If you don’t like what’s happening to interest rates, remember that although the managers of the economy have to do something to reduce inflation, it’s not a case of what former British prime minister Maggie Thatcher called TINA – there is no alternative.
As Reserve Bank governor Dr Philip Lowe acknowledged during his appearance before the House of Representatives Standing Committee on Economics last week, there are other ways of stabilising the strength of demand (spending) and avoiding either high inflation or high unemployment, which are worth considering for next time.
So, relying primarily on “monetary policy” – manipulating interest rates – is just a policy choice we and the other advanced economies made in the late 1970s and early 1980s, after the arrival of “stagflation” – high unemployment and high inflation at the same time – caused economists to lose faith in the old way of smoothing demand, which was to rely primarily on “fiscal policy” – manipulation of taxation and government spending in the budget.
The economic managers have a choice between those two “instruments” or tools with which smooth demand. The different policy tools have differing sets of strengths and weaknesses.
Whereas back then we were very aware of the weaknesses of fiscal policy, today we’re aware of the weaknesses of monetary policy, particularly the way it puts a lot more pain on people with home loans than on the rest of us. How’s that fair?
Lowe says the conventional wisdom is to use monetary policy for “cyclical” (short-term) problems and fiscal policy for “structural” (lasting) problems, such as limiting government debt.
But it’s time to review what economists call “the assignment of instruments” – which tool is better for which job. The more so because the government has commissioned a review of the Reserve Bank’s performance for the first time since we moved to monetary policy dominance.
It’s worth remembering that the change of regime was made at a time when Thatcher and other rich-country leaders were under the influence of the US economist Milton Friedman and his “monetarism”, which held that inflation was “always and everywhere a monetary phenomenon” and could be controlled by limiting the growth in the supply of money.
It took some years of failure before governments and central banks realised both ideas were wrong. They switched back to the older and less exciting notion that increasing interest rates, by reducing demand, would eventually reduce inflation. There was no magic, painless way to do it.
Macroeconomists long ago recognised that using policy tools to manage demand was subject to three significant delays (“lags”). First there’s the “recognition lag” – the time it takes the econocrats and their bosses to realise there’s a problem and decide to act.
Then there’s the “implementation lag” – the delay while the policy change is put into effect. Lowe described the cumbersome process of cabinet deciding what changes to make to what taxes or spending programs. Then getting them passed by both houses, then waiting a few weeks or months for the bureaucrats to get organised before start day.
He compared this unfavourably with monetary policy’s super-short implementation delay: the Reserve Bank board meets every month and decides what change to make to the official interest rate, which takes immediate effect.
He’s right. While the two policy tools would have the same recognition lag, monetary policy wins hands down on implementation lag.
But on the third delay, the “response lag” – the time it takes for the measure, once begun, to work its way through the economy and have the desired effect on demand – monetary policy is subject to “long and variable lags”.
Lowe said it took interest rate changes 18 months to two years to have their full effect. But I say most budgetary changes – particularly tax changes – wouldn’t take nearly that long. So, that’s a win for fiscal.
The sad truth is that measures to strengthen demand by cutting interest rates, or cutting taxes and increasing government spending, are always popular with voters, whereas measures to weaken demand by raising interest rates, or raising taxes and cutting government spending, are always unpopular.
This meant politicians were always reluctant to increase interest rates when they needed to, Lowe said. This is a good argument for giving the job to the econocrats at the central bank and making them independent of the elected government.
This became standard practice in the rich economies, although we didn’t formalise it until the arrival of the Howard government in 1996. Lowe advanced this as a good reason to stick with monetary policy as the dominant tool for short-term stabilisation of demand.
Against that, using monetary policy to get to the rest of us indirectly via enormous pressure on the third of households with mortgages shares the burden in a way that’s arbitrary and unfair.
What’s more, it’s not very effective. Because such a small proportion of the population is directly affected, the increase in interest rates has to be that much bigger to achieve the desired restraint in overall consumer spending.
But if the economic managers used a temporary percentage increase in income tax, or the GST, to discourage spending, this would directly affect almost all households. It would be fairer and more effective because the increase could be much smaller.
Various more thoughtful economists – including Dr Nicholas Gruen and Professor Ross Garnaut – have proposed such a tool, which could be established by legislation and thus be quickly activated whenever needed.
A special body could be set up to make these decisions independent of the elected government. Ideally, it would also have control over interest rates, so one institution was making sure the two instruments were working together, not at cross purposes.
Another possibility is Keynes’ idea of using a temporary rate of compulsory saving – collected by the tax office – to reduce spending when required, without imposing any lasting cost on households.
They say if it ain’t broke, don’t fix it. It’s obvious now that macroeconomic management needs a lot of fixing.