More 'should' and 'must' fun

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.