In a "better late than never" move, the RBA raised the cash rate by 25 basis points to 3.25 per cent earlier today based on stronger than expected "economic conditions" and "measures of confidence". This was not entirely unexpected, as we reported last month the only way rates would remain at 3 per cent was if the incumbent Labor party had enough sway to 'persuade' the RBA to hold rates.

The only way to artificially keep interest rates down is to increase the money supply – whether through the purchase of government securities, increasing the amount of cash in the economy or lowering the discount rate (encouraging banks to borrow more).

Record growth in M3 thanks to the loose money policies around the world following the last 'bust' (2001ish) saw the pressure on interest rates soar considerably leading up to the crash and instead of further raising rates[1] – a move that was necessary to allow the prior malinvestment to liquidate and for prices to coordinate downwards – the RBA simply flooded the financial sector with additional money thereby preventing any restructuring from occurring.

The structural flaws in the economy – a capital structure still swarming with malinvestments that are not aligned with the intertemporal (time) preferences of the consumers – have resulted in inflated prices in several industries such as housing, construction, banking and finance.

"As soon as deflation makes itself felt, there will be immediate attempts to combat it—often when it is only a local and necessary process that should not be prevented," Friedrich August von Hayek.

Inflating the money supply is a short-term solution that cannot create any additional long-term wealth. Real savings are the barometer for investments that can be successfully carried through to completion: by inflating the money supply the RBA merely deceives investors into thinking the pool of real savings is larger than it actually is. It gives them the impression that consumers have forgone current consumption thereby freeing up more capital for longer-term projects aimed at increasing the productive capacity of the economy.

Think of inflation as you would drug taking: it is disastrous for long-term health, but it can work wonders and make you feel great in the short-term. Likewise, deflation is akin to a drug taker going through withdrawals – it can be quite painful in the short-term but will result in improved long-term health. Unfortunately, the nature of politics is that only one option, inflation, is viable.

Following the outbreak of the 'credit crunch', the governments fearmongering strategy was put into good effect to gain short-term popularity and, more importantly, push for favoured policies that have turned a necessary market correction in a few selected industries into a much more severe, economy-wide problem.

To offset the inflation set in motion by the reckless monetary pumping of the past year, the RBA is raising interest rates. This will attract foreigners seeking a higher yield and should therefore strengthen the dollar relative to other currencies in the short-term. It can only be expected that the RBA will to continue to breach their policy of abstaining from currency manipulation to keep the $AUD below one $USD under the guidance of their mercantilist think bots in an attempt to avoid a slowdown in export growth. This directly contradicts their attempt at keeping inflation at bay and will instead lead to further increases in the money supply and, consequently, price inflation.

Despite relatively small 'inflation' – the CPI figure is up 1.5% YoY, the record amount of pumping undertaken by the RBA cannot be swept under the rug; it will have a serious effect on the wider economy in the future. While businesses are reducing their risk by reducing leverage, banks are still increasing their loans year-on-year (we never came close to having a 'credit crunch') within the banking sector, to consumers and into mortgages.

Unfortunately for the economy, the seeds of the next fiduciary inflationary bubble have been well and truly sown.

"The market rate of interest cannot be lowered by a credit expansion except for a short time, and even then it brings about all those effects which the theory of the trade cycle describes," Ludwig von Mises.

The Australian economy has been flooded with a fresh batch of cheap money. The level of savings is below 5% of disposable income. Private debt is still over 150% of disposable income. Housing is as expensive as ever. The 'stimulus' simply, at best, kept people employed where they happened to be (hint: areas of malinvestment), at worst further distorted the distribution of labour and capital structure of the economy. Public debt is at record highs. Unemployment will continue to get worse as the stimulus wears off and the jobs that were 'saved' are once again, necessarily, 'lost'. Price inflation will rear its head (of course with a mighty lag thanks to the heavily manipulated CPI) and interest rates will have to rise further.

The above are hardly what you would call solid pillars of growth. The economy is anything but healthy and any recovery will not be sustainable.

Unless the free market is given permission to work and the necessary liquidation and restructuring allowed to occur, problems will continue to appear and will be addressed, again and again, by policies that only deal with the immediate, visible effects; effects caused by the very policies designed to combat them! The result will be bigger government, higher inflation and our very own 'lost decade'.

[1] Of course the best way would be to leave interest rates - effectively the price of borrowing money - for the free market to determine. Government price controls never, ever end well.

The Reserve Bank of Australia (RBA), a group of government-sponsored bankers given the task of keeping the banking, finance and currency cartel going on behalf of various interest groups, decided to leave rates on hold at 3.25pc during their last meeting. Their decision was received with mixed results: the politicians were slapping themselves on the back, citing their 'stimulus packages' as having cushioned the economy while the homeowners and other debtors were moderately critical.

The minutes of that meeting which were released today have revealed that they believe "...the domestic financial system remained strong and the monetary policy transmission process was working to deliver large reductions in interest rates to end borrowers, particularly households."

Well that's true enough. The artificial reduction of interest rates below what the market rate would be will distort the capital structure of the economy and encourage malinvestment in areas such as housing. Why shouldn't people be able to buy houses that they can't afford, right?

"Early indications were that the monetary and fiscal stimulus that had been applied to the economy was having an expansionary effect, but the size of this remained unclear and it would take some time for the full impact to come through."

"The question for policy was whether further stimulus should be added at this meeting, or whether, having reduced rates at each meeting since September, the Board should pause for a further evaluation of the situation. Members could see reasonable cases for both courses of action. On balance, they judged that, having made a major change to monetary policy over the preceding several meetings in anticipation of weak economic conditions, the best course for this meeting was to leave the cash rate unchanged. Members believed this would leave adequate flexibility for policy at future meetings."

The real reason behind the RBA's decision to leave rates unchanged is the dreaded "liquidity trap" that they all fear. The theory behind this stems back to Keynes, where he said that if the rate of interest falls to a level where people prefer to hold cash rather than debt (due to the low level of interest), then central banks have lost "...effective control over the interest rate". This view is supported by central bankers around the world, including the RBA. Here's a good argument outlining the flaws in this theory.

Interest rates need to rise, not fall. Monetary and Fiscal policy will only cause long-term misery. Eventually -- I don't know when -- the stop-go inflationary policy of the central banks will have to end. Each time we have a recession (a necessary restructuring process) and it's 'cured' by said policy, the capital structure of the economy is further distorted. The Austrian's tried to let their government sort out their woes in the 20s and 30s with spectacular results,

“Austria was successful in pushing through policies which are popular all over the world. Austria has most impressive records in five lines: she increased public expenditures, she increased wages, she increased social benefits, she increased bank credits, she increased consumption. After all those achievements she was on the verge of ruin.” -- Fritz Machlup, The Consumption of Capital in Austria, Review of Economic Statistics, II, 1935, p. 19.

We can't turn stones into bread as Keynes suggested. Printing money doesn't create any wealth. If we continue down this path, unrestrained government spending will result in the "eating of the seed corn", or capital consumption, as Mises noted after witnessing the Austrian demise. There's a point at which the interventionist welfare state will have exhausted "the reserve fund" of accumulated wealth, after which the consumption of capital becomes the only basis upon which to continue to feed the fiscal demands of the state.