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Interest rates

September 2nd, 2004

Another silly feature of the election campaign is Howard’s claim to have delivered low interest rates (and, by implication more affordable housing). The variable home mortgage rate has barely moved over the eight years from 1996 to 2004, and (IIRC) it was lower in 1996 than when Howard handed over the Treasury in 1983.

It’s true of course that in between those dates, interest rates rose to stupendous levels, as high as 17 per cent. But to the extent that Labor made this mess, Labor cleaned it up. Howard had nothing to do with it (moreover, throughout Labor’s term in office, both Howard and Hewson were consistent monetary policy hawks),

This experience also showed that the link between budget deficits and interest rates (via crowding out) is not all that strong. It’s true that, if you move from large surpluses to chronic deficits, as Bush has done, you can expect an eventual interest rate response (though no such response has appeared as yet). But improving the budget balance by a few billion dollars will have no visible effect.

So, I’m disappointed to see Latham running with the government line and promising to keep interest rates low through fiscal policy. Given that world interest rates are likely to rise over the next few years, thanks to chronic deficits in the US, it’s doubtful he can deliver on this. And while it’s good to maintain surpluses on the cash balance over the course of the economic cycle, it’s silly to promise a surplus every year.

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  1. Niall
    September 2nd, 2004 at 23:25 | #1

    the real amusement is contained in the fact that politicians hold absolutely no sway over where interest rates go anyway.

  2. Jill Rush
    September 2nd, 2004 at 23:54 | #2

    What is hard to understand is why the real issue of affordable housing isn’t being dealt with. How disappointing to hear Mark Latham say that he wants private ownership of housing when what is required is to deal with homelessness through far more public housing which won’t discriminate, as the current market fix does, against sole parents, which provides housing with enough rooms to cater for the families of refugees, which offers a decent home for workers unable to break into the housing market and could offer Indigenous peoples decent housing.

  3. September 3rd, 2004 at 00:51 | #3

    Ken Davidson has a good article on the determinants of Australian interest rates which are:
    domestic inflation rate
    global base rate (for net dissavers)
    exchange rate volatility (commodity prices)
    interest rate risk (for large debtors)
    Of these, only the domestic inflation rate has unambiguously gone down, after the ’91 crash.
    The global base rate of interest is on the way up, given PRC prudence and US improvidence.
    Exchange rate volatility is still high, as the swings in our currency show, which entails an interest rate premium for AU-denominated holders of our foreign debt.
    Our credit ratings, and hence debt default risk premiums, are still not bad, as Australian mortgaged backed securtites are given a blue-chip rating by S&P.
    Davidson neglects to mention that the real rate of interest has declined due to a squeezing of the oligopolistic banks gross margins, following the (much decried by certain Green-Left economists) deregulation of the financial industry.
    The new High Street mortgage providers are a little shonky in their credit ratings but their competition has driven down the wholesale cost of credit and hence the retail interest rate.

  4. James Farrell
    September 3rd, 2004 at 01:06 | #4

    “…the link between budget deficits and interest rates (via crowding out) is not all that strong.”

    Well, I’m glad to hear you say this, John. And to my relief a solid bunch of qualified people, including Bob Gregory, said much the same on the 7.30 Rerport.

    I would go further and ask why you think there is any link at all. If despite thinking about this for twenty years I’ve failed to grasp some basic principle, then it’s really high time this lacuna was filled in.

    As far as I can tell, the interest rate is determined by the Reserve Bank, with a view to the inflation rate. The budget balance is the outcome of a very large number of processes. The crowding out could only work through two mechanisms, both very weak:

    1. If a deterioration of the budget balance is the consequence of a discretionary increase in government spending and/or a reduction in tax, and if this occurs at full employment, it may create inflationary pressure, prompting the RBA to raise the interest rate.

    2. If the aforesaid increase in spending results in a sudden current account deterioration and the threat of capital flight, the RBA might raise the interest rate to support the exchange rate.

    In any case, I remain baffled why journalists with even a moderate understanding of economics keep promoting the myth of a strong and self-evident link beween budgets and interest rates, and letting the likes of Costello capitalise on it. As for Latham, he just gets weirder all the time. Why doesn’t he try to educate the public about macroeconomics instead of getting himself tangled up in this nonsense? His stunts are even more embarrassing than Bob Carr’s.

  5. September 3rd, 2004 at 07:22 | #5

    For hundreds of thousands of people, John Howard’s allusion to 17% interest rates, is genuinely scary.

    That’s because we (me included) don’t understand how or why interest rates go up and down, but we do understand that 17% would mean significant personal hardship, perhaps homelessness. Without that understanding, it comes down to trust – we all asked ourselves, “Do I trust Mark Latham enough to bet my house?” Some of us may also read opinion and comment by a range of economists and draw conclusions from that, but not the majority.

    Mark Latham’s cardboard signing was cheesy, and I bet he felt silly doing it. Should he instead have tried to “educate the public”? Maybe over the next two years, but not in the midst of an election campaign.

  6. stephen
    September 3rd, 2004 at 11:07 | #6

    James, agree with you in general, the links are weak. Just a thought that occurred to me in reading this – could another factor in the relationship have to do with financial market sentiment? ie, running significant public sector deficits would increase the perceived riskiness of Australia and thus flow through to increased rates. I think there is a case that this relationship exists – not as a consequence of any economic fundamentals but based solely on the perceptions of the markets. IMHO it is not a necessary connection, but it is a rod we have made for our own backs through surplus fetishism. Australian governments have made maintenance of a surplus (no matter how small, as long as it is a surplus) the touchstone of good economic management. In examining any budget market analysts don’t go in to the budget details, they just look to see if it is in surplus, and if yes, the economy gets a tick. they don’t bother to look at how the surplus is derived (at least this is my experience in dealing with the budget response from such analysts). Were Australia to adopt a more sensible fiscal target – for example net worth – and make this the key measure of governments’ economic management, then the story might change.

    BTW, I do think there was a more plausible basis to the crowding out theory many decades ago when access to foreign capital was constrained and our domestic capital market smaller – but globalised financial markets have put an end to that.

  7. Homer Paxton
    September 3rd, 2004 at 11:08 | #7

    The howard thesis has a problem.
    17% interest rates coinciced with a budget surplus.
    And if budget deficits cause upward rises in interest rates then why is the US of A with a budget deficit of 6 1/2 % of GDP have double digit rates?

    Lastly why does Iron Mark who possess an honours degree in economics fall for such rubbish!

  8. Mark Upcher
    September 3rd, 2004 at 20:35 | #8

    If we accept Labor’s economically flawed pledge to maintain surpluses will be honoured, the only remaining part of the Labor policy that could conceivably lead to higher interest rates is its industrial relations policy. This could happen if the policy lead to a wages breakout that fed into inflationary expectations and forced the RBA to tighten policy.

    However, my reading of that policy is that the two main changes would be (a) the abolition of workplace agreements and (b) relaxation of unfair dismissal laws.

    In regard to (a), the vast bulk of employees are still covered by awards (Commonwealth or State) or enterprise agreements. It is not clear that this reform will have much impact on wage outcomes. Many Australian Workplace Agreements (AWAs) involve the negotiation of above award outcomes. It is, therefore, hard to believe that these changes will lead to a wages breakout.

    In regard to (b), there have been a number of studies of the impact of unfair dismissal laws and some have shown shown a possible impact on unemployment. But I do not recall any studies showing they lead to higher wage outcomes.

  9. James Farrell
    September 4th, 2004 at 12:50 | #9

    I agree with Stephen’s points.

    Mark has identified another conceivable mechanism connecting Labor and high interest rates, and dispatched it effectively as a serious consideration.

    But Mark’s opening sentence suggests that he does, after all, accept the story that lower budget balances cause higher interest rates. If so, I’m still curious – and open-minded – about the connection.

  10. John Quiggin
    September 4th, 2004 at 14:59 | #10

    James, in a closed economy, at full employment, without Ricardian equivalence and with a money growth rule for monetary policy, the links ought to be clear enough. Less government saving implies less saving at any given interest rate, so interest rates must rise to equilibrate.

    The economy isn’t closed, but it isn’t entirely open either and in this context a lot depends on what the Reserve Bank does. I think the Bank probably doesn’t ignore the stance of fiscal policy completely, so a large deficit might make it more inclined to raise interest rates, though I think the effect would be small.

  11. James Farrell
    September 4th, 2004 at 15:46 | #11

    John, I think you’re saying that if we were in an ISLM model with an essentially fixed money supply, the links would be clear. Sure. But we’re not. We don’t have a monetary target, so the Bank can accommodate additional demand for money as long as there is no inflationary pressure. But there will by definition be inflationary pressure if we are at full employment. So they will raise the interest rate. This is just my Mechanism 1. And it’s weak for all the reasons we are all agreeing on.

  12. Alan Reynolds
    September 17th, 2004 at 04:45 | #12

    A paper of mine examining the logic and evidence behind claims that budget deficits raise interest rates or cause “twin deficits� was originally presented at the U.S. Treasury and later published by the Cato Institute. I concluded: “In reality, neither actual nor projected budget deficits raise real or nominal interest rates, steepen the yield curve, reduce national savings, cause ‘twin deficits,’ or make the dollar go up or down. The logic behind such speculations is flawed and contradictory and the evidence is nonexistent� (http://www.cato.org/pubs/pas/pa-517es.html).

    Two studies have appeared since mine. One by Eric Engen and Glenn Hubbard estimated that budget deficits may have a trivial effect on interest rates, with each 1 percent of GDP lifting interest rates by merely two or three basis points (figures too close to zero to inspire much confidence). An ambitious econometric study by Roger Kormendi & Aris Protopapadakis, covering the diverse 1976-2002 U.S. experience, found “no evidence of any positive effects of either current or expected future budget deficits on either real interest rates or current account deficits.�

    Since Australia has run budget surpluses since 1998, while Japan has had deficits averaging 5.8 percent of GDP from 1994 to 2003, conventional Keynesian theory cleary predicts that interest rates must be much higher in Japan (and the U.S.) than in Australia. Australians and New Zealanders (Mr. Oliver) have to pick between such obvious facts and their (archaic British) theory. I predict that many will prefer the theory.

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