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Economic lateral thinking

The Malcolm Turnbull demand for banks to pass on the full interest rate cut has been criticised for being opportunistic and populist. And while there might be a bit of that kind of thing in it, there could also be some lateral thinking economics in this ‘courageous call’.
Most of my economics and market commentary life has been determined by something the legendary economist J.K. Galbraith once said: “In economics, majority is always wrong.”
Of course, this generalisation is not always right, but on some big economic issues it has had a pretty good strike rate.
Also at times like these when even the most respected economics commentators dare to pull out, not the R-word but the D-word for depression, that it is appropriate to recall some of the key observations of the British economist J.M. Keynes.
His theories dominated Western government policy for over five decades and among many other things he advocated government intervention when financial meltdowns threaten a global economic slump.
“The market can remain irrational longer than you can remain solvent,” Keynes once advised.
These would be telling words to day traders, hedge fund managers and very active investors who have geared themselves into precarious positions in the stock market.
In contrast, long-term investors with diverse portfolios and limited exposure to any one company are certainly out of the money now but time will eventually repair and make up for the current damage to their wealth. Super fund members are in the same long-term boat.
The worst part about our share-related wealth is that it is made too obvious to us all by my colleagues who think up the headlines in great newspaper such as The Australian.
Plenty of people have lost a fortune on their houses now and over the years but unless they have had to sell into a bad market, they are oblivious to their loss. And this is where the main issue comes into my argument and possibly Malcolm Turnbull’s — we have to stop this financial mega-problem becoming a mega-economic one.
The majority of the main players who now count — governments and central banks — have underestimated how bad this sub-prime mess could go. The post-bail out stock market reaction has shown that market players are not happy having their money exposed to companies — especially financial ones — that they don’t trust.
The only way out now is for some serious backstopping from governments who need to unequivocally stand behind their nation’s banks. The next step is to give economies liquidity and bring interest rates down. For too long the world was preoccupied with the threat of inflation but now could be devastated by deflation.
That’s why serious interest rates cut need to happen and they need to be passed onto business and consumers to ensure our economy does not go into recession.
Of course, we have to respect the need not to pressure our banks’ balance sheets at a time when wholesale funding rates are at very high levels. However, we can’t ignore the impact that frightened business owners and consumers might do confronted by all of these negative headlines.
Australians have been over-squeezed by a succession of rate rises since 2002 and the last year has been the dizzy-limit. Now it is time to release the grip and the big 1 per cent cut was great lateral thinking delivered with superb timing.
If a slow rate cut policy was tried it could have tipped us into recession and banks would have had to cope with unemployed customers and bankrupt business owners walking away from their loans.
This brings us to Malcolm’s argument that the banks can pass on the full cut.
If the global central bank assault can be coordinated it could prove to be the circuit breaker that can turn around investor sentiment. It would also inject the demand that all economies could well do with.
But be warned, the stock market is not the ultimate market litmus test on whether enough has been done to create a share price rebound putting an end to this unbearable bear market. All eyes have to be on credit markets.
These measure whether banks trust each other enough to lend money to each other. Once upon a time the difference between the 90-day bank bill and the Overnight Index Swaps was 10 basis points but it has spiked to 90 basis points and we need to see this head down before it’s safe to dive back into the stock market with confidence.
As this margin shrinks, Malcolm’s call for banks to cough up the full cut to be passed on becomes much easier to support. But note this, rates might have to fall a fair bit further.
Rory Robertson from Macquarie thinks the cash rate might fall to 4 per cent while Associate Professor Steve Keen from the University of Western Sydney thinks it could fall to 2 per cent.

If the Reserve Bank had not thought outside the square with that 1 per cent cut, I would have been a much stronger supporter of Malcolm, but for now I will leave him in the middle between the Reserve Bank and the banks. 

Published on: Wednesday, October 15, 2008

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