Interest Rates and the High Priests of Economics

There is a new religion in the world. It’s called central banking. Every month the high priests get together for a ritual called monetary policy.

Then the little people bow down and worship at their all mighty wisdom. That’s because the high priests say when they lower the interest rates it will stimulate demand and make the little people prosperous.

The bible of this new religion says that if you cut interest rates, you get economic growth. Therefore, interest is the cause and growth is the effect. That makes interest rates the key policy tool.

Too bad the entire charade is built on the same empirical foundations as the Egyptian pharaoh commanding the Nile.

Here’s the problem: there is no empirical evidence for this official story. It’s just another economic myth that circulates because we let the high priests do our thinking for us. We think their ceremonial suits and important language they use actually convey something useful. Newsflash: they don’t.

That’s the opinion of banking expert Richard Werner anyway. He says that when it comes to the interest rates, the opposite of the official story actually takes place. Higher growth raises interest rates. Lower growth lowers interest rates. It’s growth that determines interest.

Or, as he puts it in a 2012 study:

In empirical work, interest rate variables often lack explanatory power, significance or the “right” sign. When a correlation between interest rates and economic growth is found, it is not more likely to be negative than positive…

Furthermore, in terms of timing, interest rates appear as likely to follow economic activity as to lead it.

As I wrote the other week, if rate cuts did act as the high priests would have you believe, mainstream economists would have a much easier time explaining Japan.

The Bank of Japan cut interest rates a dozen times in the 1990s…and the economy still stagnated. This gave rise to Japan’s ‘lost decade’ (now actually three decades). It’s still a perennial mystery to mainstream economists. They keep pushing their foot down on the accelerator, and expecting Japan to go faster. But Japan doesn’t go faster.

So if you want economic growth, you have to look to something else. Werner says it’s not the price of credit we need to focus on but the quantity and allocation of credit. He says credit creation is the most important macroeconomic variable.

And for that, we can look to Germany.

The German economy is so successful right now that it’s actually being targeted as a threat to the Eurozone. No kidding. The British paper The Telegraph reported this morning:

Germany’s current account surplus is out of control. The European Commission’s Spring forecasts show that it will smash all previous records this year, reaching a modern-era high of 7.9pc of GDP. It will still be 7.7pc in 2016…

This is the fifth consecutive year that Germany’s surplus has been above 6pc of GDP. The EU’s Macroeconomic Imbalance Procedure states that the Commission should launch infringement proceedings if this occurs for three years in a row, unless there is a clear reason not to.’

Good lord, is it a mystical force that emanates from the forests of Bavaria that makes Germans so thrifty, hard working and rich? Should we all give up now if we don’t have Berlin as a capital and a national penchant for sausages and beer?

Or could we investigate a little further? Let’s do that for today, safe in the knowledge Australia’s politicians will do precisely nothing about it regardless.

The key to Germany’s success is not bratwurst but banking. The German model is the polar opposite of the one we have here in Australia.

For example, only 13% of the banks in Germany are large, nationwide banks. The majority of the banking system, around 70%, is in the hands of locally controlled, small banks. They lend mostly to productive small and medium sized businesses. This is the type of credit that leads to real GDP growth, and higher wages. It’s also why German unemployment is so low.

By law most of those local banks must lend to their local area. That means the health of their community is tied to their performance. And they don’t lend for speculation in asset prices.

It makes for a much more productive economy. And a much safer, decentralised banking system. Because unproductive credit creation (such as financial credit like mortgages and margin loans) is linked to asset inflation, bubbles and banking crisis.

Now compare the German system to what we have here in Australia with the ‘Big Four’ banks owning most of the banking assets of the country and financing mostly property speculation. Then the priests at the RBA go through the ritual, waiting for the Nile to rise.

Oh wait! It’s all going to be ok anyway. The High Temple at the Bank of International Settlements is going to make Australian banks raise their capital levels and make them ‘unquestionably strong’.

But…but…where’s the evidence for that working again? Oh, that’s right. Same as above. There isn’t any.


Callum Newman+,
for Markets and Money

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Originally graduating with a degree in Communications, Callum decided financial markets were far more fascinating than anything Marshall McLuhan (the ‘medium is the message’) ever came up with. Today Callum spends his day reading and researching why currencies, commodities and stocks move like they do. So far he’s discovered it’s often in a way you least expect.

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