Yesterday, our article What is a crack-up boom?, resulted in many interesting responses and questions from our readers. Each of these questions requires very long and thoughtful response. Therefore, we will slowly answer each question chronologically one at a time. If we have not answered all your questions today, please be assured that we will do so in the days to come. The answers come in a first-come-first serve basis.

Today’s article will answer this question:

Do you think that the RBA is doing the right thing then? It has raised interest rates, although it has also bailed out financial institutions.

Let’s start off with what we would do if we were the RBA (and the Federal Reserve). Not only would we raise interest rates, we would have done so very early to prick the emerging asset price bubble right at the start. So, why didn’t the RBA do that? As Ian Macfarlane, the former head of the RBA, said here,

Many people have pointed out that it is difficult to identify a bubble in its early stages, and this is true. But even if we can identify an emerging bubble, it may still be extremely difficult for a central bank to act against it, for two reasons.

First, monetary policy is a very blunt instrument. When interest rates are raised to address an asset price boom in one sector, for example, house prices, the whole economy is affected. If confidence is especially high in the booming sector, it may at first not be much affected by the higher interest rates, but the rest of the economy may be.

Second, there is a bigger issue which concerns the mandate that central banks have been given. There is now widespread acceptance that central banks have been delegated the task of preventing a resurgence of inflation, but nowhere to my knowledge have they been delegated the task of preventing large rises in asset prices which many people would view as rises in the keeping of his wealth. Thus if they were to take on this additional role, they would face a formidable task in convincing the public of the need.

The last sentence is where the problem lies. The masses have not given the RBA the mandate to spoil the asset price inflation party. Although, Ian Macfarlane acknowledged that asset price bubbles can be very dangerous for the economy, his hands were tied. Elsewhere, Coalition opposition politicians were toeing the populist line by demanding that Glen Stevens (the current head of the RBA) be grilled more frequently in order to pressure him against hiking interest rates.

The next question is: should the RBA raise interest rates aggressively now? University of Western Sydney Professor Steve Keen reckoned that it is too late to do so now. His reasoning is because at this point in time, deflation is the greater danger and that inflation, though also an evil, should be left alone for now. We believe his view is that when debt deflation takes hold, it will drag consumer price inflation along with it. Is he right? Well, we are right now experiencing asset price deflation plus commodity price inflation. If the RBA leave inflation alone, our fear is that the seeds of the crack up boom can eventually grow up to become a hyperinflation dragon.

Next, should the RBA bail out financial institutions? So far, they have not officially bail out one yet in the same way the Federal Reserve had bailed out Bear Stearns. But it has certainly absorbed some of the bad debt assets and provided more liquidity. Our view is best summed up by what Jimmy Rogers said in Jimmy Rogers: ?Abolish the Fed?,

If xyz needs to go bankrupt, let them go bankrupt. I promise you, that will send a very straight signal and you will have a lot of self-regulation when these guys start to go bankrupt.