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 PERSONAL FINANCE |
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Interest rates
RBA could let market forces decide
Nick Renton AM - May 2007
Would Australians be much better off if interest rates were set by market forces - as already happens in the case of long-term interest rates? Nick Renton investigates.
The term "monetary policy" refers to the financial policy of managing a nation's money supply by a central bank in order to achieve specific goals - such as reducing inflation or achieving full employment. These days the primary tool of monetary policy usually involves open market operations to set the short term interest rate. Such dealings do not seek to maximise gains for the taxpayers as owners of the central bank.
In Australia monetary policy currently involves the setting of an appropriate level of the cash rate target by the Reserve Bank of Australia so as to maintain the rate of inflation between 2 and 3 per cent per annum on average over the business cycle.
On occasions Australia's central bank might deliberately introduce a policy of having high interest rates in order to slow down the economy. Such a strategy can succeed only too well, with the result that many businesses fold up and unemployment soars.
A subsequent lowering of interest rates cannot restore the status quo. Those businesses that went out of existence in the meantime do not come back just because the monetary policy which had ruined them was reversed: dead is dead. Suppliers who lost their customers do not get them back; employees who lost their jobs remain on the dole; and so on. A nation cannot be built on a recession.
To have short term interest rates set by the Reserve Bank of Australia at irregular intervals may have been useful in earlier times, but in this era of having a competitive environment as an economic goal it no longer makes sense. Admittedly, Australia is not unique in this regard - the central banks in the United States, the United Kingdom, the European Community, New Zealand and many other countries follow similar policies.
Australians would be much better off if these rates were set by market forces - as already happens in the case of long term interest rates. This would lead to greater efficiency by removing investment distortions.
Another precedent is worth mentioning. Once upon a time it was thought necessary to have the exchange rate for the Australian dollar fixed by the authorities. This requirement was abolished in 1983, when the floating of the currency commenced. The roof did not fall in.
In any case, the assumption that monetary policy can fix the Australian economy on a "one size fits all" basis is a nonsense: the resource States are booming; the cities in the other States are pottering along; the rural sector is struggling in the drought; and so on. Furthermore, changes in interest rates affect households and businesses in rather different ways.
Of course, markets are not perfect either, but allowing interest rates to find their own levels by matching supply and demand seems preferable to letting a small number of individuals make arbitrary decisions on the first Tuesday of each month.
Market rates would move up or down gradually each day (as they do for the currency). On average, they would probably not be significantly different from the rates set by the present system, but they would deny speculators the opportunity to make windfall profits at the expense of the rest of the community.
Increases in interest rates give rise to headlines highlighting the plight of mortgagors - however, the irresponsible press fails to mention that increases are actually welcomed by the much greater number of depositors and fixed interest investors, including many retired persons.
Interest rates on residential mortgages are already set by competitive forces, different lenders adding their own margins to the cash rate and setting the dates on which they change the rates they charge. The excuse that they are doing this because of changes to the official interest rate would disappear and rates would become subject to less volatility, but little else would change for the borrowers.
Whatever your views, you can discuss this article - or any of Nick's articles - on our message board Your 2 Cents.
Nick Renton AM is the founder and first president of the Australian Shareholders' Association. He is a consulting actuary, commercial arbitrator, company director and writer. He is the author of 62 published books covering shares, property, managed investments, taxation, wills, the Internet and the Australian economy. He has written books about more different topics than any other Australian author. He was made a Member of the Order of Australia in 2004.
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