The Pin Factory Blog

There is much debate over the reason behind the failed recovery plan set by Chancellor George Osborne. The assumption the Chancellor made anticipated an increase in private sector output, when cuts were made to the public sector. Unfortunately this did not occur, or at least not quickly enough to appease the governments pressure groups, resulting in a U-turn on their thinking. A new programme of Quantitative Easing (QE) was introduced to ‘stimulate’ the economy, with the intention it will lead to growth.

I personally do not think that QE will lead to anything other than inflation, later on in the business cycle. I certainly do not think it will create any constant reliable growth. At best it may maintain a short period of artificial or ‘false’ growth, which many economists would call money illusion. I believe the government has not correctly addressed the problem which prevents growth. Some economists are saying the expectation of future economic difficulty is frightening consumers into saving, slowing spending.

I don’t believe this is true. When people save more, the money saved is lent to people who use that money to enable business or to consume. In short money is always doing something. There may be a lag in the time between saving and lending, which could reduce consumption. However this would generally be compensated for. People who borrow money have a higher propensity to consume than those who lend and will spend it faster. This is proven by the borrower being prepared to pay the premium of interest to consume now, rather than later.

However, banks are not lending the money they have. This is partly due to the increase in the required assets they have to hold to cover depositor’s withdrawals, as a result of the financial crisis (capital ratio). But it is mainly as a result of the banks fear of the risk in the market. This fear has prevented growth by stopping the natural transition of money from savers to consumers through the saving mechanism. Therefore, the real reason for the lack of growth in the economy is the increase, or at least the fear of an increase, in risk.

No amount of QE will reduce the risk. In fact it may make it worse. QE is a desperate action by a government in a dire situation. The implementation of such a policy will deter consumers from increasing their consumption, as it is a suggestion that their fears of economic woe are well placed. That is not to mention the fear it will put into foreign investors, who will be deterred from putting their money where they think a greater risk is.

If the government found an alternative way of reducing risk, it could restore the lending and borrowing mechanism enabling the private sector to grow again without trying things like QE. However current policy suggests potential disaster based on fear and expectations, which have originated from the messages the government is sending out. Reducing taxes and regulation will reduce risk, and deliver the growth we all want.

One of the main areas in macroeconomic analysis is the long term prediction of economic growth on a national level. It is done for many reasons, such as a guide to see which countries sovereign debt products are safest or which country provides the economic stability to enable free market enterprises to flourish. There are many methods of doing national investment analysis that provide a benchmark on the best countries for long term growth and safe returns. As an economist I have developed my own methodology to analyse where the best investment opportunities reside on a national level.

I therefore call the method the Morganist National Investment Analysis or MNIA. In this model I first find out the long term sovereign debt surplus or deficit and then calculate the mean average over the last decade or two, if possible. This shows the level of dependence on outside investment each country has. Then I calculate the standard deviation of the borrowing over the same period to show the volatility. So why is this useful? Well, if there is high debt and a high standard deviation over that period it shows there is a period when the government had to borrow a lot more than at other times.

This indicates two things. The first is the country is following some kind of business cycle, which can then help an investor estimate each country’s business cycle with a closer analysis of the debt levels over the period measured. The second is the country has to borrow in the downturn period of the business cycle, which indicates that either the country’s domestic economy is reliant on fiscal stimulus to enable growth in the downturn period or that the boom period was created through outside investment. Either way a country with both high debt and a high standard deviation is an alarm bell to an investor.

Does it work? In my recent book on the Euro crisis I used the method to predict which countries would be next to default. I stated that Latvia, Lithuania, Hungary, Malta, Poland, Slovenia and Slovakia would have a sovereign debt increase in proportion to their GDP’s and may require intervention from outside sources. A recent article states that Olli Rehn, the European Commissioner for economic and monetary affairs, has issued a warning that Belgium, Cyprus, Hungary, Malta and Poland are on the brink of recession. Although my prediction did not include Belgium, its concern is mainly down to the problems with Dexia, which is a large owner of Greek debt. As a result I would suggest that Latvia, Lithuania, Slovenia and Slovakia could be added to the list.

If you are interested at having a closer look at the analysis you can download my book for free here. The analysis starts on page 25 and the tables are in the appendix.

Usually in an economic downturn there are compensations for the negative effects of reduced demand. The reductions in income and rise in unemployment are to a degree offset by a fall in asset prices especially the housing market. The economic strategy of the Bank of England has been to set an artificially low interest rate to maintain ‘economic stability’. The actions of the central bank are based on the assumption that when house prices increase consumer consumption also increases.

This assumption may be true to a certain extent however it is built on a false sense of wealth due to temporarily high house prices created by long term unsustainable borrowing, a bubble that is inevitably going to burst. As soon as house prices start to fall dramatically the false sense of wealth will disappear and the impact low interest rates will have on aggregate prices will go with it.

In the mean time people who have seen a reduction in income have not seen a reduction in the cost of housing. The housing market has been artificially subsidised through low interest rates, which not only make first time buying harder, but also make the cost of renting higher. Greater demand for rented accommodation has been caused by a growing number of people that cannot afford to buy a house as a result of lower wages, which have not been reflected in house prices due to the low interest rate.

The consequences of this are real and severe. In the last year the number of homeless people in England rose by 14%, which could be partly attributed to the rising levels of unemployment. However there has been a 26% increase in the number of homeless people who are not helped by the local authorities into accommodation, which would indicate the cost of housing has been an issue when attempting to re-house people.

If interest rates were higher the price of housing including rented accommodation would fall and provide the compensation that a normal recession would create. This raises the question is the Bank of England’s strategy hindering more people than it helps?

Many banks have problems managing the expected withdrawals depositors make and often have to borrow money to cover the shortfall. This service was originally provided by a number of private wholesale banks, which lent money in emergency situations to prevent bank runs. Over time a number of wholesale banks were merged together and given regulatory powers over the banks that they would lend to. When this merger happened it was the birth of the Central Bank, which acted as a lender of last resort for banks with short term cash flow problems.

Since then central banks have taken on a greater role within the economy. The main secondary role of the central bank is to control money supply. The amount of debt that can be lent by banks is set by the central bank through the reserve requirement. The reserve requirement is a percentage of the funds banks have, which have to be held to cover depositor’s withdrawals. By increasing or decreasing the required reserve the availability of debt, which can be lent out to borrowers alters. The greater the required reserve the less money that can be lent out and the higher the price of debt, the interest rate, becomes. Conversely the lower the required reserve the more money that can be lent out and the lower the price of debt, the interest rate, becomes.

The Bank of England has two main functions. The first is the original function of the private wholesale banks, to lend to other banks to prevent bank runs and enable them to function in an effective manner. The second is the control of the money supply within the economy, when alterations to the reserve requirements set by the Bank of England are made to control inflationary and deflationary gaps. Both of these functions are made possible by the Bank of England’s control of the supply of debt. This control has been enhanced over time by allowing the Bank of England to create money through functions like Quantitative Easing.

During the rescue of Northern Rock and the subsequent bank bailouts the Bank of England failed to provide its primary function of acting as a lender of last resort. The size of the bailout required was so great that Bank of England Governor Mervyn King refused to lend the funds required to prevent a bank run. The Government had to step in and act as lender of last resort meaning the primary function of the Central Bank was no longer provided by the Bank of England. The secondary function of the Bank of England in regards to money supply control has also failed. The Bank of England sets a two percent inflation target that it is supposed to meet to maintain “economic stability”, however in recent months the rate of inflation has stayed far above this target.

Interest rates cannot rise due to the impact on the wider economy, which would be devastating for homeowners and businesses alike. The ability of the Bank of England to control inflation by increasing the interest rate is a bygone era. The lax control of the interest rate in the past has flooded the market with cheap debt that now has to be repaid. Due to the need to make these repayments possible the interest rate has to remain low to prevent default. Interest rates could fall further or become negative, however this would not necessarily provide the desired effect of increased consumption and may make the scale of debt even worse, kicking the can further down the road. The only real function the Bank of England can perform effectively is pump priming, which will devalue the purchasing power of the currency later in the business cycle.

Perhaps it is time to push for the reintroduction of private wholesale banks to provide emergency loans and to stop using the Bank of England as an aggregate demand control mechanism?

There has been much speculation recently as to whether the interest rate could become negative if the economic climate continues to worsen. Expectations of a deflationary gap in the near future have deterred an interest rate rise to quell current inflation. The aim of negative interest rates is to increase liquidity in the market creating higher demand for goods, artificially compensating for the decline in consumption. However there are questions as to whether a negative interest rate would actually have an impact on consumption and create the level of demand desired.

When someone borrows money from a bank their debt is bundled up with other borrower’s debt and packaged as a credit derivative. This product is then sold to other institutions who receive the payments the borrowers make on the debt. The risk is now held by the institution that purchased the debt enabling a lower rate of interest than the original bank alone could offer the potential borrower. When the credit crunch started in 2007/2008 packaged debt products became less desirable to purchase due to the increased risk of default created by the subprime market. As a result of the lower demand for credit products banks had to hold onto more of the debt they issued themselves, meaning the interest rate rose to compensate for the higher risk they carried. If the interest rate did not rise then less debt was offered and lending declined.

The interest rate in this circumstance changed from being led by a macroeconomic target to stimulate the economy, to being led by the risk element of the lending mechanism fuelled by the uncertainty of repayment. Even if the interest rate set by the Bank of England reduced and more funds became available to lend the return required by the banks to compensate for defaults increased. The demand for borrowing and risk of inability to make repayments in combination with the lack of demand for packaged credit products pushed up interest rates for borrowers. Even if the Bank of England base rate has reduced the actual rate of borrowing has increased in many cases.

In addition to risk element of lending and the effect on the interest rate, the actual link to the base rate is not present in all lending products. Only about half of the loans in the UK are linked to the base rate. Tracker and variable rate products follow the base rate and CAT standard mortgages (Charges, Access and Terms) have to have an interest rate within two percent of the base rate. However other banking products can have an interest rate at any level the bank is prepared to offer. Even if the borrowers with outstanding debt, which are linked to the base rate, receive a reduction in repayment costs due to an interest rate cut it does not guarantee they will spend it and increase consumption. In fact the majority of borrowers are taking advantage of the low interest rate to pay debt down.

The interest rate mechanism leading to changes in consumption no longer works due to the high levels of debt that already exist. The reduction in interest is merely providing more liquidity and not taking into consideration the problem is one of insolvency. The situation questions not only whether negative interest rates will be ineffective, but whether the interest rate mechanism as an aggregate demand control is capable of working at all anymore.

There has been much speculation recently as to whether the interest rate could become negative if the economic climate continues to worsen. Expectations of a deflationary gap in the near future have deterred an interest rate rise to quell current inflation. The aim of negative interest rates is to increase liquidity in the market creating higher demand for goods, artificially compensating for the decline in consumption. However there are questions as to whether a negative interest rate would actually have an impact on consumption and create the level of demand desired.

When someone borrows money from a bank their debt is bundled up with other borrower’s debt and packaged as a credit derivative. This product is then sold to other institutions who receive the payments the borrowers make on the debt. The risk is now held by the institution that purchased the debt enabling a lower rate of interest than the original bank alone could offer the potential borrower. When the credit crunch started in 2007/2008 packaged debt products became less desirable to purchase due to the increased risk of default created by the subprime market. As a result of the lower demand for credit products banks had to hold onto more of the debt they issued themselves, meaning the interest rate rose to compensate for the higher risk they carried. If the interest rate did not rise then less debt was offered and lending declined.

The interest rate in this circumstance changed from being led by a macroeconomic target to stimulate the economy, to being led by the risk element of the lending mechanism fuelled by the uncertainty of repayment. Even if the interest rate set by the Bank of England reduced and more funds became available to lend the return required by the banks to compensate for defaults increased. The demand for borrowing and risk of inability to make repayments in combination with the lack of demand for packaged credit products pushed up interest rates for borrowers. Even if the Bank of England base rate has reduced the actual rate of borrowing has increased in many cases.

In addition to risk element of lending and the effect on the interest rate, the actual link to the base rate is not present in all lending products. Only about half of the loans in the UK are linked to the base rate. Tracker and variable rate products follow the base rate and CAT standard mortgages (Charges, Access and Terms) have to have an interest rate within two percent of the base rate. However other banking products can have an interest rate at any level the bank is prepared to offer. Even if the borrowers with outstanding debt, which are linked to the base rate, receive a reduction in repayment costs due to an interest rate cut it does not guarantee they will spend it and increase consumption. In fact the majority of borrowers are taking advantage of the low interest rate to pay debt down.

The interest rate mechanism leading to changes in consumption no longer works due to the high levels of debt that already exist. The reduction in interest is merely providing more liquidity and not taking into consideration the problem is one of insolvency. The situation questions not only whether negative interest rates will be ineffective, but whether the interest rate mechanism as an aggregate demand control is capable of working at all anymore.

With the ever growing debt mountain in the UK reaching melting point the decision to go bankrupt is at an all time high. Record numbers of insolvencies, particularly in the South East, are corroding the credit ratings of the nation. It is often presumed and publicly declared that there is little consequence to the individual who is made bankrupt, but in reality there are some scary facts that are not so well known and perhaps purposely hidden.

The most alarming consequence is a legal requirement to make payments after bankruptcy. It is frequently assumed all debt is completely written off when insolvency is processed, which does happen on occasions, however it is also possible for the Official Receiver (the financial organisation that processes bankruptcy) to claim up to sixty percent of income for up to three years after bankruptcy. Although most people are aware of the seizure of possessions and potential repossession of their property they are at times not informed of the further payments they may have to make.

There is also ignorance relating to the publicity of bankruptcy. Each times a person declares bankruptcy it is advertised in a local newspaper to inform people that they are not creditworthy. The County Court also holds the case file for up to twenty years, which enables potential lenders to contact the Court to make a judgement on whether they should lend to the individual or not. Remember it is the decision of the lender as to whether they lend someone money or not, discharge from bankruptcy does not mean the bankruptcy disappears it merely means the Official Receiver is satisfied with the winding up of the estate.

The discharge of bankruptcy is another sore point. Although it is stated it is attained after one year, it often takes much longer due to complications and it is the discretion of the Official Receiver as to when it happens. These are some of the many points that do not get disclosed to potential bankrupts’. With bankruptcies on the rise, people ought to be better informed.