On Tuesday, 1st October 2019, the Reserve Bank of Australia cut the cash rate to 0.75% in order to stimulate the economy. Their objective was to reduce the unemployment rate to 4.5% and to increase wages. Over dinner that night, my daughter Kate quizzed me and Frank about how that worked. It turns out that it is not as obvious as Dr. Lowe suggests.
I see that the Reserve Bank has dropped the cash rate to 0.75%. What is the cash rate?
It is the rate that the Reserve Bank charges the banks for overnight loans.
It is the basis on which other interest rates are set. For instance, if the rate goes down then rates will also fall on mortgages and business loans, but not necessarily by the same amount. Banks source their funds from elsewhere too, and these may not be impacted by the Reserve Bank’s rate.
Do deposit rates go down too?
Yes. The interest that the banks pay on deposits will also fall if the cash rate falls. Again, not necessarily by exactly the same amount.
So how does changing the cash rate impact employment?
Well the concept is that the lower rate will encourage businesses to borrow to expand their business and that will create new jobs.
That is a bit of a long shot isn’t it? Firstly, how many business expansion projects are likely to go ahead because the borrowing rate drops by a quarter of a percent?
Secondly, there must be a time delay between getting a project approved and implemented and the employment of extra staff.
True. But the more immediate effect is that interest on home mortgages will drop. As this is a major component of most household expenditure, it means that many people will have the funds to spend on other things. Consumables. Maybe food, clothing and household goods – even a new car. This creates more activity for the firms who make and sell such products. They are the ones who will then employ more staff.
OK. The lowering of the cash rate enables the banks to loan money to manufacturers so they can make more consumable products and to retailers so that they can sell them to meet the demand generated by households having more money to spend. This in turn leads to businesses employing staff directly to make and sell the products and indirectly to create the facilities - the factories and the shops - to do so.
But where do the banks get the money from to lend to these businesses?
Sometimes I am so proud of Kate. The conversation has been drifting along in a very matter of fact way. Then suddenly Kate puts her finger on the key question.
They print it!
Obviously, no one has saved the money and deposited it in the bank.
So the banking system must create the money.
They do not actually print it. Everything is digital these days.
I don’t understand. How does it work?
It is called fractional reserve banking. Banks not only lend the savings of their customers, but also their demand deposits. Although the depositor can call on his money at any time, in fact a large proportion of it has been issued as a loan to a borrower. Every time a bank makes a loan to a borrower, they create more money. They increase the money supply.
Well I never. I thought that the banks had to borrow from someone and then they loaned it out at a marginally higher interest rate.
Well that is sort of true. It works like this.
Let us assume that the reserve ratio is ten percent. Then the bank can lend ninety percent of any money you deposit. Say you deposit $1000 and they loan me $900.
Then I buy something with the $900 and the vendor deposits that in his bank which in turn loans $810 to someone else who buys something and his vendor deposits that in his bank which in turn loans $729 to someone else. And so the process goes on. You can do the sums. Eventually the total amount loaned is ten times the original deposit.
A fundamental fact to understand about the modern financial system is that banks create money whenever they engage in lending.
Central banks control interest rates and funds available to be loaned by reducing interest rates, lowering the reserve ratio, purchasing government bonds, or relaxing lending criteria. All of these stimulate lending and create extra money.
I am going to need some time to absorb that. It is so different to how I imagined.
If money can be created by a government authority, that must have implications elsewhere. What are they?
Kate is really on the ball tonight. Her second great question.
If the money supply grows then its value declines.
Assets such as houses will have a higher price. But loans will be unchanged. The person who bought a home with a ninety percent mortgage will be much better off. But the person with money in the bank and people on a fixed income will be disadvantaged.
If interest rates are set by the market, then a low interest rate signals that there has been a lot of saving, so a business can borrow to produce capital goods that will facilitate the production of consumer goods at a later date. That is, they will invest in factories and mines and infrastructure and education knowing that, in the future, people will be able to afford the consumer goods that these capital goods facilitate. But if the credit available is not backed by savings, then there will be malinvestments as no-one will be able to afford the future products. Then there will be a recession.
Let me see if I am following all this.
Central banks all around the world are setting interest rates lower and lower. In lockstep with this, our own Reserve Bank cut the cash rate to 0.75%. Their stated objective is to grow the economy, to increase the number of jobs and to increase wages. Their method is to increase consumption.
But the reality is that prosperity and increased wages flow from increasing the productivity of the workforce. This comes from increased investment in education and training, improved management practices, in automated systems, in new inventions, in capital equipment, in a better motivated workforce etc. Investment requires savings. Savings require an incentive to encourage citizens to defer immediate consumption. This would require an interest rate significantly above the rate of inflation; I am thinking at least 3% above.
The low interest rates set by our central bankers deter saving, reduce investment and therefore limit our potential to create improved marginal productivity and higher wages. By their actions, they create the problem they intend to solve.
One wonders where they studied economics. Their ideas just do not make sense. In fact, they are counterproductive.
I think you have nailed it.
I just smile. I think Kate has a great future, provided we can get the control of supply of money out of the hands of governments and central banks.
This is part of the series, The Lockesmith Dialogues, social commentary by Loretta Lockesmith talking with her husband Frank, her daughter Kate, and her friends Ann and Marcia.
Loretta Lockesmith is a Melbourne Writer.