Marketwatch has always had a love of history. There are many mis-quotes on the subject. It is doubtful that Mark Twain said “History doesn’t repeat itself, but it often rhymes”. But Karl Marx did say, “History repeats itself, first as tragedy, second as farce”. So today, we are going to test Marx’s theory.

In the 1970’s in the United States, inflation had reared its ugly head and needed to be tamed. The then president, Jimmy Carter, appointed Paul Volker as Chair of the Federal Reserve in 1979. Federal interest rates averaged 11.2% and in March 1980, inflation peaked at 14.8%. Volker took action to remedy this issue and lifted interest rates to 20%. By 1983, inflation was 3%. But in the meantime, the US underwent a recession and unemployment rose to over 10%. Farmers demonstrated in Washington against high interest rates.

A decade later, Australia was described by the then Prime Minister of Singapore, Lee Kuan Yew as being at risk of becoming the “white trash of Asia”. He was referring to Australia’s high unemployment, inflationary pressures and rising government debt. Inflation at the end of 1990 was 6.9% and the cash rate target peaked at 17%. Inevitably the impact on business was devastating, Several banks failed. In 1990, Australia entered into a severe recession.

Fast forward to 2008 and along came the Global Financial Crisis. At the time in Australia, inflation was about 4.5% and interest rates stood at 7%. We weathered the storm fairly well as demand for resources from China sustained the broader economy. Although the need for it was not apparent, the Rudd government embarked on a significant stimulus package in excess of $50 billion. The increase in debt was justified by pointing to Australia’s relatively low debt levels relative to the rest of the world. At the same time the R

eserve Bank adopted a dramatic reduction in interest rates taking the cash rate from 7.25% to 3% in seven months. The seeds of today’s events were already sown.

As the stimulus was directed to sectors largely immune from international competition it also put upward pressure on non-tradable goods items, such as public utilities, real estate, construction and local transport, and services relative to tradable goods and services, those can be sold elsewhere in the world, which further worsened international competitiveness by another route.

It was during 2011-14 that serious fiscal consolidation, focused on reversing the stimulus spending hike, should have begun. That would have taken off the strong upward pressure off the dollar, and stopped the escalation of public debt that had by then begun in earnest, due to the historically large budget deficits.

It is a fact that the interest paid to holders of Australian government bonds now exceeds, year after year, the original cash splash of the first stimulus package. As two thirds of federal government bondholders are foreigners, the interest paid abroad to these lenders subtracts directly from national income and is about three times the federal government’s foreign aid outlays.

So two major fiscal policy mistakes were made. There was the excessive stimulus itself focused on counterproductive government spending rather than tax reform and relief, which would have delivered long-term productivity improvement. And then there was a failure to quickly reverse the spending blowout as occurred under former treasurers Keating and Costello in similar circumstances.

The exchange rate appreciation stemming from large stimulus-induced budget deficits severely worsened Australia’s competitiveness and would have cost tens of thousands in jobs, especially in manufacturing, offsetting the dubious 200,000 jobs claimed to have been saved.

Since then, economic growth has been pretty dull, largely as result of the damage we have done to our competitiveness. The Reserve Bank has tried to push it along by lowering their cash rate to 0.1% and even introducing Australia’s version of quantitative easing. And all the while, household debt continued to grow. Australian households are now more indebted than they have ever been. And why not? Borrowing money has never been so easy or cheap. The Reserve Bank consistently said that inflation was very benign (code for almost non-existent), wages didn’t need to increase, and they didn’t see the need to even think about interest rates until about 2024.

Then we had a pandemic which saw the government throw a fair bit of money at it to sustain jobs. But COVID upended supply chains around the world, oil producers declined to pump extra oil as post-pandemic demand started to rise. The US government under Joe Biden followed up Donald Trump’s stimulus with an even bigger one. Despite the protestations of a handful of economists, governments and central banks the world over stated that this time is different.

Marketwatch is a reasonably hardened soul and has seen plenty of action over the decades. But when he hears that sentence “this time is different”, he becomes fearful. And rightly so. It never is.

And once again, hey presto, the much-ignored inflation genie is among us and doesn’t seem to want to go away.

One minute we were basking in low interest rates and bathing in cheap money. And now the talk is all about interest rate rises.

But be careful what you wish for. Realistically, if you want to use interest rates to beat inflation, your rate needs to be higher than the CPI number. You will recall that Paul Volker went to 20% precisely because of that. So at a time of high indebtedness, as an example, Australia needs to contemplate an interest rate of at least 4.5%, up from 0.1%. Otherwise, rates are lower than inflation so in real terms they are negative. And that makes money still cheap.

Now that really would cause chaos. As we know, if you increase interest rates, then households have to reduce expenditure elsewhere. That means that consumption is dampened, which is not necessarily a bad thing if it is properly managed. But the risks of recession, and household and business failures are huge.

The alternative, which is probably the one central banks will opt for, is a few small-ish incremental increases. That will be like fighting a war armed with feathers. All the while you keep interest rates behind inflation, the pressure for wage increases. Those increases have an inflationary impact and, well, you get the drift.

The Bank for International Settlements, whose mission is to support monetary and financial stability and be a bank to central banks, recently gave the following warning

“A key message is that we may be on the cusp of a new inflationary era. The forces behind high inflation could persist for some time. New pressures are emerging, not least from labour markets, as workers look to make up for inflation-induced reductions in real income. And the structural factors that have kept inflation low in recent decades may wane as globalisation retreats.

The adjustment to higher interest rates will not be easy. In many countries, starting conditions complicate matters. Households, firms, financial markets and sovereigns have become too used to low interest rates and accommodative financial conditions, also reflected in historically high levels of private and public debt. It will be a challenge to engineer a transition to more normal levels and, in the process, set realistic expectations of what monetary policy can deliver.”

But the final part of the story is that this all seems to have taken bankers and governments by surprise. Not all, some economists like Larry Summers in the United States warned of this but were almost ridiculed. The warning signs were all there.

So, tragedy or farce? Its hard to tell, but, and I don’t want to be alarmist, fasten your seatbelts, its going to be a bumpy ride.

Marketwatch has been wandering through the reds again after a long, hot summer. He has chanced upon a particularly nice cabernet sauvignon from McLaren Vale. From the Dowie Doole vineyard comes a wine which capitalises on the soils of the Vale. It is the 2014 Estate Cabernet Sauvignon. A great way to start the cooler season.

[gravityform id=”1″ title=”true” description=”true”]