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Relying on the Reserve Bank

By Harold Levien - posted Wednesday, 24 September 2008

Since much of recent excess demand driving inflation has been due to banks and other financial institutions excessively and irresponsibly expanding credit should the burden of fighting inflation primarily fall on Governments undertaking essential public spending and households paying off mortgages?

That's what happens when government relies on changes in Reserve Bank interest rates to combat inflation.

To discourage the Reserve from further raising rates the Government has cut into existing programs and minimised increased expenditure even in critical areas starved of funding under the Howard government, such as public hospitals, universities, public schools, public housing, scientific research and environmental programs.


Bizarrely, if these spending sacrifices on vital public services succeed in avoiding rate increases, it could encourage private sector borrowing for developments of marginal community benefit such as shopping malls.

The Government was not prepared to abandon the politically sensitive pre-election promised tax cuts or slash much of the previous government's middle-class welfare - especially the $3.5 billion annual subsidy for private health care and the generous over-formula payments to rich private schools - as an alternative to increased funding for its priority areas.

The anti-inflation reliance on interest rates also inflicts severe stress on hundreds of thousands of households paying off mortgages; and those who can't meet repayments risk losing their homes.

Yet these households are not the target of interest rate rises. Their pain is collateral damage like innocent civilians injured in a military attack. Moreover, because higher rates reduce house buying and construction more households are forced into competing for a limited supply of rental accommodation which leads to a steep rise in rents. Apart from the unintended stress this feeds into exacerbating inflation which could trigger a further rate rise.

There are other serious consequences of rate increases. If rates rise well above those in the major economies this leads to a rise in the $A which can damage many of our export and import-competing industries.

And since a rise in interest rates is a blunt and unpredictable instrument with a significant time lag, several increases can provoke a recession before the Reserve Bank can play catch-up with rate cuts.


There is an alternative.

Until bank deregulation in the mid-80s fighting inflation was not dependent on raising interest rates. The Reserve Bank determined the volume of increased lending the economy could accommodate without inflationary pressures. In times of excess demand it could direct banks to lodge with it a proportion of their deposits (the Statutory Reserve Deposits) and require cuts in credit to particular sectors and, where desirable, regions of the economy while maintaining lending to other specified sectors of government priority - such as farmers, exporters and prospective home owners -and depressed regions.

With today's increasing role of non-banking financial institutions there is a strong case for bringing the largest of these within the Reserve Bank's purview.

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About the Author

Harold Levien, in the 1950s immediately after graduating in economics, founded and edited VOICE, The Australian Independent Monthly. It lasted for five years. As a journal of comment its contributors included many of the most respected authorities on economic and political issues of the time. He wrote Vietnam, Myth and Reality in 1967. It went into several printings. Harold has written many articles which have appeared in the Herald, Bulletin, Quadrant, National Times, Australian Options, the Journal of Australian Political Economy and others. Before retiring he taught economics for 27 years.

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