Wednesday, September 29, 2010

Save before Reserve Bank forces you

Barring some global catastrophe, the outlook for our economy is particularly bright - so a lot of people aren't going to like it. Why not? Because of something many people have trouble getting their head around, the great paradox of macroeconomics: good things happen in bad times and bad things happen in good times.

We're looking at a long period in which a lot more people find jobs and part-timers get to work the longer hours they'd prefer, while wages grow faster than inflation and business booms.

There'll be just one fly in the ointment: the Reserve Bank will keep putting up interest rates. (Of course, this will be good news for people saving for retirement or already in it.)

Variable mortgage interest rates pivot around a long-term average rate of about 7.5 per cent. They're just under that at present, but either next Tuesday or on Melbourne Cup day it's a pretty safe bet they'll be moved up.

And that's likely to be just the first of a number of increases. Mortgage rates are likely to go well above 7.5 per cent and stay high for a considerable period - maybe until the next downturn in the economy.

In principle, economists love seeing the economy grow. In practice, they get nervous when it grows too fast, fearing that if our spending on goods and services (demand) grows faster than our production of goods and services (supply), all we'll get is higher inflation.

The resumption of the resources boom means our spending is likely to grow faster than production. That's because the world is paying sky-high prices for our exports of coal and iron ore, which is boosting our real incomes, and because mining, oil and gas companies are embarking on a massive investment program that may run for a decade.

What's that? You don't expect any of this mining income to come your way? It will come indirectly, in ways you haven't thought of. For a start, the federal government gets a 30 per cent cut of the miners' profits - and more once its new mining tax gets going in two years' time.

So the extra income may start out in Queensland and Western Australia, but it gets spread around. One way that happens is via the formula by which the proceeds from the GST are shared between the states. For years, NSW and Victoria got back a lot less than their citizens paid in GST and the smaller states benefited; now the two big states are getting a lot more back and the West Australians are coughing up (and, boy, aren't they complaining).

Another way is via the floating dollar. The value of our dollar tends to rise when the prices we're getting for our commodity exports are high. (And it rises a bit more when the financial markets are expecting rises in interest rates, as now.)

The higher dollar makes imported goods - and overseas holidays - cheaper and by this means part of the benefit of higher coal and iron ore prices is transferred from the miners to those people who buy imports, which is all of us.

So, yes, spending by Australian businesses and consumers is likely to grow faster than our production and, to the extent that spending doesn't just flow into imports, it will increase inflation pressure. But not to worry: the Reserve Bank has a tried and true method of slowing the growth in spending. It puts up interest rates, which tends to discourage those forms of spending that rely on borrowing.

Just how high rates will need to go remains to be seen. Many factors will affect it. One, within the collective control of ordinary Australians, is how much of our increased household income we choose to spend. We look to be entering an almost unprecedented boom in investment spending by business. Eventually, the extra mines, coal loaders and gas facilities will add to the nation's production capacity and our prosperity.

In the meantime, however, we don't have enough labour and other resources available to cope with a boom in physical investment and a boom in consumer spending at the same time. The higher interest rates will be particularly intended to discourage consumption and so leave room for investment.

But to the extent that you and I avoid spending all the extra income that comes our way, we'll limit the rise in interest rates intended to discourage us from spending. So now's a good time for us to be saving rather than spending.

That's another thing people have trouble understanding. Everything about our consumerist economy encourages us to spend. When politicians actually urge us to spend - as Kevin Rudd did last year at the time of the $900 cheques - it reinforces the (all too convenient) notion we have a patriotic duty to spend every cent we see.

In truth, the economy moves in cycles of boom and bust and the objective of the people attempting to manage it is to flatten out the peaks and troughs. To this end, they encourage ''counter-cyclical'' behaviour: in downturns, when no one wants to spend, they encourage spending; in booms, when everyone wants to spend, they encourage saving.

But whereas politicians like to give speeches portraying spending or saving as a moral imperative, econocrats have no room for morality in their model. They believe monetary incentives - nice or nasty - speak louder than words, and so merely reach for their interest-rate lever.

In recent times, households have been saving more of their income and doing so of their own volition. As a group, Australian households are heavily indebted - mainly on their homes - and the main way they've saved is by paying down their debts.

So it's a sensible thing to do and the longer we choose to keep doing it the less the Reserve will see a need to beat some parsimony into us with the stick of high interest rates.