Wednesday, May 5, 2010

Any More Interest Rate Rises Would Be A Mistake

Yesterday interest rates went up. Today the stock market is plunging. The two are not directly related, but there is a connection beyond the fact that both are bad news for most people. Interest rates have been increased because of increasing inflation, commodities prices rising more quickly than expected, and the improving terms of trade. The approach reflects the view that the worst of the Global Financial Crisis is behind us and the task now confronting the Reserve Bank is to manage the recovery. The Reserve Bank governor, Glenn Stevens, indicated that the new cash rate of 4.5% means that interest rates are now at a level which can be considered “normal”.

But today’s price drop on the share market tells us that things are not quite normal yet. The GFC was originally triggered by debt defaults on a massive scale. In combating the crisis, governments around the world, including our own, have shifted vast amounts of debt from private hands onto the government ledger. Here in Australia, we had no government debt to start with, and the debt level now is not a serious problem, no matter what Tony Abbott might tell you. However, the same can’t be said for other countries, and today’s share market slide has been triggered by sovereign debt concerns around Greece, Spain, and the fear that other European countries may also be struggling.

The Americans wouldn’t like to admit it, but they too have dangerous levels of government debt, largely because they were already spending trillions of dollars of borrowed money on fighting a couple of wars even before the GFC arrived. As long as the debt remains, the interest payments will act as a drag in the economy, and if debt continues to grow the drag will also continue to grow. If it gets out of hand, a country winds up like Greece, begging the International Monetary Fund for a bailout which will only be forthcoming under terms and conditions which ultimately cost ordinary everyday people a chunk of their standard of living.

Here in Australia, our debt levels remain at manageable levels, but if there is a second wave of Global Financial Crisis we could not afford the same sort of stimulus spending that we have seen in the first wave. And despite the apparent resumption of the resources boom, the retail economy is still fragile. While the falling share prices today may not directly affect everyday people, rising interest rates most certainly do, and those share market prices could well be a signal that we should not assume that the GFC is completely over. For that reason, any further interest rate rises could be the wrong move entirely, and if the European sovereign debt problem gets any worse, it might turn out that yesterdays increase was also a mistake.

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