Reality Bites in Australia’s Savage Rate Cut

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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.

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About Steve Keen

I am Professor of Economics and Head of Economics, History and Politics at Kingston University London, and a long time critic of conventional economic thought. As well as attacking mainstream thought in Debunking Economics, I am also developing an alternative dynamic approach to economic modelling. The key issue I am tackling here is the prospect for a debt-deflation on the back of the enormous private debts accumulated globally, and our very low rate of inflation.