Saturday, October 27, 2007

Interest Rates

Everyone has an opinion on interest rates and inflation. Of course 90%+ of these people have no clue what these constructs are, what they do or what affects them. Usually the less one knows about these topics the louder they tend to bleat the govt's line on the economy. The following is a comment from jamesm who commented on Mikey's blog and is a handy, simple guide.

Less money in the hand means less to spend. ie. I had $100 disposable per week yesterday, now I have $90, so I buy less. Let's call that 'demand'.

But to understand how interest rates cause/curb inflation you have to understand the other side of the equation:- supply (also known as 'capacity' which is what the ALP is going on about).

I explained this concept successfully to a friend a couple of days ago with the following story.

Let's say a baker has an oven capable of making 100 loafs per day, which he does and which he sells at $1 per loaf (sorry, I know that's ridiculously cheap, I'm just making the maths simple enough to follow without a calculator.)

Let's also say we have a government cutting taxes so that people have $110 to spend at the bakers. The baker can't make 110 loaves as his oven isn't big enough - he's "capacity constrained", so instead he puts up the price by 10c. He now gets paid $110 for his hundred loaves, much quicker and easier than investing in a new oven.

He isn't producing anything extra, but what he produces costs more. His customers are spending more, but for the same result. ie. we have inflation.

(Note he could build a new oven, but a.) that will take time, b.) if he builds it just for 110 loaves it will either be swamped pretty shortly or demand may fall back to 100 loaves and c.) it'd take him a while to make back his investment. You could argue he should build for 200 loaves but that would be a risk as the larger oven would be more expensive to run, take longer to pay back and his market may never grow to 200 loaves/day so he'd be forced to run it under capacity. It's easier to just put the price up.)

At this point the RBA notices that 'demand' has gone up and puts up interest rates so there's only $100 ($100 start + $10 tax cut - $10 extra interest) to spend on bread. Suddenly the baker is back to selling only 100 loaves at the old price.

Everybody's sweet, but the economy can't grow.

At this point - in an ideal world - the government's role is to step in and encourage the baker to build the larger oven, perhaps by giving him some investment incentives or kickbacks. You know, the sort of thing the last ALP government did with those "R&D tax breaks" that Costello abolished; or the infrastructure ("ovens") that the states are building; or the education that would allow the baker to hire a smart assistant to squeeze more bread out of his oven.

Please let that sink in for a couple of moments.

The last point to understand is that this argument is _only_ valid when the economy is running at full capacity (like now). ie. extra income in peoples hands only causes inflation if the baker can't bake more loaves more or less at will (which the economy tragics would call "low marginal cost").

For example, if the same baker were only making and selling 70 loaves a day in his 100 loave oven he would have plenty of capacity to ramp up to 80 *without* raising his prices. That's why the government absolutely must be held responsible for its duty to increase the capacity of the economy so that there is room for growth.

Costello and Howard haven't done that. If anything they've spent 11 years nickle and diming us while they stash away phony short term surpluses for handouts at election time.