Rate medicine might cure nation's spending binge

Even though the decision of Mitsubishi to close its plant in South Australia preceded Wednesday's interest rate increase, the two are closely linked.

The interest rate increase was the eleventh since mid 2002.  And it has come in an environment when the US Federal Reserve is reducing interest rates.

Australia's interest rate increase is a consequence of inflationary trends.  In the US, the Fed, confronted by evidence of similar trends has been panicked by the looming recession into reducing rates.  That is probably storing up even greater future inflationary problems for the US but has immediate consequences for Australia.

Australia's Reserve Bank has taken the view that it must focus only on inflation and the sole weapon it has to combat inflation is controls over interest rates.

The real cause of Australia's inflation is excessive spending.  This results not from government budget deficits -- the sort of mismanagement we saw 1980s.  Today's excessive spending is caused by people saving too little and borrowing too much.  These developments are, in turn, due to the incentives the tax system gives us to avoid saving.

Unlike in those countries that have high savings levels -- India, China and so on -- our own savings are penalised by the tax system.

Australian incomes that are saved pay a tax first when they are earned and later on the interest income they receive.  Such measures leads us all to prefer spending and, increasingly, borrowing for houses that have seen rising prices as a result of government planning restraints.

Though interest rate increases seek to redress this, they are inferior to attacking the problem at its roots.  They have several adverse effects in addition to mortgage pain.

And this is where the link with Mitsubishi comes.  It is high interest rates, not the resources boom, that are bringing an increase in the Aussie dollar.

High interest rates, as well as dampening down domestic spending also attract overseas lending.

Payments and receipts from overseas must, however, be kept in balance.  The increased overseas borrowing therefore requires us to export less and buy more imports.

To bring about this balance the value of the Aussie dollar has to increase.  This reduces the competitiveness of those Australian goods and services that can also be supplied from overseas.

Many thought the Aussie dollar was already excessively valued before the start of 2007.  Since then however, it has risen 14 per cent against the US dollar and 7 per cent on a trade weighted basis.

The side-effects of higher Australian interest rates mean an Australian dollar that is worth more than it should be.  That's great for those on overseas trips and for buyers of plasma tvs, computers, and other goods that are not produced in Australia.

Mitsubishi was doubtless the car manufacturer most vulnerable to those external pressures impacting on Australian manufacturing competitiveness.  But all the domestic car assemblers and a host of other manufacturers facing overseas rivals will be feeling the pinch.

This demonstrates the interconnectedness of all things economic.  Once we have created a situation where domestic spending is excessive, the antidote of interest rate hikes is strong medicine that brings collateral damage across the board.

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