Posts Tagged ‘imports’

What will happen if RBA cuts to zero?

Tuesday, February 10th, 2009

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!

Falling currency and inflation

Monday, September 1st, 2008

Back in February this year, while the US dollar was still in a downward trend, Jimmy Rogers made a scathing remark about Ben Bernanke here:

We know now he doesn?t even know about economics. I mean, he?s got a PhD in economics and he was a professor of economics, but he doesn?t have a clue about economics.

I will quote you – I hate to quote you, but one more time – I was watching him testify before congress and I almost fell out of my chair. He said under oath, so we presume he wasn?t lying, that he was just a fool, he said if an American only buys American products, it does not matter to him if the value of the U.S. dollar goes down. He will not be affected. I was looking at the man to see if he was lying, giving government propaganda, but then I could see he didn?t even really understand.

He didn?t understand if, you know, even if say I?m an American, Lindsay, and I only buy American tires. Well if the price of foreign tires goes up, obviously the price of American tires are going to go up too. Plus, if the dollar goes down, the price of rubber?s going to go higher, etcetera, etcetera, etcetera.

So the man doesn?t even understand economics. He?s going to print money. He?s going to throw money out the window. The dollar?s going to go down further and further and further. Inflation?s going to get worse and worse and worse throughout the world – the world, not just America – and we?re going to have a worse recession in the end.

What happened was that Ben Bernanke swore under oath that a falling US dollar would not hurt Americans as long as they buy only American products. But as we explained before in Is the falling dollar good for the economy?, a falling domestic currency will result in a

… divergence between the internal and external value of the dollar. Since in the short term, the domestic economy cannot increase its production, effect (1) will be the result.

Since the American economy is very much dependent on imports, a fall in the US dollar will result in an increase in demand for American-produced goods. Without increased capacity in the short-term, this will almost certainly result in price 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. To make matters worse, the Australian economy is already at full productive capacity, due to reasons that include full (or almost full) employment, inadequate infrastructure, skills shortage and so on. Therefore, in order to take advantage of the increased demands for Australia’s commodities in the longer term, there will be a need for a restructuring of the Australian economy. As we explained in Is the falling dollar good for the economy?,

This means a restructuring of the economy whereby some industries will have to decline in order for the export industry to expand. This is effect (2).

The restructuring process is where the pain lies. It is a time where certain industries decline, unemployment rises and people returning to university and TAFE to retool and retrain on other skills and professions. The problem with Australia is that with far too many people and businesses filled with too much debt, such restructuring process can be too painful to be contemplated.

What can we expect in a US dollar decline?

Wednesday, December 13th, 2006

Yesterday, we mentioned about the possible scenario of a decline (or collapse) of the US dollar in Will the US dollar collapse?. Today, we will look at the consequences of such an eventuality.

As we explained in The Bubble Economy, the reason why monetary inflation had not led to severe price inflation is because of the disinflation effect of cheap Chinese imports. Thus, goods that can be imported from China have their prices being suppressed from inflating. However, goods and services that cannot be imported will suffer price inflation, most notably housing and health care. Thus, the US had been printing money and buying goods overseas with their printed money. Simultaneously, the excess printed money went into assets (housing) to cause price bubbles.

Now, as the US dollar decline, that will result in imported goods getting more expensive for American consumers. Since the US import far more than they export, the outcome will be price inflation for those imported goods. When that happens, the Federal Reserve will be forced to raise interest rates to curb inflation. If the Federal Reserve does that, Wall Street will take a big hit, perhaps triggering a sell-off in the stock market since they are expecting the Federal Reserve to cut interest rates in 2007. We guess Ben Bernanke must be in a dilemma and losing sleep over this scenario. If the Fed raises interest rate, it will probably push the already weak US economy into recession. If it does not, the result will be inflation, which if left unchecked, will lead to hyperinflation. That could be the reason why the Fed had been exasperatedly warning about inflation (i.e. interest rates could still rise) in an apparent attempt to shake off the market?s expectation of an interest rate cut next year.

The ideal outcome will be for the US dollar to decline so gradually that the US economy will have plenty of time to wean itself from cheap Chinese imports. But if some financial accident occurs and the US dollar collapses, the outcome will be unthinkable.