. This has tricked entrepreneurs and individuals around Australia to invest in various bubbles, namely the housing and building sector, thinking that the party will never be over. Well it will soon be over, and not because the circus has left town, but because the debt-servicing burden has exceeded the consumption and savings capacity of the economy. The solution to this problem is not to increase the levels of debt in the economy to stimulate more debt-fuelled consumption. This can only make the problem far worse than it is, threatening the stability of our currency and increasing the cost of living for Aussie battlers. An increase in the money supply without real growth within the economy only raises the prices of goods and services faster than wages can adjust. The RBA is trying as hard as they can to hide this in their official inflation numbers, through the voodoo of hedonics etc. But the average Australian family already knows that their heads are just below the water of rising prices.

So Kochie, the trusted financial advisor of Australia, thinks that this is all a good thing. More money printing, more debt, higher prices and further economic ruin… for predictability’s sake at least. But as long as Kochie advocates the policies of economic suicide, he will remain an enemy of the Aussie battler.