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If the ratio of lending for new dwellings to the lending for existing dwellings increased from 10% to 50% then it is likely to make a substantial drop in the increase in money supply and with it inflationary pressures. The number of new homes built would increase a little but loans for existing homes would drop a lot and with it a reduction in money supply.

If this is correct then the trick would appear to be how to get this outcome with little impact on productive investment loans. The blunt instrument of a Reserve Bank Rate rise impacts on all investment, the increase in the banks mortgage rates for houses is better but would be even better if it only applied to existing houses.

We cannot expect the banks (who are the ones making the loans) to work to reduce the loans they make because that is how they make their profits. They are probably happy with the current situation because it has enabled them to weaken or take over other lenders and so reduce long term competition and hence enable them to increase their lending margins and hence profits. They know that it is going to take a brave government to directly work to reduce the price of the family home so their loans for inflated valued houses are “safe”. It would appear we have dysfunctional capital markets that favour casino investments in inflated assets (both property and stock) not productive investments in ways to increase wealth.

Perhaps the way to tackle the problem is to directly address the fact that it is more profitable to make an individual investment in old capacity than to make an investment in new capacity. If I want a loan to invest in new productive capacity wouldn’t it be better for the economy to have a lower rate than a loan to buy existing productive capacity? In house terms wouldn’t it be better for society as whole to have loans to buy a new house at a lower interest rate than a loan to buy an existing house?

A problem is that it is normally riskier to build new productive capacity than it is to buy existing capacity and so the interest rates tend to be the other way around.

Perhaps one way of redressing the balance is to put a surcharge on loans to buy existing capacity and use it to subsidise loans for new capacity? This could be done in the case of houses by requiring lenders to have a lower lending rate for first time usage of a house versus lending to buy a house that has been occupied. This would seem a relatively easy and enforceable strategy and would not impact on existing loans.

As for the price of ‘old’ houses, they’re no different than ‘old’ shares, gold, stamp collections, paintings, factories, shops, antiques, etc, etc, although as you’ve noticed, too much funny money chasing them, coupled with the interaction of the income tax system, can produce funny prices, not to mention some other nasties like skewing real investment and savings and the balance of trade. What should we do about all this? Well that’s one helluva question, but perhaps the size and prolonged fallout from the collapse of this latest pyramid scheme, coupled with some other pressing problems with the whole constitution of our current marketplace, might make us go looking for a complete reappraisal and restructure of same. On that note I did outline one such constitutional marketplace we could have here
http://johnquiggin.com/index.php/archives/2008/01/08/ergas-v-quiggin-on-risk-and-social-democracy/
(see comment 19 and subsequent), but as you can see, it will take some real inertia for serious change from the science of muddling through we have inherited. Don’t hold your breath, because lots of people aren’t really interested in socially desirable outcomes, just power and banning plastic shopping bags and the like. Controlling investment in ‘old’ things too by the sounds of it.

Given this, surely one way of reducing inflationary pressures is to change the rules of lending for “old houses” that makes such lending less attractive to lenders. There must be all sorts of ways to do this. Think of a way that has an immediate effect, is easy to administer, and can easily be removed and let the system sort itself out.

This may result in a drop in existing house prices but as it is 3 years until an election and the restriction old house lending can be removed a year before the next election the political effect may be acceptable.

cough cough

In hindsight, it seems astonishing that the Fed raised the discount rate twice in late 1931 to 3.5 per cent even as global finance was disintegrating. It did so to halt bullion flight and defend the Gold Standard, but it failed to offset the effects with bond purchases. Britain was forced off the Gold Standard in September 1931 after the Atlantic Fleet “mutinied” at Invergordon over 10 per cent pay cuts. That proved a providential crisis – the pound fell. The Bank of England was soon able to slash rates. The slump proved less serious than in the US, and not a single bank collapsed in the British Empire.

JC, I was not implying that the promised tax cuts be withdrawn in the next budget.

Fair enough , fred. That was the impression I got, which is obviously wrong. But you would have preferred to see no tax cuts anf more spending, is that correct?

All I was saying was that, if a fiscal stimulus were needed in 2009 (and it may not), it would be more effective to do it through government spending rather than tax cuts and it would make more economic sense to select spending programs that have productivity-boosting effects (through investment in human or physical capital) rather than increase transfer payments.

Fred, my understanding is the big chunks of (productivity) beef arrive when the capital to labor ratio is increased. Graduating additional neurosurgeons or economists for that matter will do little to change that. So if you want to really raise living standards, which is another way of describing productivity increases, you want to raise the capital to labor ratio. You can only do that through private capital expenditure increases. So the best ways to raise productivity/ living standards is through accelerated depreciation allowances and say through further cuts in capital gains taxes (down the zero).

Interesting debate also between Greg Mankiw and Jason Furman in:. http://gregmankiw.blogspot.com/2008/01/cbo-on-fiscal-stimulus.html

Just showing off that I can use the Link mechanism (I think).

James, the “political” problems are not nearly as great in Australia as in USA. The bigger problem is the logistic one of quick implementation of sensible investment programs (increases in transfer payments are easier). That’s why I suggested COAG needs to plan its priorities ahead and have some projects ready for action.

James, I do feel silly not using links. I now know how. You shamed me into it.

Nicholas, I agree in principle with your ideas for an independent fiscal stabilization authority and always have. But I remain very skeptical that any government, having given up two key instruments of macroeconomic policy, will now resign itself to giving up (admittedly in part only) the fiscal one too.

There is a ray of hope however. The Rudd Government has promised us more transparency so, if difficult circumstances arise and the Opposition is playing funny games, it has the option to release formal advice it received from Treasury and RBA on the appropriateness of fiscal deficits. If I am right in believing that the RBA will, in some extreme circumstances, welcome fiscal support, such transparency could come in handy to the Government. That could be one foot in the door towards fiscal independence and it could lead to bigger things (e.g. a government admitting at times that it does not have the approval of RBA or Treasury). Even that would be dangerous politics.

We are not in a recession at present and the RBA will be mad keen to avoid one by tipping rates to breaking point amongst debt charged households.

In a recession we only need automatic stabiisers and the RBA to do their job. It is only in a depression we need fidcal policy to do its job because low interest rates don’t work.

If the government wants to spend on neccessary infrastrucute it can it just has to cut in other areas

Just recently you were against the tax cuts saying that it would be inflationary. Now you’re implying (i think) that we should do away with the tax cuts and build a few bridges.

If the problem is averting a potential recession in the private sector, why would you want to prevent the tax cuts from alleviating the stress there rather than going for the bridges?

Japan’s fiscal position remains a mess from all the Keynesian spending that went on during the 90′s and it ended up doing diddly sqwat in terms of kick starting the economy.

And just how would say spending 10 bill a year messaging the economy with infrastructure (for lord knows what) when we have a GDP at $1 trillion prevent any serious recession. It’s a drop in the bucket.

Maybe they ought to be accelerating the tax cuts offering bigger depreciation allowances and not tightening up the labor market at the worst possible time.

Major bank stocks like the NAB have fallen over 20% in the last 2 months, which is a reasonable indicator for our real estate market in some ways. The last thing the new kids wanna be doing is gluing up the labor market and taking us back to the early 90s recession.

But things change – and now it’s more likely that some independent fiscal agency even of an advisory nature would actually help the Govt run responsible fiscal policy if a downturn eventuated. One thing that’s been evident for years at the state level is how cringing the ALP is when the word ‘deficit’ is mentioned. In more and more states PPPs and privatisations have been run on the absurd grounds that they lower debt (but pushing it off the books in the former case and by selling assets and usually reducing govt net worth in the latter case). It’s been evident given this that if you want to return to a bit of simple budgetary commonsense – including budgetary commonsense – one needs to develop the institutions that can hold governments’ hands at times when their opponents are feeling like taking a free kick.

It’s interesting that the paper doesn’t mention the current account and national saving as a factor in fiscal policy; whereas her it’s still the main variable officially guiding our own fiscal policy, as embodied in the ‘Medium-term fiscal outlook’ in the budget documents, the Intergenerational Reports, and so on,

But if my worst-case scenario comes about sometime in 2008 or 2009, unemployment could be rising appreciably. In this environment, the underlying inflation OUTLOOK might well be starting to subside, even though it will not yet be showing up in the CPI figures. In this situation the RBA may be prepared to cautiously reduce interest rates. But, because our Bank likes to dribble out changes (unlike the Federal Reserve which seems prepared to savagely cut despite high inflation), and because of doubts about the effectiveness of monetary policy in a financial crisis situation, the RBA might actually welcome some support from fiscal policy. The two instruments would then be in synchrony and reinforce each other. A rigid “no deficit” stance would be very silly in those circumstances and I hope Rudd prepares the ground for it in his rhetoric.

As you know, like Bernie Fraser, I reckon it’s good to use whatever instruments one can cobble together in the circumstances to lean against the wind of the trade cycle, whichever way it’s blowing.

That’s why I want to improve the institutional architecture of fiscal policy as we’ve done with monetary policy. As I’ve thought all along, given the pop macro-economics that passes for fiscal conservatism these days, there was a fair chance we’d need those institutions (like an independent body providing public advice to the Govt on fiscal policy) at times such as those you argue threaten us now which require greater fiscal expansion.

All that having been said, I can’t see how you’ve made the case for fiscal rather than monetary policy easing – at least not with points about anti-inflation cred. If anti-inflation cred is at stake, then why would fiscal expansion be less inflationary than monetary expansion. And to the extent that fiscal expansion stimulates inflation the RBA will presumably take it upon itself to undo this with interest rate rises.

The one thing that gives me pause is that you’re describing a period of stagflation rather than recession. This has some of the same ultimate causes as the stagflation of the 70s – sharp rises in the real prices of commodities (especially oil), overly optimistic judgement by policymakers of the underlying rate of productivity growth, and massive currency misalignments due to sustained war-driven fiscal deficits in the reserve currency’s home. Keynesian policy proved notably ineffective in those circumstances.

If it happens, it won’t be a good time to be in government.