The RBA doesn’t get it

The decision of the RBA Board to leave the cash rate at 3.25% today confirmed that its members don’t understand the economy.There was an inkling of this in the statement by Board member Warwick McKibbin early last month criticising the Rudd Government’s stimulus package (”Reserve bank director opposes package“, SMH February 6):

“A RESERVE Bank board member has expressed concern about the size of the Federal Government’s $42 billion fiscal stimulus package… Professor Warwick McKibbin also accused the Government of playing politics with the economic slowdown and warned that this could shatter fragile consumer and business confidence.

31xBp9UkTAL._SL500_AA170_.jpg“Crisis? What Crisis?”

It risks turning what isn’t a crisis into a crisis,” he told the Herald yesterday.

Professor McKibbin, a prominent economist from the Australian National University, is one of six non-executive directors who sit on the RBA board with the central bank’s senior executives and Treasury secretary Ken Henry.

If it is a crisis – and I am not sure we are in a crisis – that suggests making the cash handouts even bigger will be problematic.”

McKibbin is a Professor of Economics at the ANU. If any evidence were needed of how neoclassical economics hinders rather than helps to  understand the workings of the economy, this statement provided it.  Now the Board has sung a similar tune, and halted its recent program of interest rate reductions, because “notwithstanding evident economic weakness at present, the Board judged that the stance of monetary policy was appropriate for the moment. The Board will consider the position again at its next meeting.” (The RBA’s statement announcing its decision today)

In fact, the stance of monetary policy has always been inappropriate. By ignoring asset price bubbles, and the debt levels that finance them–and yet rescuing the financial markets at every crash–the RBA and its cousins around the world have encouraged debt and asset price levels to reach heights that would have been impossible in an unregulated system. Far from being the custodians of our economic wellbeing, they have added to the tendency the system already had to cause financial crises.

It was also only a year ago–at its March 2008 meeting–that the RBA last increased rates by 0.25%. The crisis that Professor McKibbin isn’t sure about is now dated from August 9 of 2007–the day that the BNP closed three of its funds because of their exposure to the subprime crisis in the USA. So more than six months into a period when those in the real hot seats were realising that something was on fire–and it was debt, not inflation–the RBA was still obsessing with dousing the smouldering ruin of inflation.

Here are a few charts that illustrate that, far from being custodians of our prosperity, Central Banks have risked it by using a fallacious theory of economics to determine their interventions. Firstly, the US’s collapsing share market bubble was the biggest in history, far dwarfing the 1929 bubble:


Secondly, the USA had not one asset price bubble but two:


Thirdly, this was financed by an unprecedented level of debt. Without the  Federal Reserve’s meddling under Greenspan, it is quite conceivable that there could have been a crash in 1987. Though damaging, this would have had far milder implications for the real economy than the crash we are experiencing now:


Finally, this isn’t just an American problem. While many Australians like to think that this country is better regulated than America, we have been playing exactly the same debt gamble that the Americans have. We now have debt levels that are more than twice as high as those that ushered in the Great Depression, and 75% higher than those that gave us the Depression of the 1890s:


Our aggregate debt level is lower than America’s–mainly because we don’t have the same level of financial sector debt–but our households are even more indebted in the aggregate than are Americans, and the rate of growth of household debt was substantially higher here in the last 20 years than it was in the USA. We will enter a crisis when our level of deleveraging approaches those already being seen in the USA.

When deleveraging is in full swing, even zero interest rates won’t be enough to revive the economy. I expect the RBA to be forced by economic reality to renew its interest rate reduction campaign within the next few months.

Reality is so much better a guide to economic policy than neoclassical economic theory…

Originally published at Steve Keen’s Oz Debtwatch blog and reproduced here with the author’s permission.