"Bank of England questions banks over negative rates"

From the BBC:

While the Bank of England may set its base rate below zero, it is unlikely most consumers will immediately enter the topsy-turvy world of being paid to borrow money. Those on fixed-rate mortgages will see no difference, while variable-rate mortgage terms often state that borrowers will never pay less than zero.

Savers with deep pockets such as the wealthy and the banks themselves, may be charged to deposit their money. Banks depositing cash overnight at the European Central Bank currently pay 0.5% to do so. In November, Swiss bank UBS began charging up to 0.75% for cash deposits from wealthy clients.

From the BoE:

Bank Rate determines the interest rate we pay to commercial banks that hold money with us. It influences the rates those banks charge people to borrow money or pay on their savings.

This is Emperor's New Clothes stuff. Read the bit in bold!

I know that commercial banks are required by regulations to deposit a certain amount of money with the BoE, so the BoE can pay any old interest rate it likes on that, even if that is negative i.e. the BoE can charge commercial banks for holding their money. That's just a cost of doing business or a modest payment towards the value of a banking licence.

I know that there are some loan agreements where the interest rate is expressed as the BoE base rate plus or minus a certain percentage, so the contractual rate might go negative (unless the loan agreement stipulates a minimum interest rate).

And I know that in extremis, if most banks were perceived as risky, then people would accept a (small) negative interest on their deposits with those banks perceived as safe (whereby NS&I is the central bank for mere mortals), just for the peace of mind.

But there's no underlying economic reason why it should happen. It's pushing a piece of string. If it were the other way round, and banks could borrow from the BoE for negative interest rates, they would have more money to lend on to borrowers and so they might well drop the interest rates they charge. But they aren't. They are just losing money on the token amounts that they have to deposit with the BoE. So you might as well argue, commercial banks will push up the rates they charge borrowers to try and make up the shortfall (or indeed reduce deposit rates to make up the shortfall). But they are already charging as much (or paying as little) as they can get away with.

Banks do not take deposits from customers with the sole purpose of depositing them with the BoE, that just wouldn't be worth the hassle. So it's not like commercial banks have to reduce the interest rates they pay to discourage people from depositing with them. If they can get away with it, they will do it, whatever the base rate is.

Janet Yellen

Central bank interest rates cuts vs commercial bank profits

From today's Daily Mail:

Australia's wealthy banks are set to hang on to $917 million by not passing on the Reserve Bank's record interest rate cut. The big four banks - ANZ, Commonwealth Bank, National Australia Bank and Westpac - made only modest reductions to their standard variable mortgage rates and gave customers about half of the Reserve Bank's reduction of 0.25 per cent...

It comes after Prime Minister Malcolm Turnbull was left unimpressed and demanded an explanation from the bosses of the big banks for not passing the official rate cut on in full.

"They operate with a very substantial social licence," he said, "They owe it to the Australian people and their customers to explain fully and comprehensively why they have not passed on the full rate cut."

I like his emphasis on "social licence" i.e. government granted privileges.

Also from today's Daily Mail/This Is Money:

Britain's big banks are facing a £1.3billion hit to their profits if, as expected, the Bank of England cuts interest rates on Thursday.

There are fears that the banks could attempt to contain the damage by not passing on the benefit of lower rates to borrowers – risking fury from customers and regulators. Very low interest rates squeeze bank profit margins, so there will be further losses if the 0.25 percentage point cut is passed on to customers.

It's either one or t'other, surely? Unless UK banks are net depositors with the central bank and Australian banks are net borrowers from the central bank?

Nobody move or sterling and interest rates get it!

Yesterday's Project Fear output, via MBK:

From The Times:

Leaving the European Union would immediately cause the value of the pound to plummet by as much as 20 per cent, while income tax would have to rise to counter cuts in migration, a respected think tank has warned.

A vote to leave would result in a “significant shock to the UK economy”, the non-partisan National Institute for Economic and Social Research has said, as it presented prospects for the UK up to 2030 in the event of Brexit.

From The Telegraph:

The Bank of England will need to raise its key interest rate or Bank Rate to 3.5pc by the end of next year if Britain votes to leave the EU, the newest recruit to the Monetary Policy Committee has warned privately.

Michael Saunders, who was chief economist at Citibank, and will join the rate-setting MPC in August, said the drastic rise would be needed because Brexit would cause the pound to collapse, which would send inflation sharply higher.

If we were to stupid enough to reduce 'good' immigration (younger, healthier, skilled/working, ready to integrate) then yes, income tax rates on everybody else might rise a bit, some people say that would be a price worth paying. I don't think it is, but clearly, if we reduced 'bad' immigration, tax rates would go down a bit, which looks like a win-win to me.

The rest of their logic seems to be [unspecified cause] = GBP falls = inflation rises = Bank of England has to increase interest rates.

There's no particular reason to assume that Brexit would cause GBP to fall that dramatically, but even if it did, what would be the knock-on effects? No need to ponder too hard, let's just look at the last two instances of this happening - after Black Wednesday in 1992 and between 2008 and 2012, when GBP fell by a quarter each time.

There was surprisingly little impact on consumer prices (putting land prices to one side) in either instance, and the Bank of England did not increase interest rates - during both periods it actually reduced them (leading to land price inflation).

So nothing to worry about, as per usual.

Georgon Osbrown on top form

Emailed in by MBK from The Telegraph:

"We're doing the work on it now but the emerging Treasury analysis backs up what you are hearing from major banks like Virgin Money that the value of people's homes will be affected and people trying to get on the housing market would be hit because mortgage costs would go up."

Exactly not.

Future purchasers would be unaffected because the hypothetical house price fall and hypothetical interest rate rise would cancel each other out.

Economic myths: mortgage affordability

From The Evening Standard:

However, historically low mortgage rates meant that first-time buyers only had to pay nine per cent of their income as mortgage interest, the lowest proportion since records began in 1973. Interest and capital repayments combined accounted for 19.5 per cent of earnings.

The "nine per cent" figure is irrelevant. Think about it - if mortgage interest rates were zero, house prices would go up accordingly and annual repayments would remain the same. What matters is total repayments and for how long.

The blue line in this handy chart from Savills shows that twenty per cent for the first year is par for the course (remembering that this is calculated on gross income before tax; it is more like one-third of net income). Interest is like privately collected land value tax, a reduction in the tax rate benefits landowners and sellers, not buyers.

For more important is the red line, which shows that in the good old days of high inflation, your mortgage was being eroded away and your payments in real terms fell quite markedly. This is what the oldies conveniently forget.

A final point to mention is that mortgage terms are getting longer and longer, paying one-fifth of your gross income for ten or fifteen years is fair enough; paying it for thirty years is not.

Please sir, may we have some more?

From City AM:

Finally some good news: the FTSE 100 got off to a flying start this morning, gaining up to 1.8 per cent in early trading as dovish remarks from Mario Draghi sent investors' spirits soaring.

Global bourses surged, with Japanese stocks roaring out of bear market territory to make their second-biggest one-day gain in five years.

I can see why governments want unemployment to be low and the economy to be growing, and fair play if they interfere to try and achieve those, but why on earth do they want to prop up share prices? It's just as mad as propping up land prices (although considerably less damaging to the economy). Share prices are not fundamental or important in themselves; what is important is total output, total employment and of course the underlying profitability of businesses.

Which is one more argument for having deposit funded corporations instead of companies with quoted shares - DFC's don't have a share price to worry about. To the extent that the government interferes in the economy, at least it would be focusing on what matters - output, employment and profits. And seeing as output = wages plus profits, really all it needs to worry about is 'output', so an obvious first step is reducing taxes on outputs (i.e. VAT).

Sorted.

Killer Arguments Against LVT, Not (378)

I went to a Labour Land Campaign meeting last weekend to discuss "implementation".

If you want to skip the boring background to all this, click here.

Another member and I had, independently, drawn up a list of existing property/wealth taxes which could and should be replaced; added up total revenues R (about £80 bn); calculated the total amount of rental value of UK developed land and buildings which relates purely to the location premium L (about £240 bn); divided R by L and arrived at a figure of around 25% for residential and 50% for commercial.

The annual tax on the bottom two-thirds of homes would be the same as or less than their current Council Tax plus TV licence, assuming they don't claim Council Tax Benefit or its replacement. The LVT on commercial land in London would be higher and in most other places would be lower than their current Business Rates bill. That's them dealt with.

So far so good, then 'politics' got dragged into it, i.e. identifying the 'losers' i.e. those who would pay more on an annual basis, even though over a lifetime, getting rid of SDLT and IHT would largely even it out. Remember that SDLT is a very crude LVT paid in advance and IHT is a very crude LVT paid in arrears. Surely it is far better to get rid of those two taxes and ask people to pay-as-they-go?

One member present actually is a low-income pensioner whose home in London would now sell for around £1 million; we both had calculated that the LVT on such a house would be about £9,000 a year against a current Council Tax £1,500. We pointed out to him that all sensible LVT proposals include a deferment/roll-up option for such pensioners, the chances are that the deferred LVT payable when they die and the house is sold would be much the same as the comparable IHT and SDLT bills. Much less for those who die sooner, much more for those who live longer, it all averages out.

The next political objection was the diagonal opposite of the low-income pensioner in a high value home, namely, the aspiring young couple who had taken out a large mortgage to buy an expensive home and who were absolutely maxed out. My view is, they should have budgeted for an increase in interest rates of at least 1% or 2% and having to pay 0.9% LVT on the current selling price would only eat into that reserve, but was shouted down.

OK, Plan B, I said, for those borrowers whose LVT is significantly higher than their budgeted-for Council Tax, how about we just tell the banks to write off a corresponding part of the mortgage debt? Not good enough, came the reply. That would benefit people with large mortgages but not those with a small mortgage. At which stage I gave up on that line of reasoning.

So in the meantime, I have cooked up Plan C. That is simply to cap the interest rate on mortgages which were taken out prior to the introduction of LVT being announced.

Let's imagine our aspiring young couple has taken out a £900,000 mortgage to buy a £1 million home. (To justify that sort of mortgage, they must be earning around £180,000 a year between them, so they are not exactly starving, but hey…). A quick Google tells us that at the moment, they are probably paying 2.5% interest on their mortgage.

So for a 25 year mortgage, their annual repayments are currently £48,848 (=PMT(0.025,25,900000) and their Council Tax is £1,500, total £50,348.

If their LVT bill is £9,000, that leaves £41,348 to be spent on mortgage repayments, which would mean reducing the interest rate on their mortgage to 1.1%.

As far as I am concerned, we could cap the interest rate on all pre-existing mortgages at 1.1%. So nobody at the top end loses out, and people further down get a double win - their LVT is lower than what their Council Tax/TV licence was and they save a few quid in mortgage repayments.

The total annual 'loss' to the banks, i.e. land rent which they can no longer collect because the government is now collecting it would thus be be a surprisingly small £8 billion a year*. This is about the same as the pay and bonuses paid out to senior staff, or 0.1% of what they claim are their total assets; or 2% of their net assets, so nothing they can't afford.

No doubt somebody will think up an objection to Plan C, in which case, I will do a Plan D, and so on.

The only counter-objection I can think of is that banks will somehow game the system and charge more than 1.1% interest. In that case, the government just sets up a 'government mortgage bank' and offers people with pre-existing mortgages a remortgage at 1.1% interest. So the 'government mortgage bank' pays the banks the face value/amount outstanding of existing mortgages by creating more bank deposits with the Bank of England in exchange.

Let's imagine everybody did this. It would be like more QE. Instead of the BoE paying banks 0.5% interest on £300 bn, the BoE would be paying banks 0.5% interest on £1,300 bn. But seeing as the government bank is charging the ultimate borrowers 1.1% interest, that looks like a nice little earner for the government, and faced with this sort of threat, I think that banks will toe the line and cap interest rates at 1.1%.

* Total outstanding owner-occupier purchase mortgages excl. 'equity withdrawal' slightly less than £1,000 billion, average interest rate 2.5% and duration remaining approx. 15 years.
=PMT(0.025,15,1000)=£81 billion a year cash coming in.
=PMT(0.011,15, 1000)=£73 billion a year cash coming in.

Interest-ing.

What puzzles me is that banks are adopting two diametrically opposed strategies regarding how much interest they pay on deposit balances.

See e.g. This Is Money.

In the red corner

- Nationwide pays 5% on first £2,500; no further interest on larger balances.

- Tesco Bank pays 3% on the first £3,000; no further interest on larger balances.

in the middle

- Lloyd's pays 1% on the first £2,000; 2% on balances between £2,000 and £4,000 and 4% on balances between £4,000 and £5,000, no further interest on higher balances.

In the blue corner

- Santander pays zero % on the first £1,000; 1% on balances between £1,000 and £2,000; 2% on balances between £2,000 and £3,000 and 3% on balances between £3,000 and £20,000.

Clearly, having lots of small balances gives you a more stable overall figure but is more actual work/hassle; having a few large balances is a riskier business model but is less actual work/hassle.

But why do the different banks place such different values on these things? It's like one supermarket offering "3 for the price of 2" and another one offering "2 for the price of 3".

Seems like a strange thing to be boasting about.

From The Telegraph:

David Cameron said that a future Conservative government will "keep mortgage rates low" so that homeowners can "go to bed with real peace of mind". The Prime Minister said that maintaining low borrowing costs would be the first priority of the Conservative's housing policy.

He attributed Britain's historically low interest rates of 0.5 per cent, set independently by the Bank of England, to the Government's deficit reduction program...

"When confidence falls, mortgage rates can spiral, homes become unaffordable, and families risk losing the roof over their heads. That was the risk Britain faced in the last recession. But this Government came to office set in place a long-term economic plan and showed the world we were managing our economy and as a result, mortgage rates have stayed very low..."

He said that a family with a £120,000, five-year fixed rate mortgage are spending £155 a month less than they would have been in 2010.

"This has made a real difference to families across our country. Instead of couples having agonised conversations about the mortgage payments late into the night, people are going to bed with real peace of mind because our long-term economic plan is working."

Notwithstanding that...

a) What's good for borrowers is bad for savers.

b) The current low interest rate environment is a global, long term trend. If anything, the 1970s and 1980s are looking more and more like a blip and what we have today is pretty close to 'normal'.

c) Low interest rates could be a result of weak economic activity as much as sensible economic management.

d) The Lib-Cons have reduced the annual deficit slightly, but have managed to nearly double the overall accumulated national debt since 2010; and it is the overall national debt which influences interest rates.

e) The absolute level of interest rates is nigh irrelevant, all that matters is changes. Once you have taken out a mortgage, clearly you benefit if rates go down; if you have savings you lose income; and if you want to buy a home in the near future you gain nothing because house prices rise inversely with interest rate falls. If you are saving up for a deposit, you are running to stand still at best.

f) What about the 'peace of mind' that job security, economic growth, a decent welfare system etc could provide? So what if people are 'saving' £155 a month in interest relative to 2010, if real wages had increased by their long term average of about 2% or 3%, then the average household would have gained a lot more than £155 a month.

'Confusion will be my Epitaph (as I walk this crack'd and broken path)' - King Crimson

Is this total nonsense or is it total nonsense?


Update.


For completeness Verse 2:

Between the iron gates of fate
The seeds of time were sown
And watered by the deeds of those
Who know and who are known.
Knowledge is a deadly friend
If no one sets the rules.
The fate of all mankind I see
Is in the hands of fools.

Quite.

Fun with numbers: Outstanding residential mortgages x Standard Variable Rate

We know that total lending has gone up a lot over the last fifteen years (Chart A), but also that interest rates have come down (Chart B). Both of these figures are pretty meaningless; increases in total lending are cancelled out by reductions in interest rates.

The "real" £££ number is the two multiplied together:

Chart C) how much interest the banks can earn, and

Chart D) how much households have to pay in mortgage repayments.

You can draw whichever conclusions you like, but here goes.

Using data downloaded from the Bank of England's Interactive Data page…



The concept of "Standard Variable Rate" is becoming less relevant because of all the introductory teaser fixed rates, but at least there is a consistent series:


If we assume that three-quarters of bank lending to households and businesses is residential mortgages and multiply up by the SVR from Chart B, the total interest charges which banks collect are as follows, apart from the 2007-2008 'blip' just prior to the 'credit crunch':


More relevant is the overall cash flow, i.e. repayments of principal + interest. Assuming a constant remaining term of 20 years, the total annual payments booked by UK banks are as follows; this is the figure which has doubled over the last 15 years:

Fun Online Polls: Interest rates and penalties

The results to last week's Fun Online Poll were as follows:

Will the Bank of England increase the base rate before the next General Election, and if so, when and by how much?

No - 19 votes

Yes - 34 votes, timing as follows:
July - September 2014 - 5 votes
October - December 2014 - 17 votes
January - March 2015 - 8 votes
April - May 2015 - 4 votes

As to the amount, the votes were as follows:
Half a per cent - 14 votes
A quarter of a per cent - 22 votes
An eighth of a per cent - 3 votes

So overall, we are predicting a quarter per cent increase in the last quarter of 2014 (which I think is what I chose).

Hmm, we'll see.
---------------------------------------------------
Apparently there's a big important football competition on this month somewhere abroad, so to celebrate, let's do something football related.

Take your penalty kick in the side bar!

Fun Online Polls: Complete and utter chaos & The interest rate hike

The responses to last week's Fun Online Poll were as follows:

Complete and utter chaos (multiple selections allowed):

Iraq - 60 votes
Syria - 59 votes
Somalia - 59 votes
Afghanistan - 58 votes
Libya - 53 votes
Sudan - 51 votes
Pakistan - 46 votes
Palestinian territories - 44 votes
Nigeria - 42 votes
Egypt - 38 votes
Other, please specify - 13 votes

70 voters in total

So up on the podium we have those Islamic bastions Iraq, Syria and Somalia. Congrats and well done, lads!

Some people don't understand the concept of "Other, please specify", people suggested Tony Blair, Ukraine, Thailand, Kenya, Scotland, Zimbabwe and the UK, which makes seven. How are we supposed to guess what the other six were supposed to be?
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This week, nothing much new in the news, but there has been some burbling about vague possiblity the Bank of England vaguely possibly increasing the Bank of England base rate by a half a percent but more likely by a meaningless quarter of a percent or so sometime in the next, oooh, year or something, just to underline the government's anti-inflation credentials in the run-up to the next election, but Heaven forbid that anything happens to house prices.

So let's turn to the wisdom of crowds and see if we can collectively guess.

Vote here or use the widget in the sidebar.

"Adverse interest rate movements"???

From the BBC:

London's Gherkin skyscraper has been placed into receivership by its creditors after one of its owners was placed in insolvency.

Germany's IVG Immobilien, which co-owns the 40-storey Gherkin with private equity firm Evans Randall, filed for insolvency last year...

"Adverse interest rate and currency movements" added to the building's debt burden, said Deloitte, which led to defaults on the debts dating back to 2009.

The skyscraper, designed by Foster and Partners, was built by reinsurer Swiss Re in 2004 and was sold to IVG and Evans Randall in 2007 for £600m.

Very strange.

Haven't interest rates been drifting steadily downwards for the last forty years or so?

Economic myths: Asset prices and interest rates

The traditional explanation is for example here at marginal revolution:

There has been a lot of discussion recently of Fed policy, tapering, and asset price “bubbles.”

One point to bear in mind is that when interest rates are low even rationally determined asset prices may fluctuate wildly. Consider, the simplest Gordon model of asset prices in which future dividends are expected to be $100 forever, then the asset price is $100/r where r is the interest rate.

If r is .1, for example, then the stock will be worth $1,000. At an interest rate of 10% the price of an asset that pays $100 forever is just $1,000 because the future is heavily discounted. If the interest rate were to fall to 9%, the asset price would rise to $1,111.11 ($100/.09).

The asset is worth more at a lower interest rate because the future counts for more but not that much more since the far future is still discounted to near zero.

Yes there is a lot of truth in that, even though on closer inspection it is credit availability (i.e. QE) which influences 'asset' prices as much as interest rates.

But this is backwards logic; it is not the value of the actual asset which changes, it is the net present value of the future income to be derived therefrom. So using the word "asset" (or indeed "capital") to describe shares, land, government bonds etc is highly misleading.

If we think about real assets, like tools, machinery, vehicles, buildings, software, an advertising campaign to build up goodwill etc, the calculation is the other way round:

The businessman knows what it costs to buy such assets and has to make some sort of forecast of how much extra income he can derive from that real investment. Those are the two known/estimated figures. He then divides the expected return by the cost and that is the return on capital aka interest rate.

Income ÷ cost = rate of return

Faced with limited funds and a range of possibilities, he will choose the combination of projects with the highest expected overall return. The market rate of interest (in the financial sense) is dictated by whatever is the lowest rate of return; if the least promising project which is worth doing gives an expected return of 5% and the one after that only yields 4%, then the businessman will put his money in the bank for 4.5% interest; other businessmen will then borrow that money for 4.5% if they can find a project which returns more than that (ignoring the bank's spread); they are pre-spending future income and turning it into capital today.

And now for the arse backwards calculation applied to future income streams:

Income ÷ interest rate = asset price

The value of your tools, machinery, vehicles etc. does not change very much if interest rates change; and neither does the amount of income you can earn from them. Every business will try and get the most out of what they've got; so in the long run this will all level off and even out and we'll end up with business doing whatever is most profitable/creates most wealth. If expected return on capital increases, then investment in the most profitable kinds of capital increases to soak up that extra income etc.

Quite the opposite with financial assets which are in truth no such thing.

… it gets worse; if total expected earned income from real capital increases, there's a surge in demand for smartphones or apps or something, then in the medium term, the amount which businesses invest in producing new smartphones or apps goes up so more businesses are sharing more income; the real rate of return is stable.

So there's only any point in buying a future income stream if it is fairly fixed and nobody can compete it away, i.e. if there is a reasonable monopoly element i.e. rent included.

So if demand for smartphones or apps increases, the cost/value of your real assets stays the same and your share of the total income stays the same. But if rents increase then the net present value of land must also increase. The rents cannot be competed away, by definition, rents are that element of income which cannot be competed away; the part which can be competed away already has been.

[Of course smartphones and apps are protected by patents and other IP rights, which raise barriers to entry so the income from the patents and IP rights is to some extent rent, separate topic.]

… and worse. If the real economy is moribund, then businesses can't identify many profitable projects and the real return on capital falls, businesses are ore likely to put their spare cash in the bank, so credit availability increases and interest rates fall, so the net present value of rents i.e. land prices increase yet again.

So I know it is a bit clunky substituting the phrase "Capitalised value of future monopoly income streams" instead of "assets" in the context of land, government bonds, shares and IP rights, but it would be much more accurate.

The supply and demand curve for "money" (1)

The traditional view is that "money" is a commodity like anything else, with independent lines for supply and demand:

As a general way of illustrating the effects of changes in supply or demand, or taxes thereon, on the price and quantity of goods and services, which have to be produced before they are consumed, the graphic representation is most useful. But as far as "money" is concerned, it is complete hokum, unless you accept that it is an abstraction of an abstraction.

Facts are:

1. Any economy is and always will be a barter economy.

2. "Money" is a useful unit of measurement, in the same way as tonness and kilograms are useful units of measurement for agriculture. You could say a farmer produces X tonnes of potatoes, or he produces £Y's worth of potatoes, and the shopper buys X kilograms or potatoes or £Y's worth of potatoes. But tonnes and kilograms are not things in themselves, they are merely units of measurement, and "money" is just a useful measure of relative value. You can't easily convert a new car to its potato equivalent, but you can easily say what a new car costs and what a pound of potatoes goes and divide one by the other.

3. To the extent that "money" actually exists, it is merely an expression of who owes whom how much "money" (i.e. future goods and services to the value of…). All banks do is a glorified bookkeeping exercise saying who owes whom how much and running the debt-collection service on behalf of the people owed money (i.e. who have produced more than they have consumed in any time period). This last bit is also a simplification - if a land goes up in value and a landowner sells, he has not, in practice, produced anything or deferred consumption, he has in fact produced nothing and brought forward his ability to consume, but there you go.

4. You can't have "savings" or a positive bank balance without somebody else having taken out a loan or mortgage first. It is actually the borrower who creates credit or prints money.

So it is more useful to look at the demand curve, which is a distinct curve and not a straight line:

But this is also hokum - if "money" were actually produced had a cost of production in itself, then there would be no such thing as debt/credit bubbles, it would choke itself off at a certain stage. For example, I'm sure most people would love to drive round in a brand new Bentley, but we don't, for obvious reasons. So the total number of Bentleys produced is a fairly low and stable figure.

We can actually ignore the supply curve entirely for the time being because it is derived from the demand curve and focus on the demand curve. Why is is curved and how can we plot this?

It is curved because there is no demand for "money" in itself, there is demand for what you can buy with it, i.e. consume.

The interest rate you are prepared to pay is higher, the more that the following apply:
- small amount of money/expenditure required,
- how urgently you need to consume that thing NOW as opposed to later,
- for how many years you will benefit from spending money today.

So
- pay-day loans have an interest rate of 50-plus% (if you can't pay the £100 gas bill, you get cut off for weeks; if you don't buy £50 of food this week, you will starve)
- credit cards have an interest rate of 25%. If you are in the shop and overcome with an urge to buy new clothes or an electronic gadget for a couple of hundred pounds NOW, you are happy to pay fifty quid interest over the next year.
- if you need a van or a car for work, costing thousands of pounds but which will last you a few years, you are happy to take out a personal loan or an HP loan at 15%, because the £1,000 a year it will cost you in interest is less than the extra income you can earn for the next few years.
- if you are renting an average house with a build cost of £80,000 and paying £10,000 a year rent, you are happy to take out an £80,000 mortgage at 8%, pay £6,400 a year in rent and gamble on the repair and maintenance costs being less than £3,400 a year.
- if interest rates are lower than this, or if rents are higher than this, the money borrowed will be spent on land (which includes land speculation and credit bubbles, see last chart).

We also now that from the lender's point of view, those loans for which he can charge a higher interest rate have higher collection costs and higher write-offs for irrecoverable amounts, and that these tend to reduce the overall profit/return down to about 5%, for example:

- pay-day loans. Interest rate 50% minus collection costs 15%, minus write-offs 30% = net profit 5%.
- credit card loans. Interest rate 25%, minus collection costs 10%, minus write-offs 10% = net profit 5%.
- personal/HP loans. Interest rate 15%, minus collection costs 5% minus write-offs 5% = net profit 5%.
- house purchase loans. Interest rate 10%, minus collection costs 3% minus write offs 2% = net profit 5%.

With land purchase/speculation and credit bubbles, these rules no longer hold and the real return to the lender is negative.

So what does the demand curve look like from the point of view of the lender, once we deduct collection costs and write-offs?

It's fairly flat, of course:


And that dashed red line becomes, to all intents and purposes the "supply" curve as well. A saver (or a somebody who supplies goods on credit, however indirectly) is indifferent whether the customer's debts are collected by a pay-day lender, a credit card company, a personal loan/HP company or a mortgage bank:

Employees of such a company might be blissfully aware that this is how their wages are paid, but that is exactly how it works. The car worker gets £x thousand paid into his bank account each month. The car salesman sells the car on HP, and the bank (the HP provider) credits the car manufacturer and assume liability for collecting the debt.

So the car worker/manufacturer produce a car and somebody buys the car. All the bank does is debit "HP loans" and credit "car manufacturer"; there is then another entry "debit car manufacturer" and "credit car worker" at the end of the month when the wages fall due.

This is a nice simple real-world model which we can hopefully understand. And it works, in real life, there is an overall benefit to mankind and the economy from running things like this. The existence of "money" and the banking system oil the wheels and enable specialisation, spreading monthly income against daily or irregular expenditure etc.

Where the model becomes a bit fragile and breaks down is once rents are high, interest rates are low, there is an expectation that land prices will rise faster than interest rates and when bankers are paid according to the value of loans they make/deposits they take (regardless of whether the bank itself will make a profit on the deal).

I'll return to that phenomenon next week, suffice to say, over half of all lending by volume relates purely to land purchase and speculation:

Reader's Letter Of The Day

From the FT:

Sir, Your report on Mark Carney's promise to keep interest rates low missed the main flaw in the idea (Pound up as unemployment falls to 7.7%, September 12).

As ... Mervyn King pointed out, an interest-rate cut simply pulls investment forward in time. And that works for perhaps two years, after which the cut has no effect.

So while an interest rate rise would be deflationary, continued low rates à la Mr Carney will not be stimulatory.

Ralph Musgrave, Durham, UK.

Economic Myths: High interest rates encourage saving; low interest rates boost consumption

These platitudes are trotted out over and over again for example at Wiki.

There must be something in it, but Excel tells us otherwise.

1. The most important form of saving (apart from paying off your mortgage) is of course saving for your old age, i.e. a pension. Let's ignore tax subsidies/distortions and pension company charges (the two largely cancel out) and assume low and predictable inflation so all we need to consider is real interest rates.

2. Our idealised pension savers would like to have an annuity of £10,000 (the annuity company works on a remaining life expectancy of, say, 25 years) when they retire and start saving the same annual amount each year 25 years before they retire.

3. If real interest rates are 1%, they have to save up a final pot of £220,000, which requires savings of £7,798 each year. If real interest rates are 2%, they only have to save £6,095 a year to end up with £195,000. And if real interest rates are 3%, they only have to save £4,776 a year to end up with £174,000.

4. So if you are confident that real interest rates will be quite high, you can get away with saving £3,000 less every year than if real interest rates are going to be very low (they are currently negative, of course).

Of course, mortgages work the other way round.

5. Again, assuming a minimum spread for the banks of 1%, in a low real interest rate scenario, real mortgage rates are 2% and paying off a £160,000 mortgage over 25 years costs £8,200 a year. If interest rates are 4%, it costs £10,200 (£2,000 more).

6. So in a high real interest rate scenario, our typical saver couple is 2 x £3,000 better off for the 25 years they are saving for their old age and £2,000 worse off for the 25 years they are paying off their mortgage (there will be ten or twenty years in the middle where the two overlap).

7. All things considered, they are on average £4,000 a year better off with high real interest rates - they can spend £4,000 more each year - and that's ignoring the fact that they could optimise the position further by paying off the mortgage a bit more quickly and then saving more towards their pensions over a shorter period.

8. The real beneficiaries of low interest rates are of course banks and bankers, but as they are not producing anything, merely consuming other people's output (or do not produce anything extra, merely because interest rates are lower), total production is not increased whether real interest rates are high or low.

And if production is unchanged, then consumption is also unchanged, it is just that with higher real interest rates, the relative share of total output consumed by banks and bankers drops quite considerably and our hard-working hard-pressed etc. couple gets to consume more (of their own output).

10. UPDATE - as Bayard points out in the comments, large landowners benefit enormously as well because they can sell off bits of land for much higher prices.

Just sayin', is all.

Economic Myths: Interest rates and asset prices

From AME Info:

The relationship between the cost of money and asset prices is pretty well established. Asset prices tend to rise if interest rates are falling, and fall if interest rates are rising. Last week interest rates went up, so are stocks and real estate coming down in price?

... What ultimately determines the value of an asset is its return relative to interest rates. Share dividend yields can be low if interest rates are low; house rental yields can be low if interest rates are low.

But if interest rates go up then dividends on shares are worth less by comparison and so share prices generally fall. Likewise if the cost of a mortgage goes up then the value of a house has to fall to compensate for the increased cost of money and the relative decline in rental value.

That is all broadly correct of course, all things being equal.

What is a myth, or obfuscation at best, is the notion that stocks, shares and land are "assets".

Surely things like cars, machines, buildings, software, experience and know-how are "real assets"? The price/cost/value of these is largely unaffected by interest rate changes.

The "assets" whose price changes as a result of interest rate changes are not "real assets", they are flows of monopoly-type income, i.e. where the amount of income the owner receives from the "asset" is fairly fixed and cannot (easily) be competed away; the only way to get your hands on those sources of income is to buy the "asset" itself.

And taking the economy as a whole, for every recipient of such income there is a payer, and such "assets" add nothing to overall national wealth or national income.

- Interest received by holders of government bonds are matched with taxes paid by taxpayers.
- If there were no barriers to entry in any industry, then shares in companies would only be worth what the underlying "real assets" are worth, so the surplus of the share price over net asset values is a measure of any company's monopoly income. Where there are monopolies, innovation and competition is stifled and prices are pushed higher (or output pushed lower). This is bad.
- For every landlord there is a tenant - if the net present value of the rental income goes down (or up), then so does the net present value of the future rental payments from the tenant's point of view. Collecting land rents (also a kind of monopoly income) adds nothing to the economy, they are a way of redistributing GDP to landowners.

It is quite different with "real assets".

If a building burns down, or a car rusts to bits, or a machine breaks down, then clearly, not only is the individual owner of that "real asset" worse off, but the whole of society is worse off.