Thursday, March 7, 2013

Why low interest rates policies are not the answer

In her Guardian column, Ros Altmann explains why the the low interest policies being pursued in the EU, Japan, UK and US are not the answer to a bank solvency led financial crisis.

Her column is interesting for a number of reasons.

First, it comes out on the day after the Bank of England's Mervyn King said the Swedish Model under which banks recognize the losses on the excess debt in the financial system is the answer.  This comes from an individual who has tried low interest rate policies and seen that they do not work.

Second, she confirms what your humble blogger has been saying since the beginning of the financial crisis about why low interest rate policies don't work.
It is four years since the Bank of England cut the base rate to 0.5% and started its £375bn money-creation programme, quantitative easing.... monetary measures pushing lending rates lower in order to revive the economy have failed, merely resulting in stagflation. 
Yet, still the Bank believes the problem is that rates are not low enough, even floating the astonishing possibility of "negative" interest rates.
Good doctors, whose patient is not recovering, would not just continue prescribing more of the same medicine, they would look for a different cure....
To his credit, Sir Mervyn King suggested exactly what is needed.  If policymakers were to follow his advice, the Bank of England could immediately raise interest rates back up to the 2% minimum level set by Walter Bagehot and end the distortions going on in the real economy.
I believe the damaging side-effects of the monetary medicine may actually be undermining recovery. 
Yes, those with large mortgages have had a bonanza, and banks have benefited hugely, but ultra-low interest rates are hurting important sections of the economy. 
Savers' and pensioners' nominal and real incomes have fallen sharply, while companies providing pension schemes have had to pour billions into their funds rather than their businesses, as low rates push up deficits.
Your humble blogger has referred to what has happened to savers, pensioners and companies as the Retirement Plan Death Spiral.

The death spiral refers to the simple fact that savers, pensioners and companies make up for the lack of earnings on their retirement plans/pensions by cutting back current demand and saving more.  This creates an economic headwind that more than offsets any stimulative benefits from lower interest rates.
Since 2008, Bank of England policy has focussed entirely on bringing down interest rates in order to boost growth. 
Academic models predict lowering rates will boost bank lending and increase access to credit for purchases of homes or other goods and services, ensuring economic recovery. However, this hasn't happened here.
That is because the academic models are wrong!!!

Regular readers know that these academic models did not predict the financial crisis either.  So there is absolutely no reason to believe they should predict what is happening now.
Rather than rushing to spend their extra money, over-extended mortgage borrowers have taken advantage of lower rates to accelerate repayments and clear their debts. 
Meanwhile, older savers' and pensioners' incomes have been squeezed by falling rates and soaring pension costs, leaving them poorer. 
Savings rates have lagged behind inflation, reducing real incomes, eroding the real value of savings and lowering consumer confidence. Fearing for their financial future as their current or prospective income plummets, many have cut spending.
Nice description of the retirement plan death spiral that is left out of the academic models.
Of course, no one wants to see home repossessions, but artificially propping up house prices locks future generations out of the housing market, distorts rental costs and delays the banks and building societies recognising their losses. 
Around four in 10 mortgages are interest-only – with many having no strategy for capital repayment – so low rates are just a politically expedient short-term sticking plaster, not a solution....
Please re-read the highlighted text as Ms. Altmann has succinctly summarized how banks are the primary beneficiary of a politically expedient policy that is not a long-term solution.
Low interest rates act like a tax increase on savers and pensioners, by reducing their income. 
This quasi-tightening of fiscal policy has transferred national income from older savers, to younger borrowers and banks. For example, since 2008, borrowers with a £100,000 mortgage are over £2,400 better off every year. However, savers with £100,000 in Cash Isas or fixed-rate bonds are over £2,750 a year worse off.
If the Chancellor were to announce a huge tax increase on older workers and pensioners, particularly to help people who had borrowed or lent too much, there would be uproar. 
But, by doing this via monetary policy rather than fiscal policy, there has been no democratic debate....
Please re-read the highlighted text as Ms. Altmann has highlighted why the current policy responses to the bank solvency led financial crisis are undermining democracy around the world.

The policy response has benefitted the bankers at the expense of the voting taxpayers.  The voting taxpayers sense that something is wrong with how elected officials are behaving and Ms. Altmann has just spelled out what it is.

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