The main economic lever is not working—try something else

The Australian economy has a big problem. One of the key relied upon financial levers is not working. It’s broken and it has been broken for a couple of years now. And the Reserve Bank of Australia does not know what to do about it.

The problem is that as a country reduces the cost of money, which is done by bringing down the cash interest rate, the relative value of that country’s currency should come down. Australia’s dollar is generally recognised as being over-valued. It has been over US$1.00 for almost two years but the expert view is that the ‘true’ value of the Australian dollar is at least 10 cents below this. Probably more like US$0.93.

Now the magical thing is that if the dollar were down around US$0.93 then Australian manufacturing would make more money, the tourism industry would make more money, retailers would make more money, exports in general would make more money, and all those miners who have their contracts specified in US dollars (which is about 95 percent of them) would make more money.

Basically if the dollar comes down just about every industry makes more money. If industry makes more money then they employ more people and—and this is huge—they pay more tax so the government can do more stuff (or pay off debt).

So, as it should, the Reserve Bank has been progressively bringing down the cash rate over the last 18 months in a desperate attempt to make the Australian dollar adjust itself downwards a little. But every time they bring gown the cash rate they risk two nasty possible consequences which are: house prices starting to curve back upwards and self-funded retirees becoming worse off because interest paid by banks on deposits falls.

The Reserve is very concerned with both of these outcomes, but the need to try and drop the value of the Australian dollar is stronger.

However—it has failed.

The cash rate has been dropped a whopping 1.5 percent over the last two years, which should have brought the Australian dollar down by about 15 percent. Following all the best theories of economics the Australian dollar should now be sitting around US$0.88. But it is still at US$1.04. It has not moved a pence-worth with all these interest rate cuts.

That lever is broken. They should give up trying to use it because if they pull on it any harder I fear they are going to do some serious damage. Either the floor of the building where the lever is will collapse under them (because it is pretty weak and splintered anyway), or, maybe, they will cause the building to fall down.

One of my main worries is the impact on interest paid to depositors. Tens of thousands of people who retired on savings now depend heavily on the interest paid and I fear if it falls much further there will be a lot of retirees having to come to the government for assistance. This then becomes another burden on the tax payer, which then becomes another pressure on the government to cut spending and/or increase taxes.