A Shot in the Arm?

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It should have been good news. The Reserve Bank surprised everyone when it cut interest rates by one percentage point yesterday.

The cut was twice as big as expected and Australia’s big four banks got into the spirit of things, announcing that they would in turn cut their variable home loan interest rates by 0.8 percentage points. Repayments for a family with a typical home loan of $248,000 will fall by about $128 a month.

Rate cuts aren’t the only positive economic news of the week. They follow a sharp drop in world oil prices. Overnight on Monday, Australian time, oil futures tumbled by 6 per cent to $US88.56 a barrel.

In view of all these promising symptoms, why was the cheering muted?

Perhaps it was because of the looming backdrop against which developments in the Australian economy play out. As Reserve Bank governor Glenn Stevens put it, his Board acted because: "conditions in international financial markets took a turn for the worse".

On the same day, in a speech to the Infrastructure 21 Summit in Brisbane, Prime Minister Kevin Rudd admitted for the first time that global credit crisis will hit Australia hard. "These developments will affect growth," he said. "They will affect employment. They will affect government revenues." Until then, Rudd had been relying heavily on what economists call "incantation". That is, repeatedly talking up Australia’s strengths, in the hope that the situation would improve. It didn’t.

The Prime Minister is still saying — correctly — that Australia’s banks are "well capitalised and profitable". But now he is also referring to the 25 banks overseas that have either failed recently, or required bailouts. He spoke frankly about the $US700 billion rescue package that the US Government has drawn up to salvage America’s deeply troubled financial system.

The bailout is a very big gamble — especially as the International Monetary Fund now estimates that there is $1.4 trillion worth of bad debt in the US. Two dollars of dodgy debt for every dollar in the rescue package. The New York Times said the three-day-old rescue package already "looks like a pebble tossed into a churning sea".

The Reserve Bank’s rate cut is also a gamble. The bank judged "that there had been a material change to the balance of risks surrounding [Australia’s] outlook". Sadly, the balance of risks has not tilted in Australia’s favour. So will the bet pay off?

The early signs are good. The Australian stock market, for example, closed 1.7 per cent higher last night after falling 3.3 per cent earlier in the day. But nobody yet knows what will happen, either in Australia or overseas, in the weeks and months ahead. The respected US economist Paul Krugman admits that the global economic downturn might "accelerate". If that happens, Australia will not escape.

Kevin Rudd’s emergency plans are based on the premise that risk and opportunity are closely related. He is certainly not predicting that Australia will face a sharp downturn but he has explained what his Government will do if the worst happens.

Firstly, a comprehensive program of micro-economic reform to boost long term productivity growth and secondly, a $76 billion nation building plan for the future. Rudd envisages a good, old-fashioned Keynsian boost to the economy: better education systems, taxation reform, coupled with badly needed port, road and rail projects. This strategy will work well if the economy falls into a deep hole.

Rudd’s goals are realistic. Quoting a study undertaken by the Committee for the Economic Development of Australia, he claimed such an increase in public spending could boost Australia’s output by a very useful 1.8 per cent a year, and lower prices by 3.2 per cent.

But there are risks, too. Inflation could break loose again if the Rudd Government mistimed its efforts, spending heavily on infrastructure while private spending is still high. It’s a mistake which is easy to make and such mistimed initiatives have, in the past, sent prices spiralling upwards. Keynes is still revered by many but experience has taught economists, administrators and governments to apply his theories more carefully to real life situations than they have in the past.

There is bad news on the way for motorists as well. The recent fall in world oil prices is not likely to force petrol prices down at Australia’s service stations. Why? Because the Australian dollar has been falling sharply over recent weeks.

So where is the hope? The best of it lies with a gathering of the world’s treasurers and monetary authorities in Washington later this week at a series of World Bank and IMF meetings. They don’t yet have the machinery they need to tackle the job of restoring balance to world financial markets. But the risks are now so high that they might well call in the bulldozers.

New Matilda

New Matilda is independent journalism at its finest. The site has been publishing intelligent coverage of Australian and international politics, media and culture since 2004.

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