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The RBA follows the financial gospel from on high

By James Cumes - posted Tuesday, 12 February 2008


In Australia last week, the Australian Government announced that the Trade Deficit narrowed for a second consecutive month. They took $1.9 billion off the red side of the ledger in December ... Australia is finally getting some traction on all the exports to China! This news came just in time for the Reserve Bank to make a rate hike at their meeting. Which is exactly what they did.

The Reserve Bank of Australia (RBA) gets a gold star for focusing on their country's inflation and not worrying about a "global slowdown". The RBA raised interest rates ¼ point, or 25 BPS to the highest internal level in 11 years. That marks the third rate increase in the past six months, and they are all tied to inflation pressures.

I love it when a plan comes together, and it has come together for Australia. RBA Governor, Mr Glenn Stevens, said that inflation was likely to remain relatively high in the short-term, but expected it to "moderate somewhat next year".

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The Australian and New Zealand currencies and their high yields are really on a tear v the dollar: simply because of their yield differential to the US and for that matter the rest of the industrialised world. The rate differentials are here to stay. If a currency can prove it will retain its rate differential, it has a fighting chance of offsetting the unwinding of the carry trade.

But ... if those two market movers (high rates, and carry trades) cross streams ... lookout! We've even seen the carry trade running circles around stocks which are weaker recently, and the carry trade keeps on going, and going, and going. One of these days, the music is going to stop for these carry trade guys, and there aren't going to be enough chairs for everyone.

The above was first published in Everbank of New York's The Daily Pfennig Letter on February 5, 2008.

Ever since 1969, the Australian Treasury and/or the independent RBA have faithfully increased interest rates whenever an urge or a whim has taken them to "fight inflation".

In 1969, an ounce of gold was worth not much more than $A30. Now (February 5, 2008) the Perth mint puts an ounce of gold at just on $A1,000, as the mean between the buying and selling price. What is the Australian dollar now worth in terms of gold, compared with 1969? Five per cent? Three per cent? Two per cent or in a few weeks' or months' time 1 per cent or even - it’s by no means impossible - 0.5 per cent?

But perhaps you will say, gold doesn't matter.

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What about other prices?

If the Australian dollar buys anything for more than a tiny fraction of its cost in 1969, 1979 or even 1989, it will be pretty close to a miracle.That's taking account even of "cheap" imports from Asia. If the thing or service cannot be imported, then the fall in the purchasing power of the Aussie dollar has been even more excruciating.

All this has been happening while the Financial Gospel from on high has been “when inflation arrives or even threatens or even might threaten to threaten, be a good, disciplined central banker and raise interest rates. You'll qualify for the Order of Australia First Class if you do.”

It's crazy.

Raising interest rates never did "fight inflation". It has a three-way impact to INCREASE inflation: it reduces real investment, it increases production costs and it cuts back on supply. Fewer people work for fewer hours producing fewer goods or services at higher cost.

The evidence is incontrovertible. We have nearly 40 years of experience. Never mind the theories; just look at the facts. Australia is not the only economy to suffer in this way. The prime, big, single superpower or hyper-power sufferer of all time is the United States of America.

One of the great heroes of financial management in the last 40 years - at least for many Americans - is Paul Volcker. Remember he was the Chairman of the Fed who raised rates to - if I remember correctly - about 18 per cent. He killed inflation stone dead, didn't he?

Actually he killed just about everything stone dead: real investment, productivity, production, employment, any semblance of equality whether of income or opportunity and, of course, the American dream.

The one thing he did not kill stone dead was inflation - except, as it appeared, in the very short term.

The US dollar buys only a fraction of what it did in the 1980s. Except for the blessing of a technological boom in the 1990s, real investment has slipped to ever newer and newer lows, savings have disappeared, American manufacturing industry has been gutted, the external trade and current-account deficit has risen to what we would once have thought of as unbelievable heights, the American external debt - and government and household debt - is unprecedented in anyone's history at any time or in any place; and the great superpower in whom so many believed a few decades ago is sliding - or plunging - into history.

Yes, for Australia, the higher interest rate will help to keep up the value of the Australian dollar - and reduce further the competitiveness of our non-mine, non-farm exports. It will help to keep down the prices of all those imports from China, India and the Tigers which have helped make the inflation rate look good for so long and to such an extent - while at the same time they gutted Australian industry in much the same way as they gutted American industry.

We're now leaning heavily on exports of mine and farm - as we did when we were a British colony and before we started to grow up in the great years after World War II - in the quarter century from 1945 to 1969.

And yes, we've got all the “blessings” of the carry trade. That's one of the elements in the great speculative mania that has swept over the world economy in recent decades and whose denouement we are now beginning to acknowledge with the collapse of the housing market with its ATMs, the torment of the "credit crunch" and the imminent and comprehensive collapse of the whole house of cards which banks, non-banking finance houses, hedge funds, private equity and the rest have constructed with such meticulous “regardlessness” over recent years.

Ever the stakes on the gambling tables have been raised higher: ever the cost of the collapse when, inevitably, it hits us with the real force of which it is capable, grows more overwhelming and intimidating.

To have reached a stage at which the only comfort we can draw from the current situation is to welcome the hiking of  interest rates to crippling levels and the keeping of our heads above water with the help of the carry trade, is to admit that we're slipping remorselessly into the abyss.

If this sort of thinking persists, the prospect must be not for a recession but for a deep and devastating depression, certainly affecting in the most terrible ways, countries like the United States and Australia.

Those of us who lived through the Great Depression saw then the regardlessness which so many well-qualified and admirable people are now showing, once more, in our present turmoil.

The result could be a depression with political and strategic consequences even more catastrophic than those that flowed from the Great Depression of the 1930s.

Let us hope that, somehow, the new Australian Government will shake itself out of its torpor and at least acknowledge the nature and extent of the problems that now confront us.

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About the Author

James Cumes is a former Australian ambassador and author of America's Suicidal Statecraft: The Self-Destruction of a Superpower (2006).

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