What will happen if RBA cuts to zero?

February 10th, 2009

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In the United States, the Federal Reserve had set the interest rates to almost zero. In the United Kingdom, interest rates have reached 1%. Japan had cut her interest back to almost zero again. Canada’s interest rates have reached 1%. In Europe, it’s 2%. All over the world, central bankers are busily firing their interest rates guns to fight this global recession. Already, Japan and the United States had already ran out of ammunition.

As for Australia, the goods news is that our Reserve Bank of Australia (RBA) still has some ammunition remaining after cutting its rates to a low of 3.25%. The bad news is that Australia is about to enter recession, possibly a very severe one (see Realisation of hard landing ahead for Australia). So, what if Australia’s RBA runs out of ammunition too?

If Australia’s interest rates ever reach zero (as Professor Steve Keen believes it will by 2010), it will happen in the context of a hard landing or even a depression. It will be a time of debt deflation, which as we said in Aussie household debt not as bad as it seems?,

A severe downturn to the Australian economy may or may not be statistically likely, but given the level of unprecedented leverage, you can be sure the impact will not be small. Be sure to understand the concept of Black Swans (see Failure to understand Black Swan leads to fallacious thinking).

Chances are, such economic malaise will drag on for many years, similar in length to Japan’s lost decade. For investors, this will be a very trying time. The key thing for investors and savers to watch out for is the Aussie dollar. As we explained before in Can falling interest rates and rising mortgage rate come together?,

A large fraction of Australia?s borrowed money is sourced from overseas through the ?shadow? banking system. In other words, there are not enough domestic deposits to fund all the needed credit (e.g. home loans) in this country.

As a result, there is a great potential for a complication that we described in Another complication in RBA?s interest rate cut,

Today, we will talk about another issue that can complicate matters for the RBA- the pullout of foreign capital.

When debt deflation takes hold of Australia, the RBA can easily run out of ammunition. In the absence of government intervention, credit will be extremely scarce in Australia. Our guess is that in such a scenario, foreign capital will flee out of Australia, leading to another fall in the Aussie dollar. The only mitigation against our dollar in such a scenario will be to the extent that the Australian government opens up our mining and resource assets to predatory foreign sovereign wealth fund (read: China).

Everything else being equal (we will talk about the not-being-equal scenario further down), a falling dollar will be, as we described in Falling currency and inflation,

Now, we will look at the context of Australia, which is another import-dependent country. A rapid depreciation of the Aussie dollar will result in rising price inflation for the same reasons stated above.

Now, imagine the food that you eat everyday. Most of them are produced in Australia. A falling Aussie dollar implies that foreigners will have greater purchasing power for Australian-made food. Assuming that the market is still free, that means that Australians will have to compete with foreigners for our own food. Also, since Australia is hardly self-sufficient in manufactured goods, a falling Aussie dollar will imply falling purchasing power for the many imported things that we enjoy today.

What if we combine debt deflation with falling Aussie dollar? In that case, there will be massive aggregate demand destruction in the economy. Basically, this means a very drastic drop in the standards of living for many.

We shudder to think of the implication of this. We wonder whether there can be a scenario whereby there is a combination of (1) crashing asset prices (due to debt deflation) and (2) rising inflation for price inelastic consumer staples (due to the depreciating Aussie dollar)? If such an mishap eventuates, even savers have to worry about the return of their savings!

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  • Pete

    Good article Ed.

    I had a discussion with a colleague at work who is quite interested in economics at the moment and seems to get the ideas.

    Anyway, he basically said if debt, and especially foreign debt is a problem, why don’t we just tell them we won’t pay (default on the loans).

    I mentioned that this would be tragic. All international trade would be ruined as no country could trust us. Not to mention:
    – having to make everything at home is really inefficient and expensive (eg computer chips, cars)
    – not being able to export would ruin industries such as grain, wool, mining, gas/oil/uranium
    – major risk of war, especially if other countries have nothing to lose, and we lose friends (eg North Korea)

    There are so many other reasons but I won’t get into them.

    What I find interesting is this article tackles something similar, but you have logically reasoned so many different things, which is great, particularly the effect on exports.

    In Australia (and probably America, etc) we get so used to importing and exporting the same old things. I think people do not understand that their lives will most likely be much different in the coming years and the sheer potential for such changes.

    I believe this type of thinking stems from a lack of current physical evidence…we literally need to see things to believe them.

    One big problem with us and other countries (probably including China) being so set-in-our-ways when it comes to imports and exports, is that it takes time and money to change what we produce.

    For example, farmers who have been producing wool for decades can hardly turn around and start making computer chips the next week.

    Factories would need to be built, people need to be trained into new professions…who knows, perhaps we may end up as a low-cost exporter of basic goods, textiles, etc, to China who becomes an importer.

    Whilst it seems unlikely, if as you illustrate above Ed, our dollar falls low enough that we need to compete with exports for our own food, etc, then this period of transition whereby we attempt to balance the production of different goods (food, textiles, electronics, whatever) to export and consume would be a volatile time filled with hardship.

    Our way of life would be turned upside-down.

    Although, as I have read elsewhere, this may also be a good time for innovators and entrepreneurs – providing they can source enough funding to get started.

  • Pete

    Good article Ed.

    I had a discussion with a colleague at work who is quite interested in economics at the moment and seems to get the ideas.

    Anyway, he basically said if debt, and especially foreign debt is a problem, why don’t we just tell them we won’t pay (default on the loans).

    I mentioned that this would be tragic. All international trade would be ruined as no country could trust us. Not to mention:
    – having to make everything at home is really inefficient and expensive (eg computer chips, cars)
    – not being able to export would ruin industries such as grain, wool, mining, gas/oil/uranium
    – major risk of war, especially if other countries have nothing to lose, and we lose friends (eg North Korea)

    There are so many other reasons but I won’t get into them.

    What I find interesting is this article tackles something similar, but you have logically reasoned so many different things, which is great, particularly the effect on exports.

    In Australia (and probably America, etc) we get so used to importing and exporting the same old things. I think people do not understand that their lives will most likely be much different in the coming years and the sheer potential for such changes.

    I believe this type of thinking stems from a lack of current physical evidence…we literally need to see things to believe them.

    One big problem with us and other countries (probably including China) being so set-in-our-ways when it comes to imports and exports, is that it takes time and money to change what we produce.

    For example, farmers who have been producing wool for decades can hardly turn around and start making computer chips the next week.

    Factories would need to be built, people need to be trained into new professions…who knows, perhaps we may end up as a low-cost exporter of basic goods, textiles, etc, to China who becomes an importer.

    Whilst it seems unlikely, if as you illustrate above Ed, our dollar falls low enough that we need to compete with exports for our own food, etc, then this period of transition whereby we attempt to balance the production of different goods (food, textiles, electronics, whatever) to export and consume would be a volatile time filled with hardship.

    Our way of life would be turned upside-down.

    Although, as I have read elsewhere, this may also be a good time for innovators and entrepreneurs – providing they can source enough funding to get started.

  • David

    Hi, This article concludes with a disturbing scenerio. Asset price deflation with consumer price inflation. Gold is as asset class, how will it fare in this scenerio? It seems that gold is starting its transition back to being money, what would it take for that transition to happen, do you think its underway or likely? Thanks David

  • David

    Hi, This article concludes with a disturbing scenerio. Asset price deflation with consumer price inflation. Gold is as asset class, how will it fare in this scenerio? It seems that gold is starting its transition back to being money, what would it take for that transition to happen, do you think its underway or likely? Thanks David

  • Hi Pete!

    For example, farmers who have been producing wool for decades can hardly turn around and start making computer chips the next week.

    Factories would need to be built, people need to be trained into new professions…

    That’s right! In economic-speak, this is called “restructuring of the economy.”

    Hi David!

    We will write an article for your question.

  • Hi Pete!

    For example, farmers who have been producing wool for decades can hardly turn around and start making computer chips the next week.

    Factories would need to be built, people need to be trained into new professions…

    That’s right! In economic-speak, this is called “restructuring of the economy.”

    Hi David!

    We will write an article for your question.