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Token interest rate cut would be a foolish mistake

By Henry Thornton - posted Tuesday, 1 November 2011


The Reserve Bank should leave interest rates on hold today. But what the board sees as smart politics might produce an unnecessary rate cut.

The circumstances that would demand a large rate cut, up to 100 basis points, would be a "Lehman moment" in Europe, but at the time of writing a viable plan seems to be emerging.

The eurozone mess has dragged on for months. Clearly, Greece was not ready for the stringent demands of a single currency in a currency zone dominated by the powerful and productive German economy.

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Indeed, most of the nations of Europe will ultimately find the eurozone standards impossible to achieve and maintain, and countries such as Ireland, Portugal, Spain and Italy are wilting visibly.

The plan announced late last week allows for a 50 per cent writedown of official Greek debt, recapitalisation of the eurozone banks and a E1 trillion bailout fund. Experts say this fund needs to be E2 trillion or E3 trillion if Europe is to come safely through its current crisis of confidence.

The tin is being rattled vigorously via the International Monetary Fund and with individual appeals to China and other major surplus nations.

Eurozone debt owing by most of the countries listed above needs to be written down to the same degree as Greek debt if a lasting solution is to be found. Otherwise, there will be extreme fiscal austerity, unstable government and unnecessary misery for millions of people.

The weaker nations of Europe should be allowed to suspend their membership of the eurozone and reintroduce their original currencies at the pre-euro parities, or lower.

Some readers will say that debt writedown and devaluation are the soft option and bad for the character of those who find themselves unable to meet their obligation to repay their borrowings.

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Undoubtedly this is so, but the moral laxity is shared by those banks and other lenders to those who borrowed too much.

Debt writedowns will be good for the character of those who overlent, and it would be expected that they would be more careful in future, at least until the current generation of bankers depart the stage.

The US's problems are more conventional. US GDP fell about 7 per cent from its peak value and, according to history, such a severe recession, especially when reinforced by a financial crisis, can take up to a decade for full recovery (a return to GDP levels consistent with trend growth). The US is about half-way through such a drawn-out adjustment path, and there are still large amounts of unused or underused resources, most importantly labour.

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This article was first published in The Australian.



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About the Author

Henry Thornton (1760-1815) was a banker, M.P., Philanthropist, and a leading figure in the influential group of Evangelicals that was known as the Clapham set. His column is provided by the writers at www.henrythornton.com.

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