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ECONOMIC FORUM

1998 or 1988?


Most of you will I believe have realised that the latest article, A CHILD'S TALE OF MONETARY NEUTRALITY, expounds an argument more theoretical in nature than any of its predecessors; and may, at first instance, seem far removed from present events. This, rest assured, has been deliberately contemplated insofar as I believe that a proper understanding of the importance of monetary stability represents an integral part of understanding how and why it is the current economic problems were brought into being.

In the aforementioned article, the nature of the monetary expansion which wrought havoc in the lives of the Palmers may, by any modern-day account, appear somewhat simplistic and unrealistic - it all started with an irresponsible King wishing to induce a climate (allegedly) conducive to economic growth by expanding the supply of money and hence artificially lowering interest rates. Though having said that, one might be surprised to find out just how many 'Kings' there are in this world today -
successive Japanese governments for example have attempted to revive the Japanese economy from its six-year old recession by driving down interest rates to virtually zero percent! Given that money is neutral with respect to output, itis no wonder then the Japanese economy is poised for yet another year of shrinkage. In fact, from an economic standpoint, recent attempts by the Malaysian Government to resist interest-rate rises for fear that it would induce a recession amounts to precisely the sort of monetary expansion that had been wrought out of the King's scheming. So, after all, there may be more Kingdoms of Adaptive Expectations than one might have initially suspected!

I hope the reader will have by now been able to discern the manner in which the plot is unfolding in this our quest for an understanding as to the origins of our present economic woes. This I believe can already be partially deduced from a combination of the article entitled THE RINGGIT CRISIS: THE REAL CULPRIT AT LAST? and that of monetary neutrality.

The problems began with concerns, misplaced in my view, that the unprecedented magnitude of capital inflows observed in the early 1990s was resulting in an 'unjustified' appreciation of the ringgit. (I say it is misplaced because a currency appreciation is part and parcel of the adjustment process given the balance of payments surpluses which were recorded during those years.)
In the RINGGIT CRISIS article, it was explained why it is a monetary authority that chooses to control the exchange rate loses control over domestic money-supply. Thus, attempts to manage the ringgit meant that its consequences for money-supply were (had to be?) neglected. By 1993, money-supply went out of control. The narrow measure of money-supply (M1) for example expanded by some 37.5%. (Even in the Kingdom of Adaptive Expectations the expansion was only 25.87%!) This is in stark contrast to the average M1 expansion of only 8.07% during the forty-year period 1952-1991 and during which the growth in M1 was more or less stable.

From A CHILD'S TALE OF MONETARY NEUTRALITY, we know that money is neutral in the long-run; but that in the short-run, money could have real effects upon output where people either do not perceive the money expansion or realise its
consequences. As money (and hence credit) became so easily available, everybody must have thought, like their counterparts in the Kingdom of Adaptive Expectations, that there was a genuine expansion in demand or that the surge in stock-market value was one to stay. And as Farah explained it, producers and consumers both as a result make systematic errors in their optimising decisions - they decide to produce the 'wrong' amount of goods, supply the 'wrong' amount of labour, borrow the 'wrong' amount of money from the bank and so on.

So long as Bank Negara allowed money-supply to expand at phenomenal rates, the 'illusion' continued. Then came the ringgit crisis, which was brought about by the combination of the currency markets' perception that the RM.2.49/55 peg was unsustainable (and hence economically damaging in the long-run) and Thailand (as the trigger). That Bank Negara decided it was in the best interests of the country to allow a freely-floating ringgit, a decision for reasons espoused in Section Three of the RINGGIT CRISIS article I fully endorse, meant that it has now regained control over money-supply. The days of 'easy money' may thus be in the throes of death. And so like Mr.and Mrs. Palmer and Sarah, we may be learning the hard way what it means to say that money is neutral in the long-run.

Throughout the crisis, the Right Honourable Prime Minister was to have been heard quipping that "one month of raiding by currency speculators has destroyed one decade's worth of growth". What role the speculators had as the cause of this destruction is something which probably falls outside the domain of economic analysis. As it so happens, however, there is a perfectly logical economic reasoning to this observation - The effects of money-supply expansions is not only to entail too much investment, it also results in the wrong kinds of investment. Namely, it artificially inflates the profitability of the normally technologically-sophisticated industries at the expense of those which are less so. It is to the mechanism which
distorts the profitability of industries and thereby causing malinvestment we shall turn to in "1998 OR 1988?"

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