Speech in memory of Michael Joseph Savage, hosted in Wodonga by La Trobe University
Ladies and Gentlemen,
I am deeply honoured to be an Adjunct Professor of La Trobe University. La Trobe was still under construction when I was doing post-graduate studies at the Australian National University in the mid-sixties, but over the intervening period it has developed an enviable reputation as one of the finest universities in this part of the world. I warmly congratulate all those involved in this great achievement.
I am also deeply honoured to have been invited to give this Michael Joseph Savage Lecture – doubly so because I was for more than three years the Leader of the National Party in New Zealand, the party formed shortly after Michael Joseph Savage became Prime Minister at the end of 1935 and which led the Parliamentary Opposition to his Government.
Michael Joseph Savage was the 23rd Prime Minister of New Zealand. He became New Zealand’s first Labour Prime Minister just as New Zealand was beginning to emerge from the Great Depression and remained Prime Minister until March 1940, when he died in office.
He was a man greatly loved and respected by most New Zealanders at the time, and thought of as a New Zealander, even though he was of course born in the state of Victoria, and spent slightly more than half his life in this state.
He has been referred to by one commentator as “the sainted politician of the decade”.1 And he certainly did have some saintly qualities. He was a life-long bachelor who boarded with old friends, and he neither smoked nor drank. He persuaded his colleagues in the Cabinet to share their ministerial salaries with the back-bench members of his Caucus, so that all Labour MPs received the same remuneration – and I don’t under-estimate that achievement!
His Government was the architect of the modern welfare state in New Zealand and, although this resulted in his having to break a solemn pre-election promise not to increase taxation and had far-reaching and not unambiguously positive results in the years that followed, at the time his Government was seen as hugely beneficial to most New Zealanders. His Government was returned with an increased Parliamentary majority in 1938.
He was also Prime Minister when strict quantitative controls on imports were introduced at the end of 1938. With the wisdom of hindsight, it is clear that these controls did a huge amount of damage to the New Zealand economy, encouraging investment in industries in which New Zealand production could never hope to be internationally competitive, but at the time many New Zealanders were enthusiastic supporters of such controls. Ironically, it was a Labour Government which finally scrapped import controls, half a century later.
One of the first actions of his Government in 1936 was to assume political control of the Reserve Bank of New Zealand. That was probably an inevitable move, and was of course consistent with the action of other governments all over the world: in only a handful of countries are the central banks not entirely owned by government. But he wisely rejected the pressure from many of his own Parliamentary colleagues to use the Reserve Bank to “print money”. By doing that, he avoided the intense inflationary pressures which would otherwise have emerged.
I spent a lot of time thinking about what to talk about tonight. Alas, I can say nothing useful about the drought, and I’m not well qualified to offer strong views on global warming. I know nothing about Aussie Rules, and I dare not talk about cricket! It would be presumptuous for a New Zealander – albeit one who has lived for some years in Australia and has a high regard for things Australian – to talk about the new political environment which has reigned since the federal elections last year.
But Professor Harbridge drew to my attention the puzzlement which many Australians feel about the fact that the Reserve Bank of Australia has been increasing interest rates in Australia at a time when the central banks of most other major countries have been busy reducing them and, because many New Zealanders are equally puzzled that the New Zealand central bank has been cranking up interest rates on that side of the Tasman, I thought that would make a good subject for my speech tonight.
And reflecting on the fact that it was Michael Joseph Savage who was New Zealand Prime Minister when the Reserve Bank in my country was brought under direct political control, it seemed particularly apposite.
Why has the Reserve Bank of Australia, like the Reserve Bank of New Zealand, been cranking up interest rates at the very time when the Fed, the Bank of England and the Bank of Canada have been reducing them? Why is the Cash Rate 7.25% in Australia and only 5% in the U.K., 4% in the Euro area, 3% in Canada, 2% in the US, and only 0.5% in Japan? Which central banks have got it right, and which have got it wrong?
I want to spend a few minutes discussing that issue tonight, and then address another somewhat related question. What can be done to return the Australian dollar to a level which makes it just a bit easier for Australian exporters to compete on international markets – and indeed makes it a bit easier for Australian businesses competing with imports to survive.
On the vexed question of interest rates, it is entirely possible that all the central banks I have mentioned, including the Reserve Bank of Australia, have got it right in the sense that their interest rates are entirely appropriate for the state of their economies. Unfortunately, we won’t know which central banks have got it right and which central banks have got it wrong for two or three years, by which time of course it’ll be entirely too late to do anything about it. That’s because interest rates affect the real economy with a considerable delay, or “lag” in the jargon, and affect the inflation rate with an even longer lag.
But what the very different policy interest rates are telling us is that while many central banks are worried about the risk of recession, with demand falling short of the economy’s capacity to produce at current prices and consequently falling inflation, other central banks, most notably those in your country and in mine, see a different kind of risk – the risk that, despite the slowdown in the world economy, demand pressures within the local economy are such that there is little risk of recession and every risk of rising inflation.
Australian inflation in the year to March 2008 was, at 4.2%, well above the top of the 2 to 3% band which the Australian government has agreed should be the Reserve Bank’s target over the medium term. What the Reserve Bank said, in the monetary policy statement released in February, was that “The risk of inflation remaining uncomfortably high for some time is considerable. A significant moderation in demand will be needed if inflation is to be satisfactorily reduced over time. Monetary policy is likely to need to be tighter in the period ahead.” Indeed, the Bank projected core inflation as being above the inflation target band for most of the next two years.
In other words, the Reserve Bank believes that the Australian economy is in a very different space from the economies of North America, Europe and Japan. Yes, Australia will inevitably be affected, adversely, by the slowdown in those economies, and by the drought, but the Australian economy is being carried along by continuing strong demand for Australian exports of coal, iron ore, and other minerals from the still-fast-growing economies of Asia, by strong investment by the corporate sector, and by recent and promised tax cuts. The result is that businesses are increasingly meeting capacity constraints and unemployment is very low by historical standards. Businesses are finding it hard to find skilled staff, semi-skilled staff and even unskilled staff, and it is this kind of environment which tends to lead to upwards pressure on wages, salaries and other costs, and a strong desire to increase prices as well. The Reserve Bank can ill afford to further stimulate demand by cutting interest rates, and certainly can’t afford to stimulate demand by cutting interest rates to the level prevailing in places like the U.S. and Japan.
But, you may well object, doesn’t the Reserve Bank have a statutory obligation to maintain economic growth in Australia as well as keep inflation under control? And doesn’t that suggest that interest rates should be cut to some extent at least?
Yes, the Reserve Bank does indeed have a statutory obligation to maintain economic growth and minimise unemployment. Section 10(2) of the Act of Parliament under which the Reserve Bank operates provides that
“It is the duty of the Reserve Bank Board… to ensure that the monetary and banking policy of the Bank is directed to the greatest advantage of the people of Australia and that the powers of the Bank… are exercised in such a manner as… will best contribute to:
a) the stability of the currency of Australia;
b) the maintenance of full employment in Australia; and
c) the economic prosperity and welfare of the people of Australia.”
But the reality is that that Act was passed into law in 1959, at a time when many economists thought that monetary policy could actually deliver several objectives at once, including low unemployment, low inflation, and faster economic growth. I’d be very surprised if there were any economist in any Australian university today who would claim that those three objectives can in fact be achieved by monetary policy.
Yes, monetary policy does have a short-term effect on employment, and yes it does have a short-term effect on economic growth.
But in the longer-term, monetary policy has no enduring effect on employment – in the longer-term, employment is determined by things like the level of the minimum wage, the generosity of unemployment benefits, the skills of the workforce, and the flexibility of employment law.
And in the longer-term, economic growth is determined by the rate at which people are entering the workforce, and how productively they use their time, which in turn depends more than anything else on the amount of capital they have to use and how up-to-date that capital is. Monetary policy best contributes to that process by keeping inflation low and stable, so that the price mechanism directs resources of people and capital into the areas where they can be used most productively.
Ian Macfarlane, the predecessor of the present Governor of the Reserve Bank, once said that he interpreted his goal as being to operate monetary policy to achieve the fastest possible rate of economic growth consistent with keeping inflation low and stable. Quite so, and I doubt if the Governor of any other developed country central bank would see their role differently.
Interest rates in Australia are much higher than those in other developed countries (with the exception of New Zealand!) because inflationary pressures are judged to be higher in Australia than in those other countries. And, as I’ve already noted, we won’t know whether that judgement is correct until some time late next year or early the following year. What we do know, however, is that inflation is already above the Reserve Bank’s target zone and that current interest rates have certainly not led to a huge surge in personal savings or a huge drop in the rate at which Australians are taking on more debt. In the year to last December, bank lending to Australian households grew by 12.3%, a substantially faster rate of growth than that of the economy over the same period. It’s hard to argue that Australians see interest rates as too high in any fundamental sense – if they did, they would not be so enthusiastic about borrowing.
What about the exchange rate? Well, we all know that one of the reasons why the Australian dollar has appreciated so strongly against the US dollar is that the US dollar has depreciated against almost all currencies. In other words, the rise in the Australian dollar against the US dollar has in part been simply a result of the weakness of the US dollar. I spent some months in Cambodia last year, and was surprised to find that even the Cambodian currency, the riel, had appreciated against the US dollar.
We also know that Australian exports of minerals to the fast-growing economies of Asia have been very strong, and that has increased international confidence in the Australian currency, notwithstanding the very large balance of payments deficit that this country, like my own, continues to run.
But there’s a widespread view that a major reason for the appreciation of the Australian dollar over the last six or seven years – an appreciation which has taken the Australian dollar from a low of 48.9 US cents in March 2001 to almost double that today, and from 47.0 on the Trade Weighted Index in September 2001 to around 73 in recent days – is that interest rates in Australia are very much higher than those in other developed countries. That has offered Mr and Mrs Watanabe the opportunity to invest in Australian dollars at interest rates vastly more attractive than the extremely low interest rates – effectively zero in Japan – they can get at home. And that in turn has increased the demand for Australian dollars, and pushed up the Australian dollar exchange rate against the exchange rate of most of our trading partners.
I would argue that interest rates are not the whole story explaining the appreciation of the Australian dollar. It is worth noting that back in the year 2000 the Australian dollar fell almost every time the Reserve Bank of Australia increased its policy interest rate, and the Reserve Bank of New Zealand and the European Central Bank had a very similar experience that year. To be sure, at that time interest rates in the US were much higher than they are now, but Japanese rates were close to zero even then.
But it is almost certainly true that the relatively high interest rates in Australia, and the perception that those rates are likely to endure for some time, have played quite an important role in pushing up the exchange rate.
It should also be noted that, if the exchange rate had not appreciated to the extent that it has, the Reserve Bank would almost certainly have pushed up official interest rates to a greater extent than has been the case.
Why do I say that? Because the appreciation of the exchange rate has played an important part in restraining inflation in Australia – both directly, by reducing the domestic price of imports and items which are also exported, and indirectly, by reducing the real incomes of those in the export and import-competing sectors. If it had not been for that beneficial effect of the higher exchange rate on restraining inflation, the Reserve Bank would’ve had to apply more interest rate pressure to achieve the same inflation outcome.
But let’s all agree that the rise in the exchange rate has made life extremely difficult for many Australian exporters, as well as for many companies which have to compete with imports. The higher exchange rate has reduced the number of Australian dollars generated by a given volume of exports, and indeed has made some export activities completely untenable. Many export businesses have had to lay off staff, and some have moved production out of Australia to cheaper locations abroad. Companies competing with imports have faced similar pressures.
Is there anything that might be done to alleviate the strong appreciation in the exchange rate when Australian monetary policy is being tightened at a time when central banks in other developed countries are easing monetary policy?
I’m not sure whether there has been a hunt for solutions to this problem in Australia, but there has certainly been an active hunt for solutions to exactly the same problem in New Zealand. The Reserve Bank of New Zealand and the New Zealand Treasury produced a study of several policy options which might be used back in February 2006. Because the need for relatively high interest rates was regarded as related to the bubble in house prices at that time, the solutions focused on ways of defusing that bubble without the need for such high interest rates. Options included
But none of these options was seen as terribly attractive – all of them involved problems of one kind or another, or were not judged likely to have a material effect on the problem. The Governor of the Reserve Bank and the Secretary of the Treasury, in their covering letter to the Minister of Finance, noted that there were “no simple, or readily implemented, options that would provide large pay-offs in the near term”.
One option which was beyond the scope of the study was what the report called “other discretionary demand management tools (including tax ones)”. Using government taxation policy, or government spending policy, to supplement the Reserve Bank’s power to change interest rates has been discussed from time to time.
In New Zealand, the national farmers’ organisation, Federated Farmers, suggested some years ago that the Reserve Bank Governor be given authority to increase the rate of GST as a way of constraining consumer spending, and so reducing inflationary pressures. And in 1996, Professor Laurence Ball, a distinguished American economist, advocated that a special Macro-economic Policy Committee, possibly chaired by the Governor of the Reserve Bank, be given a limited right to vary income tax rates as a way of influencing inflationary pressures without varying interest rates.
I myself would be very reluctant to see the GST used as a tool to supplement monetary policy. GST is collected by many hundreds of thousands of small and large businesses, and changing the rate of GST relatively frequently would greatly increase the compliance costs carried by those businesses – and would probably also result in destabilizing volatility in consumer spending, as people tried to anticipate the impact of announced changes in GST.
It might be politically feasible for Parliament to delegate to a non-political Macro-economic Policy Committee very limited power to change the rate of income tax, but there would be substantial practical difficulties in varying the income tax rate several times a year, as may be desirable.
And while it is indeed admirable to see a government trying to restrain the growth in its own spending when curbing inflationary pressures makes such restraint highly desirable, nobody should imagine that such restraint is easy, nor that it can be implemented in the kind of flexible way which fighting inflation sometimes demands.
Having said that, I am attracted by the idea of giving the Governor of the Reserve Bank some constrained ability to take spending power out of the economy as an alternative to cranking up interest rates and thereby pushing up the exchange rate. I have suggested in New Zealand that serious consideration should be given to giving the Governor the power to vary the excise tax on fuel, not instead of his power to vary interest rates but as a supplement to that power.
The beauty of giving the Governor the power to vary the excise tax on fuel is that he would be able to have a potentially large influence on spending in the economy without having a big effect on the amount of fuel actually consumed (demand for fuel tends to be pretty unaffected by changes in the price of fuel, at least in the short run), without having a big effect on compliance costs (the tax is collected at a relatively small number of points in the economy), and without having any effect at all on the exchange rate. The Governor would almost certainly want to vary interest rates as well, but the extent to which interest rates would need to be changed would be greatly reduced, given the effect of changes in the excise tax on fuel.
For example, if inflationary pressures were growing strongly, the Reserve Bank might decide to increase short-term interest rates over 12 months by, say, 1 per cent and increase the excise tax on fuel by, say, 20 cents per litre. The alternative, without the ability to vary the excise tax on fuel, might have been a need to increase interest rates by perhaps 2 per cent or more.
At the moment, those who are most adversely affected by a tightening of monetary policy are homeowners, who see their mortgage rates rise; businesses, which see their overdraft rates rise; and all those in export and import-competing industries, who are adversely affected by a rising exchange rate. Those who benefit from a tightening are savers, who see interest rates on their deposits rise; and paradoxically consumers, who find that the price they have to pay for imports and goods which are also exported come under downwards pressure because of the appreciating exchange rate.
If the Reserve Bank had the power to vary the excise tax on fuel as a partial substitute for varying short-term interest rates, the pain of a policy tightening would be spread more evenly across the whole community, with those involved in exporting and in competing with imports spared some of the pressure of a rising exchange rate.
Some will object that giving the bureaucrats in the Reserve Bank the power to vary the excise tax on fuel would break all the usual constitutional conventions, conventions which normally reserve to Parliament the power to vary rates of taxation. Indeed, that’s true. Once upon a time, the same argument was used to oppose giving the Reserve Bank the independence to determine interest rates. But eventually, the Australian government, like governments throughout the developed world, came to recognise that giving the central bank a defined power to vary interest rates without regard to political influence was highly desirable in the longer term interest of the whole economy.
I very much hope that governments will come to see that in the same way there would be great benefit in giving the Reserve Bank a defined and limited power to vary the excise tax on fuel.
One thing is clear: export industries in both our countries are getting increasingly desperate for some relief from the present high exchange rate, and simply dropping interest rates is no answer at all.
What would Michael Joseph Savage make of this debate if he were alive today? I can’t be sure of course, but I take it from his opposition to pressure within his Labour Party Caucus to use the Reserve Bank to “print money” to finance his Government’s social security programme and expenditure associated with the war effort that he was acutely aware of the damage caused by inflation – damage not simply to the economy but also to those low-income people his Labour Party was committed to helping. Perhaps Michael Joseph Savage realised, better than many of his contemporaries, that while those with high income and plenty of assets can usually protect themselves against inflation – and indeed, can often make money by leveraging their assets with borrowed money – those on low incomes have no such opportunity.
Plenty of those on the left of the political spectrum believe that controlling inflation is some kind of right-wing policy. Perhaps Michael Joseph Savage knew better.
Copyright © 2024 Don Brash.