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Time to move: Reserve Bank must get interest rates back to normal soon

By Henry Thornton - posted Tuesday, 2 March 2010

The Reserve Bank should continue its program of restoring a more normal monetary policy today.

While the global panic has subsided, there is widespread recognition that the world dodged a bullet after the crash of 2008. Asset booms and bubbles, such as those experienced in the years from 2003 to 2007, have always led to asset crashes and often also to depression.

Examples abound: the Dutch tulip boom, the Mississippi bubble, the South Sea bubble, the British railway boom of the 1840s, the property booms of the 1880s, the panic of 1907, the great sharemarket boom of the 1920s, the Japanese real estate and share price boom of the 1980s, the internet boom of the 1990s.


No one with any sense of history could be surprised by the near-miss experienced in 2008.

Substantial fiscal and monetary stimulus helped, as did bailouts of most financial institutions in deep trouble. Now we see a tepid recovery in most Western nations and a strong rebound in the developing nations. Don't be surprised if a fresh shock reverses these improving trends. The crash of 2008 was due to lax monetary policy, especially in the US and Britain. It was also due to possibly excessive financial deregulation and irresponsible behaviour by borrowers and lenders. But it was mostly due to a generation of influential people forgetting lessons of history.

I'm guardedly optimistic. Wall Street, Main Street businesses and US households have been given the mother of all scares and should behave more responsibly for a decade or two. This should provide time for economic recovery to erode current debt commitments, for central banks to restore normal operations (including sensible levels of interest rates), and for watchdogs to devise better methods of regulating finance.

But there are clear risks. The first is that if further stimulus is needed, it will be hard for it to be effective. Monetary policy in most nations is about as easy as it could be, with official cash rates near zero. Further monetary stimulus would daunt Ben "Bubbles" Bernanke or any responsible central banker. Fiscal policy is also about as easy as can be imagined. Budget deficits are in some cases over 10 per cent of GDP.

Main Street already objects to the bailouts for irresponsible bankers and there could well be a taxpayer revolt if further stimulus is requested. This brings us to the second great risk, which involves inflation. Fiscal deficits have to be reduced. In the past, the reward has included interest rate cuts. But now rates have to rise to normal levels. They cannot fall from near zero levels.

Cutting deficits while central banks are raising rates will involve real pain. The least painful path for many governments will be to inflate their fiscal deficits away. A less likely risk is that fiscal stimulus is removed too quickly, snuffing out the incipient recovery.


There is a third risk: that the global economy bounces between a recessionary floor and an inflationary ceiling. This would be demoralising for all, embarrassing for governments and imply different rules for investors.

The risk currently most discussed is a banking/sovereign debt crisis in Europe. Greece is in dire trouble, and Spain, Portugal, Ireland and Italy are all mentioned in dispatches. One cannot see how the more responsible eurozone nations or the international agencies could help much if these dominoes begin to fall.

China quickly applied one of the biggest fiscal stimuli. Its economy recovered rather quickly and now they fear inflation. Leaders have been telling banks to slow lending. China's relatively fixed exchange rate, however, makes it impossible to run an independent monetary policy.

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First published in The Australian on March 2, 2010.

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About the Author

Henry Thornton (1760-1815) was a banker, M.P., Philanthropist, and a leading figure in the influential group of Evangelicals that was known as the Clapham set. His column is provided by the writers at

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