Why, oh why, does the mainstream media (not to mention the majority of the populace) celebrate the Reserve Bank’s announcement of a 0.5% rate cut today…?

At its meeting today, the Board decided to lower the cash rate by 50 basis points to 3.75 per cent, effective 2 May 2012. This decision is based on information received over the past few months that suggests that economic conditions have been somewhat weaker than expected, while inflation has moderated.

Slashing interest rates is a bad sign. It means things are already worse than the RBA had expected, and they’re likely to get tougher. This is not a cause for celebration!

Ouch!

Courtesy of FT Alphaville, comes the following hatchet job on Australia from Society General analyst, Dylan Grice:

When you scratch the surface of the Australian ‘miracle’ you don’’t just find an unmiraculous commodity super-cycle: you also find an equally unmiraculous credit super-cycle as well. A credit bubble built on a commodity market built on an even bigger Chinese credit bubble, Australia looks like leveraged leverage, a CDO squared.

There is no doubt that slashing 2.5% of GDP worth of spending next year will free up economic resources – that is, deflate parts of the economy – so that other parts can potentially grow more strongly without sparking inflation. And the rates “sensitive” sectors are those that will be potentially in a position to “benefit”. They do include households, who carry the nation’s huge mortgage burden, and the external sector that’s been getting hammered by the higher dollar, including manufacturing and services like tourism.

The question is, is this in the national interest? Here are some scenarios if rates fall 1% as a result of Budget cuts:

• will households save the extra cash as they are doing now? If so, the government is bringing on a recession which is clearly bad
• will households spend their extra income, providing some relief to the beleaguered retail sector? If so, growth will accelerate which is potentially good and you can expect a rally in retail stocks on this possibility. However, it would be much better to see the newly created economic space filled by expanding exporters
• will households spend the extra income and resume borrowing for housing, causing house prices to rise again? If so, the rate of deposit accumulation at the banks will fall and they will accumulate further wholesale debts in foreign markets. This would also fire up a short term cyclical stocks rally which would include the home builders. But it is very bad in the medium term and would very quickly result in either ratings agencies or the RBA stomping on the brakes
• what degree of downwards pressure will a 1% fall in interest rates place upon the dollar? This is not an easy question to answer. Interest rate differentials are only one of Deus Forex Machina’s five drivers of dollar value.  My guess is that such a level of cuts would push the dollar into a new trading range somewhere below parity assuming global growth remained decent, but not much lower. Thus, we’d see a boost in currency exposed stocks and some boost to the export sector more generally

In other words, the Government’s planned Budget cuts are a big gamble. The Australian economy is caught in a trap that has been fifteen years or so in the making. The teeth on one side of the trap is offshore borrowing and the teeth on other is housing deflation.

George Soros has warned that the eurozone has entered a “more lethal phase” and outlined a series of measures to solve the crisis - including an idea that all countries should be able to refinance their debt at the same interest rate.

Soros, known as the man who broke the Bank of England by betting that the UK would be forced to devalue the pound during the 1992 currency crisis, said that “far from abating, the euro crisis has recently taken a turn for a worse”.

Soros, who is chairman of Soros Fund Management - which in 2011 stopped managing money for outside investors - warned that Europe was facing “a long period of economic stagnation or worse” whether or not the euro endures. He also warned that while countries in Latin America suffered a lost decade after their economic crisis in 1982, the European Union would not survive such an economic malaise.

“The deflationary debt trap threatens to destroy a still incomplete political union,” he said in an article published in the Financial Times.

Australia’s recent history has been remarkably free of recessions. For nearly 20 years up to the global crash of 2008/9 the country clocked up regular growth. Call it good luck-call it good management, but it’s a fact.

In all likelihood that remarkable record is about to change because Australia has resolved to shoot itself in the foot. This it will do by contracting Government spending at the same time as other sectors of the economy are coming under heavy stress. If you follow events in Europe you will recognize this as the German disease.

Let’s look at some high level numbers.

Recall that GDP is the sum of government sector spending (the fiscal deficit or surplus), household consumption, business investment and net exports. If all these components are shrinking then GDP must shrink. If only one or two are shrinking then that shrinkage must be matched by growth in the others if recession is to be avoided.

We know what the Government is going to do in the Budget for next year-it is going to show a small surplus because that outcome has been politically pre-ordained. We also know that the projected deficit for this year is about $40b and growing thanks to falling corporate tax revenues and falling GST. So, if all things remain equal, to reach balance next year the Government is going to have to cut roughly $40b from its expenditures. That equates to around 2.5% of total GDP of approximately $1600b.

Coincidentally, the whole economy is currently growing at around 2.5 % so, broadly speaking, that implies zero growth for next year unless one of the other sectors expands.

Where will that compensating expansion come from? As Tim Colebatch of The Age has rather neatly demonstrated in a recent note this is something of a rhetorical question because to achieve normal growth of 3.0% next year in the face of a Government sector contraction of 2.5% you have to believe that if the Government maintained its current course the economy would grow by around 5.5% pa. In last year’s Budget the forecast growth rate for 2012-13 was 3.25%, and that is about the limit. Growth of 4% would be extreme. So a recession seems assured on these assumptions.

Someone’s getting filthy rich out of this resurgent mining boom, but it ain’t the federal government.

The secretary of the Treasury, Martin Parkinson, has used his first anniversary in the job to warn that Australia faces a decade of ”razor-thin” surpluses despite the biggest boom in the nation’s terms of trade since the gold rush days…

Hitting the government’s surplus target for 2012-13 will be no easy task.

The simple facts:

This dual pattern of growth has been seen before in Australia and largely arises from our status as a primary commodity producer (and exporter) rather than an industrial nation.

Some sectors (such as manufacturing and tourism) and regions (such as Sydney and Melbourne) are struggling while other sectors (such as mining) and regions (such as Western Australia, Northern Queensland and the Northern Territory) are booming.

These trends – popularised by the term ‘two-speed economy’ – whereby serious sectoral and regional imbalances accompany overall economic growth, challenge the fundamental patterns of our economic and social settlements and threaten the financial viability of many Australian households.

While the term ‘two-speed economy’ has taken on a number of meanings in different countries the imbalance of most interest here is the precariousness of the East coast economy (particularly, NSW and Victoria) where the majority of Australians live and where most of the employment is generated, relative to the prosperousness of the mining regions of Western Australia, Queensland and the Northern Territory.

Several coincident factors are driving the ‘two-speed’ economy some of which have not received much public attention.

First, our terms of trade for non-rural, particularly base metal commodities are booming but delivering uneven benefits to Australian regions. Further, Australian manufacturing is declining with regionally concentrated costs. Consequently, unemployment is falling in some areas but rising elsewhere.

Second, the major city property booms in recent years have abated with households left holding record debt levels. In some areas, household finances are now highly vulnerable to minor interest rate variations and increasing unemployment.

Third, the Federal Government is now engaged in its obsessive pursuit of budget surpluses. The resulting squeeze on household disposable income combined with recent increases in interest rates, has elevated the danger that economic slowdown in some areas (like Sydney and Melbourne) will bankrupt many households.

And what it means for the Budget:

What the declining growth rate tells us is an overall spending is insufficient to maintain production levels. What that means is that firms are unwilling to produce more goods and services because they know that aggregate spending is in retreat.

The slowing economy, in turn, undermines the growth in tax revenue and hence makes it did difficult, if not impossible, for the government to achieve its budget surplus ambitions in the time-frame noted.

The signal that should send the government is that its budget surplus ambitions are contrary to what is required for overall economic health. The slowing tax revenue is not a sign that governments should cut spending harder. Rather, it is a sign that government should expand net spending (that is, increase the budget deficit).

If is the task of achieving a budget surplus is “difficult” then that tells us that such a task is inappropriate at that point in the business cycle.

See the full MacroBusiness article (login required) for:

“the meat of yesterday’s Credit Suisse report which declares the “commodity super cycle” dead.  If you take just one point from this analysis it should be this: China can keep growing at 7-8% without Australia benefiting one jot. And remember, this is the optimistic scenario for China. The pessimists see the transition to internally-led growth as far more damaging.”