2008 Crunch Time for the Australian Economy?

By: Gerard_Jackson

The economy is beginning to look more and more like the proverbial "poisoned chalice". The Treasure, Wayne Swan, is complaining about interest rates putting "financial pressures on families". This bloke is every bit as bad as Costello. If he really wants to know what is happening he should visit the Reserve Bank, there he will find that the bank's balance sheet is collapsing, not that he would know how to interpret the figures.

Total assets for last December were 92,812 against 135,216 for May 2007. This is a 31.4 per cent drop. The bank's assets have been falling since last may. What our economic commentariat overlook is that the Reserve's monthly balance sheet is an indicator of the direction of the money supply in that when the bank accumulates assets it expands the money supply. We can therefore safely assume that the reverse is true. This means that if the trend continues the Australian could very well his a brick wall before anyone realizes it.

As is always the case, the problem is lousy economics. There's an old saying in economics: If you target interest rates you will lose control of the money supply. If you target the money supply you will lose control of interest rates. This is probably what is happening. The Reserve is targeting the official cash rate at 6.75 per cent. When we consider both the target rate and the plunge in the bank's assets the suspicion mounts that the target rate might be too high. If this be so, then a credit crunch will emerge because the banks' ability to lend will be curtailed which would certainly raise short term rates. In other words, current monetary expansion could be facing a rapid deceleration leading to a recession.

What is missing from all the commentary relating to interest rates is any acknowledgement of the vital fact that interest is a market phenomenon just like any other market phenomenon. If any central bank could really control interest rates then they could successfully control all other prices. So why do these central bankers and their legions of economists imagine that interest is in a different category that allows it to be successfully manipulated to stabilize the price level and promote economic growth?

Interest is the price of time and is determined by time preference. It's the price of having today what you would ordinarily have to wait for. Now interest also performs the key function of balancing the supply of capital goods with the demand for capital goods. Not just in the present but, as it were, through time. When central bankers force down the rate of interest they are signaling — though they don't realize it — that society's rate of time preference has fallen. Business interprets this as meaning that more capital has been made available.

If the rate of interest was set by the market then — in the absence of central bank interference — short-term rates would tend to equal long-term rates. It is a law of the market that there exists a tendency for the price of any good to be the same (ignoring transport costs) irrespective of its location, with any differences in the price being eliminated by arbitrage. The same would go for interest rates. As Knut Wicksell put it:

It is important to notice that the long-term rate of interest (the bond rate of interest) must correspond somewhat closely to the short-term rate of interest (the bank rate of interest), or at any rate that a certain connection must be maintained between them. It is not possible for the long-term rate to stand much higher than the short-term rate, for otherwise entrepreneurs would run their businesses on bank credits — this is usually feasible, at any rate by indirect means. Similarly it cannot stand lower than the short-term rate, for otherwise most capitalists would prefer to leave their money at the Bank … (Knut Wicksell, Interest and Prices , Sentry Press, New York, N.Y., 1936, p.72)

To see how changes in interest rates affect investment decisions, imagine that at a rate of 4 per cent a firm would borrow $100 million for investment. By forcing the rate down to 3 per cent you raise the firm's borrowing capacity to $133.3 million. Raise the interest rate from 4 per cent to 5 per cent and the firm's borrowing capacity dives to $80 million. Interest is indeed a very powerful instrument.

At the moment, we find ourselves in a situation where firms have — because of a manipulated rate of interest — invested in projects that are in fact unprofitable. To keep going many of these firms will bid for short term rates — even if a decelerating money supply is raising them — in an effort to stay afloat. Fully solvent firms will also be competing for short term loans, unless they are fully cashed up. It's not a pretty picture.

It's quite clear that the Rudd Government — as was the Howard Government — is completely clueless on what is happening to the economy. Comments about "profiteers", and putting "downward pressure on inflation" by tightening fiscal policy and maintaining a budget surplus only serve to reveal just how adrift on economic this mob is.

By Gerard Jackson
BrookesNews.Com

Gerard Jackson is Brookes' economics editor.

Copyright © 2008 Gerard Jackson

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