Will RBA’s cutting of interest rates help?

October 26th, 2008

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Recently, Associate Professor Steve Keen made the prediction that interest rates in Australia will be cut to zero by 2010. As this news article reported,

University of Western Sydney associate professor of economics and finance Steve Keen is radically bullish on interest rates, predicting a 2% cash rate by the end of 2009, dropping to 0% in 2010.

Dr Keen said the RBA would become more concerned about high household debt levels than inflation, as deep rate cuts in 2009 failed to stimulate the economy.

”The debt bubble is bursting and when it bursts, people stop spending and borrowing,” he said.

Investors should realise is this: if interest rates is ever cut to zero (i.e. Zero-Interest-Rate-Policy or ZIRP), it will not be good news for the economy. It will reflect the complete failure and impotence of monetary policy in regulating the ‘temperature’ of the economy. In other words, to arrive at ZIRP, it means that the economy is in a very serious trouble.

Japan fell into ZIRP in the 1990s. As we all know, the malaise in the Japanese economy lasted 16 to 17 years before a glimmer of hope was seen at around 2003. Today, due to the global credit crisis, they are falling back into the recessionary hole. With interest rates at 0.5%, they have no more room to cut further.

One thing that is different about the Japanese economy from the Australian/UK/US economies is that Japan had a relatively high savings rate. During their lost decade of the 1990s, the Japanese drew on their savings and retreated to their economic bunkers as their economy and asset prices contracted year after year.

In contrast, Australia/US/UK today have no savings and are heavily indebted.

If the RBA cut interest rates further, it will be in reaction and anticipation to Australians closing their wallets, cutting up their credit cards and shunning debt. As we explained before in Will Australia?s own pump-priming work?, all we need is for Australians to stop borrowing in order to induce a deflationary force of $250 billion. This deflationary force alone will wreck havoc to many Australian businesses, which in turn will wreck havoc to the employment market. Once mass unemployment appears, a lot of prime debt will become sub-prime debt. When debt becomes sub-prime, cutting interest rates to zero will not help.

Dangling pornography in front of a dead man will not induce him to open his dead eyes. Likewise, the RBA dangling free credit to banks (i.e. ZIRP) will no longer induce banks to lend because of the pervasive fear of bad debts. To understand this, we highly recommend that you read What makes monetary policy ?loose? or ?tight??.

Currently, Australians are voluntarily shunning debt (as shown by the rapidly decelerating rate of credit growth) as banks are still willing to lend money (although lending standards are tightening). When this voluntary action crosses over to involuntary, it will be the day when the deterioration will accelerate.

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