The “liquidity” crisis & interest rates

There has been a lot of talk lately about troubles in the housing market, the liquidity crisis, interest rates, a potential recession in America and the generally uncertain economic future. But what does it all mean?

America is facing some problems. In recent years, lots of money has flowed into American property. Many people were able to take out “sub-prime” mortgages (known as “low-doc” or “no-doc” loans in Australia) that require little or no checks and consequently have a higher risk of default. American retail banks then sold about 70% of these loans (and the associated risk) to other market players, primarily investment banks. While the property market was hot, money kept flowing from investment banks to retail banks and on to people who bought property.

But the property market didn’t stay hot. House prices have stagnated or fallen… and in some places they have plummetted. People started to default on their loans, especially in the sub-prime sector. Banks with exposure to sub-prime mortgage risk have lost billions of dollars, and many people have lost their homes.

But this isn’t the main problem. On it’s own, a few bank losses and mortgage defaults is a relatively small economic bump. The bigger problem is that investment banks understandably don’t want to provide cheap finance to retail banks, who are then unable to provide cheap finance to consumers. Liquidity has dried up, which is pushing up interest rates, which is leading to more people defaulting on their home loans.

The bank losses from these defaults have lead to lower share prices, and could in some cases be a knock-out blow. Bank failures can be big business, and inevitably lead to call for the government to bail out the stricken bank to protect depositors and investors. This would be a mistake.

Like all businesses, banks must be allowed to succeed or fail based on their performance. Government protection of bank deposits (deposit insurance) seems nice, but it undermines the important market pressure for banks to maintain a high-quality investment portfolio. In the long run, the consequences of a protected (and consequently inefficient) banking sector is bad investments which end up with lower growth, further bail-outs and eventually a larger collapse. One example of this is the East Asian Financial Crisis, which was in part a response to the bad investments built up by government banks.

America looks like it’s heading into a recession. One of the best explainations for recessions is the Austrian Business Cycle Theory, which blames monetary policy mistakes. Excessively low interest rates distort prices, leading to mal-investment (investing in the “wrong” capital), and then when prices adjust the mistakes are realised and the bad businesses go bust. Even without monetary mistakes, economic booms often conceal bad investments that eventually will be corrected. And of course, governments can contribute to economic slowdowns by distorting the market with taxes, spending, deficits and regulation. While the housing market and liquidity crunch might be the triggers, a recession is generally caused by one or more of these underlying factors.

In response to these problems, the American federal reserve (“the fed”) has decided to cut interest rates. This is a mistake. The fed is trying to ease the liquidity problem, ensure the continued existence of cheap credit and therefore prevent further losses. But the low interest rates are artificial, and maintaining artifically low interest rates is actually a long-term cause of recessions (as per the Austrian Business Cycle Theory). Previous low interest rates were partly based on an incorrect assessment of risk, and it is appropriate for these to adjust upwards.

Artificially low interest rates cannot undo the fundamental problems in an economy. They can delay the correction, but only by first causing more mal-investment, which will eventually require a larger correction. Not only do the lower interest rates not help, but they are likely to lead to higher inflation. There is a possibility that America is not just heading for recession, but stagflation (recession & inflation).

But we shouldn’t be too pessimistic. Market economies are amazing in their ability to adjust and move forward, and despite a slow trend to bigger government, the American economy is still relatively free. With a bit of luck and a bit better policy, it would not suprise me if the American recession was short-lived.

The Australian economy is in much stronger shape. I believe that nearly all of the problems of the American economy are absent in Australia. Property prices may be too high in some places, but many of the price increases represent real demographic and supply-side factors. More people are moving to s/e Qld than houses being built — so of course prices are increasing.

In addition, while investment banks contributed about 70% of home-loan financing in America, they make up only about 17% in Australia. Consequently, the liquidity crunch will not hit Australian interest rates as hard as it does in America.

We also have had consistently better monetary policy than America. While we do face some inflation risks, I don’t believe that our monetary policy has been far wrong and so I don’t think we’ve suffered much mal-investment. And in the face of inflationary pressure, the Reserve Bank of Australia (RBA) has done the unpopular but correct thing in increasing interest rates. And in contrast to America’s budget deficit, the Australian government is maintaining a large surplus. Perhaps too large.

With coming tax cuts and a continuing good investment environment, I think that Australia remains on track for strong growth while also being able to control inflation. Interest rates will remain high for a while and this will hurt some people, but I don’t see a collapse or recession in the near future. But then… I’m generally an optimistic sort of person.

43 thoughts on “The “liquidity” crisis & interest rates

  1. I agree with pretty much all of this. Australia is in good shape. The RBA is doing a good job relative to the US Fed.

    In my view the RBA should be seeking a stronger aussie dollar (relative to the inflating US dollar) in the current environment without using the blunt instrument of an interum interest rate target. Our current inflation problems are mostly imported. As I’ve said many times I believe interest rates should float. Monetary policy should use commodity spot prices as a reference signal not the domestic price of credit. We don’t live in a closed economy. A fix to gold in the current era of floating currencies may cause some unpalatable volatility in our terms of trade (except in mining where they would have a more stable sale price) but it would ensure both low inflation and an influx of cheap credit (and hence low interest rates).

    Tax cuts will lift supply partly via better incentives but mostly through a better division of labour. As such recent trends towards lower rates of income tax should continue and ideally accelerate. In particular the top two rates (40%and 45%) need a good trim as does the bottom end 15%. The means based taper rates on welfare should also be reduced where appropriate.

    The Austrians have a lot to be proud of in their contribution to economic thinking. However they do have their unfair share of oddball fringe dwellers. A bit like the general libertarian cause I suppose. It is the price of appealing to independent thinkers.

  2. John

    I agree with your assessment of the US situation and Greenspan’s terrible mistake (he, a libertarian too) of keeping interest rates too low for too long.

    However, i don’t share your optimism on Australia.

    Exactly the same problems that are facing US consumers are also present for Australians – namely too much leverage.

    Property prices have risen in SE Qld for good demographic reasons but are now way too high relative to what people can afford. Globalisation is a good thing but it means that countries with open borders cannot avoid the problems of others.

    China will stumble as it exports mainly to the US and its stockmarket is absurdly over-valued (PE of 60). Australia will then falter as China stumbles. The Oz economy will then slow down, unemployment will rise and people with second homes will sell them rather than pay mortgages of 10%. This is already happening in Palm Beach, of all places.

    But i am and always have been a natural bear. I am invested in a mix of oil stocks (very poor decision despite oil of $106), commodity stocks (good up til this week), gold and cash (8% term at Rabo).

  3. Greenspan needed to slash rates because back in the early 2000s deflation still loomed. However I agree that todays problems are largely because they were kept low for far too long. The fact that they are still low bodes very badly in terms of the risk of an inflation break out.

    Interest rates are an even worse instrument in the USA than in Australia because so many borrowers have long term fixed interest loans. Notionally it takes a bigger jab on the interest rate peddle to send the same wake up signal. I don’t know much about the structure of US business loans.

  4. To quote from Sinclair’s paper: Three public policy failures contributed to the current global financial crisis; low interest rates over the past several years, restrictive building policies, and affirmative action.

    There is another element of government policy at play here. Two of the biggest players in the buying and selling of mortgages in the American market were Fannie Mae and Freddie Mac. These are government-sponsored entities.

    I forgot about that “Brisbane Club Lecture”. Hope it went well. Apparently, it was organised by Duncan Macfarlane, who used to be associated with the ALS.

  5. Fannie Mae and Freddie Mac deny being explicitly or impliclty being Government sponsored enterprises, but in reality they have a line of credit to the US Federal Treasury.

    I agree with Sincalir Davidson. It should be also noted that interest rates weren’t just low, they were artifically low. Inflation was a result, as I believe were malinvestments (as per the Austrian Business Cycle Theory).

    A good starting point for an explanation of this theory is in “The Capitalist Alternative: An Introduction to Neo-Austrian Economics” by Alexander H. Shand, G. L. S. Shackle

  6. When you assert that interest rates were too low can you put some dates around that. There are times since 1995 when I think that US interest rates were not low enough. I’d offer my own set of dates for that statement but I’m not in a position to check my history right at this moment.

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  8. John Humphries says “While we do face some inflation risks…”
    Come on, John, inflation has been running at over 10% for many years (REAL inflation, that is; not the pseudo inflation that is measured by the CPI). Surely this is one of the reasons that many wives have had to continue or resume work – inflation has eroded real wages.
    I think that the US recession will be long and deep because of the huge number of malinvestments that will have to be liquidated. On top of that savings will need to start again so that the next level of investment can be made. This will not occur overnight.

  9. Graham,

    Inflation is one of those words that gets defined differently by different people at different times. The mainstream economists describe it as a rise in aggragate consumer prices. The Austrians define it as an increase in the volume of money (with arguments about whether you should use M0, M3 etc). So given that context can you tell us what defintion you use when you say “REAL inflation”and “pseudo inflation”.

  10. Terje

    Why over-intellectualise a very simple issue?

    ‘stuff we buy’ aint going up at 2.9% per annum. The UK tax office website provides every tax payer with an inflation calculator so that people can determine their own level of inflation. when i tried it, it came out at 6-7% despite ‘official’ inflation of 2.2%. i havent seen a similar calculator here but would guess the results would be the same.

  11. Pom’s right inflation for the middle class around the wrold is running at around 7-8%. For the rich it’s about 10%.

    That rally last night was truly impressive, pom. Can’t be ignored.


    A lot of people use catarpillar inc. as a good proxy for what’s happening deep in the innards of the US economy. It’s fallen , but not as much as one would expect.

  12. Pommy – so you’re with the mainstream economists but you think the CPI basket is unrepresentative. You may be right. I know that Rio Tinto wants to put up the contract price for iron ore sales to the chinese by 70%. I don’t buy much iron ore myself so it’s not on the “stuff we buy” list but when I read news like this I do feel very much like we are in the midst of a stong inflation current.

    Can you offer a better way to measure inflation objectively?

  13. Bah… CPI has mistakes, but so does any measure. Sometimes price increases represent a quality improvement, and this shouldn’t be counted as inflation. That would be like saying that it’s inflation that good computer costs more than a bad computer.

    The GDP deflator is a relatively good indicator of inflation, and it is fairly consistent with CPI. If people honestly think that inflation has been running higher than nominal GDP growth then they are saying that Australia has been in a recession for a while. Does anybody believe this?

    Some people (including some austrian economists) are always predicting recession. Of course, as long as they don’t put a time-limit on their prediction, they will eventually be right. Like predicting that it will rain in the future. Not very useful.

    There has been mal-investment (there always is — humans make mistakes), and there will need to be an adjustment. But likewise, there will be continued investment and strong growth in other areas of the economy. The good news is that this can soften the recession. The bad news is that it also hides bad policy, which allows policy-makers to make the same mistakes again.

  14. John H

    How do you explain away M1 growth of roughly 10% since 1994.the deflator doesn’t meausure asset price inflation which is where the problem lies.

  15. and yes john, I think a large number of people are worse off. If you haven’t owned a house in the past 10 years, didn’t own stocks, had to send kids to a private school, vacation costs have gone through the roof. ….theatre tickets……….

    Believe it or not, i know a guy who earns around a million a year and he thinks he’s having it tough. Doesn’t own a house as he comes from the US.

  16. I’m sure some people are worse off — but do you honestly think we’ve been in a recession since 1994, with national GDP decreasing every year? I find that highly unlikely at best.

    I understand the argument that inflation has been hidden in asset prices. This is a reasonable argument. People who ignore this aspect of our economy don’t realise the potential problem, but I also think that some people who realise this potential problem consequently over-state the issue.

    If the appreciation of land is in response to real factors (which I believe it mostly is), then it may have been appropriate to have relatively high monetary growth. The alternative may have been delfation.

  17. There is a huge incentive for governments to skew the official inflation figures down as govt sector wages are generally benchmarked to inflation and central banks set interest rates according to official figures.

    One example in the UK of the inaccuracies of the official CPI number –

    If a computer increases its processing power by 100% but the price remains the same, the CPI figure will show a halving of its price. Fair enough.

    But if a government service gets worse, say, the trains become more crowded or more services are cancelled, this is NOT included as price inflation in the official CPI.

  18. Terje – you buy lots of stuff made from iron ore!

    JC – sell any rally! the ASX is going to 4,500.

  19. Pommy – I agree that commodities are a prime input to the price of most stuff. Thats part of why I bang on about the importance of commodity prices as a monetary signal. However it is also because commodity spot prices are a fast moving signal (lag matters in a feedback system – such as monetary management – especially if you want to avoid oscillations), that are set globally and because commodities are highly fungible (unlike computers). The price of labour and capital are also important but commodity prices also reflect these to a large extent. However iron ore isn’t a consumer product.

    When I compare monetary policy systems then success in keeping CPI inflation low is an important benchmark. But the gold standard not only kept CPI inflation low it also kept the price of credit (interest rates) low and stable, exchange rates didn’t fluctuate and commodity prices were not so volatile. As a price stabilising monetary system history would suggest that the gold standard is second to none. Heck Alan Greenspan even claimed once that the gold standard kept down the cost of being governed, and a quick glance at the data would suggest some correlation for this claim within the data.

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  21. One of the difficulties with our monetary system is that we insist on using the same money for everything. When we get a problem in one area – say US Home loans – then the problem flows through to other areas where there are no difficulties. If we had a system that still allowed funds to travel between sectors but made the different money areas distinct then the system would be able to better adjust itself. Think countries within countries. Some immediate “obvious” classifications or countries within countries would be loans for old houses ($240 billion a year), credit card debt, cash, investment dollars for renewable energy. The mechanics of moving money between areas is simple enough to do in today’s electronic world and it would be simple enough to implement.

  22. I’m not defending the official CPI statistics. Everybody knows they are not perfect (though mistakes go in both directions, the stats often don’t fully pick up quality improvements).

    But I note that the pessimists haven’t answered my question. If we’ve had real inflation of about 10% since 1994, then Australia has been in a significant depression since 1994. Does anybody believe this?

    During this depression, unemployment has just dropped to 4%, which is the lowest in over 30 years. At the same time, participation has increased. We’ve also attracted huge amounts of foreign investment, business seems to be going fairly well and our dollar is strong.

    Either we’re in the middle of a very weird, hidden super-depression… or there is a different answer. I suggest there is a different answer.

  23. I fully support the anti-inflationary stance taken by the Rudd Government. It is a pro-job stance.

    If only the detractors and Govenrment knew that wages growth and balanced budgets tax cuts are not inflationary.

  24. John, I don’t think I can fault your logic on this point. However let me have a poke around at the fringes.

    GDP measures production. CPI measures the price of consumables (ie what do all that production cost). Capital (eg assets) is the stuff that assists with production. Can the price of assets rise even whilst output is maintained and the price of output is stable?

  25. Terje — yes, that can happen.

    The issue is why the prices are changing. If consumer prices are constant and asset prices are increasing for real reasons, then there is no inflation.

    However, it is also possible that consumer prices are constant, but asset prices are increasing only because of inflation. This inflation is hiding where the CPI indicator can’t find it… but when the asset bubble bursts then it will hit the consumer market. This is the fear of pommy, JC & Graham.

    According to that thesis, if we didn’t currently have inflation, then asset prices should have risen and consumer prices should have fallen. But the 10% inflation has shown up as consumer prices staying stable and asset prices rising even more. So to assess your real position, you need to discount your consumption by 10%. As nominal consumption has been increasing by less than 10%, such a discount would mean that we’re in recession and steadily becoming poorer.

    Some people appear to believe this (though I’m not sure if pommy, jc & graham do). I was worried that Ron Paul may have believed this given some of his comments. I find it highly unlikely, and a bit wacky.

    The pessimists could explain away the low unemployment rates by saying that real wages have been falling. But it is more difficult to explain the strength of our dollar, high foreign investment, high participation rates, strong business performance etc. None of these are consistent with the idea that Australia has been in a hidden super-recession for the past 10 years.

  26. However, it is quite possible that we see simeltaneous growth and an ongoing malinvestment sickness at the same time. Ongoing distortions from fiscal policy and credit market mispricing create a ball and chain on growth.

    I believe this happens even in the best managed or most laissez faire economies. No one has perfect information and markets don’t always clear in a timely fashion. Of course, encouraging mispricing will leave you worse off.

  27. The strength of our dollar could be explained by the weakness of the US dollar. High foreign investment could be explained by us having to sell our assets to keep eating. High participation rates could be explained by desparate times. Strong business performance could be explained by asset inflation. The thesis that we are in a super-recession could be argued if these are the only obstacles. Not that I’m making that argument.

  28. And the world could be run by an army of super-smart kangaroos from their power-base in Swaziland.

    Foreign investment flows to places where they get a positive return. Our dollar is strong against many currencies. Pariticipation rates have always been positively correlated with real wages. Inflation-induced business success should have resulted in massive failures by now. The weight of evidence suggests our economy has done fairly well over the past 20 years. Which is exactly what you would expect following micro-economic reform.

    Mark — I aboslutely agree.

  29. And the world could be run by an army of super-smart kangaroos from their power-base in Swaziland.

    Well that would explain all the inflation we’ve been having lately. 😉

  30. JC — of course you can. But if nominal growth is 5% and inflation is 10%, then real growth is -5%… which is not just a recession, it’s a depression. And if it’s been happening since 1994 then Australia should be poorer than Russia by now.

  31. Maybe the swaziland kangaroos are measuring nominal growth as badly as they measure the CPI. Maybe all the numbers are crooked and I’m actually really, really poor.

  32. John:

    We’re getting back to the definition of inflation. I think it’s the increrase in the money supply over the growth in GDP.

    Inflation doesn’t have to show up in the prices of goods and services. It can show up in any part of the economy.

    Narrowing of credit spreads was one example.

    You can’t ignore monetatary and credit expansions.

  33. We need more specific terminology when Austrians talk to MSEs. Something like this:-

    InflationQ = an increase in the money supply.
    InflationP = an increase in aggregate prices.

    To be sure the two are linked but they are not the same thing.

  34. What I am saying is that inflation can’t be quantified once it leaves the bowells of the central bank in the form of high rates of growth in the money supply.

    It is impossible to measure. To argue otherwise is to argue that money is neutral.

  35. JC — I didn’t say that inflation had to show up in consumer prices. Indeed, I clearly said that your fear is that inflation is being hidden in asset prices. I clearly said this several times and I’m hoping I won’t have to clearly say it again.

    I’m not ignoring monetary expansions and I’ve never argued that money is neutral. But monetary expansions only lead to inflation when they are in excess of real GDP growth or real asset price increases. That’s why this entire debate comes down to whether the asset price increases have been real (as I argue) or a product of inflation.

    But you can’t escape my previous comment. If we’ve had 10% inflation, then you need to discount our welfare by 10% per year. As we’ve had about 5% nominal growth, that means 5% negative growth each year for 14 years. That is basically a halving in welfare. I don’t believe this and I think it’s basically a crazy idea.

    You need to decide whether you think there has been *real* growth in Australia over recent years. Because that implies inflation has been lower than nominal growth. I think the answer is an obvious “yes”.

  36. But you’re alos only paying lip service to what I have said. I said that youc an have rising living standards during a period of inflation. In fact credit and subsequesnt monetary expansions more or less underwrite that.

    I didn’t ignore your point about nominal GDP and the deflator.

    You keep insisteng that inflation is an expression of prices whereas I argue that inflation begins as a large rise in the money supply. We’re both using different definitions as to what inflation represents.

    Here’s my point.

    Is a million dollars measured in 1998 dollars have the same purchasing power in 2008. I think the rate of debasement is higher than what CPI shows. In fact it would track pretty well by the increase in M1.

  37. No JC… I directly responded to everything you said. I explicitly responded that of course it’s possible to have real growth and inflation.

    The options of “inflation is an expression of prices” and “inflation begins as an increase in money supply” aren’t in conflict. They are both self-evidently true. The reason an increase in money supply is a problem is that it leads to an increase in prices (ie inflation). But this is only true if the increase in money supply is in excess of the needed increase in money supply! If money supply was kept perfectly constant, we would have deflation.

    Nominal GDP isn’t wrong. It’s easy to measure. There are actually three ways to measure it — either add up all the production in an economy, add up all the consumption in an economy, or add up all the incomes/returns in an economy. If you think we’re systematically missing an extra 10% nominal GDP growth every year then you have a lot of explaining to do. And then a nobel prize to receive.

    We know our nominal GDP and nominal growth statistics with enough certainty. What we don’t know is how it is split between inflation and real growth. Nominal growth has been about 5% a year… I think that is about half growth and half inflation.

  38. John:

    You need apprx 1,300 in 2008 to equal 1,000 in 1998 at the rate of 2.5% inflation you suggest. I think it’s higher than that if you live a middle class existence , which was my point.

    Has GBP also measured the rise in hard asset prices. If it hasn’t I would argue that the stating point of using the GDP deflator as an infaltion indicator is wrongly premised.

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