RBA gets it wrong again

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The RBA has put rates up now on the belief that the finan­cial cri­sis is behind us, and it has to return to its estab­lished role of con­trol­ling infla­tion.

That this deci­sion was like­ly was flagged by the speech by Antho­ny Richards last week, which implied that the RBA, hav­ing ignored the house price bub­ble cre­at­ed by pri­vate cred­it growth in the pre­ced­ing two decades, was wor­ried about the renew­al of the bub­ble ini­ti­at­ed by the Gov­ern­men­t’s First Home Ven­dors Boost (I refuse to call it by its offi­cial name, since the mon­ey clear­ly went to the ven­dors, while the buy­ers copped only high­er prices).

Need­less to say I am all for try­ing to con­tain the house price bub­ble, which I regard as a dis­guised Ponzi scheme that has sucked Aus­tralian house­holds into unsus­tain­able debt lev­els. It is quite pos­si­ble that the increase in inter­est rates (which is sure to be ful­ly passed on by lenders and will add $20 a week to the ser­vic­ing costs of a now com­mon­place $400,000 home loan), com­bined with the phas­ing out of the Ven­dors Boost, will be enough to prick the bubble–especially if it is fol­lowed by anoth­er rise next month.

But the RBA is doing this in the belief that the econ­o­my will return to nor­mal after the recent mild recession–normal mean­ing grow­ing at about 3% per annum in real terms, and faster than that as it rebounds from the reces­sion.

Unfor­tu­nate­ly “nor­mal” in our post-War expe­ri­ence has  also involved a return to a ris­ing pri­vate debt to GDP ratio. Every reces­sion has involved a fall in debt-dri­ven demand, and every recov­ery has involved a return to debt ris­ing faster than income. As the glob­al finan­cial cri­sis has made many peo­ple realise, this is sim­ply a for­mu­la for avoid­ing a cri­sis now by hav­ing a big­ger one in the future.

I doubt that the RBA appre­ci­ates this even today. It is still mired in a neo­clas­si­cal way of think­ing about the econ­o­my, which myopi­cal­ly ignores the impact of debt-dri­ven demand on the econ­o­my. This is why it can put up rates now in the belief that this will mere­ly fine tune the econ­o­my’s performance–reducing the like­li­hood of infla­tion in the future.

I think it is like­ly that the RBA will achieve far more than it intends. The last time the RBA put rates up to attempt to con­trol an asset price bub­ble that was already out of hand was back in 1989. That exac­er­bat­ed the eco­nom­ic down­turn that was already in train as the debt bub­ble of the 1980s start­ed to col­lapse. I expect the out­come of this rate rise will be sim­i­lar: a down­turn that is already in train as a debt bub­ble bursts will be made worse by this increase in rates at a time of great­ly height­ened finan­cial fragili­ty.

The prob­lem this time is I believe far worse than 1990. Then the house­hold sec­tor had a rel­a­tive­ly low lev­el of debt–the mort­gage debt to GDP ratio was a com­par­a­tive­ly triv­ial 18 per­cent, com­pared to its now record lev­el of 87.5%. It was there­fore pos­si­ble for the finan­cial sec­tor to lend willy-nil­ly to house­holds, some­thing neo­clas­si­cal econ­o­mists facil­i­tat­ed by their enthu­si­as­tic dereg­u­la­tion of the finan­cial sec­tor.

Who is there to lend to today? All sec­tors of the econ­o­my except the gov­ern­ment are car­ry­ing record lev­els of debt. Thus while the Ven­dors Boost and oth­er entice­ments encour­aged some addi­tion­al bor­row­ing by the already mas­sive­ly lever­aged house­hold sector–and gave us a house­hold debt to GDP ratio that now exceeds America’s–I sim­ply can’t imag­ine who (apart from the gov­ern­ment) the finan­cial sec­tor can now sell debt to.

As a result, I doubt that we will see any sus­tained accel­er­a­tion in the debt to GDP ratio, with the con­se­quence that the debt-financed com­po­nent of aggre­gate demand will be anaemic at best. Since that has been the major source of growth in aggre­gate demand for many years now, I expect that eco­nom­ic growth will be sub­stan­tial­ly less than the RBA antic­i­pates.

If so, just as it killed a drag­on that was­n’t there by its infla­tion-fight­ing rate ris­es up until March of 2008, it may be tam­ing a lion that is sound asleep with its rate ris­es now. If eco­nom­ic growth does in fact stay well below lev­els that reduce unem­ploy­ment in the com­ing two years, then there will be very good grounds for revok­ing the inde­pen­dence that the RBA has had in set­ting mon­e­tary pol­i­cy. We may as well hand it back to the politi­cians, if the alter­na­tive is to leave it with neo­clas­si­cal econ­o­mists who don’t under­stand the dynam­ics of our cred­it-dri­ven econ­o­my.

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