Roger Thornhill left this comment here (which doesn't show up, comments are on the blink again):
Interest rates should be kept at a level to preserve the value of the currency, not protect house prices. If you stray away from that path, you are adding new distortions to anything you think you are "correcting".
Nope. Any argument based on the word 'should' fails by definition, and in any event it's not clear whether RT means the exchange rate or inflation (and if so, whether he means price inflation or monetary inflation).
The exact level of a currency (as measured by its external exchange rate) is no more business of a small committee of political appointees than any other economic variable, such as minimum or maximum wages, export or import quotas, the price of houses or indeed interest rates*. The best thing you can do for a currency is abandon exchange controls, which happily we did in the 1970s, with a brief reversion to intervention in the late 1980s/early 1990s. If people think their domestic currency is overvalued, they can swap into another one and vice versa.
As a massive debtor, the government is honour bound to minimise the interest rate it pays to reduce the burden on the taxpayer, which could be best done by just paying off the debt - the main driver of government interest rates is the debt-to-GDP ratio as I showed here.
If RT means monetary inflation, then see the second half of this post.
* We agreed by a reasonable margin that the best thing the MPC could do at its next meeting is to disband itself. The MPC has far less impact on interest rates than people think, and whatever it decides leads to more distortions etc. What has had an impact on interest rates is the £300 billion plus soft loans which the government gave to UK banks under the guise of the Special Liquidity Scheme and the Credit Guarantee Scheme, all with the aim of propping up house prices, of course.
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From diametrically opposite on the economic spectrum, Robin Smith commented thusly here:
... no need to nationalise banks. But the issuing of the people's money certainly must be taken away from private hands.
A lot of people think that it is the preserve of 'the state' to issue money, but as I've explained before, anybody can 'issue money', provided people trust that person to back it up. Anybody who has ever bought anything on credit has 'issued money', whether that is a hastily scribbled IOU in a corner shop or merely waving your credit card at the bar maid at the start of the evening. But the next time you pop into the shop, the shopkeeper will expect to be repaid, and at the end of the evening, the pub will be most dischuffed if your card payment doesn't clear.
You might get away with not honouring the occasional small debt, but on the whole, if you are seen as somebody who does not, or simply cannot or will not honour his debts, your 'credit rating' (i.e. your ability to buy goods on credit or issue your own money) is at an end.
I assume that RS is referring to the misconception that banks 'issue money' when they grant mortgages. Wrong. The banks actually 'issue money' when they issue shares or bonds or indeed take deposits. They take your state-backed money and give you a piece of paper with a number on it saying, "The bank owes you the sum of £xxx". (It's exactly the same as the shopkeeper giving you a packet of fags on the day before pay day in return for you giving him a piece of paper saying "IOU £6").
This practice is quite innocuous, provided the bank has assets to back this up, i.e. it takes your money and puts it to a slightly more profitable use than you could. In practice this means lending it to somebody who can easily afford the repayments of interest and principle. (It's exactly the same as any other business issuing shares or bonds - it has to invest that in something sensible that will make a profit out of which it can repay you).
By and large, and in the absence of a bubble in the perceived market value of land and buildings, the banking system (in the UK and in most other countries) works fine. Even in the most favourable economic climate, one loan in two hundred will go bad, so the interest the bank pays you is 0.5% less than what its borrowers are paying but you would rather accept the slightly lower interest rate from the bank than run the risk that you lend money directly to the one-person-in-two-hundred who defaults.
It is only in bubble conditions that it goes horribly wrong.
The banks lend £x00,000 to somebody to buy a house (which a few years ago would have sold for half as much), who dreams that even if he can't really afford the repayments, he will be able to sell on the same house to A Bigger Fool, repay the loan and trouser a tidy profit. The purchaser never sees the £x00,000 the bank lends him, because his solicitor gives that to the vendor's solicitor who pays it straight back into the bank. Within a split second, the bank's assets (the loan to the borrower) and the bank's liabilities (the deposit from the vendor) have both increased by £x00,000.
The problem is that once house prices have risen high enough, the last purchasers in the pyramid scheme cannot keep up repayments, so the whole bubble bursts. As between borrower and bank, this gets ugly enough, but what of the vendor who deposited his money with the bank on the assumption that the bank knew what it was doing? So, he panics and there's a run on the bank - some depositors are repaid, others aren't - so now three people are agonising over the same loss (the borrower, the bank and the disappointed depositor).
So the government steps in to bail out the disappointed depositors, and now a fourth group has to suffer, and so on. it's even worse if you have a government that is Hell bent on keeping house prices as high as possible, they have to pump in money to keep the bank afloat and then as much again in the vague hope that the bank will keep lending enough money to an eternal supply of Bigger Fools. The government in turn has to suck this money out of the productive economy - which has already taken a big knock because of the loss of confidence - and the economy goes into a Home-Owner-Ist death spiral.
To cut a long story short, the best way to prevent banking crises is to prevent there being bubbles in the price of land and buildings in the first place, which is of course something that our old chum Land Value Tax would do on his afternoons off.
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5 comments:
Here´s my 2 cents worth on paying down the debt. Check my logic and see if it makes sense.
Let´s say I`ve worked really hard to pay off my mortgage and now I´m free and clear and after a year I have £20,000 in savings sitting in my checking account earning no interest.
We´ll assume 0% growth in the economy to keep the amount of goods and services the same. I decide to buy a £20,000 10yr treasury bond paying 5%. So now there is £20,000 less cash in the money supply thus making all the cash outstanding worth more. Interest rates go up, prices go down.
So one year later let´s say the government decides it´s a good idea to pay down the debt. So they have to offer me more than $20,000 to get me to sell them my bond. Let´s say $24,000 to keep things simple.
To do that they decide Richard Branson is too rich and annoying so they tax him an extra £24,000 to pay down the debt. So Richard Branson is £24,000 poorer and I have £24,000 in my checking account instead of £20,000 + interest in my savings account.
How is Britain better off?
At the macro level all bonds do is adjust inflation and interest rates. They don´t pay for anything.
1. "I decide to buy a £20,000 10yr treasury bond paying 5%. So now there is £20,000 less cash in the money supply thus making all the cash outstanding worth more."
Well no, because you bought the bond off somebody else who now has more money. And if you bought a new one issued by govt, the govt takes your money and gives it to a public sector employee etc.
2. "How is Britain better off?"
Because of the reduction in interest rates and the total amount of interest that future taxpayers will have to pay. Otherwise there would be no point in anybody ever paying off any debts ever.
I admit it's a fairly marginal thing, but an overall benefit, however small, is an overall benefit.
Okay here´s another thought experiment on debt. Let´s say David Cameron goes on TV and appeals to the public and says in the interests of our children and for the solvency of the country we ask that everyone who has a government bond trade it in for a 0% bond that can be traded for cash on demand at any date. And in return we promise to always run a balanced budget.
So now bonds are essentially the same as cash. The government has no real way to control interest rates. They can add money to the system by printing it but they have no way to remove money when there is a downturn in the economy (ie. fewer goods and services - leading to inflation) other than taxation.
And as everyone knows taxes are a blunt instrument. There is a long lag between their implementation and the results (usually unintended).
Andy, that's not a very good thought experiment, is it?
a) Why would anybody accept this? Admittedly the govt did it back in the 1930s and a lot of people accepted it in the spirit of national unity etc.
b) Does 'balanced budget' mean radical cuts in wasteful spending or massive tax hikes?
c) "They can add money to the system by printing it...". Hang about - you said 'a balanced budget'. Printing money is the same as borrowing money is the same as running a deficit.
d) "they have no way to remove money when there is a downturn in the economy". Always remember that THERE IS NO MONEY! Once you net off all monetary assets and all monetary liabilities you always get precisely zero. In a downturn the amount of assets and liabilities goes down all by itself.
Let me show an example of a case where the BOE would print money with a balanced budget. Let´s say we are in a booming economy and the BOE has overnight rates target set at 2%
British Telecom decides they want to buy Telefonica and they go to RBS to borrow 1 billion. RBS looks at the prospects and decides it would be a good deal for them and they agree on a 5% loan.
Now RBS are already at their reserve limit so they will need to borrow the reserves from another bank. All the other banks are tight on reserves too and so RBS will borrow excess reserves in the banking system until the excess is exhausted and then they will have to borrow from the BOE at the marginal rate which is higher than the overnight rate
At the BOE they create a loan to RBS on the asset side of BOE´s balance sheet and create reserve notes on the liability side that RBS can draw on.
Those reserve notes are created out of nowhere. Some people call this printing money but I would say they had credited RBS.
The government hasn´t done anything in this case it was the BOE who voted on the target rate. Although you could say the BOE board is a part of the government.
Take another case
Let´s say the BOE board decides to lower the overnight rates from 3% to 2%. To do this they need to add reserves to the commercial banks. So they start buying government bonds on the open market. The money they use to buy the bonds is printed money.
Now the government has to pay the BOE the interest on the bonds they just purchased and the BOE just gives that money back less their operating expenses.
Risk of default
This is why governments with sovereign control of the currency and floating currency exchange like Britain, Canada, USA or Japan can never go broke because they control the interest rates. The central bank has no reserve ratio.
If they don´t like the interest rates they are paying they just print some money and essentially retire government bonds through open market operations thus creating more reserves and lowering interest rates.
However Ireland is VERY different case because they have little or no say on what the overnight rate will be and therefore do not control their own interest rates.
So let´s take a case where the ECB has set the overnight rate at 3%. This is the minimum rate at which Ireland could issue its bonds.
If a commercial bank in Ireland (or anywhere really) has excess reserves they go on the open market where they can buy new issue bonds. The Irish economy looks dodgy right now and so Ireland will have to offer a premium on their bonds versus bonds from stronger economies like Germany to make up for the risk of possible default.
Sorry this is such a long comment but I think it´s an important issue which most people don´t understand.
This why Britain should NEVER EVER give up sovereignty of the pound and any politician that says Britain should switch to the Euro ought to be strung up.
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