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.

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