RBS' Stephen Hester ends myth that monetary policies pursued by central banks will end financial crisis

The Telegraph reports that the head of RBS, Stephen Hester, has said his bank is swamped with funds to make loans, but businesses don't want the loans as they don't see an increase in demand to generate cash flow to repay the loans.

Regular readers will recognize Mr. Hester's observation as exactly why your humble blogger predicted the central banks' monetary policies of zero interest rate and quantitative easing would fail when they were first announced.

When business looks to make an investment, its first consideration is whether there is going to be an increase in its top line from demand.  It doesn't look at how cheaply it can fund the investment until after it has determined there is demand.

The problem with low interest rate policies is that once interest rates drop below 2%, both consumers and companies don't respond to a drop in interest rates the way they did when rates were lowered from say 9% to 8%.

This change in behavior has been known since at least the 1870s when Walter Bagehot, who invented the modern central bank, observed this change and said that interest rates should never be lowered below 2%.

This change in behavior has been confirmed with the Retirement Plan Death Spiral.  Under the Retirement Plan Death Spiral current demand is lowered as both individuals and corporations are forced to save more to offset the lack of earnings on the money in their retirement plans.

In the case of businesses, money that could be used for reinvestment and growth is instead put into pension plans.  In the case of individuals, money that could be spent today is instead saved.  This includes paying down debt as well as putting money into savings.

This change in behavior from interest rates being below 2% has been shown in Japan for 2+ decades.  Deflation has set in as Japanese save rather than spend despite 2+ decades of zero interest rate and quantitative easing monetary policies.

Stephen Hester has waded into the controversy about an apparent lack of lending for smaller businesses, saying Royal Bank of Scotland (RBS) £20bn of cash it was “desperate” to lend out, but companies were not prepared to borrow as they lacked faith in the economic recovery.

“We are lending as much as we can,” Hester said. “We are not constrained by either capital or funding, Mr Hester told The Sunday Times. “The only way I could see for us to lend more would be for someone to say we did not have to operate by any commercial standard – that we could undercut everyone because we did not have to make a profit.” 

He also said that RBS had “deposits coming out our ears”, an apparent shot across the bow of Sir Mervyn King, governor of the Bank of England, who has called for RBS to raise more capital or be broken up. 

Banks have been accused to stifling the recovery in the UK by failing to lend to businesses. However, Mr Hester’s statement imply it is lack of progress in improving business confidence that is stopping companies from investing for growth, rather than banks constraining lending criteria. 

Mr Hester said he could not “force companies to borrow”.

Please re-read the highlighted text as Mr. Hester has has confirmed why low interest rate monetary policies are doomed to failure before they are even enacted.