Wednesday 29 August 2012

Western Debt Junkies

In my last post, I talked about how the UK's Monetary Policy Committee (MPC), the European Central Bank (ECB) and the US Federal Reserve contributed to the financial crisis through improper use of loose monetary policy, thus incentivising a build up of debt, which resulted in a boom in residential house prices and the subsequent financial problems.

It is somewhat disturbing that the chosen 'cure' for the Western debt problem is more debt.

The Bank of England base rate has been slashed to 0.5%, the
UK's current account deficit figures are huge (the deficit was £15.2 billion in the third quarter of 2011, the highest on record). Total Public debt is over a trillion, that’s £1,000,000,000,000 expressed in numerical terms, about £16,000 for every man, woman and child in the country.

Lower interest rates = more incentive to get into debt = more debt = bigger problems down the road.

Japan is a prime example of this, since their asset price bubble popped in the early 90s their base rate has been close to zero. They have been in this situation for about 20 years now. It should come as no surprise that Japan is now the world’s most indebted OECD country by far, with debts around 240% of GDP (up there with Zimbabwe). They have dug themselves into a very deep hole from which there is seemingly no escape; we in the West are making that same mistake.

As well as incentivising debt, low interest rates also damage cash based investment returns. What is the point in having money in the bank earning 1.5% interest, when inflation is running at 3%? You are technically losing money. This doesn't just affect the rich, it affects everyone (who has a pension or savings). Pension funds need exposure to dependable cash based investments, low interest rates are damaging the returns on these investments leaving less money for people to retire on. Also annuity rates are linked in part to interest rates and as such are very low right now.

People retiring now who have been prudent and saved their whole lives are facing a double whammy of diminished pension pots and bad value from annuities. This will have a long term detrimental effect on the economy as their spending in retirement will be curtailed.

As our debts increase, our sensitivity to a rise in interest rates also increases, making it harder to return to a situation of normality.

I'm not suggesting a swift hike in rates as that could be very damaging. Rather a gradual elevation of about 0.5% a year.

The sooner we get ourselves off the faux life support system of cheap debt, the better our chances of a sustainable recovery.

Monday 6 August 2012

UK Residential Housing, The MPC & Interest Rates

When the Labour party came into power in 1997, one of Gordon Brown's (then Chancellor) first moves was to hand over his interest rate setting powers to the Bank Of England's Monetary Policy Committee (MPC).

In one of said government's more laudable moves, it attempted to end the use of our interest rate as a political weapon. Messrs Brown and Blair announced that their new government heralded the end of boom and bust.

Unfortunately what we actually got was a little different, the biggest boom in recent history, followed by a spectacular bust that we are still reeling from today. It seems that the MPC, although politically impartial, is not infallible.

Residential property represents almost 50% of total personal wealth in the UK. Therefore someone attempting to smooth out the boom/bust cycle should pay very close attention to this market.

As we can see from the graph below, residential property prices started to spiral upwards around 2001/2002, yet at this time the MPC were actually cutting rates (as shown in the second graph). They really should have been putting rates up at this stage to stabilise house price growth, not incentivising people to borrow even more money.

UK house prices 1975-2009 (adjusted for inflation). Source: Nationwide Building Society
 File:UK interest rates, May 1997 to present .svg
 UK Interest Rates - Source:Wikipedia
The MPC of course was chasing different targets. Headline inflation was low, and the economy had been growing consistently for quite some time. There was little question about where this growth was coming from (debt!!).

If interest rates had been raised earlier in the cycle, thus making debt more expensive, the housing market would have cooled. It's true that this may well have caused a recession in itself, but surely it is better to have much smaller more frequent recessions than huge busts that seem impossible to climb out of?

The trouble is that the members of the MPC are too scared of 'pruning' the economy. GDP growth figures can be very misleading and are a bad target to aim at, sometimes it is necessary to sacrifice short term growth for long term stability and prosperity.

Unfortunately the US Federal Reserve and the European Central Bank were both guilty of making the same mistake as us. Property prices throughout the Western world all rose on a tide of cheap debt, and have since come crashing back to reality bringing about a global slowdown and a myriad of associated problems.