Record Low Interest Rates

When he was still the prime minister, John Howard famously claimed that interest rates would always be lower under a Coalition government. And it seems he was right.

Yesterday the Reserve Bank of Australia cut interest rates to a record low, from 2.5 to 2.25 per cent.

But we desperately need to move beyond the simplistic notion that higher rates are bad and lower rates are good. From a personal point of view, it really depends on whether you are borrowing or saving. From a macro point of view, it really depends on what is happening in the economy and whether intervention is needed to boost or restrain demand. For example, high interest rates might hurt those with a variable mortgage, but in the conditions that call for high rates, everyone in the economy would suffer from high inflation if the RBA didn't lift them.

Treasurer Joe Hockey tried to move the debate on this a couple of years ago, albeit for purely political purposes. When interest rates hit record lows under the Labor government, he had the following to say:

They [The RBA] are not cutting interest rates because the economy is doing well. Interest rates are being cut to 50 year lows because the economy is struggling.

If your argument is that the lower the interest rates the better the economy, go and ask the British or the Americans or the Europeans that have interest rates at zero how their economies are going because I tell you what, we are now beyond emergency levels."

If anyone thinks that the Reserve Bank acted today because the economy is doing really well, and Labor's doing a terrific job running the economy, they'd be deluding themselves.

This presents something of an awkward moment for Mr Hockey as it, presumably, means the economy is doing worse now than when Labor was in government.

But it is a little bit more complicated than whether the economy is doing "well" or "poorly", or whether the government (which is but one of many players in determining the health of the economy) is doing a good job. It is (still speaking simplistically) about demand in the economy, and whether the demand is sufficient to see continued economic growth and a lowering of the unemployment rate (which is too high by historical standards).

As we have outlined earlier, economic growth can be stimulated by boosting demand. Policymakers can achieve this through either monetary policy (dropping interest rates) or fiscal policy (spending money).

As we noted then, monetary policy is something of a blunt instrument. It hits the whole economy. This is why the RBA has been reluctant to drop rates in recent times in spite of continuing poor economic news - because the housing market is hotting up, and lowering interest rates could blow enough air into it to form a bubble.

Fiscal policy, by contrast, can be targeted to some extent. By propping up demand through spending, the government could essentially boost economic growth, and boost job numbers, without inflating a housing bubble.

The incredible thing about the current situation is that it would cost the federal government almost nothing to let loose with some fiscal stimulus. As Peter Martin recently pointed out, the ten year bond rate is currently at an all time low, which means that the government could borrow billions of dollars at an interest rate around the same level as inflation.

The government could be flooding the economy with cash, by funding a wide range of infrastructure programs. It would create jobs. It would stave of low level inflation (or worse, deflation). And it would not create a debt problem, because the money is practically interest free.