Today, from this article: Rules to deter risky mortgage sales, we read about what we foresaw before. We can always trust some politicians in a democracy, who cannot see beyond the next election, to bow to popular will, which often turns out to be a mistake. As we said before in A painful cleansing or pain avoidance at all cost?, which clearly illustrates this point,

… the Fed will have no choice but to acquiesce to the desire of the mob, whose aim is to avoid immediate pain as much as possible.

Please do not misunderstand our point?we abhor dictatorships immensely?our conviction is that the quality of a democracy lies in the quality of its politicians and electorate. If mob rule takes over the electorate, we can only pray and hope for the best. Other than hope and prayer, the next best thing to do is to educate the mob through the promotion of debate and discourse, which is what we are hoping to achieve with our miniscule effort. Anyway, back to the main point of this article…

In that above-mentioned article, it says that

US politicians are drawing up a bill that could make it less attractive for Wall Street investment banks and other financiers to repackage risky mortgages into securities and then sell them to investors around the world.

The question to ask is this: how did Wall Street becomes so reckless in the first place? We believe the fault lies in Alan Greenspan. Having slashed interest rates to a recklessly low of 1% at the beginning of this century, the US was embarking on an extremely loose monetary policy (see What makes monetary policy ?loose? or ?tight??). With the economy flushed with a massive sea of money and credit in the financial system, do you expect money not to be reckless lent? Imagine yourself being a banker who is crammed with a glut of fiat cash. What will you do with it? You will have to get rid of it by lending it out. What if you run out of borrowers? Easy! Just lower the credit standards! This is what is happening in the US.

Unwisely, as the article mentioned, the mob laid the blame on the ?greedy? financiers and lenders:

Politicians and consumer groups blame such flows for the lax lending practices that developed in the sub-prime market in recent years.

So, if this bill gets through and becomes law, what will be the consequences? Definitely, credit will tighten enormously. What follows will have serious effects. Our previous article, Marc Faber on why further correction is coming?Part 2, will elaborate more on the consequences.

Elsewhere in the article, it said,

Lawmakers said they would summon stakeholders to a crisis summit, while the Bank of America responded to the political pressure with an announcement yesterday that the two largest US banks would make $US1 billion of loans available on favourable terms to borrowers on the verge of losing their homes.

This is what we foresaw before in Inflation or deflation first?,

Now, faced with the threat of a deflationary recession, what can the Fed do? Politically, it is impossible for them to allow a recession run its full course in order to clean up the prior excesses of the bubble. They will do anything and everything to ?prevent? another recession. The only way for them to do that is to do what they always did?pump even more liquidity into the economy (a.k.a ?print? money).

That is the power of the printing press! Buy gold.

By the time you read this, the interest rate decision by the Reserve Bank of Australia (RBA) would have been announced. For us, we were writing this article before the announcement. Therefore, we were not in the position to know RBA?s decision. Nevertheless, our opinion is that the timing of interest rate rise is not important. What are more important are the underlying economic forces that make a rise inevitable.

From our observation of the market, we find something rather amusing. Before the RBA?s decision, the market was embroiled in a flurry of tealeaves examination activities in its attempt to divine what the RBA would do with the interest rates (see Economists punt on Aussie interest rates). The funny thing is, the RBA probably did not know what its decision would be until it was made. That was the purpose of having the meeting in the first place?to decide on something that had not been decided yet! If the RBA did not know what its decision would be, how on earth can the others know for sure? That is why we called any of such ?prediction? a punt.

Anyway, let us go back to the main point of this article. What will be the outlook for interest rates in Australia? To answer this question, we need to have an opinion on the outlook for price inflation in Australia. This is because one of the major mandates of the RBA is to achieve ?low and stable inflation over the medium term? (see the RBA?s web site). The main tool that the RBA is using to achieve its mandate is the setting of interest rates.

What is our view on price inflation in Australia? As we have said before more than a month ago in Have we escaped from the dangers of inflation?, we doubt it is a problem that can go away quietly. At this stage of the business cycle, Australia?s productive capacity is already at its peak (see Where are we in the business cycle?). Also, despite the interest rates rise since 2003, Australia?s monetary policy is still ?loose? (see What makes monetary policy ?loose? or ?tight??). If you look at the RBA?s financial aggregate figures, all measures of money supply are still expanding in the vicinity of around 12% to 14% year-on-year since 2006. From June 2003 till February 2007, Australia?s broad money supply has increased by almost 50%! This tells us that as long as Australia?s economy is ?strong,? its price inflation problems are not going to go away. Therefore, there is going to be pressure on the RBA to raise interest rates in order to truly ?tighten? liquidity in the economy.

However, there is another issue that complicates the whole thing. The risk is that with so much debt in Australia, interest rate rise can burst the debt-driven asset bubble, hurtling Australia down into a deflationary recession. But we believe it is better to burst the bubble earlier than later because any delay will result in the unavoidable burst having a more painful impact. Unfortunately, the RBA does not have the mandate to prick dangerous bubbles.

What is the implication of this?

It means that given the mandate constraint imposed on the RBA, it can only raise interest rates to ?fight? price inflation (the idea of a central bank ‘fighting’ inflation is flawed- see Cause of inflation: Shanghai bubble case study). Consequently, asset price bubbles will be allowed to balloon further (i.e. ?loose? money) as long as price inflation seems to be under control. When the inevitable bursting of the bubble happens, Australian household will bear the brunt of a severe recession.

We encourage you to read this article about this warning from Ian Macfarlane, the former RBA governor: Next economic dip will hit households.