This week, nine individuals got together and decided on the price of oranges in Australia. None of them are orange farmers. They decided to reduce the price of oranges by 50 basis points, noting that orange consumers had fallen on hard times and needed some relief.
Does this sound stupid to you? Well, it's actually dangerous. When the Americans implemented price controls on food, including fruit, in Germany after World War 2, it led to starvation. Your editor's grandparents still eat their apple cores as a result.
In fact, they even used to eat your editor's apple cores when he sat on their lap. Anyway, the Americans also tried price controls at home and had to abandon them because of all the shortages and surpluses it created.
You see, when the government sets prices, it always gets them wrong. If they set prices too high, there is a surplus of goods produced, causing wasted goods and resources, and shortages in other areas.
If they set prices too low in an attempt to make things more affordable, it creates a shortage because producers don't bother producing for such a low profit. If they set the price where the market would have, the market price has probably changed by the time they get their news release out. And besides, different prices are appropriate in different places around Australia.
The Germans after World War 2 eventually abolished price controls without seeking permission from the Allies like they were supposed to. By the time the Allies figured out what had happened, the shelves filled with goods as people responded to the true market price, which satisfied buyers and sellers.
Just about all economists have figured out that price controls are a bad idea when it comes to oranges. And every other good and service. How many politicians advocate regulating the price of whatever you sell at work?
Price Controls for Interest Rates
But what's odd is that everyone continues to believe in price controls for interest rates. They think someone must control the price of debt. But debt is just another good or service. People sell the use of their savings, and people buy the use of those savings. The price is the interest rate. Why does the government need to meddle with this?
Their answer is nefarious and complicated. But it tells you why Australian property owners will face far worse headlines than this one from the Herald Sun: 'Melbourne house prices plummeting'. A 7% drop over the past year is just the beginning of the consequences we might be facing from manipulated interest rates.
You see, savings and borrowings aren't actually as simple a good as they seem. Debt is in fact a transaction of buying and selling time. This is the ingredient that very few economists understand, which leads to complete confusion and ridiculous conclusions on their part. So how is borrowing money in reality borrowing time?
The fact that you have to pay the money back in the future is the big clue. Normal transactions take place with a give and take at the same time. But the agreement between the saver and borrower is an exchange of the same good (money), but in two different time periods.
It's an agreement for the use of funds that the saver does have now but doesn't want, and the borrower who doesn't have them but wants them. The key to the transaction is the difference in time between the give and the take.
The interest rate is the price of the agreement - the price of time. Another way to think about it is that the interest rate is what you get for parting with your money for some period of time, or the price you pay for someone else doing the same thing for you.
Money itself is of course just consumption to happen in the future. We don't want money for the sake of it, but for what it can, will and could buy.
Interest Rates and the Housing Bubble
What does all this have to do with the Australian housing bubble? You need to know just one more thing before we connect the dots. You earn money by producing. You save by not spending all the money you earned.
But when the central bank prints money, it creates savings that were not first earned by the production of something, and not first saved by forgoing the consumption of what was earned by producing. This link between production, earning and saving is broken when the central bank creates artificial savings to manipulate interest rates.
Phew. Now to the Australian housing bubble.
When interest rates are kept artificially low, it sends a signal to people that savers are willing to part with their money for a period of time at quite a cheap rate. So people borrow lots, often for houses. Some people who would have saved at the true interest rate turn into borrowers because the interest rate is so low.
This creates a surplus of debt relative to real savings because the price of borrowing is so cheap and the central bank stands to flood the market with fake supply to keep rates low. More debt in the economy means house prices can be bid up. Rising house prices encourage more debt. This is called the 'positive feedback loop'. It is self-sustaining.
For a while. Eventually, the interest expenses on the vast amounts of debt reach such proportions that lenders get worried about their borrowers. They stop lending, which stops the debt fuelled price rises. Let's call this the negative gearing part of the boom because rental income isn't offsetting interest expense. That's where lenders alarm bells begin ringing because they care about the ability of borrowers to pay their bills.
As soon as prices stop rising (they don't even have to fall), the whole bubble is doomed because the capital gains justifying the negative gearing stop, creating a selling panic. Sometimes rates can be lowered to reduce the interest expense of borrowers. But there's a limit to how low they can go.
If you think all this is a bit abstract, just look at the RBA's press release. It's all about how the economy is just fine, until it mentions borrowing - a reference to mortgage rates:
'Financial market sentiment has generally improved this year, and capital markets are supplying funding to corporations and well-rated banks. At the margin, wholesale funding costs have declined over recent months.
'...growth in domestic demand ran at its fastest pace for four years.
'Labour market conditions softened during 2011, though the rate of unemployment has so far remained little changed at a low level.'
If everything is hunky dory, why cut rates? You guessed it:
'A reduction of 50 basis points in the cash rate was, in this instance, therefore judged to be necessary in order to deliver the appropriate level of borrowing rates.'
So that's how the housing bubble works. But it gets even worse, because a housing bubble causes problems for the entire economy. We'll leave that for another day.
for The Daily Reckoning Australia
- The Greatest Interest Rate Fix featuring… Mario Draghi and Friends
- Mortgage Rates Increases: Wrong Questions, Wrong Answers?
- How Will the United States Finance the Biggest Deficit of All Time?
- The Great Correction Continues on the US Housing and Mortgage Market
- Will Synchronized Rate Cuts Solve International Financial System Problems?
About the Author
Nick Hubble is feature Editor of The Daily Reckoning Australia – weekend edition. You can subscribe to the Daily Reckoning for free here. Nick has spent the last three years discovering lots of new, exciting and surprisingly simple ways to generate money for retirement. He’s put all these ideas into his investment publication The Money for Life Letter. If you're already a subscriber to these publications, or want to follow Nick's financial world view more closely, then we recommend you join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails.