In These New Times

The unkindest cut
Cutting interest rates was a mistake. Easy money got us into this mess and it cannot possibly be what will rescue us

Edward Harrison
guardian.co.uk,

Friday November 7 2008

Yesterday, Will Hutton penned a commentary, “A rational cut for irrational times,” in which he praised the Bank of England’s 1.5% interest rate cut as “a necessary move.” But, was it? I would argue that, while monetary easing can provide stimulus on the margin, this cut was neither necessary nor prudent. Quite simply, it is the quantity of credit and not the price of credit which has created hardship.

Conventional wisdom holds that cutting interest rates provides monetary stimulus by allowing businesses to borrow more cheaply, which in turn increases economic activity, hiring and eventually, demand. All of this is quite positive. However, cutting rates also has unintended consequences, and one of them is increasing the appetite for risk. Before I go into why this is so, let me explain how interest rates actually work.

For a brief moment, consider money just as one would any other good. Looking at money in this way, a loan is essentially an exchange of a “present good” (money that can be used today) for a “future good” (an IOU or money that can be used later). Because people will always prefer having any good straight away over receiving that good later, the present good commands a premium in the marketplace. That premium is the rate of interest.

Interest rates, therefore, represent the time value of money. It is the mechanism through which individuals express “time-preferences,” ie how much more they value receiving money in their hands right now as opposed to waiting until a later date. The premium of present money over future money fluctuates according to people’s time preferences; if people want money today very badly, the premium for money today (interest rate) will be high.

So, the purpose of credit and interest rates is clear. It is the mechanism by which one is compensated for deferring consumption today for later consumption.

Loans on credit also create the boom-bust business cycle. In our fractional reserve deposit banking system, banks must keep on hand only a portion of the money we deposit. The rest is lent out as credit. Therefore, if all depositors were to rush to the bank to redeem their deposits, the bank would not have enough cash on hand and would be declared insolvent. This is what happened to Northern Rock. To avoid a run of this sort, banks must maintain the confidence of depositors by acting prudently and cautiously in extending credit. If not, they risk insolvency.

The problem is that human nature steps in; as the business cycle progresses, banks lend more and more money. Naturally, some of those loans are “bad” loans, ie the debtor cannot pay back the full principal at the required time. The banks must account for these bad loans in their loan loss reserves.

However, at some point, when the credit cycle has progressed too far, one of two things occurs: The economy “overheats” and inflation starts to rise. Whispers start circulating that the central bank will raise interest rates and that inflation is spiraling out of control. The central bank does increase interest rates and many loans that looked good in a lower interest rate environment start to go sour. Banks simply start lending to too many questionable debtors and more loans go bad than anticipated.
As rumors circulate that this bank or that bank has been lending imprudently, lenders begin to pull back and restrict credit. Interest rates go up, credit contracts, and the economy goes into recession.

This is the business cycle. It is a natural part of our capitalist system and is entirely created by the extension of credit.

The problem with cutting interest rates as much as the Bank of England has done is that it distorts time preferences and investment decisions, causing individuals and companies to take on more risk, which they will later regret having taken. In effect, the central bank is goading people into misreading the level of risk inherent in the decisions they are now making by keeping interest rates artificially low.

A perfect example is the previous housing bubble. If interest rates should be 5.5%, but they are 3.5% as they were in 2003, then house builders are going to increase their indebtedness to take on more projects with longer and longer completion time frames. A project that comes online five years out looks much less risky when you can borrow at lower rates.

Another example of this right now comes in the form of levered ETFs in the US. These are exchange traded funds that allow speculators the opportunity to double and even triple the gains from investing in the stock market.

While gains are levered, so are losses. I am amazed that there is so much demand for this product amongst investors after the drubbing we all took in October. But, when interest rates are cut to 1%, as they recently were in America, the appetite for risk increases.

Ultimately, it is not the price of credit – the interest rate – which is problematic, it is the quantity of credit that is concerning. By lowering interest rates so dramatically, the Bank of England cannot make banks lend to more companies any more than they can force more borrowers to take out loans. They have simply made credit less expensive, favouring debtors over savers and increasing the appetite for risk.

Easy money is what got us all into this state. It cannot possibly be what will rescue us.