Tag Archives: interest

Inflation – what to do depends on your starting point

I have a T-shirt that I am wearing as I type this. On its front, in mock Gothic text are the words:

The wealth of those societies in which the capitalist mode of production prevails, presents itself as “an immense accumulation of commodities,” its unit being a single commodity. Our investigation must therefore begin with the analysis of a commodity.

These are the opening words of Marx’s epic work, Capital. As openings go, it is not as memorable as “In the beginning God created the heavens and earth” (Genesis), or “Man is born free, but everywhere is in chains” (Rousseau), or even Marx’s own “There is a spectre haunting Europe”.

However, it was only after reading Anwar Shaikh’s Capitalism and listening to his lectures that I realised the importance of this opening to Capital.

T-shirt with the opening words of Marx's Des Capital.

Comparing starting points

Marx’s words here are a recognition that to analyse capitalism we must start with the production of commodities, and their expression/capture of value. In capitalism, production does not happen as a charitable act or even as a provisioning of society in response to demand for goods and services (because we know that many people are not provisioned and some demand for necessities is unmet). Rather, production is organised and happens in the expectation of profit. From this starting point comes an analysis of:

  • how the production process is structured and contested,
  • the extraction of value beyond the cost of inputs into that production process, and
  • how this surplus is shared through the community – initially the distribution between capital and labour, but subsequently through flows to different parts of capital (e.g. financiers, technology owners) and finally through tax and transfers to different parts of the economy and society.

By contrast, much mainstream economics tends to start from exchange in a market – the price at the meeting of supply and demand. The production process is almost assumed (at least in the first instance). The return to capital is naturalised at an equilibrium rate determined by the market, while at the macrolevel, equilibrium can be obtained (or at least approached) by management of supply and demand – because what governs the economy is not a pursuit of profit but a market whose “natural state” is equilibrium.[1]

At one level, the different starting points mean that we are simply asking different questions and one may choose a theory depending on what question you want answered. However, it is more complicated than that, partly because the above is over-simplified, but also because, as I argued long ago, such theoretical starting points do not just ask different questions, they actually create different objects of inquiry – “the economy” is a different animal in the different theories.

But beyond that, the different starting points may have very different policy outcomes. Take for instance our current problem of persistent inflation.

Inflation

Regardless of the external factors that may have kicked off inflation (e.g. COVID, war, energy shocks), if your economic starting point is a supply and demand equilibrium, you are likely to see the need to reduce demand in the economy to ensure that demand is not exceeding supply and thus pushing up prices. At the most basic level, reducing demand at the macroeconomic demand can be done by:

  • fiscal policy, that is, increasing taxes to take money out of households and business, thus reducing their demand for goods and services), or
  • monetary policy – that is, increasing interest rates which in theory will increase savings (or loan repayments), similarly meaning there is less money to demand goods and services.

Fiscal policy is regarded as dangerous, partly because neoliberalism has convinced us that taxation is bad (and even undemocratic) and partly because surpluses lead to political pressures to cut taxes or spend more – which would be inflationary. So, we are left with the Reserve Bank increasing interest rates to try to dampen demand and bring inflation back to its target zone (2-3% p.a.)

However, if you start your economic analysis not from a theory of equilibrium supply and demand, but rather from a theory of capitalism and flows of value in an economy, then firstly, you might question the possibility of macroeconomic control by demand-management – as Shaikh does. Secondly, you might want to trace the impact of interest rates on flows in the real economy, where higher interest rates represent a bigger claim on surplus by finance capital. In this analysis, those seeking to make money out of non-finance capital are forced, to the extent possible, to increase their prices to maintain their return on capital.

This is most evident in the housing market where rental prices are increasing faster than inflation (September Quarter 2023 CPI: 5.4%, rent increases 7.6%). Higher interest rates increases costs and lowers the return to landlords with mortgages. They then put up rents to cover their increased costs, while landlords without mortgages can cash in on the higher rents attainable in the market. In this scenario, interest rates are driving rental inflation. Further, as the ABS has highlighted, rent increases are one of the major contributors to overall inflation. This is not to deny that there are supply problems in the rental market, but it does suggest that increasing interest rates may have a contradictory inflationary impacts.

Similarly, the conventional wisdom of higher interest rates taking money and demand out of the economy is challenged by the fact that around one-third of Australian households are not paying a mortgages or rent. For many of those households, higher interest rates translates as increased income from their savings. They have more money to spend and there is a growing recognition that this is promoting demand in those groups and undermining the demand-reducing purpose of increasing interest rates.

Conclusion

Put most simply, increasing interest rates to control inflation makes sense if your starting point is a conventional supply and demand analysis where macroeconomic outcomes can be regulated by demand management. But increasing interest rates to attack inflation makes less sense if your analysis starts by looking at how capital will respond to such an increase, and how that will impact on economic flows in the economy. In this scenario, increasing interest rates is possibly counter-productive (even in its own terms – and not even thinking about the human cost of the “desired” economic slowdown). At best it is a blunt instrument when more direct market interventions (such as price caps or taxes) could better impact on the particularly economic flows driving of inflation.

Or, to put it another way (in light of populist media attacks on Philip Lowe and Michele Bullock), don’t blame the person or personality of the Reserve Bank Governor – blame the economic theory.

[1]              In Shaikh’s analysis, this supply-demand-equilibrium applies as much to Keynesian and neo-Keynesian economics as to neoclassical economics, it is just that the former theories recognise that the equilibrium may, without state stimulus, be below a full employment of resources.

Debt, Interest Payments and Choices: A Surprise in the SA State Budget

As we make our way through the first month of a new financial year, political economic debates are dominated by inflation, interest rates and “full employment”. But the discussion of interest rates is generally focused on their impact on inflation at the macro-level, and on mortgages and cost of living at the micro-level. The impact of interest payments on government budgets is usually noted in budget night commentary on the deficit/surplus scorecard, but promptly forgotten for the rest of the year.

However, an unusual occurrence (at least in recent times) in the South Australian state budget should serve to illustrate why interest rates matter to government and to the community. In 2023-24 the amount of government expenditure going to servicing state debt ($1,254m) will eclipse the budget for the Department of Human Services (DHS) ($1,148m). This difference grows over the forward estimates with the DHS budget subject to real cuts (low indexation and older operational savings) while interest payments increase substantially. By 2026-27, interest payments are predicted to be $1,684m, by comparison with a DHS budget of just $1,233m.

Column graph comparing SA State Budget expenditure showing interest payments increasing from 2022-23 to 2026, while DHS expenditure remains stable.

In practice, this means that we are spending more on debt repayments than we are on the Department that is the primary provider of support services for the most vulnerable and disadvantaged people in our state. That feels wrong – but apart from the shock value, does it really matter, or it is just a statistical coincidence with no budget or social impact?

A Debt Problem?

As I pointed out in SACOSS’ post-budget analysis, government debt and deficits are not necessarily a problem – and may represent important economic stimulus or long-term investment. And there is no suggestion that this level of debt in unsustainable, although the budget papers show that a 1 percent point increase interest rates in 2023-24 would equate to an extra $203m in service payments. That would obviously be a significant imposition on the budget, but even with the debt-to-income ratio rising, the government can clearly still maintain payments. However, if debt is unchecked or interest rates continue to rise, at some point interest payments either become unsustainable, or more likely, a significant constraint on budget spending in other areas.

In that sense, the comparison of interest payments and the DHS budget is important because it reminds us of the potential impact and opportunity cost of state debt. I am not suggesting that if we were not paying that money in interest, we would be spending it on human services. That would be wishful thinking! However, all government spending has distributional impacts, and interest payments are no different. The comparison with DHS expenditure simply serves to focus the interest payment discussion on inequality.

Debt, Interest Payments and Inequality

In providing concessions and emergency supports to those on low incomes, and funding charities to provide a range of other supports, the Department of Human Services functions to transfer money and resources from the budget to those most in need. By contrast, interest payments are a transfer from the budget to government bond holders – who, by definition, are those with excess cash to afford to lend money to the government (by buying bonds).

As Piketty has pointed out, (and [as ever] some of the concerns here come from my reading of his work) it is far more advantageous to those with capital to have public deficits and receive interest on their money than to have that capital taxed to balance the budget (Capital in the Twenty-first Century, p.130). So, in creating government debt we have already chosen to favour those with capital by borrowing rather than taxing their money and creating an ongoing flow to rather than from that capital.

Seen in this light, the contrast between the DHS budget and the amount going to debt servicing is an indicator of choices about government priorities – the choice to provide relatively less to the poorest in society (via government expenditure) than to those who are better off (via taxes foregone and interest paid out).

Caveats

Of course, as with everything in economics, it is not as simple as that. The initial use of borrowed capital may be used for things which support those on low incomes, and inflation may quite separately have a counter-balancing impact by undermining the real value of bonds and the interest payable on them. Further, bond-holders may not be South Australian residents and may therefore be outside the tax ambit of the state government. In that sense the taxing v borrowing from capital argument above is not about individual bondholders. Rather it is illustrative of the options of government in general and operates at the level of class: that is, the state government has options to tax local capital rather than borrow from capital in a national or global market.

To the extent that we can look at individual bondholders, it is also worth noting that, as Piketty points out, they are no longer necessarily the wealthiest people in society (as the super-rich can invest more lucratively elsewhere). ABS wealth statistics do not record bonds as a separate category, so it is hard to confirm this. However, it is clear that the low-inflation era of the first years of this century made bonds a safe investment for middle class superannuation and investment funds, so when we talk about bondholders it is likely we are talking about middle and above-average income earners (often via superannuation or investment trusts). In that sense, the DHS/interest payment comparison is not so much about rich vs poor, but about a form of middle-class welfare instead of a transfer to those in most need of the supports that a DHS might offer them.

Finally, there is another (non-taxation) route to balancing the budget and avoiding interest flows to capital owners. That is by cutting expenditure. However, cuts to expenditure (and therefore to services) usually impact disproportionately on the poorest people. Those with the fewest economic resources are likely to be most reliant on support services and have limited or no alternative options, so expenditure cuts usually also impact most on the poor. Further, it is notable that in this SA budget, government debt continues to increase even with operational surpluses from 2023-24 onwards, so balancing the budget is not simply done by cutting expenditure. However, there is little doubt that when government services are cut (the “austerity approach”) this exacerbates inequality, so if fairness or equality is a consideration in balancing the budget, we must ultimately return to revenue issues – and our preference for borrowing rather than taxing capital.

Why Debt and Interest Payments Matter

Budget deficits and surpluses matter, but not for the reasons often touted in economic commentary (“responsible government”, “living within our means”). They matter because they determine the level of debt, which in turn, within any given interest rate regime and revenue base, impacts on the money available to spend on services. And as interest rates increase, so too does the cost of servicing government debt. The choices made to borrow rather than tax capital increasingly manifest in a distribution of government revenue to the middle and upper middle classes rather than to those on the lowest incomes who would benefit most from government service provision.

The fact that the SA state government interest payments now eclipse spending on the Department of Human Services should make us think about government priorities and the need for a stronger tax base.