By Bernard Hickey Here's the quick version. All the bailouts and debt-funded attempts to kick-start consumer borrowing and spending will not work. We all secretly know it's not sustainable and don't buy it. New Zealand and the other current account deficit-funded countries must reduce their spending and increase savings to rebuild an unbalanced and damaged global economy. Central banks in deficit-funded countries like New Zealand should keep interest rates high to encourage savings and discourage consumption. Governments should do everything to increase savings while keeping a basic safety net to ensure the vulnerable survive. Indebted consumers should accept they will have to live with a lower standard of living for some time while the economy uses the increased savings to rebuild productive capacity. Businesses should cut their cloth to fit and use the extra savings to slowly rebuild production and productivity. This is a long, slow grind with no quick fixes. Let's stop wasting money and time on the quick fixes and accept the inevitable long, deep recession. It is what happens after a debt-funded consumption binge. Otherwise, we risk making it worse and leaving our children indebted for decades. There is a global cacophony right now calling for emergency rate cuts, mass money printing, bank bailouts and government spending blowouts. The accepted wisdom from the great and the good is that the only way to avoid a depression is to jump start economies with a series of 'Pulp Fiction' style hypodermic needles to the global economic chest. Virtually no one is questioning this theory. Keynes was right, they say. Urgent action is required, they urge. Confidence has evaporated, they opine. They point to the lessons of the 1930s. As Roosevelt said: "We have nothing to fear but fear itself." Obama concluded: "We have chosen hope over fear." If only we can get the banks to lend again and consumers to spend again, then we can re inflate the bubble and get out of jail without too much damage. I am starting to get a bad feeling about all of these schemes and dreams to turn back the tide, to plug the holes and to pull us back from the brink. It's all starting to feel a little desperate. It's all starting to feel like everyone is flogging a dead horse and all we have left is a dead, but flayed horse that's beginning to get rigor mortis and smell.
So far, nothing appears to have worked. The US Federal Reserve and the big central banks have slashed interest rates to virtually nothing. The US, UK and European governments have launched a big first round of bank bailouts designed to 'stabilise the situation' and get bankers lending again. They are all spending taxpayer money on projects and wars and tax cuts to kick-start consumer spending. None of it is working. Britain has just had to launch a second round of its bank bailouts. It has had to virtually nationalise the nation's biggest bank and use the central bank to lend directly to companies. New corporate lending has collapsed from 18 billion pounds a month to 1 billion pounds a month. Consumer spending has ground to a halt. House prices are in free fall. Unemployment is skyrocketing. 'The drugs don't work,' as The Verve sang. Elsewhere in Europe the same 'pump the bubble back up' medicine is also not working. Ireland is on the verge of defaulting on its foreign debts. There are serious suggestions it may withdraw from the Euro. Spain's unemployment rate is heading for 20% rapidly and it has just been downgraded by Standard and Poor's. Social unrest is building in Latvia, Hungary and Iceland. Protestors fired skyrockets and threw yoghurt at the Icelandic parliament this week. The same failure of the horse flogging is evident in America. The banks are frozen in the headlights fighting for survival. Lending to consumers and businesses is the last thing on their mind. There was US$350 billion in the first round of the TARP bailout package that disappeared down a black hole of sub-prime losses and bonuses for 2008. Obama is about to call on the second US$350 billion which will go down the same black hole. But this is just a drop in the ocean. Nouriel Roubini, the once reviled and now widely respected New York University professor who predicted the scale and sequence of the Credit Crunch, said this week that banks face US$3.6 trillion of losses in America and that the American banking system is now basically insolvent. America is not so much printing money as creating it out of thin spreadsheets. For now, the US dollar is partly protected because many financial institutions are US based and need to preserve and repatriate US dollars to repair their balance sheets. At some stage that will end and investors will opt for currencies like the Euro, Yen and Yuan (if it is allowed to float) that are backed by economies that save a bit. Meanwhile, the US Federal Reserve and the Bank of England are printing money hand over fist to reinflate their economies and try to avoid a deflationary spiral. No one really knows when the balance will tip and this money printing simply fuels an inflationary spiral that devalues currencies and destroys savings. Everyone hopes the central banks will withdraw the punchbowl at just the right moment. The run on the British pound suggests many investors don't trust the central banks and are worried about nations defaulting on their foreign debts, which cannot be inflated away to nothing. Iceland is the best example of what happens when a nation relies too much on foreign savings to fund consumption at home. Eventually the current account deficit, which includes interest payments on the previous debt, overwhelms foreign investor confidence and causes a currency collapse that forces consumers to stop buying expensive foreign things and start saving (to take advantage of the high interest rates in place to defend the currency). Foreign investors are now asking questions about current account deficits and ratings agencies are helping them identify the culprits. The announcement this month by Standard and Poor's that New Zealand's credit rating may be downgraded was a shot across our bows. We have been warned to reduce our spending and current account deficit or suffer the consequences. Yet no one has taken that message seriously or is prepared to deliver the tough medicine to avoid a very hard landing. The new National government seems to be gearing up for rising and large deficits out as far as the eye can see. The Reserve Bank is about to cut the Official Cash Rate next week by as much as 150 basis points to a record low 3.5%. This is exactly the wrong incentive to give to spenders and savers. As it turns out, it may well be wasted on the people who need it most -- businesses. Banks are not passing on the OCR cuts to businesses. Business base rates have dropped just 65 basis points to 13.25% in the last six months as the OCR was cut 325 basis points to 5%. Banks want a higher return for lending to businesses because their incomes are more volatile than the wages and salaries of mortgage borrowers. Variable mortgage rates have dropped at least 302 basis points over the same period. With painful irony, banks are choosing again to encourage households to borrow more to buy houses and spend on consumer goods, rather than encourage businesses to invest in productive capacity. New Zealand's historically low mortgage default rates and the subsequently low requirements for equity capital to back mortgages have ensured this behaviour. We now have a mortgage rate below 6% at a time when our current account deficit is 8% and climbing. This is ludicrous and international investors will not stand for it for long. That's why I think policy makers around the world and in New Zealand should stop hunting for the magic wand to arrest the downward spiral. There is no magic wand. We don't really believe in magic. We simply have to spend less and save more. The only way to do that is to keep the OCR at 5% and for the government to return the budget to a surplus as quick as possible. That means reducing government spending on middle class welfare such as Working for Families and abandoning the tax cuts. It means reworking government spending to focus on investment in productive capacity and on social, educational and medical safety nets rather than on current consumption. This will mean the retail sector focused on unnecessary current consumption (hospitality, electronics, household goods, luxury goods and cars) should shrivel. We just have to get by with less and we have to save more. Critics will point to the 'Paradox of Thrift' as a reason why the 'grind it out' strategy will fail. That may be relevant for a closed economy with a dominant manufacturing sector and high savings rates. New Zealand is certainly not in that camp. We spend more than we earn and have a very open economy. Unless we rebalance our economy, fearful and vengeful foreign investors will make us do it in a brutal fashion that involves ruinously high interest rates, a real currency collapse and record high unemployment. We would be much better off controlling that process ourselves than having it forced upon us.