More on interest rates and tax cuts

Cub Troppo readers have presumably been following my discussion with Brendan Halfweeg on the comments thread of Nicholas’s post on interest rates and tax cuts, with the eager fascination normally reserved for a match-point rally in a Wimbledon final. The ball is currently in Brendan’s court, but in the meantime Nicholas has brought to my attention an opinion piece by Sinclair Davidson and Alex Robson, which sounds similar in flavour to what Brendan was arguing. Whether Brendan read some earlier piece by the same authors, or whether the arguments have been doing the rounds in ‘Austrian’ circles that both Brendan and Davidson-Robson are wired into, I’m not sure. But if this is the complete argument, then there is no need for Brendan to continue, because I’m now satisfied that it’s the most perfect nonsense, and my curiosity is fully exhausted. A line-by-line examination is the best way to show what’s wrong with it.

The question is whether the tax cuts promised by the Coalltion and Labor will aggravate inflation. Davidson and Robson note that the received view is they will. They cite Saul Eslake and Peter Hartcher as representative of those who think the proposals are irresponsible… and then they’re off:

Neither is arguing that tax cuts per se cause inflation; they’re suggesting that economic growth and full employment cause inflation.

Actually, they’re not saying either of those two things. They’re saying inflation is triggered when aggregate demand grows too fast for productive capacity to keep up and systematic labour shortages arise.

True, as the economy approaches capacity prices will rise.

Indeed it’s almost true by definition. ‘Full capacity’ is not easy to define or measure, but a common operational definition is that it’s a level of output at which, if demand exceeds this level, prices must rise.

This simply reflects that resources, including labour, are now more valuable and are being employed in their most productive use.

Here is where the argument starts to take on its distinctive, and weird, flavour. What on earth does this mean? It’s quite simply a logical impossibility for all resources to increase in value as a result of higher domestic spending. The joint value of resources is determined by their productivity in terms of domestic products and by the country’s international terms of trade. Neither of these changes when taxes are cut. If the price of labour increases the return on capital goes down.

But let’s suppose we’re just talking only about labour. What would it mean to say that labour ‘is now more valuable’? In a given country, labour has a demand price (determined again by productivity and the terms of trade); and a supply price, (determined by how the worker values his leisure time, as well as the cost of training.) If the ‘value of labour’ means either the demand price or the supply price, neither of those things is altered by a tax cut. The actual price of labour — the wage rate — in a free labour market will obviously be somewhere in between. But at full employment competition will drive the wage up to the supply price of the marginal worker. It can’t go any higher than that. On average, that is. Individual firms will try to poach workers by offering higher wages, so gaining temporary advantage in the competition. But they will raise their selling price to keep their profit margin intact, and by doing so reduce everyone else’s real wage just a little. Note that if they don’t do this, and simply accept lower profits, then it must be case that there were previously paying below the demand price; so by definition we are not yet at full employment, and there is no need for an interest rate rise.

Economists refer to this as a change in relative prices.

Yes, they do. But as we’ve just seen, there is no change in relative prices.

Inflation is something different. Inflation occurs when the value of money itself falls.

The value of money falls when prices are on average higher than they were before. An adjustment of relative prices may or may not involve inflation depending on the circumstances, but it’s true that the two are conceptually different things. However, this is all irrelevant since there is no relative price adjustment going on. What is, in fact, occurring is inflation. But here the argument takes an audacious turn.

Historically, spending policies that have tried to promote full employment have tended to debase the currency.

‘Debasement of the currency’ is just a quaint expression for inflation. The statement is correct, however.

This is not likely to be the case now. Both major parties are committed to budget surpluses, and the Commonwealth has no net debt. There is no deficit to be monetised.

‘Monetising’ a defict means financing it with newly created money. But our governments have never financed budget deficits this way; we’ve always financed them by borrowing from the public. (Strictly speaking, the central bank monetises some of the outstanding debt over time, but at a rate of its own choosing, according to the growth of transactions in the economy). This being the case, there is nothing inherently inflationary about deficits. What matters is whether a given increase in spending or cut in taxes is adding to total demand. This is not to say that deficits are never inappropriate or even harmful (this depends on a whole lot of circumstances), but as far as inflationary forces are concerned, whether the budget is initially in surplus or deficit is neither here nor there.

The mechanisms whereby full employment can cause inflation are unlikely to operate.

This statement is apparently meant to clinch the argument. But if the mechanisms alluded to are not the ones we have been talking about — excess demand, labour shortages, rising wages — ought not our authors to tell us what what they are? Actually, the mechanism in question is probably some dogma connected with the quantity theory of money, to the effect that additional demand can only be inflationary if it’s accompanied by an increase in the monetary base. But since the story is not spelled out here, and in any case the premise about budget deficits being monetised is wrong, it is difficult to make any sort of response.

We should reflect further on these criticisms of tax cuts. Are people really suggesting that policies promoting full employment should be avoided simply because they may lead to higher interest rates?

Yes, and higher interest rates mean less investment in plant and equipment, which is what we need to expand productive capacity.

This is advocating a form of voluntary unemployment; as a society should we choose policies that lead to unemployment to avoid paying an extra 0.25 per cent on our mortgages?

No, the argument is that we are already at full employment. If that’s the part that Davidson and Robson disagree with, then by all means let them argue for more labour market deregulation, the abolition of of minimum wages and so on. But until such measure have been carried out and seen to succeed, it is ludicrous to advocate tax cuts when inflationary pressure is already in evidence.

This type of policy choice constitutes a wealth transfer from those on the margins of the labour market – often disadvantaged individuals – to those who can afford a mortgage.

On the contrary, if the interest rate rises, and the prospect of more of them, tip the economy into recession, your disadvantaged individuals will be the ones who really suffer. Long term unemployment is a safe bet for most of them.

Inhibiting economic growth and full employment is a remarkably regressive policy.

Even supposing the unemployment rate could be reduced to, say, two percent, this would be associated, as far as I can tell, with a one-off increase in GDP of around one percent. How is keeping the unemployment rate at four percent rather than two ‘inhibiting growth’?

Even if tax cuts and full employment did lead to higher interest rates, it is still not clear that government shouldn’t pursue that objective. In the first instance, we should recognise that higher levels of disposable income will allow people greater choice in how they live their lives and pay their bills, including their mortgages.

That’s an entirely separate issue. Through a combination of inflation and interest rate rises, the higher consumption will crowd out some investment and net exports, increasing our national liabilities and reducing our future productive capacity. Maybe it’s a free choice in some sense, and maybe that means it’s a good thing. In any case, it certainly doesn’t mean it’s not inflationary.

Over time, with a growing economy, the mortgage burden should fall as home owners’ incomes rises.

This is not an argument. You could say this to justify any proposal whatsoever. In any case, higher interest rates reduce investment in plant and equipment, which is harmful for growth.

In any event, governments have a responsibility that goes beyond home owners. There are still about 470,000 unemployed Australians. That is still almost double the number of jobs created in the past year. The personal and social costs of unemployment and sustained welfare dependency are likely to be much greater than another 0.25 per cent on the average mortgage.

You can’t have it both ways. Either we are below full employment, in which case there is no inflationary pressure and we don’t need higher interest rates; or we are at full employment and would benefit from a fiscal stimulus.

We shouldn’t forget interest rates fluctuate far more than the cost of unemployment. High housing prices and low unemployment are a sign of economic prosperity.

This piece of gobbledygook is a fitting way to wind up a generally incoherent line of reasoning. Does it mean that interest rates fluctuate more than unemployment? Do they? And when did the volatility of this or that variable become part of the discussion? High housing prices are a sign of prosperity, along with high wages and high interest rates, it seems. Is there any relative price that doesn’t become high in a growing economy under this argument?

When interest rates and the unemployment rate were gradually falling, over most of the period since the last recssion, the big debate was over how low unemployment could get. Eventually, everyone agreed, somethreshold would be reached, and signs of overheating would appear. Some economists have been surprised that the unemployment rate was lowered so far; others are much more optimistic, and think that it can go even lower. The role of industrial relations legislation and imported labour are hotly discussed. There are all legitimate questions. For those who think there’s scope for reducing unemployment any further, it is consistent to advocate continued strong growth of aggregate demand. This could be achieved either by keeping interest rate low, or by means of a fiscal stimulus. But it makes no sense whatsoever to advocate a fiscal expansion — especially in the form of tax cuts — while conceding that this will make an interest rise necessary. The arguments about resources ‘increasing in value’, and about ‘monetising the deficit’ are completely spurious.

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14 years ago

It perplexes me that Sinclair Davidson is a Professor of Economics at RMIT. He tries hard, but the quality of his work does not seem to justify a professorship.

Alex Robson
Alex Robson
14 years ago

James: So does that mean an increase in taxes would lower inflation? If that’s the case, why do we need the Reserve Bank?

James Farrell
James Farrell
14 years ago

Yes, of course, in an overheated economy a tax increase would dampen inflation. I can’t believe it’s even an issue. As for the second question, the Reserve Bank has a prudential role in addition to its role in macroeconomic management, so I assume the question refers only to the latter. We use monetary instruments to manage aggregate demand because (1) two instruments are better than one, and fiscal policy is subject to other constraints and objectives; and (2) the monetary authorities are independent of politics, which is now understood as crucial to their credibility, and in turn to its ability to influence expectations. These are hardly revolutionary propositions — I’m only setting out the received wisdom here.

14 years ago

There are numerous examples of nations raising taxes and inflation isn’t dampened. South America will oblige as a case study.

Managing inflation through the tax rates is taking us back to the 70’s. In other words it is sheer twaddle.

Inflation- currency debasement- is a monetary problem and nothing else while tax policy is all about raising money to finance government expenditure.

Robson”s point is a good one. Why have a central bank if you can manage currency debasement through tax rates? Just keep changing the tax rates every month to hit the CPI target. That ought to do it. Piece of cake, right?

James, try this thought experiment. Take Mugabe land. Raise the tax rate 30% and then see what happens to the 1 mill% inflation rate. It wouldn’t budge simply because the printing presses are on 24/7.

We were messing with tax rates all through the 70s as a demand management exercise and it was a sorry Keynesian mess. Every budget produced changes to tax rates and inflation simply went one way. Inflation is monetary problem and that can only be managed through monetary policy.

Why not manage fiscal policy through the monetary levers then. Oh, we already do that.

“Yes, of course, in an overheated economy a tax increase would dampen inflation. I cant believe its even an issue.”

Follow the money chain, james and you will have yoru answer. the money has to come from somewhere, right? The central bank put the money in circulation in the first place, which is then taxed and returned to the government in the form of a surplus through taxes. If you think the surplus being returned is inflationary than you need to ask why that money was printed in the first place. Look no further than Martin Place.

A surplus is an exercise in wastful futility. The money ought to be returned to its rightful owners.

Nicholas Gruen
Nicholas Gruen(@nicholas-gruen)
14 years ago

Alex – is there any chance of drawing you out further in your own defence? Because I can’t make head or tail of your article.

You call a rise in prices of “resources, including labour” a change in relative prices. What is the change in ‘relative’ prices relative to? It looks to me like the price of all resources rises – presumably in the empirical world there’s a spread of price rises – with some average overall price rise being involved. That looks like a change in the price level to me.

You then contrast this with ‘inflation’. Now I expected you to say – along the lines of Brendan’s discussion with James in the earlier thread that ‘inflation’ is an ongoing change in prices. Whereas what we’re witnessing is (according to certain assumptions) a one off change.

But you don’t say that.

You say “Inflation occurs when the value of money itself falls.”

Well, call me old fashioned but I can’t see the difference in the general price level rising and the value of money falling.

Then you propose this idea that tax cuts will increase employment. I don’t follow this. As I understand it, if tax cuts increase demand beyond a certain level the RBA will feel forced to raise rates to restore price stability – and when will they be comfortable that they’ve achieved that? At about the level they were at before the tax cuts.

So I can’t see how you can say that the tax cuts increase employment. (Indeed it’s hard to see them doing it even temporarily, because the RBA will react pretty immediately and is forward looking as are the markets).

So it’s all a mystery to me. As you can see, James analysis leads to similar conclusions about your argument (that it is fallacious) via a quite different route. I’d be grateful for some explanation of what that argument is and how it survives our critiques.

Nicholas Gruen
Nicholas Gruen(@nicholas-gruen)
14 years ago

Well I must say, I’m disappointed with the response from both Alex and Sinclair. If I put an argument into the public arena I try to defend it when it comes under attack.

I try to admit it when I’m wrong.

I’m not sure what the point of this blog would be if that wasn’t going on. That’s it’s point for me anyway. But we can’t get engagement from Alex or Sinclair on their ideas.