The RBA is Wedded to Monetary Theory, Not Monetary Reality

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It’s a reasonably well known historical fact that Sir Isaac Newton blew himself up; not by performing a science experiment, but with an ill-timed punt on shares in the South Sea Company.

After the dust had settled, and after Newton had presumably moved through the denial and anger stages, he accepted the results of his folly and reportedly said:

I can calculate the movement of stars, but not the madness of men.

Ain’t that the truth, Sir Isaac!

One of the great fascinations about the stock market — for me at least — is how it is inextricably linked to human nature. It is a market, after all, and a market requires the interaction of buyers and sellers, which happen to be humans like you and me.

Insanely, classical economic theory assumes that all participants in the marketplace are rational operators. Perhaps they modelled this assumption on how people generally behaved at any local weekend produce market.

That is, buyers assess available supply and compare prices across a range of suppliers. Suppliers in turn adjust prices as they need to in order to clear their stock for the day.

According to the theory, everyone goes home with more or less what they need for the week. No one gets into a fight, panics about cabbage shortages, or loses money.

But anyone employing a modicum of common sense knows this is not how the stock market works. It’s prone to imprecise information, fuelled by rumours, which are in turn fuelled by the play of human emotions.

History is littered with examples of how men and women (but mostly men) have lost their heads when it comes to the stock market. The gut-wrenching and paralysing fear of seeing your portfolio head south, and the exhilarating excitement of seeing the same portfolio head north (due to your brilliance and investing nous), forces us to make decisions that we wouldn’t normally make under a more stable emotional environment.

But history isn’t as replete with examples of the guardians of finance losing their minds. It was their job to step in with a cool head when everyone else was losing theirs. That’s exactly what JP Morgan did in 1907. He averted a major panic by injecting cash into the system and restoring confidence.

These days, we have nothing like the experienced and cool hand of a JP Morgan running the show. Instead, we have academic central bankers who have, quite frankly, lost the plot.

Australia’s RBA is the latest central banking institution to succumb to the same dumb policies that have beset the northern hemisphere for years.

On Tuesday, I wrote that there was no reason to cut interest rates. I said a cut would have no impact on the currency and would only encourage more debt accumulation in the economy and, over time, increased financial instability.

In addition, it would strip savers of income, encouraging them to take on even greater risks to earn a decent return.

Tuesday’s cut resulted in the currency actually increasing, while the market and bank shares in particular sold off heavily. What does that tell you?

It tells me interest rates cuts are having an ever smaller effect on both the economy and bank profitability. I wonder when this will dawn on the RBA, or whether they’ll think they simply haven’t done enough. I’m tipping it will be the latter.

Tuesday’s rate cut came with the standard bunch of cheerleading from Australia’s assorted (and sordid) bunch of rent seekers. Bank economists in particular were uncritical of the move.

I’m not sure how long this will last, though. Banks are now actually under threat from interest rates falling further. They need to keep deposit rates attractive enough to ensure people keep their money in the banking system. The lower rates go, the more deposits will decline. This puts greater pressure on ‘wholesale funding’, which refers to the banks having to borrow in offshore markets to fund their loan books.

Given this dynamic, plus the need for banks to raise more capital to strengthen their balance sheets, it means pressure will remain on bank earnings for some time to come. The only hope is that lower rates will spur even greater borrowing, which will in part compensate for these other pressures.

So I’m thinking you might see a change of tune from bank economists in the months to come. Instead of cheerleading for more interest rate cuts (because it’s obviously SO good for the economy), they might start to pull their heads in and argue that monetary policy has done its job, and that more cuts would be counterproductive.


But it’s going to take a lot for a central bank to admit that it’s out of ammo. Looking at the RBA Board, both governor and deputy governor are academics. They’re wedded to monetary theory, not monetary reality. Glenn Stevens has been at the bank since 1980!

The rest of the RBA Board has very good representation from the Australian business community. But only one member, Alan Moss, has any genuine experience with financial markets. And in this day and age, with the enormity of financial markets, and their ability to influence policy, I would argue that a board needs more than one experienced ‘market participant’ to help not only make the right decision, but to communicate in a way that is effective.

Because the RBA’s communication is completely ineffective. Recent rate cuts have done nothing to lower the dollar, and that is precisely because the communication that accompanied each announcement was weak.

More effective ‘jaw-boning’ would have achieved a different outcome.

But even effective jaw-boning isn’t going to cut it when China’s on a stimulus rampage. In my view, this is the real reason behind the dollar’s rally this year.

Is it about to come to an end, though? Data out a few days ago showed a key manufacturing index starting to contract again. From MarketWatch:

BEIJING—China’s official manufacturing purchasing managers’ index slipped below 50 in July, indicating a contraction in the nation’s factory activity for the first time in five months, official data showed Monday.

The index fell to 49.9 in July from 50.0 a month ago, pointing to a slowing of growth momentum in the world’s second-largest economy. A PMI reading above 50 indicates an expansion in manufacturing activity, while a reading below 50 points to a contraction.

It’s only one data point. But an economy that relies on stimulus will inevitably slow once that stimulus wears off. And as I’ve said before, I think China now has its foot off the accelerator.


Greg Canavan,
For The Daily Reckoning

Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also 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. For more on Greg go here.

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