Monetary policy is really weird
Why attempt to stabilise the macroeconomy via mortgages and house prices?
Imagine that you host a meeting of the smartest economic experts you can find because you are the leader of a country facing disruptive economic cycles. You want to minimise the cycles and the disruption they cause.
One of the experts pipes up with a suggestion.
“We could regulate the price of food. When the economy heats up, we increase the price of food, and then lower food prices when there is a bust.”
Great. Someone has an idea. This is progress. The expert carries on.
“If the price of food goes up, people will have to still buy the same amount of food, which will cost more, so that they have less money to spend on other goods and services.”
“When that happens, all those businesses relying on that spending will see lower sales. They will reduce their input orders any pull back expansion and investment plans, and with a bit of luck, that means they will start firing people.”
“And what do we call an economy where people are being fired and investments aren’t being made? Definitely not a boom.”
“See. We can solve economic cycles.”
The other experts sit quietly, pondering the sheer brilliance of the idea.
“And the beauty of this idea is that when there is later a bust, we simply decrease the price of food again and all that extra spending will go to businesses who will happily rehire their staff and invest in expansion.”
That’s it. Amazing.
Of all the possible ways to manage the economic cycle that these experts can think of, this is clearly the best one. Forget that the next best option, and their only other option, was to do nothing.
So goes the story of how we started managing the macroeconomy via the price of food.
The story of managing macroeconomic cycles by manipulating the price of food should seem weird. Increasing the price of food in the hope of crushing other businesses so that they fire people doesn’t seem like a sophisticated way to manage the economy.
But I hope it also demonstrates that the story we now take for granted of managing the macroeconomy through the price of money, which primarily means the cost of mortgages and housing, is also weird. Monetary policy is intended to increase the cost of mortgages so that people have less money to spend elsewhere, crushing businesses that will respond by firing people.
People are noticing
I’m not the only one to notice how weird monetary policy is.
Dean Baker pointed out how the whole intention of tight monetary policy is to make more people unemployed.
Paul Williams noted how in practice we manipulate a financial market on a computer somewhere in the hope that people stop building new houses.
The puzzle to me is why these weird elements of monetary policy are so rarely discussed. Not just now, but in the past three decades of the monetary policy era. After all, the textbooks have explained exactly how raising interest rates is meant to increase mortgage costs, decrease housing asset prices, reduce spending, and make more people unemployed.
We are trying to manipulate the housing market
Recently, RBA Governor Phil Lowe was interviewed by Leigh Sale on ABC 7.30 where he subtly admits that the housing market is the key way in which monetary policy works.
Leigh Sales: Other than interest rates, what other factors are likely to drive the Reserve Bank’s thinking on interest rates? For example, if housing prices fall significantly, would that play a role in what you decide to do?
Philip Lowe: Not directly. We don’t target housing prices, nor would it make sense to do so. But we know that swings in housing prices affect people’s consumption decisions. For many people, if the value of the house is falling, they’re going to spend a bit less. So that’s the prism we look at this through. We don’t target housing prices and I think … I know the banking system’s very strong at the moment. So we’re not worried that declines in housing prices will affect the banking system. So it’s really what effect does it have on household consumption.
So we’ve got declining housing prices, but we’ve got to remember as well that households have saved this extra $250 billion and the current rate of saving is very high. And unemployment is low and the number of job vacancies at the moment is extraordinarily high.
So there are a lot of other factors that are influencing consumption other than housing prices and our job is to work out what the balance is amongst all those factors.
This is exactly what the economics textbooks say, and how central banks themselves describe what they are doing. Looks an awful lot like all the action is in the housing market.
Lower interest rates for loans can encourage households to borrow more as they face lower repayments. Because of this, lower lending rates support higher demand for assets, such as housing.
A reduction in lending rates reduces interest repayments on debt, increasing the amount of cash available for households and businesses to spend on goods and services. For example, a reduction in interest rates lowers repayments for households with variable-rate mortgages, leaving them with more disposable income.
Lower interest rates support asset prices (such as housing and equities) by encouraging demand for assets. One reason for this is because the present discounted value of future income is higher when interest rates are lower.
Higher asset prices also increases the equity (collateral) of an asset that is available for banks to lend against. This can make it easier for households and businesses to borrow.
An increase in asset prices increases people's wealth. This can lead to higher consumption and housing investment as households generally spend some share of any increase in their wealth.
When we use monetary policy in the opposite way, to dampen the boom, these mechanisms happen in reverse—reduce demand for housing assets, increase mortgage repayments leaving people with less disposable income, lower house prices, decrease equity, decrease wealth, decrease new housing construction.
There is no alternative
A striking feature of using monetary policy as the primary approach to macro-stabilisation is how globally accepted the approach has become. A country like Australia is a small cog in a much bigger financial system where the major players believe that monetary policy is the economically pure and perfect way to manage the economy.
Using more fiscal policy is one way to help smooth the cycle without doing it via the price of mortgages.
For example, during a boom, governments can delay major government capital spending programs, and ensure they have a progressive tax system that automatically taxes more. During a bust, governments can accelerate capital works programs (dare I mentioned public housing construction?) and put money in people’s bank accounts. Automatic stabilisers in the form of lower taxes and higher welfare payments also help.
It is also possible to try and dampen the cycle itself by limiting the speculative incentives in financial markets that drive the boom and bust cycle. Higher taxes on capital gains from asset ownership, and limits on access to high-risk credit, especially in housing markets, are just a couple of ideas.
The problem is that in practice, these types of policy options require a lot more capability, capacity, and desire for the government to play a more hands-on role. With monetary policy, we pretend it is a magic wand, not the outcome of a very hands-on interventionist central bank and active discretionary policy choices. It is so remote from the daily lives of everyday people. It all happens behind the scenes in office towers and on computers, in accounts that few ever see or understand. A true Wizard of Oz situation.
Few are yet willing to pull back the curtain and ask whether we want to manage economic cycles via the price of mortgages and housing. But I think it is time we did.
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