It won’t surprise you to read that we don’t have a problem with the taps being turned off on credit. The last twenty-plus years has seen a massive increase in credit to consumers and businesses.
It was such a massive expansion that money was being produced out of thin air. Especially in property. House values would rise – borrowers would get the value of the house appraised – the valuer would ask “what do you think it’s worth” – he’d knock that down by 5% – submit the forms to the bank, and hey presto, cash would appear as if by magic into your ‘savings’ account.
But where did that money come from? How can you suddenly have an extra $50,000 (for instance) in your bank account? You haven’t sold your house to someone who’s paid cash for it. You haven’t sold it to someone who has borrowed money from a bank in order to give the cash to you – in exchange for a house.
Therein lays the problem. The problem of banks lending too much on one side of the ledger and then having to back it up by borrowing the money on the other side of the ledger.
So, what did they do? Well, obviously they wouldn’t go off and borrow small amounts each time a home owner wanted equity from their house. That’s where they rely on depositors (savers) and access to other forms of borrowing.
The banks are pretty certain that not everyone will want to withdraw all of their money at the same time. Therefore, they can afford to shuffle it around behind the scenes.
If you take an extreme example of a bank with just two customers. One is a saver with $50,000 in his account, the other has a loan with the bank for $30,000. The bank has taken the $30,000 from the first customer and given it to the second customer. Interest is charged on one side and paid on the other and the bank keeps the difference – that’s the ‘spread.’
If the second customer wants to increase the loan by $10,000 then the bank will allocate a further amount from the first customer to the second. Of course, all along, the first customer still sees a balance of $50,000 plus any interest earned.
The problem comes if the first customer wants to withdraw their funds, and or the second customer is unable to repay the loan. That is the situation you’ve seen in the US and the UK.
OK, so what does that have to do with lower interest rates and the consumer’s current aversion to credit?
Well, let’s look at it this way. In the US and UK, central bank interest rates are almost down to zero. In the US the target range is 0%-0.25%. In the UK, the Bank of England last night cut its rate to 0.5%. In addition to that it has cranked up the presses to print money.
Or rather, it will electronically add 75 billion pounds to its balance sheet – just like that.
In Australia our central bank hasn’t moved that far yet. But that doesn’t mean to say it won’t happen. Even with interest rates at record lows here, the evidence seems to be that consumers are not consuming, and with that, neither are they borrowing.
Could it possibly be that lower interest rates globally is actually putting the handbrake on borrowing? Let’s take a very brief look at the evidence.
The theory is that when interest rates fall, the cost of money is cheaper, so people and businesses are more inclined to borrow to invest, or borrow to consume. When interest rates move higher, the cost of money becomes more expensive and so the demand for borrowing drops.
Now it seems as though everything has been turned on its head. And it’s primarily because of the attitude to borrowing/lending from consumers and banks.
Let’s take the consumer (borrower) first. Credit has been so easy to obtain for years. That means the majority of the population who have needed a loan, probably has one. And, with falling interest rates, the evidence has been that people are choosing to pay off more from their loan than they need to.
To them it doesn’t matter that interest rates have fallen to historical lows, they don’t want or need to borrow any more. In fact, because of the rapid cut in interest rates, even if they did want to make a big purchase, they could do so by just reducing their mortgage payments to the minimum for a few months and save the money instead of taking out an additional loan.
There is also, the prospect that interest rates could fall further. Why take out a loan now, when you may be able to borrow at a cheaper rate next month or next year. It’s a similar argument to the argument put forward by the mainstream about the perils of deflation on the economy. Consumers may delay spending if they believe prices will fall further.
In both cases, mainstream economists and policy makers view this as a negative. It isn’t, it’s a positive.
But also take a look at it from the bank’s perspective. In the above example of the two-customer bank, the saver was lending to the borrower. This scenario works fine providing the saver doesn’t want to withdraw all of his savings.
Could this be why banks are seemingly reluctant to lend? When interest rates are cut, most of the attention is focused on the savings to borrowers. But if interest rates are cut so low, what is the incentive for savers to save? The fear for the banks must be that savers will just not bother to keep cash in the bank, or hoard it, or spend it, or even do something crazy like buy physical gold.
Therefore, far from lower interest rates having a stimulatory effect on the economy, as it is intended, it is entirely possible that it is having the opposite effect.
The only other concern for the banks is if borrowers default on loans and the bank is left holding residential property valued below the outstanding loan amount. Again, that would explain why banks are quite happy for borrowers to be repaying more than the minimum – for the moment anyway.
If we are right, then the sensible course would be for the RBA to stop manipulating the interest rate market now, before they cut to a level so low that they will be forced into inflationary policies as witnessed in the US and the UK.
Other Stuff on the Markets
It seems as though the market has spoken. The US government’s bail-out of General Motors is looking to have been in vain. Will the company see out the month?
The Dow Jones Industrial Average hits a new twelve-year low.
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