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Why Low Interest Rates are Bad for the Economy

Hmmm, it appears employment stalled in Australia during 2011. Following a loss of around 40,000 jobs in the last few months of the year, the economy shed 100 jobs in 2011. That’s not good. And you can bet a cut in interest rates will follow.

The growing global economic slowdown just reached our shores. Well, it’s actually been here for a while. But China and chunky government deficits have served to ‘insulate’ our economy. Up until now.

China is past its peak growth rate. The Western world is in a low-growth debt bog. And the government, trying to hold on to the credibility it has left, thinks rushing the budget back into surplus by 1 cent in 2013 is a good idea.

For the record, that projected budget surplus is as good as gone. It was only ever a political pipedream. It relies nearly entirely on the mining tax. And with the heat still to come out of the Chinese asset boom this year, revenue projections will prove way too optimistic.

The reality is the global credit boom created a massive misallocation of resources. That includes labour. According to the Bank for International Settlements, Australia’s household debt rose from around 45 per cent of GDP in the 1980s to peak at 157 per cent of GDP in December 2007.

The increase in credit built a consumer society. It also buoyed asset prices, which built a financial services society. Clearly the credit/debt boom created overcapacity in these industries.

Now, with the credit boom over, it should not surprise you to see job losses in the retail sector and, more recently, in financial services. It’s the economy’s way of adjusting to a new level of demand.

And because this is a structural change in demand, not a cyclical change, you should expect these job losses to continue.

Although many hailed the government’s 2008 stimulus package as a ‘success’, all it did was perpetuate the imbalance and prolong the adjustment phase. By handing out a wad of cash to those with a bent to consume, the economy fired off a false price signal to those in the retail industry. It was fleeting, artificial demand.

Making matters worse, the government pumped money into the residential housing market via grants and buying up mortgage-backed securities. Again, it created distortions in the market by setting off false price signals.

Now the government can’t afford to throw more money at ailing industries, so the adjustment that is already underway might gather pace.

The financial services industry in particular suffers from overcapacity. For decades, universities churned out finance, commerce, accounting and economics graduates to feed on the ever-growing credit bubble.

Because finance was always the closest industry to the source of the economy’s money and credit, it has a legacy of high wage rates. The industry is labour, not capital intensive. Without ‘human capital’ these businesses have no value.

So what do you do when the flow of credit – and revenue and profit – slows? Cut jobs.

This bad news on the employment front means you can just about guarantee another cut to official interest rates in February. And another…and another in the months that follow.

A year ago, the RBA and the horde of market economists who hang on its every word expected interest rates to be higher by now. Even as late as September 2011 the RBA was sitting on its hands, unsure which way to move.

The direction of interest rates seems pretty certain now. But before you rejoice, here’s something to think about…

As an economy’s debt load grows – and that debt turns bad – interest rates must fall to historically low levels… even zero. Japan has endured (not enjoyed) zero interest rates for over a decade. Following the credit crisis, the US, UK and Europe all have very low interest rates. And it will stay that way for a long time.

This is not a positive. It’s a sign that these economies are full of bad debt. The only way to prop up the bad debt is to bring its servicing costs down. But ultra-low interest rates discourage saving and distort the whole economic process.

Australia is not there yet. Our interest rate suggests we’re still in relatively healthy shape – as a whole. But the direction is a concern. We’re following the Western world down.

What could Australia’s source of bad debts be? How about mortgage debt. And rising unemployment is about the last thing the property market needs now.

Regards,

Greg Canavan
for The Daily Reckoning Australia

Greg Canavan
Greg Canavan is a feature 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 Sound Money. Sound Investments, 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.
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4 Comments

  1. garyb says:

    The two recent cash rate cuts by the RBA show it’s as irresponsible as every other central bank. Slashing rates when Aus has massive private debt levels just to appease whining retailers and the property industry. Central banks are meant to manage inflation, not dish out welfare to retailers and property speculators, or prop up share markets.

  2. Rob says:

    I agree with your analysis entirely, Greg, and find the Daily Reckoning articles very good indeed.

    With regard to falling interest rates, the government constantly bashes the banks to reduce interest rates when the RBA lowers them. This may be justifiable if the cost of bank borrowing is low, but not otherwise. The lowering of interest rates obviously helps mortgage-holders but entirely disadvantages self-supporting retirees, many of whom are living off bank interest income, particularly when it appears improvident to be in shares. The more interest rates fall, the more retirees will be forced to seek government pensions. Gillard, Swan and Co. need to wake up to the increasing burden this will put on government. I have not heard them mention self-funded retirees in relation to the question of interest rates. About 95% of the working age population (based on ~5% unemployment) have salaries which help them pay their mortgages irrespective of interest rates; if interest rates drop to near zero, retirees will have to live off what capital they may have. With inflation this capital erosion will sooner or later put increasing numbers of retirees on government pensions. Perhaps one of your many articulate contributors might write an article on this in Daily Reckoning.

  3. Ross says:

    The other side of the coin is that high local interest rates against a global average are bad for the economy as it induces carry trades.

    Carry induces asset price inflation in unproductive and highly liquid short term investments (like bank stocks that effectively pay dividens out of capital and releverage equity into real estate prices). Such short term investments also in turn raise reverse carry risks.

    And when a Goldman guy gets the ECB jersey guess what he produces?

    http://www.bloomberg.com/news/2012-01-22/draghi-makes-euro-favorite-for-most-profitable-carry-trades-with-rate-cuts.html

    Isn’t that where all the money Bernanke printed went? It certaionly didn’t go into US long investment or to refloating the US real estate bubble did it?

    So we’ve heard that story before and the beneficiaries were the 1% and the long tail liability sits in the crappy asstes on reserve balance sheets and future ‘flationary expectations with the middle and lower classes?

    We don’t live in a bubble in Australia, there was irrational exhuberance before the 1840 and 1890 busts as well.

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