Tuesday, January 19, 2010

Bank of England Mistaken on Short Term Interest Rates

The wizards of money are already between a rock and a hard place in Britain, and that squeezed feeling may well be hitting Ben Bernanke soon as well.

Bloomberg.com reports in U.K. Inflation Jump Won’t Speed Rate Increase, Scots Funds Say that:

British consumer prices climbed 2.9 percent in December from a year earlier, 1 percentage point more than in November, as oil prices advanced and after a cut to retail-sales taxes a year before, the Office for National Statistics said today.

The article also reports that:

Standard Life Investments still predicts the Bank of England will wait until toward the end of the year before increasing interest rates . . .

“This is not the start of an upward trend that’s going to bring the Bank of England to make changes to interest rates,” said Douglas Roberts, an economist at Standard Life. “I couldn’t say it wasn’t a disappointing number.” . . .

“The path we’re on is not an inexorable run of inflation but I can’t deny it’s coming in a bit higher than expected,” said Roberts. “The monetary authorities are in a very difficult position. To exit from the present policies is going to require wisdom and luck,” he said.

The Big Lie is that low borrowing rates (0.5% benchmark rate in Britain) are a benefit to the economy in an economy that is already highly leveraged. Low borrowing rates have a flip side, which is low returns to savers. This is a zero-sum situation. What is really going on is that borrowers such as banks are being systematically aided on the backs of savers. But it is saving that is virtuous, as it means being more productive than one needs. It is saving that it the essence of capitalism. The war on savers that has gone on most of the past decade is a disastrous war on the most productive, frugal members of society. The borrower gets to use the saver's capital and if he/she does not pay it back, well, debtor's prisons have been abolished. Default is not fun, but the saver lost the use of his/her money; at least the borrower had the use of it.

As lenders, the banks make a nice spread, and if they don't want to lend, they can book current profits by simply buying higher-yielding Treasuries, financing these purchases with cheap short-term money. Borrow short, lend long. Hmmm . . . How innovative is that? NOT . . .

Perhaps the central banks of Britain and the U. S. are praying for an economic boom.

Unfortunately, stagnating real wages, massive shrinkage of the work force at the end of 2009, technical near-insolvencies in 3 of our largest states, and growth in large part due to inventory changes provide no evidence that a true sustained boom will occur in the U. S. The Economic Cycle Research Institute, which called for the end of the recession to occur in the third quarter of 2009, is already looking forward to a relatively short cyclical upturn and a return to the cyclicality that was common in, say, the 1920s and 1950s.

The financial markets and economic boom of the late 1990s was said to be the first in U. S. history in which the average financial strength of corporate America actually declined. In other words, the IPO boom aside, corporate America was leveraging up along with households, while the Federal government was running modest cash surpluses (but accruing deficits due to social programs). This worsening financial status continued through the quasi-boom of the mid-aughties, but came to a head in 2008 with the great, global financial crisis.

The solution of the powers-that-be was to leverage further, and the U. S. now is widely reported to have a record amount of debt relative to GDP when all governmental levels are consolidated with households and companies. This increased leverage is likely to be unstable, as inflation of even 2.5% and borrowing costs near zero will lead to inflationary growth and, at some point, tightening and yet more pain of defaults.

This is why the bailouts were misguided. The corporate failures or near-failures were a standard result of over-leverage. Now that some of them are essentially on the sovereign's balance sheet, the can has been kicked down the road, but the stakes are greater. Corporations have no nerve endings. Restructurings as occur in bankruptcies are not truly painful except psychologically.

Governmental bankruptcies are different.

Governments and central banks need to stop suppressing short-term interest rates and deal with the consequences. The longer they wait, the worse the problem.

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