Key Points:

Money does matter. Alasdair Thompson addressed a fundamental question in economics in his opinion piece on Monday.

He says that the easy money policies in the United States and other countries that have contributed to the credit crunch mean little to the real economy of physical production and employment. He argues that despite the nefarious dealings of money men the actual ability of an economy to produce goods and services is little affected.

This question has puzzled economists for centuries. The question is: does money matter to national prosperity? The classical economists such as Adam Smith and David Ricardo believed money was largely neutral in its effect on the real economy.

An increase in the money supply and lending would lead to a proportional increase in price levels, meaning inflation. It would have little impact on real activity such as output and employment.

Mr Thompson (chief executive of the Employers and Manufacturers Association [Northern]) states that the current financial crisis will have little effect on real economic activity, provided that central banks ensure the availability of credit is not shut off due to a crisis of confidence by depositors.

This crisis of confidence has seen the collapse of several lenders such as Northern Rock and Bear Sterns.

What he has failed to appreciate is that the damage of easy credit policies in other countries on the New Zealand economy has already occurred. The full realisation has yet to become apparent.

The main effect of loose monetary policy and lending practices in other countries on the real economy of New Zealand has been a major distortion in resource allocation.

Easy credit overseas has allowed our largely Australian-owned banks and other financial institutions to borrow cheaply offshore. They have pumped this money into the lending market in New Zealand. Most of this lending has been for housing finance. This has created a boom in house prices. An obvious real effect has been on young first-home buyers. They have had to saddle themselves with a massive mortgage in order to own their first home.

The effect has been to create a class of young Kiwis who are effectively working as indentured labour for the banking system in order to service very hefty mortgages. These mortgages are way out of kilter in proportion to incomes compared to previous generations.

The banks have been able to borrow New Zealand dollars from overseas at cheaper rates than locally. This means they have little exchange rate risk should the New Zealand dollar fall.

Overseas lenders such as the legendary Japanese housewives have been willing to take the risk of holding New Zealand-denominated debt. Should our exchange rate fall, their willingness to lend our own dollars back to us will quickly end.

They have been able to get hold of New Zealand dollars because of our massive current account deficit.

The essence of the story is that we spend more overseas than we earn. The extra New Zealand dollars this provides to foreigners is then lent back to us to allow us to bid up our own house prices. We are attractive to lend to because overseas interest rates are low, whereas ours are high due to our tighter monetary policy.

When Mr Thompson says that money shenanigans don't affect the real economy, he is ignoring the impact of the process described above on our export firms or any local firm that competes with imports. These businesses have been shredded in the past few years. Our high exchange rate, as a result of people wanting to invest in New Zealand dollars, has decimated these industries. It has also meant they have had little ability or incentive to invest in new capacity.

The key point is that money matters. The availability of money and credit in an economy as determined by a country's monetary policy has a major effect on the real economy. The New Zealand dollar is overvalued against our major trading partners because of our high interest rates compared to other countries.

The statistical evidence of this is our massive current account deficit. This deficit exists despite the boom in dairy exports.

An analogy would be to compare the New Zealand dollar to Wile E. Coyote clinging to a branch on a cliff face. The branch is the Official Cash Rate set by the Reserve Bank. When the branch finally snaps the New Zealand dollar will fall. The branch will snap at the first hint that the Reserve Bank is about to lower short-term interest rates.

At this stage the full realisation that we have been living beyond our means will become apparent. Long-term interest rates will remain high as overseas lenders become less willing to lend to us due to the exchange rate risk. The credit crunch is already starting to cause this to happen.

Petrol prices will rise as will most import prices and foodstuffs that we export because exporters will be able to get better prices offshore. The cost of living vice that is becoming apparent will tighten.

Mr Thompson's assertion that money and credit do not matter as long as central banks step in to maintain confidence is not correct. The availability of money and credit, if poorly managed, can create major distortions in economies.

This leads to real job losses and real hardship. Money does matter.

* Peter Lyons teaches economics at St Peters College in Epsom and has authored several economics textbooks. E-mail Peter at A href="">