Token interest rate cut would be a foolish mistake

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.

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.

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.

Complicating the economic problems is a dysfunctional political situation. In my opinion, the Tea Party Republicans would prefer an extended recession to the re-election of Barack Obama. This plan is likely to be thwarted by the gradual return of confidence and faster recovery than seen hitherto.

There has been much talk of a "double dip" recession in the US on top of the possibility of more serious trouble with eurozone debt. China has been trying to slow its overheating economy and evidence of (slightly) slower growth in China has produced falls in commodity prices and equity prices. Even Australia's "world's best" Treasurer, Wayne Swan has begun to sound slightly nervous.

But overall, Australia still has a massive mining boom in the pipeline, a boom in which labour shortages are already being felt.

With the battle for skilled labour, a relatively high Australian dollar is squeezing other sectors of the economy, which is exactly what Adam Smith's invisible hand should be doing about now.

There is much hand-wringing from real estate agents and retailers at weak sales and pressure on profit margins, although neither the home-owning business or retail sales are in freefall. The plain fact is that, for the past 30 years, Australians have invested far too much in houses and have spent far too much on consumer rubbish, called "consumer land fill" in Henry's household. The quality of the hard rubbish placed on footpaths when collection day approaches has to be seen to be believed. Most Australians could go for years without buying more future landfill, yet the current revival of thrift is bewailed by retailers and most commentators.

Switzerland is a country with a very high standard of living without massive spending on consumer landfill. This is partly because Swiss people have a more sensible approach to spending, and partly because their houses are far too small to clutter at Australian rates.

Lower house prices are painful for those who paid top dollar in the late house price boom, but there are many who will benefit, particularly young first-home buyers.

A return to sanity in both housing and retail markets is an outcome highly desirable, and would be encouraged, not bewailed, by a competent government with a strategy for Australia beyond the next election.

There is also the threat of goods and services inflation to consider. The latest inflation outcome surprised by being less than expected, which is unambiguous good news. But underlying inflation is still above the RBA's target band, and wage claims, especially in the public sector, are creeping up.

The RBA's senior officers would, I think, be firmly on the side of those who promote thrift, productivity and sensible decisions by households and businesses. Deleveraging at this time of global economic danger is entirely sensible behaviour, and bringing this to an end by cutting interest rates would be foolish.

I expect the RBA to leave interest rates unchanged today, although given all the international uncertainties, I would expect the board to give the governor approval to slash interest rates if there were a serious economic meltdown in the eurozone.

The board may conclude that a token rate cut will protect it from allegations of heartless rationalism. This would be, in my view, like a sled full of Russian aristocrats pursued across the deep snow by a pack of ravening wolves, throwing the oldest peasant off the sled. Equally useless and actually the more heartless action, but the actions of Russian aristocrats were ever thus.