Sunday, 1 December 2013

The supply and demand curve for "money" (2)

Continuing my post of last week, where I looked at the supply and demand curve down to about the interest rate which people are or would be prepared to borrow to spend on bricks and mortar, which is about 8%.

If we just look at this supply and demand curve, we observe that the net return to savers is pretty flat whoever the borrower is.

But there is something else dictating interest rates. There is a subtle difference between 'saving' and 'investing'. Basically, households 'save' and businesses 'invest'. (It is quite possible that household savings go into business investment, which is double plus good, but that is a overlap and not the main event).

The distinction is this: let's say a farmer normally harvest 52 units (weeks' worth) of food, exactly enough to see himself through the whole year. In a hypothetical good year he harvests an extra 20 units.

i. He can 'save' those 20 extra units by selling it to hungry people on credit, so when the harvest is not so good, he can call in the loan of food. He can also demand the payment of interest on that loan (he gets back more food than he lent out), so in future, he could, if he wished, consume an extra 2 or 3 units a year for the rest of his life, but that is only at the expense of the original borrowers, who have to make do with consuming 2 or 3 units less than otherwise.

ii. Or he can 'invest' that food by exchanging it for better implements, or by exchanging it with somebody who will improve his walls and drainage. In future, the farmer can now produce 2 or 3 extra units of food each year, but without anybody else having to consume less.

That is what drives the minimum interest rate which 'savers' will accept. If the farmer knew he could increase his future potential harvest by an extra 4 units a year by 'investing' 20 units this year, then a buyer on credit would have to offer to pay at least 4 units a year in interest before the farmer will consider 'saving' rather than 'investing', and so on.

(The problem is that savers cannot just invest in productive assets, because those are all monopolised by limited companies, so before savers can get a share of the profit from the underlying productive investment, they have to pay a ransom payment to an existing shareholder, which pushes up returns to existing shareholders at the expense of future shareholders and the economy in general, separate topic).

As we observed last week, the interest rate which people are willing to pay depends largely on how much they need to borrow, how quickly they need to spend the money, and how soon they hope to pay it back.

That all makes sense so far and the arrangement is to our overall benefit. Where it goes crazy is once interest rates drop below that rate of approx. 8%:

Broadly speaking, the descent into insanity goes in the following three stages, but the general rule is still that the further into the future the borrower's hoped for extra consumption will be, the lower the interest rate he is willing to pay:

1. If you can borrow money for less than 8%, then the lower interest rate just goes into higher land prices (rather than bricks and mortar), i.e. if you can rent a house for £6,400 (net of landlord's costs) and borrow at less than 8% to buy the building, you are happy to do so. But if you can borrow at (say) 5%, it is worthwhile paying/borrowing £128,000 (it still only costs you £6,400 a year), and that extra £48,000 just goes into the land monopoly black hole.

2. If people expect nominal land prices to continue to rise at a long term rate of 5% or more a year, then if you can borrow at less than 5%, it makes sense (on an individual level) to buy land for the sake of it (money into the LMBH), whether you need it or not, because you can realise a gain (more money into the LMBH) in future which will pay off the interest for you.

3. Because bankers seem to get paid according to the volume of loans they can make, rather than the bank's actual profit margin, bankers try to "grab market share" by lending out at very low rates (Bradford & Bingley, Northern Rock etc), the bank itself (the bankers' employers) make losses on such loans of course. It is no coincidence that the cumulative losses of all UK banks over the credit bubble decade were approx. equal to the total bankers' bonuses paid in those years.

None of these three stages are of any remote benefit to society in general or the productive economy as a whole, and are in fact incredibly damaging. They do not help people spread consumption over their lifetimes by borrowing/saving; they do not lead to any investment in productive capacity.

Bricks and mortar are of course productive capital if they are in the right place, but the land is not, and even it were, pushing up the price does not increase the amount available - and a society which believes that house price rises are A Good Thing tends to be a NIMBY society, so we end up with less productive capital (housing, factories and so on).

Why UK and other governments think it is a good idea to constantly nudge the economy towards these final three stages, and why so many people go along with this nonsense is a mystery to me.


James Higham said...

He can 'save' those 20 extra units by selling it to hungry people on credit, so when the harvest is not so good, he can call in the loan of food.

Providing they're still able to respond to that.

Mark Wadsworth said...

JH, you'll have to read the first part.

Such loans are only made at very high interest rates because the write offs are very high as well, but the two net off to a normal return to the lender.

Dinero said...

Dont't you need to include the location value as well as the re-build value of the house in the capitiled rent calulation. Unless you are happy with something that looks like a circular argument on first glance.
By starting with a calculation that did not ammortise the cost of buying the land and then concluding that anything over the rebuild cost of the house is an excess.
You could simply say that the rent included both I suppose.

Mark Wadsworth said...

Din, I wasn't being hyper-scientific.

The total rental value of a site always breaks down into "bricks and mortar" and "rent".

By and large, the capitalised value of the use of bricks and mortar = the current value of the bricks and mortar.

That "rent" is in turn shared between "land owner" and "bank" in any old way they agreed between themselves. You can call it "rent" or "mortgage interest", it doesn't matter.

Dinero said...

But you didn't include the cost of buying the land.
which limits the conclusions you can draw.

Dinero said...

instead of 8%

you would have the result of 6400 divided by the sum of 80 000 build and 80 000 land.

= 4%

Mark Wadsworth said...

Din, all payments for "land" are pure "rent" or "ransom" payments.

You can muck about with the percentages all you like, any payment for land + buildings in excess of the rebuild cost/value of the building is for the land. The land price is just a balancing figure.

Therefore, the much-vaunted "house price bubble" is no such thing, it is a "land price bubble". The value of the bricks and mortar didn't change at all.

And what, in the context of this post, pushes up the price of land is…
- the expected future rises in house prices (i.e. land prices)
- the interest rate
- the easy availability of credit