Andrew Charlton on interest rates and the election

Andrew Charlton has an article in the new Monthly about the myths surrounding interest rates and government. Excerpt:

The second aspect of the government's economic spin is that budget deficits cause high interest rates. ... At the launch of his 2004 election campaign, Howard said, "Nothing is more certain than if economic policy is allowed to slip into the hands of those who, when they last had control of it, delivered five budget deficits in a row, that there will be massive upward pressure on interest rates."

There is, in theory, a relationship here. It is as follows: if the budget is in deficit, then the government's tax intake is less than its spending. To pay the bills, it must borrow the shortfall. And when the government goes to the money markets to borrow, it increases the demand for the pool of available funds for loan. By increasing the demand for funds, it raises the price of funds: that is, the interest rate. If the government adds itself to the queue of people wanting money, it makes it harder and more expensive for the private-sector borrowers to get cash, meaning that they are less likely to borrow and less likely to invest and spend.

This sounds logical, and indeed it is. It's logical, but it is not significant. Australia is, of course, part of a global economy: neither the nation's government nor its businesses are constrained to borrowing in the domestic economy. They meet their financing needs not just in the lap pool of Australian savings but in the ocean of world savings; and the impact of the government's borrowing on global debt markets is near negligible.

This is a principle well known in the United States, which has long since lost the fiscal fetishism that still holds Australians in the thrall of budget surpluses. Says the American journalist James Ledbetter: "Today the thesis that such measly sums [moderate budget deficits] could control or even significantly influence the overall economy will produce, at best, polite throat-clearing from the average American banker of businessperson."


...

When government's face recessions and crises of confidence, they try to prime the pump by spending and going to debt, to get shoppers back in the malls and CEOs back in the investing game. At the same time, the central bank pitches in by cutting interest rates to defibrillate the economy with a shock of cheap credit. In recessions, low rates and high deficits go hand in hand. Even in a boom, where excessive government spending can over-stimulate the economy, the relationship between rates and deficits is weak.

...

[M]onetary policy is based on the level of activity in the entire economy, of which stimulus from the government is just one small part.

Charlton describes wonderfully the precise moment when Labor lost my vote at the last federal election:

In 2004, the then Opposition leader, Mark Latham, had the opportunity to call Howard's bluff, to point out the errors in the prime minister's claims about interest rates and trust that an honest argument, backed by economists and the Reserve Bank, would cut through the the electorate. Instead, Latham proffered a marker pen and an oversized sheet of cardboard inscribed with three promises that made up what he called the "Labor Low Interest Rate Guarantee". Sheepishly, Latham signed a commitment to put "downward pressure on interest rates" by, you guessed it, "keeping the budget in surplus ... and bringing down net debt".

With that one gesture Latham told Australians that the bogus link which the Coalition had made between deficits and interest rates was genuine, that Labor had a lot to apologise for from its last time in government, that the only way for the party to be accepted in the political mainstream was to confess its sins and never re-offend. Standing on the podium in front of the cardboard guarantee, Latham looked like a schoolboy blustering his way unprepared through a class presentation. He looked down at the ground as he uttered the phrase "fair dinkum". He knew he was being dishonest, and knew he was selling out past Labor governments and making it harder for future Labor leaders.

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The former Governor of the Reserve Bank, Ian Macfarlaine, gave last year's Boyer Lectures. I recommend it if you want to know more about what the Reserve Bank does, why interest rates change, and what influence government has on it. You can listen to them online here.