Tough Economic Choices Ahead

The Reserve Bank’s decision to cut interest rates yesterday suggests that the impact of the economic slowdown in China is starting to bite here. The drop in commodity prices (most noticeably iron ore) which have been sustaining the Australian economy for many years has caused the Reserve Bank to act.

Most forecasters are predicting that this is the first of a number of successive rate cuts which could see the RBA official cash rate around 2.5 per cent or lower in the next 12 months. This is good news for borrowers if the cuts are passed on by the major banks, but sends warning signs at what lies ahead.

Across the world reserve banks have used monetary policy as a means to try to stimulate domestic demand. It started in Japan over two decades ago and has since spread to the USA, UK and other nations. Apart from some short-term spikes, it hasn’t worked particularly well mostly because consumers are already financially maxed out.

When interest rates fall close to zero, as they are in the nations mentioned above, there is little else that can be done.

In some countries like Germany and Switzerland, bond investors actually receive a negative rate of return in exchange for the perceived ‘safe haven’ status.

The next economic trick for the moribund economy is for bankers to implement the benignly named ‘quantitative easing’ which basically means printing more money.

This inevitably devalues a currency and we are currently witnessing an almost competitive devaluation scenario in an attempt to kick start their economies. Over time this will have potentially serious inflationary consequences. However, while inflation has been quite rightly demonised as theft of savings, it is precisely what some governments are seeking to induce.

They realize that the level of government and consumer debt is so high that the only way to eliminate it (other than to default) is to create inflation. The premise is that a dollar of debt today is worth much, much less in a decade’s time thanks to inflationary pressures.

After two decades of these measures being implemented in Japan, following the economic excesses of the 1980s, neither have shown any signs of working yet.

That’s why there is growing concern in some quarters that, rather than being on the cusp of recovery after the GFC, we are about to enter another, even more virulent negative phase; a protracted and coordinated downturn in the world economy which could potentially devastate the retirement savings and plans of millions of Australians.

The ‘bears’ see much higher unemployment ahead as consumer demand slows. This will be coupled with a fall in asset prices, principally in the share and housing markets. Inflation will start to creep up but interest rates will remain low – in the short-term.

Whether this comes to pass or not will only be seen with the benefit of hindsight but some have predicted that a significant decline could begin with dramatically falling stock prices beginning in 2013.

The implications for governments of such a scenario eventuating would be significant. Revenues from taxation would fall but the demand for services and welfare from struggling citizens would inversely increase. Given the handout mentality that has gripped so many Western governments, unable to resist buying off the electorate for political gain, this will have major budgetary implications.

The temptation will then be to raise taxes, initially starting with the ‘rich’ as they are the softest targets but inevitably tax hikes will spread to the middle class – making it even harder for families to make ends meet.

Of course, there is an alternative path; that of austerity – actually cutting your cloth to fit your budget. This isn’t something that only families should practise; it needs to be embraced by governments too. In the case of Australia, the sooner the better.

If we can act now and reduce the size of government, reduce the tax burden on everyday Australians and allow (expect) them to take more responsibility for their own welfare, we can avoid the worst of what some predict is to come.

By acting early, we can avoid the social unrest and paralysis that is gripping parts of Europe and the growing welfare state demands evident in the USA from spreading here.

Yes, it will hurt for a short while but the alternative is to suffer for a much longer period.

And what if the economic soothsayers are wrong?

Well, we would have reduced taxes, shrunk government, restored personal responsibility and lowered national debt.

Sounds like a win/win to me.

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