growth

The Emperor’s new clothes

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Ever heard of the Emperor’s new clothes? There’s a financial institution that is hoping you haven’t…

The Reserve Bank wants to reduce the rate of inflation, which is a measure of the extent of price increases; so it increases the cost to the banks of borrowing money. Guess what the banks do when their cost of borrowing is increased? They pass it on to their customers with the result that the cost of borrowing increases. This is said to be anti-inflationary.

 

What happens when the price of oil goes up in the gulf? The oil companies pass the cost on to their customer with the result that the cost of energy goes up. This is said to be inflationary.

 

So the banks can pass on their increased cost of borrowing to the customer and this is not inflationary but when the oil companies pass the increase in the cost of energy on to their customer, this is said to be inflationary. Give me a break!

 

Whenever a cost is passed on to the consumer, it is inflationary because it increases the cost of living.

 

The very fact of increasing the cost of money is inflationary, with the result that the tool used by the Reserve Bank to curb inflation (increasing interest rates) actually exacerbates the situation.

 

“But wait!” says the Reserve Bank. “We aren’t done yet. There are more increases in interest rates in our cupboard. If this round doesn’t do the trick, the next round might, but in any event we will keep upping the anti until inflation is tamed.”

 

We can deduce two things from this. The first is that the Reserve Bank doesn’t know what it is doing (more of this a little later) and second that there is an underlying assumption that when interest rates reach an intolerable level, people will go broke, stop spending money and the economy will go into a tail spin – at which stage, the Reserve Bank will say: “We have taken the sting out of inflation”.

 

In fact, what the Reserve Bank will have achieved at that stage is the destruction of a lot of businesses, the forfeiture of many family homes, the write off of huge losses by the banks and a “recession that we had to have”.

 

Let’s look at the performance of the Reserve Bank and its use of the tool of interest rate management to manage the economy.

 

In the late eighties, by a continued series of incremental increases in the official interest rate to something like 18%, they tame inflation. Hell; how many people went broke and how many increases in interest rates did it take to achieve the economic havoc of the early nineties? Why did it take so many increases in interest rates to wreck the economy and reduce inflation?

 

The answer is that the Reserve Bank didn’t know the answer and had to keep experimenting with the interest rate tool until it finally did the trick of bringing about disaster.

 

So then the RBA says: “Hey guys, we might have gone too far, let’s start reducing interest rates until the economy is resurrected”. So, once again by incremental reductions, they finally discover that by getting interest rates down from 18% to 4%, borrowers are out of bankruptcy and can start borrowing again.

 

Wonderful! The economy takes off again and everyone has a wonderful time borrowing money at record low interest rates. We take on debt the likes of which has never been seen – 110% financing of our inner city apartment; unlimited credit on our credit card with a “make the minimum payment and things will be just fine”; borrowing against the paper increase in the value of our apartment and spending it on a buying binge.

 

“Look guys, we have got it right,” says the RBA. “The economy is on fire and we have killed inflation.” My foot! What it has done is to put in place the ingredients for perhaps an historic increase in the rate of inflation.

 

Then: “Oops boys, we might have just gone too low by a wee bit; the economy is really turning up the heat and perhaps we ought to start increasing interest rates to keep things under control.”

 

So, here we are with these incremental alterations in interest rates by which the RBA hopes that each one will do the trick, but if it doesn’t then it will keep trying.

 

Just imagine you have something wrong with you, and you go to the doctor and the doc says: “Take two of these, two times a day”. You do it, but go back to the doc and say: “Doc, I am feeling a little worse.” And so the doc says: “We will have to increase the dosage; you will have to take two of these three times a day.”

 

As you get worse, the doc continues to increase the dosage. Are you going to stay with the doc who doesn’t know what he or she is doing? Well, why should we stay with the RBA which, over the past 10 years, has continually played around with interest rates hoping that it will be able to control the economy.

 

How do we let them get away with this baloney? The Emperor’s new clothes. One day, someone will wake up that the pretenders at the RBA have no more idea of how to manage the economy than you or me.

 

They will be seen naked and laughed out of town. At that stage, we might let the market manage the economy and a lot fewer people will go broke or lose their homes.

 

While the RBA pretends to have some clothes on, it is going to be tough going for growing companies.

 

 

To read Louis Coutts’s newsletter, which goes out once a quarter, go to the Coutts and Connor web site and click on the tab for articles and newsletters. To read more Louis Coutts blogs, click here .

 

Comments

Simon G in Balmain writes: Great analysis Lou. Consumer confidence is already falling so already the Reserve Bank is behind the eight ball.

Adam Gilbert writes: It could be argued that raising interest rates could disproportionately hurt those already under financial stress. Far better to ensure that everyone takes a hit. Therefore any time we increase rates we should increase petrol tax by a similar proportion. Even the rich cannot escape petrol prices, from their BMWs through to first class international flights, even if it is a small part of their expenses. More than that, increased petrol tax would effect almost every aspect of the economy and effectively slow it down more quickly than interest rates movements could ever achieve. Additionally, by increasing petrol tax we would force a reduction in emissions and move more quickly towards more sustainable and healthy lives. Would make the couch potatoes less likely to order a home-delivered pizza due to extra delivery charges; they might even be inclined to walk to the shops to buy it. We must increase petrol tax in unison with interest rates. Political suicide but undeniable logic.

 

 

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