Wednesday, 16 December 2009

The evil of keeping the interest rates low

Just as it has been done for the past year…

Easy come, easy go. Our approach to many things depends on the price we had, have, or will have to pay for them. Human life is (considered) priceless, but the respect to material goods is highly correlated with their value. If we buy a brand new car, we polish it every weekend and park it very carefully so that we don’t scratch it. If you are an owner of a new car, this scratch probably breaks your heart, buy if what you possess is a clapped-out banger, you usually don’t care. This does not apply to everyone, may the author of this blog serve as an example.

The respect for items is in my theory conditioned on the replacement costs, including transaction costs, in more simple words, the crucial criteria are price and availability or effort that has to be made to procure a certain good.

The natural economy is the thing of the past. In the contemporary world, money is used to value goods, fix prices and serves as a legal tender. But in the light of my theory, can you figure out, what the respect for money is contingent on? The most common perception, often instilled in children during the upbringing process is that the more people respect money, the harder they had to work to earn it. In terms of life this can be seen as golden rule, especially when we see the guys (called “politicians”), whose livelihood is spending someone else’s money. In economics, things tangle up a bit, but the phenomenon of ‘price approach’ remains applicable.

Can money have its price? How is this price fixed? In the market economy, price is usually driven by the market forces, so when the supply and demand meet, a certain amount (quantity) of a certain good is sold at a certain price. But hang on! Two questions slip into our reasoning. Firstly, how can the money be valued, is a 100 zł note worth more or less than 100 zł, or maybe as much as the paper it is printed on? And secondly, how do supply and demand on money can look?

The first questions is followed by two answers. The first is based on the existence of exchange rates – money as a currency of one country can be valued in another currency, but that’s not what I’m going to deal with today. In the second and final answer, we assume the money is a specific good, which can be neither sold nor bought, but can be lent and borrowed. Hence, the price of money is the interest rate.

And the “supply and demand” matter. Every student who has completed the basic course of macroeconomics should know the supply of money is controlled by the central bank, which runs monetary policy, either directly, by setting money supply, or indirectly, by setting interest rates. A demand on money is in turn generated by private persons, legal entities and governments and is basically conditioned on its price. So when the cost of money is brought down, demand on it automatically rises. So I’m responsible only for the demand… I cannot just print money at home, go to the shops and use the notes as a legal tender – this is a crime. Central banks, as the current practises of Federal Reserve or Bank of England show, can print as much money as they want and it is not a crime – how funny!

Look at the history: low interest rates in Japan fuelled stock bubble, which later on caused a financial meltdown and the decade of stagnation. Why had it happened? People ahd borrowed money cheaply and invested it in shares, as long as their valuations were on the rise they borrowed even more, hoping the trend would continue. But the moment when the growth potential reached its limits has come, and those people and businesses that had their money in stocks were left with little capital and debts they had to pay off. So instead of spending money on consumption, they had to return it to their creditors, who also had lost as a result of numerous write-offs.

At the beginning of twenty-first century, Alan Greenspan as a Fed governor hit upon a mould-breaking idea that every American should afford to buy a house (as Mr Greenspan declares on pages 229 and 230 in his book “Age of Turbulence”, I quote the original edition), no matter how poor they were (the second part of the sentence is where the author calls a spade a spade). To that end (and some others actually), Fed shaved federal funds rate to only one per cent and kept it down for a few years, until 2006. Availability of cheap subprime mortgages combined with low interest rates, high gains on property and stock markets and new inventions of financial engineering whetted the appetite for risk and blew up sizeable bubbles. When they burst it was too late. In his book, released in 2007, Mr Greenspan admits he had seen the bubble rising, however he claims an average family could move to a posh house and improve their standard of living thanks to his policy. Many of those families found their houses foreclosed, when the rising inflation made Fed jack up the interest rates and adjustable-rate mortgage repayments became they burdens many households could not carry.

A year ago, in an unprecedented move, Fed once again slashed the interest rates almost to zero. The action was intended to ease the pain of financial markets and to boost customers’ confidence. The latter was somehow propped up, but rather by expansionary fiscal policy, not by better access to consumer loans. American customers after they had been taught a hard-knock lesson are still reluctant to spend and borrow. The distressed markets, in particular banks gave a warm welcome to the liquidity injection the were granted. In a short term this move prevented a knock-on effect and ultimate collapse of financial system. After a few months it turned out that big investment banks used the cheap cash for aggressive speculation on stock, gold, crude oil, or copper markets. At the end of the year their balance sheets grow robust and bankers once again grant themselves generous bonuses. The real economy, though in recovery, still does not keep up with the markets.

Interest rates are going to remain low, so the ecstasy on financial markets will continue. Then the inflation will drive the rates higher and the next bubble will be punctured. Why is it so likely to happen? It is in the interest of US government to see the higher inflation which would decrease the real amount of its debt…

Hey, how about Poland? Unlike United States and most of EU countries Poland has not been troubled by deflation and therefore had to keep its interest rates higher in nominal terms. But in real terms our benchmark rate fluctuates around zero (the rate is currently 3,50%, whereas inflation in the recent months has been between 3% and 4%, but beware, this calculation, though commonly used is flawed, because the interest rate refers to the future period and inflation to the past).

Whenever somebody speaks about the factors that have contributed to positive economic growth in Poland, they accentuate two of them: consumer confidence and depreciation of złoty. I cannot deny their role, but hardly anyone mentions the monetary policy run during the boom. Unlike the Baltic States, Poland has not fallen into the indebtness trap. The burden of debts has not clamp down on our development, which, a bit stifled in the years of boom, now turns out to be sustainable. We owe our success not to government of Law Justice, nor to the current cabinet of Donald Tusk, but to the restrictions on denominated loans and other, imposed by our financial supervisory body and to higher than postulated by some “illiterate economists” interest rates, which tightened the credit criteria and prevented the growth of domestic subprime loan market.

To sum up, I see four main reasons, why the interest rates should be kept relatively high.

1) The influence of consumer stances. When the loans are more available (more people can afford them when they have pay not much more than they had borrowed), consumers tend to spend more and more recklessly and find it harder to estimate, what they can afford. Meanwhile their propensity to save declines, because depositors are given lower interest rates in the banks.

2) Flawed investment projects. When the interest rate is low, more business venture become viable, because for a lower interest rate on the borrowed capital, the net present value of the project is more likely to be above zero. Those enterprises turn out to be very vulnerable to any external factors that can hamper their business.

3) Inflation. Dariusz Filar, currently the member of the Monetary Policy Council has put forward a rule that the benchmark rate should be set around two percentage points above the inflation rate. In the present circumstances it should be raised to 5,25% and nobody would agree on it, but in the long term I see it as a sound principle of money value protection. Once the inflation spirals out of control it is hard to pull it down, the effects of the therapy are severe and those who lose the most are usually the poorest.

4) Risk management. When a year ago I paid almost all my savings into a 12M deposit I was bid a decent interest rate of 8,5 per cent and it did not occur to me to seek any other investments when I was given a fixed-income deposit with honest interest. But if I had been given the interest rate of 1,25 per cent on the same deposit, would I have been so eager to leave my money in the safe haven? Probably not, because the secure profits would be tiny and I would be more keen to invest that money in a risky securities. That it what has happened this year – being faced with low interest rates big market players took the chance and earned ten times more than the author of this blog!

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