Since the middle of last year the US Federal Reserve has reduced interest rates from 5.25% to 3%, most of that reduction coming in the past fortnight.
Faced with a looming recession, the housing debacle and a sharemarket reaction, the Administration, Congress and the Fed have reacted with deficit spending and an expansion of credit availability.
The economic commentariat in Australia has focused on inflation increases and has been forcefully promoting fiscal tightening (by increasing the budget surplus, thus effectively raising taxes) and higher interest rates. Reserve Bank watchers are almost unanimous in predicting an increase in official rates when the bank meets next week. The RBA has been increasing official rates since mid-2002 and the cash rate now stands at 6.75%, 0.5% up in the past six months.
The official reactions in the US are ill-judged and likely to store up problems for the future control of spending and inflation. They also signal to risk takers that the authorities will back them if their excesses get them into difficulties.
Even so, for Australia to adopt the opposite policies, even if they were appropriate in a self-contained economy, is risky. Not only are interest rates a key factor in the money supply but interest rates, budget and trade balances, domestic savings and investment, production and employment are all interconnected.
The first thing to happen if interest rates are raised in Australia when they are being reduced elsewhere will be a vast increase in capital inflow.
Australia is already running a big imbalance in its goods and services trade. Imports over the past year were $216 billion, or more than 8%, higher than exports. And although 8% is about the average since 1980, persistent capital inflows of this magnitude for an economy that is not experiencing stellar economic growth brings vulnerabilities. Debts always have to be repaid or serviced and this means tightening belts down the road.
In real terms the capital inflow and the high interest rates behind it imply Australians are not saving enough. Using government budget surpluses to combat this is an inadequate incentive to save created by the tax system. This is compounded by housing policies that in restricting land availability have forced up house prices. Nationally, half of household wealth is now tied up in housing, the price of which has been artificially inflated by regulatory policies.
The Government does not seem to have understood the importance of these distortions and, in any event, unwinding them cannot be done overnight.
Using higher taxes to mop up excess demand may have merit but using higher interest rates for the same purpose risks of causing considerable damage. Sucking in overseas capital puts upward pressure on the Australian dollar, such as happened yesterday after the US increased rates.
A higher dollar may dampen inflationary pressures but it will also reduce the competitiveness of exporters and companies competing with imports, which can result in lower output and employment in those sectors.
Hence an exclusive focus on inflation, which is the RBA's sole domain, can cause more harm than good if other policy settings are misaligned.
In the context of the turmoil created by a US Administration intent on boosting demand and a US Federal Reserve focused on bailing out those who have made poor business decisions, a further interest rate rise now could send the Australian economy into a recession that could be difficult to restrain.
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