The interest rate debate has once again entered the mainstream in Australia with Westpac becoming the first major bank to forecast that the next move the Reserve Bank of Australia (RBA) makes will be a 25 basis point cut in December of this year, followed by another three 25 basis point cuts next year (bringing the cash rate down from the present 4.75 per cent to 3.75 per cent). This is in line with what the bond market has been showing for a while and was followed by comments from bloggers and financial / economic pundits all providing their two cents on the issue, with opinions varying on whether rates should increase (actually, I have yet to find anyone supporting an increase – while the ‘experts’ are forecasting a rise, most think it is unwarranted) or decrease.
While there is nothing wrong with trying to predict the RBA’s moves – in fact, in today’s world of fiat currencies and a centrally-planned cash rate, it can be incredibly profitable for the savvy investor to correctly predict the moves of their favourite central bankers – it is wrong for people to make claims that the RBA “must” either increase or decrease rates when these claims are based on fallacious reasoning. Most of this reasoning proceeds like this:
1) Analyst ‘sees’ X industry or industries suffering
2) Concludes rates are too high for non-miners
3) Insists that RBA must cut rates
But to suggest policy recommendations on this reasoning is extremely dangerous. For one, who says that the current state (or some past state) of X industry is the proper state? Perhaps it is rife with malinvestment and the marginal businesses within X industry are finally starting to liquidate, allowing for the necessary restructuring and capital reallocation process to begin? Lowering rates would simply delay this process and squander even more capital with the piper still to be paid down the road.
Imports, not exports…
Another classic fallacy that is tossed around as if it is fact is that a cut in the cash rate and the subsequently weaker dollar it will create as capital inflows reverse is that it “…will be a boost to manufacturers and exporters.” But this is the oldest trick in the mercantilist book and can only be believed if you ignore the wider effects this policy has on the economy rather than the visible gains of a few select industries and the balance of trade; it is the zero-sum idea that all that matters for economic wellbeing is that the balance of trade remains positive. However, the “boost” received by exporters and manufacturers is largely illusory; while some industries will undoubtedly gain, domestic prices will rise faster than any gains those industries receive from increased sales. Given that everyone is also a consumer, they and everyone else in the economy now have to pay more for everything they consume. With a weaker dollar, the entire country has to export more and work harder to pay for the same amount of imports received before the devaluation of the currency. When you have to trade (export) more ‘stuff’ for the same amount of ‘stuff’ as you could buy before (import) then it is a net loss, not a gain.
Back to interest rates…
There are only two ways to avoid a boom-bust cycle induced by exogenous factors (e.g., monetary expansion in the US/China): maintain a cash rate that is perfectly aligned with the natural rate of interest – that is the rate that Knut Wicksell initially defined as the equilibrium interest rate that balances saving and investment in an economy over time – or with sound money such as a true gold standard (this is of course assuming government control over money; if money was privatised, true free banking – under the institutional setting of private property, contract and consent – would be the ideal method).
We know for a fact that all central planners, even the ‘elite’ planners who sit at the top of currency boards known as central banks, suffer from the same knowledge and rational calculation limits as all central planners do and can never equal or better a private competitive market in the allocation of scarce resources. They suffer from what Hayek, in his Nobel Laureate acceptance speech, called the “Pretence of Knowledge”; a belief that they can “manage” something that is impossible to manage. Thus, the only option available under fiat currency – that of keeping the cash rate perfectly aligned with the natural rate – is impossible beyond the occasional fluke. This means that unless the central bank raised rates to a level that stifled all economic growth, it is almost a certainty – especially when the insights of the public choice school are factored in – that the cash rate will be held below the natural rate more often than not. When this happens, there is only one outcome: relative price distortions, an unsustainable boom and the subsequent malinvestment that goes with it.
The reality is that any policy that cuts the cash rate below the natural rate of interest will cause inflation and even though it will be touted as an attempt to “fix” the economy it will not in fact “fix” the economy but will instead be nothing more than a transfer of wealth to debt holders (banks, government, corporations, mortgagees) at the expense of everyone with savings (anyone holding bonds, bank deposits, insurance policies or super, i.e. most people). Likewise, if the cash rate is held above the natural rate of interest a reverse transfer will occur. As Bob Murphy noted,
“In truth, there's no obvious right or wrong answer to this question [what interest rates should be]. It would be akin to asking, "How many cars should the Soviet planners have produced in 1983?" One is tempted to say, "Ideally, the number of cars that would have been produced if there had been a capitalist economy," but not only is that impossible to know; it's not correct. The very existence of a centrally planned apparatus changes the real economic data, and so changes what the "correct" number of cars should have been, even if we could agree on the criteria for correctness.”
One of the reasons people believe they can achieve economic prosperity through price manipulation (interest rates) is that they have no concept of capital; it is simply this homogenous blob of putty which can be moulded in any shape or form. In reality, capital can do no such thing; once it is ‘formed’ it differs in how easy it is to reallocate to other uses, from virtually impossible (say a bridge to nowhere) to relatively easy (human capital).
“The more elastic is the currency system the longer can a more or less constant difference persist between the two interest rates [actual and natural] and the greater, therefore, will be the influence of this discrepancy on prices,” Cf. K. Wicksell in Geldzins und Giiterpretse.
Australia has had over 20 years of relative prosperity, in part financed through unprecedented levels of personal and now government debt. There are now massive structural imbalances in the economy (housing for one!) that have accumulated over these years as a result of interest rate targeting and a floating fiat currency. Another rather unfortunate aspect of interest rate manipulation is that it covers up the distortions the government itself has – the burden it inflicts is allowed to grow without the effects being felt for a significant amount of time. To paraphrase Milton Friedman, the “Iron Triangle” of politicians, special interests (e.g. banks) and bureaucrats (e.g. the RBA) is able to grow significantly larger than it would under a free market and the most effective way it does this – by stealth – is through its control of the interest rate.
In summary, by maintaining relatively stable interest rates, a flexible exchange rate and growth in the (aggregate) price level consistent with its stated goals over the course of the past decade – in other words, by doing its job – the RBA allowed relative prices in Australia to be slowly but surely distorted and malinvestment to ensue. Cutting the interest rate in an attempt to distort the correct functioning of the price system and prevent the appropriate feedback mechanisms from reaching actors in the economy will at best delay the inevitable (and cause further resource misallocations) and at worst fail completely, resulting in a prolonged downturn as restructuring is made virtually impossible.
While cutting the interest rate may spare many marginal firms and individuals in the short-run, in the long-run there will be significantly less wealth (not false wealth i.e., as recorded by GDP, but a smaller pie - a smaller quantity of goods per capita) for all Australians. Marginal and unsound firms – the ones most affected by the false signals sent by the RBA’s price manipulation – have to be allowed to restructure or liquidate, correcting Australia’s structure of production, allowing sound businesses to grow and letting economic recovery occur as quickly as possible. This can only happen if the natural rate of interest is allowed to reveal itself through the market system.