Interest rates rise in the UK after 10 years…

Liquidity used to mean cash in hand; now it means access to credit.

Henry Kaufman

When you combine ignorance and leverage, you get some pretty interesting results.

Warren Buffett

Given this blog is partly a diary I wanted to note for future reference. This is a bit wonkish and unless you are interested in the wider economic issues I’d suggest you ignore this post. It’s something I want as a note to self.

Last week base rate was raised in the UK by a mere .25% to .5%. I think its been lost is how long and extreme these rates have been and the side-effects of such extraordinarly low rates. Base rate dropped from 5.75% in 2007, to .05% in 2009 and remained there for the best part of 8 years.

I have been interested in interest rates from a young age, as I have written before one of my defining economic memories was the wage and price freeze in New Zealand. My parents were civil servants with fixed salaries, that were frozen by the government in an attempt to control inflation in 1982, a Labour government was elected and interest rates rose again and mortgage rates peaked at  over 20% briefly in 1985, and my parents nearly lost their house.

NZ Mortgage Interest Rates

NZ Interest rates

If you tell most people now that mortgages rates were 20% they would struggle to comprehend it. Yes inflation was much higher, but that’s my point: just how different the modern economy is. It changes so incrementally you can easily lose sight of the changes and also we are used to a lack of volatility in the economy.

The New Zealand Experiment, as it was later dubbed, included many measures that are standard economic perscriptions now, but they included being the first country in the world to grant the central bank autonomy to set interest rates taking into account inflation and monetary stability only.

The defining economic period for my professional career has been called “The Great Moderation”, the taming of business cycle volatility led to fairly consistent economic growth . The term is normally applied to the US where the name originated but was a fairly consistent pattern in the Western World. The downside was it created hubris amongst central bankers, who ignored the genius of Minsky and the financial imbalances building up in the economy, and led to the Global Financial Crisis… The apogee of this institutional arogance could well be this cringe-inducing speech Gordon Brown gave at Mansion House on the 20th of June 2007:

So I congratulate you Lord Mayor and the City of London on these remarkable achievements, an era that history will record as the beginning of a new golden age for the City of London.

And I believe the lesson we learn from the success of the City has ramifications far beyond the City itself – that we are leading because we are first in putting to work exactly that set of qualities that is needed for global success:

  • openness to the world and global reach,
  • pioneers of free trade and its leading defenders,
  • with a deep and abiding belief in open markets,
  • champions of diversity in ownership and talent, and of flexibility and adaptability to change, and
  • a basic faith that from wherever it comes and from whatever background, what matters is that the talent, ingenuity and potential of people is harnessed to drive performance.

And I believe it will be said of this age, the first decades of the 21st century, that out of the greatest restructuring of the global economy, perhaps even greater than the industrial revolution, a new world order was created.

In August 2007 the interbank market effectively froze while the Bank of England and the Federal Reserve were forced to inject massive liquidity into the system. The US housing market collapsed over the following summer and Lehman Brothers filed for bankruptcy on September 15 2008.

The three main reasons advanced for the Great Moderation are:

  • Good luck: The shocks that derailed growth and price stability in the 1970s and early 1980s failed to rear their ugly heads over the subsequent 20 years.
  • Structural change: Improved information technology, especially related to inventory management, and financial deregulation resulted in much smoother economic progress.
  • Better monetary policy: Former Federal Reserve Chairman Paul Volcker set a precedent of aggressively reining in inflation.

Unsurprisingly St Louis Fed officials think the last two reasons were more important.

And the rest is economic history as even the Queen realised. And Brown’s 2007 view of a new industrial revolution based on self-regulation of the finance and shadow banking industry turned into an enormous taxpayer funded rescue of that same industry. Although I will give Brown some credit for ensuring the UK didn’t join the Euro he really didn’t deserve to ever be PM after such an enormous lapse in judgement and is a prime example of what economists call regulatory capture.

Cometh the hour and cometh the man… Ben Bernanke, a great and assiduous scholar of the Great Depression is in the Fed along with the intellectual Mervyn King at the Bank of England, and reluctantly Mario Monti at the ECB. Recognising that banking failure was a great cause of prolonging the downturn they flooded the market with liquidity and a core part of doing this was keeping interest rates low, but not saisfied with that they enourmously expanded the money supply. While there is no doubt the measures undertaking to keep the payments infratsructure working and financial markets open stopped another great depression there was a flip side:

since the 2008 credit crisis, it has risen sharply: the level of global debt to gross domestic product is now 40 per cent — yes, 40 per cent — higher than it was in 2008. The world has responded to a crisis caused by excess leverage by piling on more, not less, debt.

Major Central Bank Balance Sheets (Assets)

Major CB BS

The resulting asset price inflation that can be seen post 2008 is obvious:

Asset price inflation.jpg

This isn’t really the place to go into it but there is a big debate in economics between those who argue the structure and function of the financial infratsructure is important, and therefore favour raising interest rates, and another camp of economists who view money as merely a signalling device and believe in the “neutrality of money”, and want to keep interest rates low until economies revover to an output level that relfects the long run trend (since the 2008 crisis all G8 economies have grown below this). Despite promoting Keynsian type measures it should be noted Keynes rejected the neutrality of money both in the short and the long run. It may surprise non-economic readers to know the core models most economists in use assume the neutrality of money yet most economists who work in financial markets don’t accept money neutrality either.

The problem is further complicated by the fact that the market itself is driving interest rates down, Bernanke argues there has been a savings “glut” with Asia pushing capital West to find a safe home. As Cabellero et al., note:

For the last few decades, with minor cyclical interruptions, the supply of safe assets has not kept up with global demand. The reason is straightforward: the collective growth rate of the advanced economies that produce safe assets has been lower than the world’s growth rate, which has been driven disproportionately by the high growth rate of high-saving emerging economies such as China. If demand for safe assets is proportional to global output, this shortage of safe assets is here to stay.

My core problem with this, if anyone is still reading, is the structural reliance of debt in the economy without the safety of equity,. When the dotcom crash happened in 2000 it has minor effects on the rest of the conomy because it was equity financed. Credit recessions have more severe macro economic effects. The tax shield provided to debt over equity encourages share buybacks and leveraged finance over more cautious capital structures. I’m erring with the crowd who believe perpetually low interest rates are distorting the financial infratsructure.

And ultimately, as this seminal paper shows the economy has fundamentally changed as debt becomes a greater part of economic activity (see figure 1 at the top):

In the past four decades, the volume of private credit has grown dramatically relative to both output and monetary aggregates. The disconnect between private credit and (traditionally measured) monetary aggregates has resulted, in large part, from the shrinkage of bank reserves and the increasing reliance by financial institutions on non-monetary means of financing, such as bond issuance and inter-bank lending.

Private credit in advanced economies doubled relative to GDP between 1980 and 2009, increasing from 62% in 1980 to 118% in 2010. The data also demonstrate the breathtakingsurge of bank credit prior to the Global Financial Crisis in 2008. In a little more than 10 years, between the mid-1990s and 2008–09, the average bank credit to GDP ratio in advanced economies rose from a little under 80% of GDP in 1995 to more than 110% of GDP in 2007.

What has been driving this great leveraging?…

[m]ortgage borrowing has accelerated markedly in the advanced economies after WW2, a trend that is common to almost all individual economies. Mortgage lending to households accounts for the lion’s share of the rise in credit to GDP ratios in advanced economies since 1980…The main business of banks in the early 1900s consisted of making unsecured corporate loans. Today, however, the main business of banks is to extend mortgage credit, often financed with short term borrowings.

 

Fig 3 The Great Remortgaging

The counter-arguement from (the Nobel Laureate) Shiller and the SNB. Although anyone still reading who has been in offshore or shipping will appreciate this diagram from the SNB:

Excess credit

Ultimately for 8 years, a third of my professional life, the economy has been marked by low interest rates and prior to that it was the great moderation. Ironically within this I choose to work in sector with enormous volatility which just highlights the huge variance within the averages of a modern economy.

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