Swan song for the RBA

The power of our independent Reserve Bank to set interest rates is crumbling, and the only person left outside of the big four with full control is Wayne Swan – not that he has sought it.

One of the pillars of the Australian financial system, the independence of the Reserve Bank of Australia to set interest rates, is crumbling. It will soon be apparent to all that if anyone outside the big banks has the power to set interest rates in Australia, it is Treasurer Wayne Swan.

Successive Australian treasurers, including Swan, have endorsed the independence of the Reserve Bank and this new power is not one that the current treasurer desired. And I am not sure that either he or Treasury have fully grasped that the game has changed.

With the benefit of hindsight we should have realised that the ability of the Reserve Bank to be the main determiner of interest rates was weakened when Australian banks in the last two decades – but particularly in the last 10 years – turned their back on using local Australian savers but rather funded their growth by massive overseas borrowing on the wholesale banking market.

At the time, they could obtain funds overseas much more cheaply than local savings and this was a contributor to the large growth in bank profits and the Australian economy. But if we had thought about it, we would have realised that we had greatly lessened our power over Australia’s interest rate destiny.

On two occasions in the last four years, international events have boosted the cost of this wholesale funding and it is possible the current high cost of overseas bank money will continue for a long time.

Right now the fundamental change is being obscured by a treasurer playing politics and blaming the banks. I am sure Wayne Swan knows that if the banks allowed their profits to fall at this time, the cost of this overseas money would skyrocket further, forcing even higher interest rates. But the government is under pressure so Swan must do his part and pass on blame to the nasty banks.

As it happens the Reserve Bank‘s recent analysis of the Australian economy is suspect. They almost raised interest rates around the April-July period of 2011 but thanks to the stand of Business Spectator and later Westpac economist Bill Evans, they were saved from making a major error. I have stepped back because the Reserve Bank began lowering rates, but its latest statements have rekindled my fear that it is again out of touch with what is happening in the real, non-mining Australian world. But let us not make that judgement yet.

But even if the Reserve Bank reduced interest rates, it only affects part of the bank funding base. In other words, the RBA no longer has full power. In my view the only person with that power is Wayne Swan. Overseas investors are scrambling to buy Australian government paper and the government can borrow at much lower rates than the banks. Swan should be ready to tap that market and fund maturing overseas bank borrowing at much lower rates. This would enable banks to lower interest rates. He would make a profit and set some conditions about pass on, etc. Swan would boost the economy and may even lower the dollar.

No treasurer in modern history has had this power and Wayne Swan has not sought it. But when unemployment in non-mining Australia starts to jump, it will be time to exercise it.