I am not an economist

I am not an economist, but I did study it in year 11.

So forgive me if this is uninformed brainless speculation, but I was thinking about yesterday’s interest rate rise.

I understand the principle of the Reserve Bank of Australia fiddling with interest rates when inflation is high, to scale back demand, though I wonder if it really works as well as it’s meant to. And although some calculations of inflation include things like petrol (which to a certain extent keeps selling no matter what the price, because so many people have no viable alternative to driving) and bananas (which are not only expensive, but physically hard to find at the moment, so most people aren’t actually buying them), the RBA’s calculations don’t include these, and still come out at 3.3%, which is apparently high.

Is it the case that RBA fiddles interest rates because that’s about the only mechanism it has to affect consumer spending? I’m not sure if this is intentional or just the way the economy ended up by accident, but it seems to be a rather clumsy approach, given that it only directly hits people with loans. (Yeah I’m one of them, though I’m not so close to the line that it’ll cause me any problems.) Are there any more practical ways of doing it? (It’s not like the government is going to give the RBA the power to cut wages or fix prices to slow down inflation.)

As it happens, on the same day the RBA made its decision, I got my first council rates notice. I’m becoming ever-more aware of the financial costs of owning a house, and I can understand why some say it makes better economic sense to rent, and invest.

I really like being in charge of my own place, though.

By Daniel Bowen

Transport blogger / campaigner and spokesperson for the Public Transport Users Association / professional geek.
Bunurong land, Melbourne, Australia.
Opinions on this blog are all mine.

6 replies on “I am not an economist”

Interest on credit cards is extremely high, comparatively. Many shift the credit card debt to their mortgage, and then do it again a few years later. Instead of increasing general interest rates, they should have increased the interest rate on cards to an impossible level, as if it is not high enough already. That surely would deter your gerneral person from racking up so much debt on their cards.

While City of Port Phillip spends far too much on ‘the arts’ and public housing, City of Glen Eira spends far too much on itself. At least I can see where money goes/is wasted/misspent. Where Glen Eira’s rates goes could only be a guess. I suppose the streets are quite clean.

It’s so nice that the extra money we get in tax cuts, which is supposed to increase consumer spending and stimulate the economy, gets eaten up (and more) by the increase in the interest rate, which is done to reduce consumer spending and slow the economy. We can’t win.

Daniel, I am an economist, but not a macroeconomist so I can safely speculate without having to be right.

The RBA has targeted an inflation rate of ‘2-3 per cent, on average, over the cycle’ since the mid ’90s. All the ‘on average, over the cycle’ means there are no hard and fast rules (and that they can sensibly exclude stuff like expensive bananas that nobody is buying anyway), but I guess 3.3% is bit higher than they’d like.

Interest rates are not the only mechanism to affect consumer spending, and indeed are not a particularly good one (the effect is lagged by ~18 months I think). The government can also affect aggregate demand by tax cuts, baby bonuses and various other mechanisms. Governments (not ours apparently) can also fiddle exchange rates to some extent. In fact when the RBA sets an interest rate target it actually goes about implementing this by adjusting to quantity of money available to banks, rather than the “price” of money (which is the interest rate). There’s no reason it has to be this way, and other countries do things differently, but it seems to have worked okay for the past decade. There has been some talk around the blogosphere about whether the RBA could adjust the rate of GST… but I can’t imagine shopkeepers would appreciate re-pricing all their stock every time the RBA changed it’s mind.

And finally, the interest rate doesn’t just affect people with loans. At it’s simplest, the interest rate is a price, and reflects the relative value of money today vs. money tomorrow. Sure, it affects homeowners already locked in to a loan, but it also affects businesses deciding whether to borrow and invest.

The real difficulty is the mismatch between the economic performance of the various parts of the country. WA is going gangbusters and NSW is “not performing optimally”. The RBA can only change interest rates nationally – so NSW gets hit hard and WA will barely notice the blip (at least the economy as a whole). In fact, the Chamber of Commerce and Industry here in WA had recently called for a rate rise to help slow the WA economy.

If you could get access to the Financial Review any more, I’d suggest a couple of articles from yesterday’s edition that set out the difficulties for the RBA in managing a fragmented economy. And, yes, one of the answers is better and more strategic government intervention (dare we suggest uneven allocation of GST??) but I can’t see politicians of any persuasion actively managing the economy – we might hold them accountable!

Ideally you’d want something that didn’t hurt business (= employment generating) investment but slowed down the excesses of borrowing households.

In regulated times they could have had a credit squeeze (as occurred in 1962 & 1974) but given deregulated markets, this wouldn’t be fashionable. So instead the price of money goes up and interest rates rise, with the hope that more marginal borrowers would reconsider.

Alternatives could include short-term levies on credit cards, personal loans and use of home equity, or other measures to make it harder. For instance, compulsory waiting periods for new applications, a personal debt tax or a $500 up-front fee (payable in cash at any post office) before the holder is allowed to get a credit card.

Though better targeted than a general interest rate rise, all these sound heavy handed in the current economically liberal millieu and may not be electorally favoured either.

John makes a good point about the ‘two speed economy’. It is one reason why European-style currency union isn’t necessarily a good idea as it implies a ‘one size fits all’ approach to interest rates despite different growth rates (and need for lower or higher rates) between members.

Of course there are sections of the community that are over the moon about the rate rise – retired people who now get a little more income from their interest-bearing investments for example. Given that this is a growing percentage of the population, and the general “avoid debt” mentality of this age group – it’s hard to see how the interest rate lever will be as effective for slowing demand going forward.

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