Raise interest rates
Raise interest rates

The Reserve Bank of Australia (RBA) reduced its cash rate to 4.5 per cent from 4.75 per cent. While it is good that Australia still has positive interest rates, this is a bad move.

When an economy has total debts (household, corporate and government) of 235% of GDP it should be reducing debt, not increase it. Australia’s 235% Debt/GDP ratio in 2010 is in the same territory as Greece at 262%. While different compositions of the debt and cultural attitudes to tax affect the likelihood of it being paid back, private as well as public debt affects growth.  Money used to service debt, particularly if foreign sourced, is money not spent on other things. Australia now has some of the highest levels of household debt in the world.

The Bank of International Settlements (BIS) produced table copied below shows just how indebted Australia and the rest of the developed world are.

The RBA is acting as if we still operate in a relatively debt-unconstrained world. That by tweaking interest rates it can painlessly boost the economy or constrain inflation. If such a world ever really existed, it certainly does not now. Yes the RBA can kill the economy by cranking up interest rates, but it does not necessarily follow that it can make it grow by reducing them.

Things change. The developed world has an aging population. There are lots of retired people and people saving for their retirement. Reductions in interest rates hits their hip pocket. This will constrain their consumption. Despite the bleating of assorted officials that all is well, many people know it is not. They are trying to reduce their debt. A decrease in interest rates will supply welcome relief, but will not necessarily drive them to the shops in an orgy of GDP boosting wanton consumerism. Some will reduce their rate of debt accumulation or even reduce their total debt.

Then there is the currency effect. The Australian dollar has been very strong. This has made imports, including fuel cheap. If lower interest rates result in a lower dollar, this will increase the price of imports. Increased import process, particularly of fuel, suck the life out of an economy. It is worse than a tax. At least governments tend to spend much of their tax take domestically. Even if the government expenditure is largely wasted it will still provides some benefit, at least for a while. But putting more money into some oil Sheiks pocket does not. It particularly does not if that money is then used to propagate Wahhabist ideology around the world. Who says Saudi Arabia exports nothing but oil?

A falling currency is a mechanism for reducing domestic production costs compared to those elsewhere. But it is not a painless panacea. The flip side of a falling currency is a relatively poorer nation. Although if internal markets, such as that for labour, are relatively inflexible then it can help. But devaluation is a very blunt instrument.

Rising import prices cause pain, but the source of the pain is hidden. Politicians tend to like that, making it a feasible policy choice. Of course, not all countries can devalue at once. Devaluation is a relative game, if some currencies are falling then others must be rising relative to them. That all, or even many might try and devalue at once is what keeps the gold bugs warm at night. In nominal terms, under such a scenario the price of real things will rise. This is not a prediction for immediate inflation. There is a high chance of falling prices as money and valuations are destroyed in a cyclone of credit defaults and forced sales. Although what happens after that is another story.

The Australian economy is in a perilous state. Outside mining related areas and the public service things are dire. But for the good of the nation as whole people need to reduce their consumption and increase their savings. The savings then have to be used to fund productive investments, not just speculation. This move in interests rates will encourage the opposite. It increases the chance of Australia following the US and UK path. It may delay the inevitable housing market correction, but at the cost of making things worse when we do eventually experience our correction. Australia has approved covered bonds, so crony capitalism is alive and well down under.

The Keynesian influenced mindset driving policy does not adequately take into account the starting point. Accumulation debt may have beneficial effects, but too much of it is an economy killer. Much of the developed world is past that point.

Given the level of indebtedness of the developed world there almost certainly will be:

Sovereign defaults. Debt holders do not get repaid in full and on time.

Great stagnations. Prolonged periods of low growth.

Financial repression. Low nominal interest rates help reduce debt servicing costs while a high incidence of negative real interest rates liquidates or erodes the real value of government debt.

There is a non trivial chance of a Great Depression, perhaps the Greatest Depression. The developed world is overdue for one. Our authorities also seems to be taking steps to guarantee that it will be big. Hopefully while the decline may be greater than that experienced in the 1930’s, it will still end at a much higher levels of absolute wealth. We live in hope.

We must also hope that aspects of the 1940’s are not repeated. National and international socialism have always and everywhere been bloody phenomena. But this will be the subject of another post.

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