Welcome to Eureka Street

back to site

Rising interest rates point to a larger problem

1 Comment


The recent rise in the official interest rate by the Reserve Bank signals the end of a decade-long fall that has profoundly distorted the Australian economy and produced rampant asset inflation. 

It is worth looking at how the Reserve Bank has sought to manipulate the economy over the last 20 years. From the late 1990s up to the Global Financial Crisis (GFC) in 2007-08 the cash rate roughly moved in the range of five to seven per cent. The Bank then dropped the cash rate down to three per cent to cope with the after shocks of the GFC, then pushed rates back up to almost five per cent in 2012, a return to the previous range. Since then, however, the rate has steadily fallen, down to almost zero. It is now back up to 0.85 per cent, the first rise in 10 years.

The question that should be posed is how effective has the Reserve Bank been at ‘managing’ the economy and financial system? ‘Not very’, has to be the answer. Not that the RBA is alone. The same pattern has been seen across the developed world. Central banks have one weapon at their disposal, the cost of money (the interest rate), and there is not much evidence they have used this tool to make their systems sustainable. Mostly, they have made matters worse. 

The canary in the coal mine was Japan’s central bank in the 1990s. In the 1980s the country was awash with ludicrous levels of debt, a bubble that was pricked early 1990. The Bank of Japan tried to stimulate the economy by reducing interest rates to negligible levels and it also invented quantitative easing (QE), the technique of money printing that central banks, including the RBA, have been using around the world in the last two years to address the damage caused by the Covid-19 lockdowns. 

It did not work. No matter how low the interest rate was sent – at times it was actually negative – the Japanese did not want to borrow. Their economy became moribund for 30 years. 


'None of these initiatives addresses the core problem: how to maintain reasonable controls over the quantity of money while still allowing relatively free markets.'


The central banks in Australia and the United States have recently adopted a similar tactic of lowering rates and introducing QE to recover firstly from the GFC, and then Covid. This had the effect of triggering a massive accumulation of debt – it was already too high – as people took advantage of the cheap capital. In Australia, it catalysed the rise in household debt, which is over 120 per cent of GDP. 

In the United States a similar pattern occurred, albeit in different parts of the economy. Total private and government US debt is approaching 300 per cent of GDP; it is about the same level for the European Union. When other types of financial debt exposures are included, the figure approaches 800 per cent for the US and Europe. Although much of this may never be realised, it gives some idea of just how distorted and debt-laden Western markets have become. Nor is it just the West. China also has a debt-driven property bubble. The conclusion seems to be that central banks relying on interest rates has little or no effect on financial distortions.

The mistake that led to this situation was made about four decades ago, when financial deregulation was rolled out across the developed world. This deregulation meant that authorities could no longer control the quantity of money. Private actors instead were allowed to determine how much money was created: banks, through their lending, traders and absurdities such as the derivatives markets (it may not be right to call derivatives money in the conventional sense, but they are a kind of notional debt obligation). 

The surge in the quantity of money has been, completely inaccurately, blamed on governments and ‘fiat currency’. In fact, what occurred was a lack of government fiat, governments giving up having any control over how much money was in the system. The financial markets ran amok – always making sure to blame governments for the problems they caused, of course. Initially, this financial debauch resulted in rampant asset inflation; now it is spilling over into consumer price inflation.

Bitcoin and the other cryptocurrencies are no different. They are marketed as the counter to fiat currency and the failure of governments, but they are just another instance of private actors inventing their own form of finance. Neither are they currencies because real money tends to stay at the same value. They are digital assets that are extremely volatile; in the last few weeks their value has fallen about two thirds. 

In one respect, though, the Bitcoin protest against the current financial system has merit. There is a finite amount of Bitcoin; the quantity is controlled and it is that lack of control over quantity that is the core of the problem. To that extent, the crypto diagnosis is right.

Another, extremely sinister, option being considered is central bank digital currencies (CBDCs). This is money created by central banks, a sort of formalisation of quantitative easing. It is not a desirable solution. The government surveillance and potential control it could make possible is horrifically dystopian, as a glance at China’s combining of its CBDC and social credit system demonstrates. 

It is also unlikely something so radical would be allowed to dominate the financial system. If CBDC money has no interest rate on it, then the banks could not compete; no-one would want the banks' money because it has an interest rate on it. There would be a war between central banks and private banks.

None of these initiatives addresses the core problem: how to maintain reasonable controls over the quantity of money while still allowing relatively free markets. Answering that question is essential if we are to make money a tool and not our master. 

For thousands of years when debt has got out of control it is forgiven or in some way converted. There may be some way to do that without collapsing the banking system; some are calling for the government to create money to lead to a debt jubilee although this does not reduce the quantity of money. Another much touted approach is a return to the gold standard, when the amount of money was limited to the amount of gold in the world. It is hard to see how this is feasible, though. 

What is clear is that the current absurd invention of multiple types of money has to be reigned in. Especially as we now know that only manipulating the cost of money, the interest rate, is not the answer.





David James is the managing editor of personalsuperinvestor.com.au. He has a PhD in English literature and is author of the musical comedy The Bard Bites Back, which is about Shakespeare's ghost.

Main image: A general view of the Reserve Bank of Australia building in Martin Place in Sydney. (Brook Mitchell/Getty Images)

Topic tags: David James, Finance, RBA, Interest Rates, Fiat, Currency, Money, Crypto



submit a comment

Existing comments

As David suggests, fractional reserve banking, the method used banks around the world, is directly responsible for inflation.
Banks create money to lend - which causes inflation.
Also govts give tax breaks to those who can invest in property thus stimulating inflation further. So govts encourage inflation.
That is the larger problem.
The only answer to this is for governments to begin regulating their country’s finance again themselves by not allowing banks to lend anything without having reserves to cover the entire loan.
Or else form govt-owned banks which would act similarly. Or a combination of both.
And governments should not encourage people to keep buying houses as investments by giving tax breaks for such unproductive enterprises. Unless they built new ones.

Malthus Anderson | 01 July 2022  

Another woeful result of neo-liberal economics. I look forward to the day when economists finally admit they really have no idea about anything.

Erik Hoekstra | 01 July 2022  

If one puts money into the system by quantitative easing or other means, why not take it out by taxing excessive spending? This should include the purchase of foreign currencies.

Peter Horan | 01 July 2022