Big little economic lies

By Hugh Giddy |  30 June 2021
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Economics falls under the social sciences but calling it a science is far from appropriate. The scientific method involves formulating a theory and making a hypothesis, which may then be tested and independently verified via real world experiments.

Over time economics papers and research have increasingly used mathematics and statistics, lending an air of science and fact-based theory to the field. The use of mathematics requires modelling behaviour into formulas, and making assumptions about how people behave, normally excluding other factors from changing, which in the real world is seldom the case. Even allowing for the questionable assumption that you can prove causality while keeping normally dynamic factors constant, over 70% of the results claimed in economic journals cannot be independently reproduced. Given such a questionable theoretical backdrop, one would think policymakers would be highly circumspect before interfering in the economy and livelihoods. Instead, they express confidence that their policies will have assured and favourable results.

Much of society and the media therefore do not question the many myths that justify policies which may be hurting us over time. Here are a few of the most important myths.

Most western economies are largely free market, capitalist economies

The pricing mechanism is assumed to be governed by market forces, with justifiable intervention by governments to limit monopoly power, or to protect the environment or basic rights such as freedom from slavery. Market forces do not work properly when there is essentially unlimited supply of something that should have a value. That is the case with fiat currencies, particularly as central banks are freely printing money or increasing the money supply by buying government debt (effectively practising Modern Monetary Theory, a theory endorsed by few reputable economists). Central bank control and manipulation of interest rates, perhaps the most important price in the economy, leads to inevitable distortions. The capitalist system no longer operates as effectively, with excessive risk being taken, moral hazard and limited creative destruction as uneconomic businesses are not allowed to fail.

Australia has had a pleasingly rapid recovery from a brief recession. Much of this has been attributable to government spending and subsidies with soaring housing approvals, and direct household income support. Businesses are now experiencing skills shortages. Almost free money has led to inflating asset prices around the world, stretching from houses to equities and commodities. If interest rates were set by the market, such rampant inflation in so many prices would have seen interest rates rise substantially. A normal assessment of risk would require interest rates above inflation. It is unlikely people would then be committing to ever higher house prices. Matthew Wilson of Evans and Partners calculates that average mortgage payments consume around 30% of gross household income, close to previous peak levels, despite interest rates being much lower. Sensitivity to interest rate rises has increased, making households vulnerable should inflation force interest rates higher.

Markets are rational

People are assumed to behave rationally in their economic actions, leading to a stable economic equilibrium. When purchasing goods and services consumers mostly adhere to the theory, buying more at low prices and less at high prices. When it comes to financial assets such as houses and shares (and speculative playthings like cryptos), demand and interest increases as prices rise and value diminishes. Booms and busts are common. Policymakers avoid restricting booms, indeed they often foster and cheerlead such booms. However, they always step in and attempt to minimise the busts that are the inevitable result of excessive speculation.

House prices are high in Australia because of limited supply

Choose your own adventure: land shortages (in Australia?), living by the coast, Chinese buyers, and other factors are claimed as the reason for the seemingly perpetual rise in house prices relative to incomes in Australia. By contrast, for most of the OECD the ratio has been fairly steady over a long period of time.

The truth is that rising house prices seems to be a plank of policy. House prices have been pushed up relative to incomes by low interest rates, longer mortgage terms, negative gearing, stamp duty concessions, and first home buyer grants. Without the rise in credit availability - if banks only lent up to a traditional multiple of income - house prices could not have risen as much as they have done.

Encouraging higher house prices effectively fosters greater inequality as renters are disadvantaged relative to homeowners. There are downsides to higher house prices – council rates and land taxes go up in excess of inflation, as does stamp duty. Unless a house is sold to move to another country with cheaper housing, the benefits are limited. Moving within Australia is only advantageous if you sell to move from high priced areas like Sydney or Perth to a regional area but since most house prices have increased at similar rates, the advantage is not materially greater than if house price rises had only matched incomes. The most certain downside is that there is a generation of people who feel that they will never be able to own their home.

Low interest rates help the little guy or man on the street

Clearly, low interest rates do not help people reliant on interest income, like retirees who have seen interest on their term deposits evaporate. Surely it helps “the battlers” who have debt? Credit card and payday loan rates have not fallen materially but mortgage rates have fallen. However, as noted above, mortgage payments are historically high relative to gross household income because of the rapid rise in house prices, pushed up by confidence and the greater affordability initially created by low interest rates. If low rates push up other prices too, as perversely wished for by central bankers, history has shown wages often lag inflation, leaving workers worse off.

Why do such myths perpetuate? Policy makers are understandably unwilling to accept blame for promoting inequality. It is convenient to postulate housing supply shortages rather than admit to monetary settings being too easy for creating a bleak financial outlook for most young people. Humans also cling to a vision of rationality and prefer intelligent causation over herding behaviour, both by individuals and authorities, in understanding markets.

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While the information contained in this article has been prepared with all reasonable care, Investors Mutual Limited (AFSL 229988) accepts no responsibility or liability for any errors, omissions or misstatements however caused. This information is not personal advice. This advice is general in nature and has been prepared without taking account of your objectives, financial situation or needs. The fact that shares in a particular company may have been mentioned should not be interpreted as a recommendation to buy, sell or hold that stock. Past performance is not a reliable indicator of future performance.
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