Interest Rates, Budget Surpluses and Other Economic Fallacies

By: Gerard_Jackson

One only has to read the financial pages of any newspaper to fully experience the poverty of economic thought that pervades the media. It is important to understand that what is considered by the media as sound economics is — bye and large — merely a reflection of the economic thinking that dominates the Treasury and the Reserve Bank. Terry McCrann — Herald Sun finance writer — is an excellent example of what I mean. I want to make it clear, however, that I am not picking on McCrann. I am only trying to clear the economic waters that the likes of McCrann have inadvertently muddied.

As we all know the Reserve recently raised interest rates. McCrann’s Panglossian response was to argue that the rise was telling us how good the economy really is. He then compounded this economic faux pas with the opinion that the Reserve’s successful manipulation of the money supply had prolonged the boom and that this was likely to continue. In addition, he surmised that one could

make a theoretical case that if the government had run a $40 billion budget surplus each year instead of a $15 billion one, then rates would on balance have been lower. ( I’m certainly not sorry, John , 8 November 2007)

The previous day McCrann had defended the rate rise on the peculiar grounds that it was the product of rising prosperity. ( Higher rates a consequence of our prosperity , 7 November). That it was the result of a criminally loose monetary policy never entered his head. Unfortunately this is also true of every other economics commentator. And it is certainly true of Treasury and Reserve Bank officials.

As is always the case with this lot, the missing element is money supply, something I have been stressing for more years than should be necessary. So here we go again. From March 1996 to July 2007 currency grew by 101.6 per cent, bank deposits by 177.7 per cent and M1 by 169 per cent. Now from August 2006 the Reserve let M1 jump by 16 per cent. Bank deposits rocketed by 18 per cent while currency rose by 6.6 per cent.

It’s perfectly obvious that the largest component of M1 is credit, and this is where the inflation is really taking place. But neither McCrann, the rest of the media nor his pals in the Reserve cannot make the connection between monetary expansion, interest rates and the current account deficit which is running at over 6 per cent of GDP. (The Reserve’s monetary policy also rests on the implicit assumption that money is neutral and that capital is homogeneous).

Believe it or not, readers, there was a time when any economist worth his salt would have immediately pinpointed the cause of our ailing current account deficit. For example, Heilperin stated:

In a free economy the principal cause of a cumulative deficit in a country’s international payments is to be found in inflation. . . In a country whose currency is not convertible into gold, inflation leads to its continuous devaluation in terms of foreign currencies. (Michael A. Heilperin, International Monetary Economics , Longman’s, Green and Co., 1939, p. 123).

The same goes for our private debt which now exceeds 160 per cent of GDP. Yet these people — and that includes the media — are unable to find a link between our accumulating debt and monetary policy. One can only draw the conclusion that money for this lot really does not matter. So where do they think all this spending power came from? They’re not saying because the question is never raised — at least among themselves.

The Reserve’s monetary policy has distorted domestic production, given us a sky-high private debt problem, fuelled the current account deficit and created a massive housing boom. And what does McCrann give us? Panglossian economics. The key to the problem is interest rates. These have been raised by the Reserve — even though it does not realise it — to curb its only monetary excesses!

We now come to deficits and interest rates. McCrann’s view that a bigger surplus would have lowered interest rates is firmly rooted in the mercantilist fallacy that interest rates are determined by the supply and demand for money. In other words, interest rates are a monetary phenomenon. (Keynes also subscribed to this fallacy). In reality, interest is the price of time. But mainstream economics has it that it is the productivity of capital that creates interest. Böhm-Bawerk was able to show that productivity theories of interest were untenable*. In his critique of various interest rate theories he made the correct observation that interest

. . . Can be derived from any capital, no matter what be the kind of goods of which the capital consists, from naturally fruitful, as well as from barren goods, perishable as well as from durable goods, from replaceable as well as from irreplaceable goods, from money as well as from commodities. (Böhm-Bawerk, Capital and Interest Vol. I, Libertarian Press, 1959, p. 1. Also see chapters VII and VIII for a comprehensive critique).

The only way a surplus could relieve pressure on our interest rates is by keeping aggregate money spending lower than it would otherwise be, which brings us to the method by which the surplus was accumulated. Monetary policy raised nominal incomes and lifted aggregate spending. This increased tax revenue. Dollars set aside for the deficit have been deposited with the Reserve. In a sense, then, they have been temporarily sterilised even though they are still part of the money supply.

From this we deduce that upward pressure on interest rates comes from the government competing with the private sector for funds. Therefore the surplus did not create a favourable environment for investment. The effect of the fallacy that surpluses lower interest rates is to divert attention from government spending, which has increased significantly under the Howard Government.

The fallacy that interest rates can be manipulated so as to raise investment and real incomes is a very old one. In 1621 Sir Thomas Culpeper — a proto-Keynesian — argued that a low rate of interest explained Holland’s prosperity. ( Tract Against the High Rate of Usury , 1621). His solution was for the English government to set the maximum interest rate at the Dutch level. Culpeper’s son was still pushing this line in 1688, in this he had the support Sir Josiah Child.

Fortunately men like Edward Waller and Colonel Silius Titus were able to perceive the fallacy. They rightly pointed out that interest was a market phenomenon and that it was prosperity that gave Holland lower interest rates. In support of their argument they challenged Culpeper to explain that if lower rates are the result of legislation how was it that the Dutch managed to have lower rates in the absence of such legislation. Culpeper found himself without an effective response. (It is now 2007 and we find that the media, the Reserve Bank and the Treasury are riddled with little Culpepers).

We could conclude that the Culpeper debate demonstrated that rich counties would have lower market rates of interest than poor counties. Is this true? Yes and no. Hayek explained that because in the short term capital goods and the supply of consumer goods are basically fixed the rate of return

. . . will depend not so much on the absolute quantity of real capital (however measured) in existence, or on the absolute height of the rate of saving, as on the relation between the proportion of the incomes spent on consumers’ goods and the proportion of the resources available in the form of consumers’ goods. For this reason it is quite possible that, after a period of great accumulation of capital and a high rate of saving, the rate of profit and the rate of interest may be higher than they were before — if the rate of saving is insufficient compared with the amount of capital which entrepreneurs have attempted to form, or if the demand for consumers’ goods is too high compared with the supply. And for the same reason the rate of interest and profit may be higher in a rich community with much capital and a high rate of saving than in an otherwise similar community with little capital and a low rate of saving. (Friedrich von Hayek, The Pure Theory of Capital , The University of Chicago Press, p. 358).

What is being said is that the rate of interest will rise if consumption increases relative to investment. This is the kind of thing that is never discussed here. Instead we have economic commentators peddling egregious fallacies.

By Gerard Jackson
BrookesNews.Com

Gerard Jackson is Brookes' economics editor.

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