The myth of the dual economy is back in town, only now it's called the "two speed" economy. Some years ago economic commentators were telling us that Australia had a dual economy with consumption rising but manufacturing lagging. We got a similar approach from Steve Slifer, chief economist at Lehman Brothers, who said of the US economy in January 2001:

It's really an odd-looking slowdown. The manufacturing sector is, in fact, in a recession but not the overall economy. At least not yet.

Now we have Ken Henry, Secretary to the federal Treasury, telling us that we have another "two speed" economy - only this time it is not consumption that is fuelling the economy while manufacturing contracts: it is China's demand for resources.

The thesis is very simple. China's demand for Australian resources raises this sector's demand for capital and labour. Moreover, this shifts the terms of trade in Australia's favour but lowers the prices of imports which cause some parts of manufacturing to either reduce output or shift operations offshore.

Therefore the resource boom is having the result of squeezing manufacturing by outbidding it for capital and labour. This means that those states were manufacturing is dominant will lose out to resource-rich states like Western Australia and Queensland.

It is indisputable that statistics appear to support Henry's argument. For instance, the Australian Industry Group has been wailing that by the end of the year something like 25 per cent of Australian manufacturing production will be offshore compared with 15 per cent last year.

In addition, the group claims that Chinese imports helped destroy about 30,000 manufacturing jobs last year. They now expect about 40,000 job losses this year, with one third of them in Victoria. These job losses have been going on for quite a while. Last October Tony Pensabene of the AIG admitted to being dumbfounded by what was happening in the economy. In his view

... something different is going on in manufacturing. In the 12 months to August, the overall economy added 352,000 jobs. In the same period, manufacturing lost 46,800 jobs.

The use of these statistics to confirm the Treasury's thesis reminds me of those economists who claimed that statistics confirmed the Phillips curve conclusion that there is an inverse relationship between inflation and unemployment. Therefore whenever unemployment rose the government could offset this by increasing the rate of inflation and so reduce the level of unemployment. The economics profession now rejects this proposition. I fear Mr Henry's thesis is heading in the same direction.

But let us look at the situation from another angle. For sometime I have been arguing that the Reserve Bank's loose monetary policy is a recipe for recession. I have also stressed that the first signs of an impending recession will emerge in manufacturing in the form of job losses and reduced output. This is what is happening now. Moreover, it parallels what happened to the Clinton economy.

Anyone with sufficient knowledge of economic history and the history of economic thought will immediately recognise the symptoms of the classic boom-bust situation. The central bank forces the interest rate down below its market rate which then triggers a boom. Eventually the central bank is force to apply the monetary breaks to bring the boom to a halt.

As I have already said, it is in manufacturing where the symptoms of an emerging recession first appear. We now have two theories using the same statistics to arrive at different conclusions. So which one is right? Is it the one that explains the situation in terms of China's demand for resources or is it the one that explains the situation as a classic boom-bust one?

That capital and labour will flow into industries that are making profits is part of standard economic theory that explains how returns are equalised throughout the economy. (Just as an aside, this is the "equalisation problem" that confounded Marx and Engels and their disciples). Let's see if we can do this by the numbers. The alternative theory - which not new, by the way - states that a credit expansion starts the boom.

RBA figures show money supply has been criminally loose for most of the last 10 years. Since March 1996 to March 2006 M1 (currency plus bank deposits) grew by 119 per cent, currency by 97 per cent and bank deposits by 129 per cent. We can easily see that bank deposits are by far the largest component. Something like this is what the alternative theory would expect.

From February 2005 to February 2006 we find that currency rose by 6 per cent, M1 by 11 per cent and bank deposits by about 12 per cent. These figures clearly show that the expansion has been through credit. Moreover, the same period saw the RBA's assets leap by 44 per cent. The RBA acquires assets by issuing cheques and by doing so it expands the money supply.

On closer inspection we see that M1 and bank deposits began rising in October 2005 until December, after which they were comparatively flat. However, February until March witnessed an acceleration in both figures. From February to April the RBA's assets jumped by 9 per cent.

These figures suggest we should be watching what the bank is doing. Keeping an eye monetary figures is extremely important, irrespective of the received wisdom among the economic commentariat. Some of these commentators recently pointed out that in 2001 the RBA cut rates from 6.25 per cent to 4.25 per cent, a full two per centage point which prevented unemployment from rising. What is still overlooked is the monetary fact that the RBA let loose with the money supply, allowing M1 to rocket by 22 per cent and bank deposits to explode by 25 per cent.

All of this fits the alternative theory which has it that manufacturing - the higher stages of production - are sensitive to changes in the money supply. (It's actually a little more complex than this). I could be wrong but I do not think that the recent monetary expansion will be sufficient to delay a recession.

Rather than damage manufacturing the significant improvement in the terms of trade actually helped it by lowering the costs of imported capital goods. This view seems to be borne out by Treasury figures showing that about 66 per cent of imports are capital goods (including intermediate goods). It's these imports that for a time lessened the pressure on manufacturing costs.

The alternative theory also predicts that eventually manufacturing will face a profits squeeze as the rising costs of inputs wipeout profits. Moreover, the monetary expansion creates malinvestments which now appear as idle capacity and rising unemployment.

The PricewaterhouseCoopers' report for April makes grim reading. It tells us that manufacturing unemployment actually accelerated in April. It also pointed out that the employment index for April 6 stood at 45.6 as against 51.0 in April 6 2006 and production had fallen from 50.0 to 49.3 while input prices had risen from 68.6 to 73.6. If it were not for the resources boom the economy would officially be in recession regardless of the demand for consumer goods.

It's extremely important to stress that the alternative theory on the effects of credit expansion on the economy leads to the conclusion that the higher stages of production (the manufacturing chain) will not only suffer the most damage but a cluster of failures, a fact that was observed in the early nineteenth century, will emerge. My point is that Mr Henry's terms-of-trade argument cannot account for this phenomenon.

The conclusion is that the above figures support the alternative theory that the problem does not lie with China's massive demand for resources - which is largely driven by China's loose monetary policy - but in our monetary policy.