An Interest Rate Cut That Starts A Nation

Newcastle Herald

Wednesday November 5, 2008

Steve Keen

THE Reserve Bank of Australia yesterday cut interest rates by 0.75 percentage points.

This is the third cut in three months, bringing the cumulative reduction since September to 5.25 per cent.

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 bull's 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 only things that can go wrong, according to this theory, are the product of government decisions where the discipline of the market can't exist.

The RBA was openly critical of government policy in the previous years, regarding it as too inflationary.

This is why it put interest rates up last November, during the 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.

It wasn't Goldilocks taking out the debt, but Daddy Bear, under the influence of naive 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 ABS 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 per cent 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 US, private debt rose by $US4.5 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 per cent fall in sales.

Sales by all car manufacturers were severely down, with sales in October 32 per cent lower than a year ago.

Australia is not quite so debt-dependent, but even here increased debt accounted for $260 billion of spending last year, compared to our GDP of $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 been put in this position in the first place.

A generation of bankers, and of economists, have a lot to answer for.

Steve Keen is an associate professor of economics at the University of Western Sydney and author of the Debtwatch Report (debtdeflation.com/blogs).

© 2008 Newcastle Herald

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