TCS Daily

Jakarta's Engine is Still Sputtering

By Christopher Lingle - December 8, 2005 12:00 AM

Questions loom over the cause of the ongoing economic instability of the Indonesian economy. Jakarta was expecting the full-year rise in consumer prices to be 8 percent for this year and 8.6 percent for 2006. But an unexpectedly high rate of 17.89 percent in October induced the central bank to continue raising its benchmark BI Rate to 12.25 percent, the fifth rate hike since July.

A combination of rising consumer prices and higher interest rates is limiting economic growth prospects by reducing purchasing power while pushing up lending costs. The consensus growth forecast for Indonesia's economic growth is 5.7 percent for this year, lower than Jakarta's 6 percent target.

So, what is behind all these economic woes? While many blame global capital flows or market forces, the reality is that most economic instability is caused by irresponsible monetary policies. It is remarkable that Jakarta learned nothing from the havoc that the inflationary policies of the central banks wreaked on many economies during the 1960s -- up to the 1980s.

Bank Indonesia, like most other central banks, merrily pushed down interest rates in a misguided belief that doing so can promote economic growth. But loose monetary policies cause economic overheating that arises from an artificial boom. As central bankers become aware of rising prices from an inflated money supply, they raise interest rates to reduce monetary growth. And so begins an economic contraction that was set into motion by the initial decision to make interest rates artificially lower.

Myths in the Central Bank

There is an enduring myth that recessions are the result of inherent flaws in market economies, and that such recessions must be cured periodically by central banks lowering interest rates. Unfortunately, this belief in the instability of markets invites a misplaced faith that central bankers can stabilize economic conditions by making credit artificially cheap.

On their own, monetary disturbances create clusters of ill-advised investments in productive capacity during a boom by promoting credit expansion and increased money supply growth. And so it is that irresponsible credit expansion prompted the boom and record current account deficits for the US while encouraging households to acquire record levels of debt.

Loose monetary policy sends signals that divert real funds from wealth-generating activities to activities that are unsupported by fundamental market conditions. A reversal of the central bank's monetary stance slows down or ends the diversion of funding and undermines the survival of investments sparked by artificially-cheap credit.

Sustained increases in real wealth are not brought about by printing money or through artificially-cheap credit. Sustainable increases in economy activity must be supported by new wealth created by capital accumulation and funded by additional savings.

Trying to create something (consumption spending or capital goods) out of nothing (cheap credit or new paper money) introduces massive distortions into an economy. But the ensuing boom based on an increase in the availability of credit is not supported by economic realities.

When central banks artificially-lower interest rates, they run an open bar that gets industrialists and businessmen drunk on unsustainably-cheap credit. Eventually, the mistakes made on investment decisions will become apparent when the wave of consumer spending ends. But then a new set of pressures will be brought to bear to bail out insolvent activities that were inspired by irresponsible monetary policies in the first place.

Conglomerates' Piggy Banks and Poor Supervision

But the misbehavior of Bank Indonesia goes beyond its mishandling of monetary policy, itself something shared by so many other central banks. It has been guilty of poor supervision that set up the condition for the financial meltdown of 1997 by allowing many banks to act as piggy banks for conglomerates.

After the crunch came, BI provided emergency liquidity loans. After these funds were released, BI admitted more failures in bank supervision in that it was unaware of the real condition of most banks.

Yet the misuse of the liquidity support was massive. Either there was an unbelievable amount of technical incompetence or some collusion with central bank officials. The latter seems more plausible, since most loans were made after the government granted blanket guarantees on bank deposits and to creditors in late January 1998.

Again, the myth that economic instability is the result of market flaws - coupled with nostra by central banks such as lowering interest rates - leads us down the road to negative unforeseen consequences. Such arises from a faith that central bankers can stabilize conditions by making credit cheap. But it is easy to see that the actions and reactions of Bank Indonesia have worsened economic and financial conditions. One need only look at Indonesia's sputtering economy.

Boom-and-bust cycles are triggered by central banks, and can be avoided. To this end, governments seeking sustainable economic growth should take an inventory of policies and institutions to eliminate those that inhibit private saving or discourage profitable investments.

Christopher Lingle is Adjunct Scholar at the Centre for Independent Studies in Sydney.

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