It’s all About Mood Swings and Interest Rates

Never mind mutually beneficial exchange, creating something of value and improving your life. Apparently economic activity is all about mood swings and interest rates. That’s what Reserve Bank Governor Glen Stevens explained yesterday at a parliamentary committee. summarised his remarks:

‘The RBA governor argued that while the central bank’s monetary policy could aid the economy, it was up to politicians to work out how to encourage “animal spirits” in non-mining sector businesses amid the winding down of the resources boom.’

Encourage animal spirits? Are they nuts? Humans are greedy enough as it is. If they’re not borrowing at record low interest rates, there’s probably a darn good reason for it. Maybe they’ve borrowed enough already.

It’s the corporate sector that Glenn wants to spur on. He complained, ‘Many businesses were more focused on sustaining a flow of returns to shareholders rather than implementing plans for growth.’

How weird is that? Businesses avoiding bad investments and focusing on returns to shareholders. Whod’ve thunk it given it’s their job to do so? More on the dividend and buyback boom tomorrow.

What sort of policies might Glenn have in mind to spur animal spirits anyway?

The idea that economic activity is something that government can spur is just odd. Humans are greedy. They want to make money. Short of defrauding someone, making money means serving others by creating value. You have to provide something or improve something in a way that leaves the whole worth more than the sum of all parts. If people aren’t undergoing economic activity under these terms, those opportunities aren’t around. Forcing or misleading people into investments with debt binges or animal spirits just directs valuable resources into ventures that don’t end up creating something of value.

Of course, if Glenn got his way and the economy did pick up after animal spirits broke out, he would just pull a fast one. He’d raise rates and expose those business decisions as nothing but misguided ‘animal spirits’. He’d probably criticise businesses for being too greedy.

That’s why we’re more worried about the watermelon moment than the lack of animal spirits.

The what? The watermelon moment.

Never mind the economics of it. That can come later. First, what is it?

It’s a reference to the greatest moment of reality TV. Ever.

Contestants in the Amazing Race were tasked with shooting watermelons at suits of armour using giant slingshots. Once they’d sent the rusty shell of a man with a feather on his head to its watery and seedy grave, they could move on to the next obstacle.

After a series of misses, a lady we know only as ‘Sister’ announces she is ‘getting frustrated’. She aims for what her sister calls ‘right in the kisser’ of the suit of armour. She draws back the sling. And keeps going further. Until the draw of the giant slingshot is so strong it begins to pull her entire body weight forward. And then she releases.

The watermelon promptly goes flying as dramatically as stocks on the day a central banker announces quantitative easing. But then something odd happens.

The cup of the slingshot somehow flicks around the far side of the watermelon just as it’s supposed to release the green bullet towards the suit of armour. Its intended victim doesn’t even blink as the rubber bands of the slingshot stretch out a second time in the opposite direction. And then the watermelon begins to make its way back towards Sister.

Sister, meanwhile, is sitting utterly defenceless on the ground. She barely has time to blink herself before a rather large watermelon explodes around her face. You can watch the ‘too good to be true’ video here.

Or you can read the Federal Reserve’s minutes from 2007 for the same effect. Or the economic literature of the day, which is full of references to ‘the great moderation’.

You see, central bankers thought they’d figured it out, just like Glenn Stevens does today. Inflation targeting and boring monetary policy had fought off any serious business cycle for years. But then the central bankers’ tools turned on them like a giant slingshot with a watermelon in it. The rate cycle of 2007 was one shot too many.

It turns out that inflation targeting generates a false sense of security in the economy. It allows animal spirits to get out of hand. You can only delay the business cycle and make it worse by trying to avoid it. And that’s what happened in the lead up to 2008. American central bankers launched a series of rate increase watermelons beginning in 2006 (see the black line below). But in 2007 something went wrong.

Click to enlarge
Source: Federal Reserve Bank of St Louis

The rate increase exposed all the economic activity of the early 2000s was driven by central banks and animal spirits. The financial crisis watermelon got caught on their slingshot, turned on them, and smacked them in the face. They had no clue what happened for years.

Just like Sister in the Amazing Race, central bankers eventually recovered. And then did more of the same to fix the problems they created — some people’s definition of insanity. They lowered interest rates and then called up bigger watermelons like ‘QE’ and ‘the discount window’.

So now the Americans are in the same situation as 2004. But with far less impressive economic growth. The masters of your currency and financial markets are launch watermelons at a perfectly innocent suit of armour. Eventually, the watermelon will catch and come back the other way.

There are plenty of ways the watermelon could decide to change direction. One of them is flashing red right now.

Central bankers in the US and the UK are turning hawkish. They want to begin easing up on quantitative easing. Even increase interest rates! Remember 2007? How many of the investments made these last few years were driven by animal spirits and low interest rates? How many will be exposed?

Here’s the key phrase from the Fed’ minutes:

…participants noted that if convergence toward the Committee’s objectives occurred more quickly than expected, it might become appropriate to begin removing monetary policy accommodation sooner than they currently anticipated.’

Of course, the theory goes that central bankers will walk up rates only as appropriate. For now, central bankers at the American Federal Reserve are saying they need ‘more evidence’ before making any changes.

But a market that expects a rate hike cycle to begin is a very different one to a market that sees the Fed in rescue mode.

With 77 million Americans, according to the Urban Institute, already facing debt collectors and a 70% surge in car repossessions for the second calendar quarter, imagine what would happen if rates really did rise!

Several speakers discussed just that question at our World War D conference. Your opportunity to watch them is drawing very near.

Back in Australia, the question is whether we’ve already had a build-up of investments driven by animal spirits and low rates. Or whether that’s yet to come, under the direction of Glenn Stevens and whatever animal spirits the government can conjure.

Either way, in the end you can expect to see the watermelon turn on the central bankers all over the world. Then, in the words of rugby player Nick Cummins, they will once again ‘run around like a horse up stairs’.

And financial markets will join them like in 2008.


Nick Hubble
For Markets and Money

Having gained degrees in Finance, Economics and Law from the prestigious Bond University, Nick completed an internship at probably the most famous investment bank in the world, where he discovered what the financial world was really like.

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