Yesterday the RBA (Australia’s Central Bank) cut its reserve rate by three quarters of a percent, to 5.25 percent. This is the third cut in 3 months, bringing the cumulative reduction since September to 2 percent

This is a far cry from the RBA’s expectations in 2007, that in 2008 it would be raising rates to constrain a booming economy and bring inflation back down to its target range.

Inflation is still above its target, but clearly that’s a bulls eye the RBA is no longer aiming for. What on earth went wrong with the RBA’s predictions for 2008?

The RBA’s mistake was to follow conventional economic theory—known as “neoclassical economics”. This theory completely ignores private debt, in the belief that private debt reflects rational decision-making and will therefore always be at a “Goldilocks” level—“just right”.

The things that go wrong, according to this theory, are the product of government decisions—where the discipline of the market can’t exist. The Reserve was openly critical of government policy in the previous years, which it regarded as too inflationary. This is why it put interest rates up last November, during the Australian election campaign—an unprecedented move.

It’s also why the Rudd Government made every noise it could about being fiscally responsible earlier this year, to signal to the RBA that there was no further need to raise interest rates.

The RBA did increase rates twice more of course—in February and March of this year. Then just six months later, it changed tack—cutting rates first of all tentatively, and then decisively.

In doing this it is now going directly against the theory that once guided it—because that theory is clearly wrong. Above all else, it is now obvious that private debt levels aren’t the result of rational decision-making, but the product of an irrational exuberance that asset prices would always increase. 

In other words, it wasn’t “just right Goldilocks” taking out the debt, but Daddy Bear, under the influence of naïve theories about the economy that were every bit as intoxicating as bad beer. Now with falling share prices everywhere, and house prices tumbling almost everywhere (even in Australia on the latest Australian Bureau of Statistics figures), the global economy is being driven south by an enormous debt hangover.

The RBA is being forced to follow, and it deserves some kudos for so rapidly turning around from administering the wrong medicine to at least trying to reduce the pain of the hangover. But there is much further to go. Each 1 percent reduction by the RBA reduces the interest payment burden on the economy by $18 billion a year—if the cut is passed on. But as the Bear family goes from irresponsibly bingeing on the credit card, to trying to live within its means and reduce debt, spending in the economy dives by far more.

In the USA, private debt rose by US$4.5 trillion in 2007. That figure is rapidly spiralling down towards zero now, and with it consumer spending is collapsing—as General Motors confirmed on Monday when it reported a 45 percent fall in sales. Sales by all auto manufacturers were severely down, with sales in October being 32 percent lower than a year ago.

Australia is not quite so debt-dependent, but even here increased debt accounted for A$260 billion of spending last year, compared to our GDP of A$1.08 trillion. As we stabilise debt, the economy itself will destabilise. The RBA, and the Government, are doing all they can to tip the balance back the other way, but we should never have got into this position in the first place. A generation of bankers, and of economists, have a lot to answer for.