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RBA decision exemplifies a deep macro policy imbalance

Today, the Reserve Bank of Australia (RBA) announced that its policy rate will rise by 0.25 per cent to 4.5 per cent. This will push mortgage rates well above 7 per cent. Every time the RBA lifts its rate by 0.25 per cent, the average mortgage holder is $A46 a month worse off. Since this tightening cycle began in October 2009 there have been 6 such rises which makes the average mortgage holder $A276 per month worse off than they were in September 2009. Most will be even worse off given that the commercial banks have been gouging larger proportional increases over this period. The decision also comes in the same week that the Final Report of the Australia’s Future Tax System Review was released. The Government has rejected certain recommendations from that Review which were aimed at providing a fiscal redress to the tightening housing market and by implication reducing the need for monetary policy tightening. What this tells me is that the neo-liberal economic policy dominance that pushed the world into the current crisis remains firmly in place. The result will be entrenched labour underutilisation, rising housing stress and ultimately another economic crisis. Maybe the next crisis will see the demise of this nonsensical approach to macroeconomic policy making.

In the statement from the RBA Governor we read that:

Recently, forecasts for world GDP growth have been revised up again, and growth is expected to be at trend pace or a little above in 2010 … In Asia, where financial sectors are not impaired, growth has continued to be strong, contributing to pressure on prices for raw materials …

Australia’s terms of trade are rising by more than earlier expected, and this year will probably regain the peak seen in 2008. This will add to incomes and foster a build-up in investment in the resources sector. Under these conditions, output growth over the year ahead is likely to exceed that seen last year, even though the effects of earlier expansionary policy measures will be diminishing. The process of business sector deleveraging is moderating, with business credit stabilising and indications that lenders are starting to become more willing to lend to some borrowers, though credit conditions for some sectors remain difficult. Credit outstanding for housing has been expanding at a solid pace. New loan approvals for housing have moderated over recent months as interest rates have risen and the impact of large grants to first-home buyers has tailed off. Nonetheless, at this point the market for established dwellings is still characterised by considerable buoyancy, with prices continuing to increase over recent months.

Recent data on inflation confirm that it has declined from its peak in 2008 … and … now appears likely to be in the upper half of the target zone over the coming year …

The Board expects that, as a result of today’s decision, rates for most borrowers will be around average levels. This represents a significant adjustment from the very expansionary settings reached a year ago.

So an emphasis on housing markets and not a word about the labour market other than static wages growth has been evident over the last 12 months.

I am always in two minds when it comes to thinking about these decisions. On the one hand, monetary policy is a very ineffective means of managing aggregate demand. It is subject to complex distributional impacts (for example, creditors and those on fixed incomes gain while debtors lose) which no-one is really sure about. It cannot be regionally targeted. It cannot be enriched with offsets to suit equity goals.

So, fiscal policy (when properly designed and implemented) is a much better vehicle for counter-stabilisation. However, the impact of monetary policy also has to be considered in relation to the levels of debt that households are currently holding. Australian households have record levels of debt and in the financial crisis lost a large slab of their nominal wealth. The RBA has always claimed that the debt was manageable because asset values were rising at a faster rate.

I always found the argument to be dubious given that a rising proportion of the “assets” being purchased with the increased debt were subject to significant private volatility (for example, margin loans to buy shares). But even more troublesome was the direct link between the debt-binge and the real estate booms which have pushed “investment” funds into unproductive areas at the expense of other areas of economic activity which would have generated more employment.

Part of the genesis of the financial – then real – crisis has been the skewing of economic activity towards “financialisation” and away from productive enterprise. So I found the RBA’s line unsatisfactory in that respect. Moreover, now that the household sector has responded to that sort of encouragement, the RBA thinks it is reasonable to punish the most marginal of this group with higher interest rates. Some people will default on their housing mortgages as a result of today’s decision.

The other reality is that the recession was not deep enough in Australia to really force a significant de-leveraging within the private sector. There is still considerable vulnerability there despite the rising household saving ratio.

I will come back to the macroeconomic policy imbalance in Australia presently.

Current inflation trends

What is the current inflation data telling us? In this blog – Rates go up again down here – I provided an explanation of the different inflation measures that are published in Australia and how the RBA uses them. Some of the measures used attempt to derive a central tendency by giving lower weighting to volatile elements. One such “trimmed” measures that is used by the RBA is the “the 15 per cent trimmed mean (which trims away the 15 per cent of items with both the smallest and largest price changes)”.

The following graph shows the four (data) that are published by the ABS – the annual percentage change in the all items CPI (blue line) and the annual changes in the trimmed mean (green line). The two red horizontal lines represent the upper (3 per cent) and lower (2 per cent) bound that the RBA targets.

My interpretation is that inflation has moderated and is within the RBA’s inflation target band.

Rising housing prices

Yesterday (May 3, 2010), the Australian Bureau of Statistics released the latest House Price Indexes: Eight Capital Cities for the March quarter.

This series is now used a key indicator for the likely direction of interest rates – but in saying that I also note that this dependence exemplifies the imbalance in the use of aggregate policy in Australia in this neo-liberal era. I will come back to that point later.

The price index for established houses for the weighted average of the eight capital cities increased 20.0 per cent in the year to March quarter 2010 which the ABS said was the “largest annual increase since the series commenced in March quarter 2002”. It is only a preliminary result and could be revised next quarter.

The following graph shows the annual changes in the housing price index since March 2004. This data release sent commentators into a lather and it was claimed that it guaranteed that the RBA would hike interest rates again today – which they did.

These price movements have to be put in the context that Australia has the most unaffordable housing market according to the Sixth Annual Demographia International Housing Affordability Survey published in 2010:

In Australia, there is consensus in both government and the private sector that there is a severe housing crisis, with rampant unaffordability and a housing shortage … across Australia, conditions appear to be worsening.

The national distribution of housing affordability is indicated in Table ES-4 which is taken from the Demographia study and shows that Australia has the worst relative outcomes of the countries included in the survey.

The primary reasons for the appalling housing situation in Australia has been dysfunctional planning systems (under neo-liberal ideology governments abandoned regional development strategies and downgraded non-market planning) and a chronic lack of supply, particularly in public housing.

The other factor has been the push by the Government to increase the population growth rate via immigration. They have been consistently lobbied by industry to increase migration to ensure a steady supply of skills as the economy grows.

This policy is being promoted at the same time that the Australian economy has around 12.8 per cent of its willing labour resources underutilised (that is unemployed or underemployed). Further, this situation has persisted for years now and even at the top of the last boom the broad underutilisation rate was around 9 per cent.

So you might ask why the unemployed and underemployed who have had to endure the costs of the government’s failed macroeconomic strategy of high interest rates and increasing budget surpluses (up until the crisis) have not been provided with sufficient opportunities to develop the requisite skills.

Why would we ignore the idle labour resources we already have in abundance and, instead, bring in migrants who then push up demand for housing?

Answer: ideology – the unemployed serve a purpose – to keep wages growth down and allow a rising profit share to occur unopposed.

I considered these issues in more detail in this blog – The Australian labour market remains tepid.

In this blog – Asset bubbles and the conduct of banks – I considered what the best policy approach to price rises in specific asset classes as opposed to generalised inflation driven by aggregate demand outstripping the real capacity of the economy.

I also considered the issue of public housing and the pending tax review in Australia.

The Australian Government instigated Australia’s Future Tax System Review in 2008 and it was chaired by the Treasury boss Ken Henry. The Final Report was made public last Sunday (May 2, 2010).

In a major speech in October 1, 2009, Treasury boss Ken Henry argued that apart from the ridiculous generosity to high income earners via the concessional superannuation the graph also shows that:

Ignoring local property levies, whose incidence is most probably capitalised into property values, owner-occupied housing is outside the capital income tax base and faces a zero effective tax rate.

Rental properties, however, face different effective tax rates depending on the financing choice of the saver – a low positive effective tax rate when equity financed but a negative effective tax rate when geared. The tax treatment of a negatively geared property would typically involve the taxation of rental income and the deduction of interest and other expenses at the full personal marginal rate, with capital gains taxed at a half rate due to the capital gains tax discount. This throws up a significant asymmetry.

It has long been the case that so-called negative gearing distorts the housing market and inflates asset prices. The Australian Taxation Office (ATO) permits real estate investors (in rental and other non-owner occupied property) to reduce their taxable income by claiming losses on the property.

Those with high incomes can gain very significant tax concesssions by purchasing several investment properties and running them at a loss (thereby reducing their current taxable income) and then, eventually, cashing in on the capital gain sometime in the future.

So given the housing crisis in Australia, one might have expected negative gearing to be a major focus of the tax reform.

We read on Page 410 of the Volume 2, Section E4, which covers housing affordability, that:

Australia currently has one of the highest rates of home ownership in the OECD. In total, 68 per cent of Australians own or are buying the home they live in, compared to an OECD weighted average of 63 per cent.

While I was hoping that the Tax Review would recommend the scrapping of negative gearing, they only recommended modifying the scope of it to reduce the capacity of high-income earners to write down their income tax obligations via the “losses” and they also recommended increasing the capital gains tax to further erode the incentive to engage in unproductive real estate speculation.

In response to the Tax Review’s proposal to rational all the current investment tax breaks with a single 40 per cent discount on the marginal tax rate, the Australian government said that they would “would never reduce the existing concessions on negative gearing and capital gains tax” (Source).

The ABC economics correspondent Stephen Long, wrote that “Rejecting negative gearing changes is ‘cowardice'”. Long quotes a senior property valuer in NSW as saying:

Negative gearing inevitably puts house prices up because what happens is you get investors competing with first homebuyers who are also being incited to enter the property market and those investors and first homebuyers compete with mums and dads in the very same property market,” he said.

This inevitably puts pressure on property prices, disadvantaging those people in the middle which are generally regarded as your mum and dad property owners.

So the Government is once again demonstrating that it cannot manage fiscal policy in the national interest. They have fallen prey of the very influential real estate and housing developer lobby in Australia who cannot see beyond their vested interests. They have always fought to keep the negative gearing handout.

For example, in 2007, the Property Council of Australia, who amuse me everytime I see their logo which says – The Voice of Leadership, said this in relation to the deteriorating housing affordability crisis in Australia.

One suggestion which continues to be a focus of attention is the idea that negative gearing should be abolished. The argument goes something like this: negative gearing allows investors to offset the losses made on investment properties against other forms of income, thus lowering taxes … This makes investment properties sought after and, because of demand, raises prices. So, it is thought, eliminating negative gearing will keep home prices from rising. In reality, there would be far less rental property available if it weren’t for this provision because the investment property would become less attractive relative to other investment opportunities … Those without the resources to buy would simply suffer, those who could buy, would, replacing the demand gap left by investors and so keep demand (and price) from falling.

They went on to say that “‘negative gearing” is ‘negative’ … [because to get the tax benefit] … the investor must make a loss on the vestment property”.

First, if you eliminate the tax gains via negative gearing and force the investors to bear all the costs then the assessment of capital gains become more intense and important. If you, in turn, tax the capital gain more rigorously then you can mostly eliminate the speculative market for housing. People will still compete for the scarce assets but within a much different costs and benefits environment which would put a brake on the speculative excesses (for example, owning multiple properties).

Second, a crucial point about the arguments surrounding rental property availability, is that they usually ignore the provision of public housing and never consider the obvious solution for low-income earners – a publicly-provided fund for house purchase.

Public housing has been subjected to the neo-liberal attacks on government spending over the last 20 years or so and waiting lists remain very high. There is a huge shortage of low-end housing stock in Australia as a result.

The Treasurer was reported as saying that the Government “rejected recommendations from the Henry review that did not fit with Labor values and philosophy”. We should always remember that the Labor Party, which is now in government began as the political arm of the trade union movement but has shifted well away from that value-base over the last 30 years.

In that regard, since when has been the policy of the workers’ party to use tax policy to redistribute public spending (effectively) to the richer citizens who can afford to sustain the cash losses on multiple, highly-geared properties, in order to gain the negative gearing tax advantages – not to mention the capital gains that follow down the track?

My perspective is also reflected in comments made by a leading property valuer in NSW. ABC’s Stephen Long wrote that he “says subsidising the high-income earners who invest in property at the expense of low and middle-income families is a strange reflection on Labor values”. The valuer was then quoted as saying:

Essentially what happens today is that taxpayers subsidise investors. We subsidise them when interest rates go up by the tune of their marginal tax rate, which might be as much as 48 cents in the dollar … It’s a regime that encourages investors to make losses which is inevitably picked up by the taxpayer. Then taxpayers subsidise the capital gains.

Well from a Modern Monetary Theory (MMT) perspective I would not put it in this way but the point is clear. Those who can afford to take out multiple home loans for investment properties and have the cash flow to “fund” the losses to secure the tax advantage, enjoy higher disposable income and then cash in later on the very generous provisions applying to capital gains.

A worker without access to mortgage credit or without sufficient income to fund the cash losses associated with negatively-geared rental properties can never enjoy these advantages as the following graph from the Henry Review demonstrates.

The following graph is taken from Volume 2, Section E4 – Chart E4-5 and shows that advantages of the current tax system for highly geared individuals investing in rental property.

The problem is that the policy environment has become so politicised that the government will allow monetary policy to indiscriminately scorch aggregate demand – whether it be for productive investment or house speculation – while they provide massive fiscal redistributions from poor to the rich via their distorted tax system.

The rentier class, which is a powerful political lobby in Australia, has always argued that the negative gearing benefits ensure there is an ample supply of rental accommodation always available. However, if our governments were less obsessed with running surpluses and abandoning their responsibilities to provide first-class public housing then we could have as much rental housing as was required at all time, administered within the public sector.

The neo-liberal years have seen the provision of public housing fall dramatically.

In a recent AHURI report – What future for public housing? A critical analysis – there is an interesting account of how the neo-liberal era has dramatically changed the way public housing provision is seen by governments.

The author says:

Such neo-liberal ideology has guided key agencies managing UK and Australian public housing services (Beer et al. 2007). Examples include the requirement that public housing should be only made available for those with acute needs, the introduction of probationary tenancies as a way of regulating behaviour, and providing subsidies to landlords to encourage investment in the private rental market … public housing should remain a residual service, targeted only at those in acute need.

This approach has delivered a substantial decline in the stock of public housing available and a marginalisation of the tenants of such housing. The following graph is taken directly from the AHURI report and shows the ideological swing in public house provision in Australia. Prior to the neo-liberal onslaught, government was strongly involved in ensuring there was an adequate stock of public housing

After 30 or so years of cutbacks, Australia now has a considerable shortage of public housing at a time when housing affordability is at all time lows. It is abundantly clear that the economic rationalist approach based on the primacy of the private market does not provide adequate housing for all Australians.

Macroeconomic policy distortions

What all this leads to is the conclusion that macroeconomic policy in Australia is very imbalanced and relatively ineffective.

Today’s RBA decision is further evidence that things are returning to the pre-crisis emphasis on monetary policy. The main macroeconomic policy agenda since the neo-liberal paradigm became dominant gas not been to operate the monetary system to its potential (that is, to achieve full employment and price stability) but rather to hamstring fiscal policy to give more space for the private profiteering.

The neo-liberal assualt was mounted on two fronts. First, the capacity of workers to gain wage rises was attacked to ensure more of the real product was available to the profit share. The neo-liberals have been very successful in this quest – pressuring governments to bring in anti-union legislation and diminished safety net procedures (that is, minimum wage adjustments).

Second, the effectiveness of fiscal policy was denigrated and monetary policy was promoted as the primary counter-stabilisation tool.

Despite fiscal policy “saving” the world from a major depression, monetary policy remains firmly entrenched as the macroeconomic counter-stabilisation policy tool of choice. I should add that the concept of counter-stabilisation has also been diminished in the last few decades and should now be taken to mean – a singular focus on inflation control – with key components of the real economy (for example, unemployment) now being seen as a policy tool to be manipulated in search of price stability.

So the concept of counter-stabilisation now focuses on inflation rather than income and employment. This is a reflection of the NAIRU belief that if an economy achieves price stability it will enjoy maximum growth potential and full employment. There is no hard research evidence to support this belief.

As I explained in this blog – The Great Moderation – the costs of this policy approach in terms of permanent real output losses and persistently high labour underutilisation rates belie the rhetoric. The so-called “natural rate” story is just blind ideology that comes from those who have an intrinsic loathing of government activity – unless of-course it is benefiting them directly!

I consider that the housing problems have been seriously exacerbated by the poor design and implementation of fiscal policy in Australia. In that regard, I believe an appropriately designed taxation system with targetted policies to stop housing speculation would be far more efficient at controlling asset price bubbles than using the blunt end of monetary policy.

Monetary policy is a very inefficient policy tool. It cannot discriminate across regional space. We have seen that in recent decades a booming capital city can be accompanied by stagnant regional and remote economies. And the considerable regional disparities in economic performances have persisted even during the growth spurt.

In cases like this, when, say a major city (for example, Sydney) is booming and housing prices are escalating, increasing interest rates impacts severely on the stagnant areas of the country.

This would not be the case using a well-targetted fiscal instrument – mostly in the form of specific taxation measures that can discriminate by region and demographic-income-property cohorts. You can never get that richness in policy design using monetary policy.

Further, if public housing is considered undesirable as a solution the federal government (with some constitutional reforms) could set up a fund to allow access to cheap mortgage instruments to low-income families and allow them to purchase housing (publicly- or privately-provided) with minimal distortion to the price distribution. MMT tells us that the federal government can always afford to do this

Of-course, the promotion of fiscal policy as the primary macroeconomic policy tool is met with derision these days. In the up-coming May budget we will be bombarded with the need to generate budget surpluses as soon as possible while at the same time the RBA is tightening interest rates.

We will be told the government has no further fiscal space and that interest rates will rise further if the public debt ratio is not reigned in.

Of-course, from a MMT perspective, the government just borrows back what it spent anyway (in a macroeconomic sense). There is no scarcity of funds. The government provided the funds by its prior spending. Some will argue that while this might be so, those funds could be better used by private investors and that preference is reflected in rising yields on public bond issues.

Meanwhile, interest rate rises will begin to squeeze private investment spending – one of the engines of growth and endanger the balance sheet viability of the still very-indebted household sector.

Further, housing affordability will continue to decline. Monetary policy is not the best tool to deal with this issue. Changes to fiscal settings – in particular the abandonment of negative gearing is desperately required along with a major expansion of public housing.

The national government can “afford” (in financial terms) to implement both of these fiscal policy initiatives and should be working on making such a shift back to fiscal policy primacy politically palatable. Thirty years of deficit terrorism will take some time to counter in the political debate.

Further, while the Australian economy still is operating below full capacity there is no urgency about the composition of public spending and the danger that the interest servicing payments might squeeze out other desired government spending or force a rise in taxes to reduce the capacity of the private sector to spend and thus keep aggregate demand below the inflation barrier.

There is still a need for on-going budget deficits to stimulate national income growth and provide increased capacity for the private sector to save which means that there are more funds available for borrowers anyway.

Consider one of the tax review recommendations that the Australian government did accept. Their Resource Profit Tax Fact Sheet outlines the reasoning behind the decision to impose a 40 per cent tax on “super profits” from July 2012.

Apart from statements about sharing the benefits of the “exploitation of its non-renewable resources” across all the community the logic is to provide a fiscal relief valve to avoid the mining boom being driven by the strong economic growth in Asia from overheating the domestic economy. So this is an example of a specific tax – that is, targeted at a specific sector – being used to reduce the pressure on aggregate demand so as to avoid inflation.

This policy initiative is consistent with the role of taxation in functional finance and MMT. Please read the blog – Functional finance and modern monetary theory – for further discussion

The reality is that in our ridiculous system of “central bank independence” (another ideological construct from the neo-liberals to reduce democracy in the policy setting process) – the interest rate rises are the sole prerogative of the RBA board. Their logic is very simple and transparent – and erroneous.

They are single-mindedly focusing on the inflation rate and aiming to keep it within 2 to 3 per cent. So anything that pushes their estimate of the inflation rate above their threshold will bring interest rate rises; an export boom; a private investment boom; a private consumption binge; and a government stimulus. Further, the inflation might not even be driven by demand-pull factors. A supply shock (in some imported raw material; or profit push from the corporate sector) will elicit the same response.


So what I take out of today is that the mainstream economic policy agenda that took us into the crisis is still alive in Australia. We have been lucky this time courtesy of our association with China (an unfortunate one should I add given the human rights abuses there) and the significant and early fiscal intervention by the federal government.

But we still have very high rates of labour underutilisation with no policy development in sight to redress this wastage.

Further, trying to halt a housing price escalation using monetary policy is an extremely inefficient strategy. Fiscal policy should be used to target price rises in specific asset classes. Monetary policy should be a passive instrument at all times.

That is enough for today!

This Post Has 13 Comments

  1. Surely pre-emptive battering of the housing market with interest rate hikes is a good thing, as allowing further price increases only lowers the purchasing power of the ordinary person looking to buy a home and increases the likelyhood they will take on a dangerously large amount of debt to finance the purchase.

    If anything, wasn’t the mistake made in many countries in the lead up to the housing bust that they didn’t attack the housing market hard enough to stop irrational price increases? Interest rate hikes would seem a very effective way of killing speculation in this asset before it becomes dangerously out of control. While you can say this hits ordinary families the hardest, nobody is forced to go into massive debt to “own” a large pile of slowly rotting, neatly stacked stones and cement. I think policy that reduced the level of home ownership would be of good benefit to most societies. Renting is nearly always cheaper when true costs are taken into account and makes it much easier for the occupant to move to a new location should there be better job opportunities or other benefits.

    In saying that, if house prices can be better deflated through use of fiscal policy then I would certainly be in favour of the fiscal option, having been most convinced by the many blog posts you have made on the topic of fiscal vs. monetary policy.

  2. Hi digitalcog.

    The Australian cash rate rose from 4% to 7.25% over the course of our housing boom but this did little to curb runaway prices. Eventually, rising interest rates would bring prices down no doubt but the RBA’s scorched earth approach would cause much damage first.

    Many prospective first-time buyers cannot afford a mortgage now – but how much less of a position are you in to afford one if you are unemployed because the RBA has scorched the economy?

  3. “Further, trying to halt a housing price escalation using monetary policy is an extremely inefficient strategy. Fiscal policy should be used to target price rises in specific asset classes. Monetary policy should be a passive instrument at all times.”

    What about raising the margin rate (the down payment)?

  4. “Further, trying to halt a housing price escalation using monetary policy is an extremely inefficient strategy. Fiscal policy should be used to target price rises in specific asset classes. Monetary policy should be a passive instrument at all times.”

    If other asset prices (including housing) are going up because of debt, is that a sign that the labor market needs to be tightened?

  5. From my earlier post:

    “According to the research, buyers in synthetic CDOs are normally aware that their products will perform according to collateral performance.”

    Does that mean buyers in synthetic CDOs don’t worry about the ability to make the interest payments, only about the collateral?

  6. From the Krugman link Default, Devaluation, Or What?

    “Consider what Greece would get if it simply stopped paying any interest or principal on its debt. All it would have to do then is run a zero primary deficit – taking in as much in taxes as it spends on things other than interest on its debt. But here’s the thing: Greece is currently running a huge primary deficit – 8.5 percent of GDP in 2009. So even a complete debt default wouldn’t save Greece from the necessity of savage fiscal austerity.

    It follows, then, that a debt restructuring wouldn’t help all that much – not unless you believe that getting forgiveness on much of Greece’s existing debt would make it possible to take on substantial new debt, which doesn’t seem very likely.”


  7. Professor Mitchell, I sent you an email/file about the “card economy” and wealth/income inequality.

    I was wondering if you would be willing to do a post about it. Thanks!

  8. Digitalcog,

    When you have an undersupply and favourable tax treatment of houses, the prices are not that irrational.


  9. kwijibo
    Prices not irrational but not favourable. lets take an example where due to structural constraints petrol prices are now to be 2.20 compared to 1.20 in US for a litre. All factors in Australia support this price. The implication of this is, everything produced in Australia will have to factor higer costs, making goods and services uncompetitive.

    Let us say all workers go on a strike because they want higher wages to cover higher mortgages. If these wages are relatively higher than comparable markets, our goods and services will be uncompetitive relative to theirs.

    Eventually such structural problems should be removed to enhance productivity!

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