Central Banks Throwing Savers to the Wolves

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Cheaper energy costs should be a good thing, right? Given its near ubiquitous use in all forms of production, lower energy costs are great news for the global economy. That’s assuming supply increases are behind the price falls, rather than a big drop in demand.

While the global economy is by no means robust, it’s not exactly in the toilet either, so I think you can safely assume that the recent drop in oil and related energy costs are much more supply side oriented, thanks to OPEC’s (actually Saudi Arabia’s) decision to keep the oil pumping.

That means lower energy costs act as a form of natural stimulus as costs fall across the board. As far as stimulus measures go, this is a good one.

But do you think the clowns over at the European Central Bank (ECB) see it this way? Of course not. They see it as a threat to their all-important inflation target!

Overnight, the ECB met to discuss monetary policy. After promising for months he was ‘gonna’ do something, like really soon, Mario Draghi disappointed the market by failing to act. Stocks fell and the euro surged. There is still dissention in the ranks, with the German contingent against a European version of QE.

The Germans espouse the principles of Austrian economics…everyone else at the ECB is a Keynesian. These two schools are mutually exclusive in terms of policy prescriptions, so getting any sort of consensus on monetary policy will remain difficult.

Good on the Germans for sticking to their guns. They’re about the only people employing common sense these days. We’ve had years of QE in the US and decades of it in Japan, and what has it done? Where is the cost benefit analysis? The benefits are meagre, but the costs and risks are hidden deep within the financial system.

Getting back to the oil price, its recent fall gives you a good example of muddleheaded central bank thinking. Reporting on comments from the ECB’s overnight meeting, the Financial Times says the board members agreed that if the oil price continued to fall and threaten the inflation outlook, they will have to reconsider urgent action on the stimulus front.

‘The council was in agreement, however, that if lower oil prices began to threaten the outlook for inflation, or its existing measures disappointed, then more radical easing was warranted.’

So a supply led oil price shock, despite being good for the economy (as it would remove input costs, lower prices, and increase real wages) would be bad as far as the ECB is concerned because it would threaten their inflation target.

That is just crazy and goes to show the kind of warped problems you get when nations’ debt levels increase beyond the capacity to service them. Put simply, the ECB, and all central banks for that matter, are terrified of ‘deflation’ (very narrowly measured in terms of prices for local goods and services) because it increases the real debt burden of an economy.

And because it is banks that are the conduit for, and creators of, debt in an economy, the desire for inflation is all about maintaining the illusion of bank solvency.

The other way of looking at it is that it’s all about maintaining the solvency of the debtors…full stop. Anyone with debt is a protected species in this society. Savers (creditors) are the first to be thrown to the wolves to save the debtors.

In Australia, you’ve seen this in action in recent years. By early next year, you’ll probably see it again. That’s because theReserve Bank of Australia (RBA) will move to cut interest rates to prop up a badly flagging economy.

The graph below is a version of one that I’ve shown Sound Money. Sound Investments. subscriberson a few occasions in recent months. It shows the nominal growth rate in households’ debt servicing costs.

You can see that when growth in interest payments goes negative, it usually corresponds to a rate cutting cycle. The deepest cuts (and the biggest benefit to households) came during the global crisis of 2008. For a brief period households’ interest expense dropped nearly 40%, which alleviated a lot of potential stress in the sector.

Source: Australian Bureau of Statistics

Thanks to those cuts, Rudd’s handouts and Chinese stimulus, the effects were short lived. But the post 2008 Chinese credit explosion created another terms of trade boom and led to the RBA raising rates significantly.

That’s why you see interest expense rebounding sharply higher after the brief 2008/09 dip.

Soon after, the terms of trade peaked and started falling, which necessitated another round of interest rate cuts to ‘stimulate’ the economy. But as I mentioned yesterday, this brought about an increase in debt accumulation so now household interest expense is rising again.

This is happening while the terms of trade continue to fall…which sucks income out of the country.

So what do you expect the RBA to do in such a situation? They’ll cut rates of course. The only question is when.

The market is already pricing a cut in. Hence the sharp drop in the Aussie dollar and the strong market rebound over the past few days. You can see a chart of the Aussie versus the US dollar below. It was clinging onto 85 cents when the economic growth numbers hit on Wednesday. Since then it’s lost more than 1 cent, which is a lot in the land of foreign exchange.

That’s the market betting on interest rate cuts. But it looks like an increasingly overcrowded trade now, and I’d be hesitant to jump on the short Aussie dollar bandwagon here. It wouldn’t surprise me to see another rally at some point up to the 86-87 cent region before the slide continues.

That’s the key takeaway here. The trend is down for the Aussie, and no one knows where it will stop. In 2015, you’ll probably see it in the 70 cent range. There will be winners and losers from such a significant currency correction.

It will revive struggling export industries and damage those businesses that enjoyed the healthy margins from a rising Aussie dollar.

Theory says that Australia should benefit from a weaker dollar…as it will make us more competitive. The problem with that theory is that Australia doesn’t really compete globally in any industries apart from mining…or at least not on any scale that would improve our economic well-being.

The prolonged strong dollar period (and the decade plus China boom) fundamentally altered our economic structure. We shipped dirt and leveraged the gains into property…and restructured jobs and industry around servicing this grand economic aim.

I’ve said it before, and I’ll keep on saying it: To change the structure of the economy in a beneficial way requires structural change. That means changes to the incentives provided by, amongst other things, the tax system, which has a big say in the deployment of a nation’s capital.

To prosper and increase living standards, we need more than a model of mining and debt dependent asset growth.

Greg Canavan+
For The Daily Reckoning Australia

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