Markets do set rates: A reply to Julien Noizet

Financial analyst and blogger Julien Noizet has replied to my article on mortgage rates on his blog. It is a good piece, worth reading, but I still think I am right. It is perhaps true that Noizet is right too, because my claim was really very modest: in total, mortgage interest rates do not mechanically vary with the Bank of England's base rate; we can show this because the spread between them and the base rate varies extremely widely; and since we have very strong independent reasons to expect that market forces largely drive rate moves, that should be our back-up explanation. The implication of this I was interested in was that this meant a hike in Bank Rate wouldn't necessarily drive effective rates up to a point that would substantially increase the cost of servicing a mortgage and hence compress the demand for (London) housing.

Even if the first graph in Noizet's blog post did appear to support his narrative that effective market rates follow Bank Rate moves, I'm not sure why these disaggregated numbers matter given that the spread between overall effective rates on both new and existing mortgages varied so widely. If it turns out that specific mortgage types varied closely with Bank Rate but the overall picture did not, then markets still control effective rates, they just do it via a changing composition of mortgages, not by changing the rates on particular products. The effect is the same—and it is the effect we see in the Bank's main series for effective rates secured on dwellings. But the graph, to me, looks a lot like mine, despite the effect of new reporting standards: mortgage rates are about a percentage point from the base rate until 2008, then they don't fall nearly as far as the base rate in 2008 and they stay that way until today. If other Bank schemes, like Funding for Lending or quantitative easing were overwhelming the market then we'd expect the spread to be lower than usual, not much higher.

His second big point, that the spread between the Bank Rate and the rates banks charged on markets couldn't narrow any further 2009 onwards perplexes me. On the one hand, it is effectively an illustration of my general principle that markets set rates—rates are being determined by banks' considerations about their bottom line, not Bank Rate moves. On the other hand, it seems internally inconsistent. If banks make money (i.e. the money they need to cover the fixed costs Julien mentions) on the spread between Bank Rate and mortgage rates (i.e. if Bank Rate is important in determining rates, rather than market moves) then the absolute levels of the numbers is irrelevant. It's the spread that counts. But the whole point of my post is demonstrating that the spread changes very widely, and none of Julien's evidence seems to me to contradict that claim. Indeed, Noizet's very very good posts on MMT, which stress how deposit rates are much more important as a funding cost than discount rates for private banks, seem at odds with what he's written in this post. And supporting this story is the fact that the spread between rates on deposits (both time and sight) and mortgages changes much less widely. If we roughly and readily average time and sight on the one side and average existing and new mortgages on the other, the spread goes no higher than 2.3 percentage points and no lower than 1.48.

In general with the post I don't feel I understand the mechanisms Noizet is relying on, perhaps I'm misunderstanding him, but the implications of his claims regularly seem to contradict our basic models of markets. For example, he says that a rate rise would lead banks to try and rebuild their margins and profitability. But I can't see any reason why banks wouldn't always be doing that. The mortgage market is fairly competitive, at least measured by the numbers of packages on offer and the relatively small differences between their prices. I don't think Julien has presented any mechanism to suggest why banks would suddenly want to maximise profit after a rate rise but wouldn't beforehand—or why they'd suddenly be able to ignore their competitors but couldn't beforehand. It's possible there is one, but I can't see that he's explained it. Overall I suspect I've missed something crucial, so I welcome any more comments Julien has on the issue.

Why we can't plan the economy part DXVI

This is a lovely little tale from Paul Ormerod in City AM:

Igal Hendel and Yossi Spiegel document the evolution of productivity over a 12 year period in a steel mini-mill, producing an unchanged product, working 24/7. The steel melt shop is almost the Platonic ideal from a national accounts perspective of output measurement. The product – steel billets – is simple, homogenous, and internationally-traded. There was virtually no turnover in the labour force, very little new investment, and the mill worked every hour of the year. Yet despite production conditions which were almost unchanged, output doubled over the 12 year period. As the authors note, rather drily, “the findings suggest that capacity is not well defined, even in batch-oriented manufacturing”.

This is a product of the point that Hayek made, that all knowledge is local. This increase in production from the same assets and workforce came not because anyone outside the plant had anything at all to do with it. There was no governmental either mandate, nor advice on how to do it. There was no technological breakthrough, no scientist involved, no research. Simply people getting better at doing something simply by doing that thing. And note that production doubled in 12 years just from this factor.

This isn't something you can do by plan nor is it something that can be accomodated in a plan: for obviously it's not true of all processes all the time. Another blow struck against the idea that the centre can possibly detail how an economy should work.

Yes, we do indeed still need the centre, there are some things that can only be done there. But as I've remarked before we should be using central government only for those things that both must be done and can only be done by central government.

A lie can be half way around the world before the truth has got its boots on

This is a little story close to my heart in the day job:

"I think there is a great commercial potential on the moon," he added, citing significant reservers of helium 3, which is rare on Earth and which could be developed into a clean energy fuel ideal for nuclear fusion. The lunar soil is also rich in coveted rare earth elements: 17 chemicals in the periodic table that are in an increased demand because they are heavily used in everyday electronics. "There are a vast amount of opportunities for a wide variety of companies not only in America but across the globe," Gold insisted, emphasizing Europe and Japan, as well as the US Congress, are enthusiastic about a return to the moon.

The lunar soil may indeed be rich in rare earths: I have no idea myself but it could be. However, absolutely no one, ever, is going to try and mine rare earths on hte Moon and then return them to Earth. It simply isn't going to happen.

What I think has happened here is that people have absorbed the stories of the past few years about impending shortages of the rare earths. All that stuff about China reducing exports of these metals so vital to modern electronics. And thus there's a feeling that any deposit of them, even somewhere as inaccessible as the surface of the Moon, must be something that people would want to exploit.

The problem is in the initial story: yes, China did limit exports but that does not mean that there's any shortage of these minerals here on out little planet. Several of them, individually, are as common as copper down here. And we produce millions upon millions of tonne of that each year while we use only 140,000 tonnes of all 17 rare earths together. There's simply no long term shortage.

And there's absolutely no way therefore that anyone's going to try and mine the Moon for things that can be had down here for $10 a lb.

My major point here being that these people are apparently basing their plans about lunar mining on something that simply never will be mined up there: at least not for returning down here. And it's inevitable that if you start basing your plans on untruths then your plans are going to fail at some point.

Quote of the week

"The miracles of the past three and a half centuries – the unprecedented improvements in democracy, in longevity, in freedom, in literacy, in calorie intake, in infant survival rates, in height, in equality of opportunity – came about largely because of the individualist market system developed in the Anglosphere. All these miracles followed from the recognition of people as free individuals, equal before the law, and able to make agreements one with another for mutual benefit."

– Daniel Hannan
How We Invented Freedom & Why It Matters

Why financial regulation fails

The supposed prime objective of banking rules and regulation is to protect and reduce risk. As the credit crisis has clearly demonstrated regulation has failed to do so. Despite this the proposed solution is more regulation.

Rules and regulations are focused on mechanically risk weighting loans and allocating capital against that perception of risk in a prescribed formula that sounds complicated and is complicated. The capital charade and secrecy with government backing for large banks and almost all deposits means market scrutiny is all but removed from the banks. Detailed P&L and balance sheet data only goes to a few regulators opposed to the many that deposit, invest and research the banks thus limiting market review, risk assessment and analysis.

There is also a major skill set asymmetry with the many PhD brains of the banks easily able to outwit a few £60,000 a year PRA and BoE staff. Consequently the SIV CDO3, inverse IO and many other regulatory compliant but circumventing structures and strategies are created. The fixed formula driven official capital ratios all look to be unchanged at a level we are told is strong. The risk weighting of a loan to a business that is 1000% geared with no sales is the same as a loan to a 1% geared business that has a 50% operating margin from 50 year government contracts. The market would never be so simplistic and will always look forwards opposed to regulators that tend to look backwards. The market would allow much more leverage for genuinely low risk lenders and require much less for high risk lenders.

Today all banks essentially work to a very similar core capital ratio. The regulation based system allows banks to disclose as little as possible to as few as possible, complicating obscuring and circumventing. A market based system would encourage transparency, simplicity and full disclosure to as many as possible. Without regulation there would be little restriction on new banks being created and consequently there would be more specialists and more competition.

The abolition of regulation would make banks less risky. With banks that are too big to fail and deposit protection all banks can borrow cheaply regardless of the risks they take. Removing this will require banks who want cheap deposits to prove they are worthy of them. A market based pricing structure will be created with each bank having to fight for its funding. With very low real deposit returns the demand for disclosure, balance sheet transparency, simplicity and capital strength will be high. Where this is not the case real returns for depositors will be high.

With depositors now determining how much capital is required for any given deposit cost the subordinated debt now, now not ranking in line with the depositors will be priced based on the preference and equity capital structure. Today return on equity is maximised by reducing equity as much as the rules will allow with there being no correlation between capital strength and funding cost. In a market driven world the key funding cost will fall as equity increases. The correlation analysis below shows not only that pre-crisis capital and risk were inversely correlated, but also that risk and return were even more strongly inversely correlated. The strongest inverse correlation is, however, between Growth and Risk.

With rules based regulation that evolves slowly and usually only changes after a major problem banks can easily manipulate their balance sheets to comply with the letter if often not the spirit of the regulation. With the market/depositors setting a bank’s funding cost, the risk perception and analysis of anything new, complicated, or unclear should immediately impact the bank. Consequently the banks focus will shift to genuine economic profit based risk and reward analysis opposed to regulatory arbitrage.

Over time better banks will secure more funding at better terms rewarding appropriate risk assessment with those who operate inappropriately way failing. Evolution will be returned to the banking sector by the removal or regulation. Largely unregulated sectors such as retail have evolved rapidly providing customers with the Amazon service they desire replacing the Woolworths service they do not.

You've got to understand a problem before you can try and solve it

We've yet another dodgy report from yet another dodgy think tank being written up today. You know it's dodgy when the writye ups, to create the narrative, arrive before the full paper can be checked to see what they're really saying. But here's part of the report:

While most people will live to state pension age and beyond, a large proportion are unlikely to get there in good health, especially in more disadvantaged parts of the UK – places like inner city Glasgow, where the healthy life expectancy is just 46.7 years – close to 20 years lower than the national average of 65.

No, that's not really true.

The difference in disability-free life expectancy between women born in the most and least deprived areas was 11.6 years in 2001-04. By 2007-10 it had increased to 13.4.

And that's absolutely not true. The problem, here is that no one is understanding what these numbers are, how they're collected, and they are thus using them in highly inappropriate manners.

Lifespan, healthy lifespan, these are not the numbers from people born in certain locations. Nor of people in certain income bands, social classes or anything else. They are collated from the places and ages at which people die. It's vital to understand this difference.

As an example, consider two people who live at some point in their lives in those inner-city areas of Glasgow. One is born there, joins the Army, retires to Eastbourne and dies at 90. The other is born in Eastbourne, drifts along, gets tied into drug addiction and dies at 40 in some squat in Glasgow with a needle in his arm.

That first person, given that we count these things as where people die, leads to the average age at death in Eastbourne rising: that second, for the same reason, lowers that average age at death in Glasgow. But clearly and obviously neither of them have anythiing at all to do with the average age of death in their birth places. And yes, people do indeed move around: and one of the greatest prompters of people moving is a change in their economic circumstances. So, therefore, a goodly part of what we're seeing here when poor areas have lower lifespans than rich ones is not that living in a poor area kills you but that people self-select into poor or rich areas based upon their wealth.

Another way of approaching the same point is to consider the mistake that Michael Marmot has been making for decades. There is most certainly a link between economic inequality and health inequality. Living in a disease ridden slum will indeed make you more susceptible to said diseases. However, there's also an obvious link between health inequality and economic inequality. One acquaintance was hit with a series of severe illnesses in his mid-40s. Sufficiently bad that he entirely dropped out of the workforce for four years. All terrible of course: but his subsequent economic inequality was a result of his initial health inequality, not the other way around.

If we start to assume that this lifespan inequality is a direct and sole result of economic inequality then we're going to get any plans to solve it all entirely wrong. It's vital that we also accept that health inequality happens, as does movement of the population, and that both of these will lead to the economic inequality that we see.

Why this insistence that things that need to be collectively done must be centrally done?

I find this an intensely irritating argument:

Government reaction to the floods in Somerset brings into sharp focus a central conundrum for any rightwing, neoliberal administration. It is the battle of populism versus ideology. An emergency on this scale requires them to behave, quite simply, like socialists. It requires a well co-ordinated, firm, top-down response, and the spending of tax revenue to alleviate misery, on the strict basis of need rather than worthiness.

The irritation comes from the British Left's standard response to anything, which is that whatever it is must be organised centrally.

I think we're all prepared to agree that managing the drainage boards of an area that is below the high tide line is something that is going to have to be done communally. But why on earth must it be done centrally? Under the control of a man whose only formative working experience was as a housing charity worker? What special skills does he bring to the questions of how or not parts of Somerset should be drained? Or, if we're honest, the 11,000 or so people who work for this centralised organisation?

For there is indeed another method of communal action. Local and voluntary action, even local and forced action. Just thinking off the top of my head the people who live in the areas likely to flood might band together (and use the law to make sure there's no free riders) and create, ooooh, I dunno, drainage boards or summat. They all pay in a bit each year, call them just to be ambitious drainage rates, and then those boards can hire a few people to dredge the rivers, man the pumping stations and all that. We might also expect the locals to clear the ditches on their own land, those boards being responsible only for the larger efforts necessary.

And now to the big reveal: this was of course the way that the Somerset Levels were managed for centuries since their first draining and it's only since the service was centralised under the Environment Agency that it's been a complete cock up.

As I say I find this an intensely irritating argument that the British Left keep coming back to again and again. That anything that must be done collectively must also be done centrally, in a "top-down manner". When in fact a very large number of things that do indeed need to be done collectively are better done on a local basis, more bottom up than top down.

You know, by people who might actually know what they're doing? With the added attraction that since they actually live in hte affected areas they might also care about what gets done?

The positive money idea refuses to die

This idea is being given another run around in The G today.

But the 1844 law was never updated to apply to electronic money and still only applies to paper notes. Metal coins and paper notes now make up just 3% of all the money in the UK. The remaining 97% of money consists of essentially numbers in high street banks' computer systems. Banks create this electronic money through a simple accounting process whenever someone takes out a loan.

Yup, same ol' same ol'.

If the Bank of England created all that electronic money instead of the private banking system creating it then we'd be in the clover. And as ever, the idea just doesn't work. Consider just this one point:

Government finances would receive a boost, as the Treasury would earn the profit on creating electronic money, instead of only on the creation of bank notes. The profit on the creation of bank notes has raised £16.7bn for the Treasury over the past decade. But by allowing banks to create electronic money, it has lost hundreds of billions of potential revenue – and taxpayers have ended up making up the difference.

OK, that number for seigniorage is roughly correct on the physical money. But what's wrong with the number for electronic money? Hundreds of billions? Well, the contention is that this value has been created by those private banks: that's how, if the BoE creates it instead then the BoE gets that hundreds of billions in revenue. Excellent: so, if the private banks have been creating all this money then those private banks must have been making those hundreds of billions. Or someone, somewhere, has been.

And the thing is, there just isn't anyone out there who has that hundreds of billions. There just ain't. Therefore, somehow, the creation of that credit (to give it its proper name, not money) doesn't carry a seigniorage profit of hundreds of billions. And thus the BoE cannot appropriate that non-existent seigniorage by doing the credit creation directly.

I agree entirely that it is indeed the banking system (but not an individual bank) that creates credit. But there isn't some hundreds of billions of profit to be made out of doing so: for no one is in fact making that hundreds of billions. Thus it's not possible to the Bank of England to appropriate that hundreds of billions.

It's interesting to note that this idea is backed by Andrew Simms of Not Economics Frankly fame. Sigh.

Interest rates are set in the market place

The London housing market is booming. According to Nationwide, prices rose 14.9% over 2013. According to Halifax, they climbed 9.4%. According to the Land Registry they were up 11.2%. The Office for National Statistics hasn't quite got data for the whole year yet, but their numbers show prices up 11.6% in London in the 12 months to November 2013. No doubt Rightmove, LSL, Hometrack and all of the many other indices echo this finding. While we at the ASI have pointed out how the government has jacked up demand with the Help to Buy scheme (some have quipped it might more accurately be termed "Help to Sell") the Bank of England and Treasury have dialled down the housing element of the Funding for Lending Scheme in response to worries about a bubble and unaffordability.

But however much these schemes are artificially adding to demand, it is certainly clear that London houses—a desirable place for natives and people across the world to live—face a huge demand and are in limited supply. Since this is clear, I have been loath to call the situation a "bubble"—a bubble seems bound to pop, but tight supply and ample demand suggests a situation where prices will remain high (see an excellent post from my colleague Sam for more detail). However, it was recently pointed out to me that since a high fraction of UK mortgages track the Bank of England's base rate, a jump in rates, something we'd expect as soon as UK economic growth is back on track, could make mortgages much less affordable, clamping down on the demand for housing.

This didn't chime with my instincts—it would be extremely costly for lenders to vary mortgage rates with Bank Rate so exactly while giving few benefits to consumers—so I set out to check the Bank of England's data to see if it was in fact the case. What I found was illuminating: despite the prevalence of tracker mortgages the spread between the average rate on both new and existing mortgage loans and Bank Rate varies drastically. For example, it was almost one percentage point in January 2004, fell to 0.5pp by July, rose to around 0.6pp where it stayed until July 2006 when it crashed to nearly zero in a year, before rising to 1pp in October 2008 and then almost 3.5pp in April 2009. Since then it has steadily trended down to around 2.5pp. There are lots of interesting and obvious stories to tell here, hearkening back to my piece about the confusion between interest rates as a stance of monetary policy and interest rates as the actual cost of borrowing firms and consumers face, but what is clear is that tracker mortgages be damned, interest rates are set in the marketplace.

What this means is that the fact the Bank's base rate will almost certainly be hiked in the next couple of years if economic growth continues at its current healthy pace is not a reason to worry that London's housing bubble will pop. Indeed, the only way London house prices are likely to drop from their current stratospheric levels is if we get a good honest bit of planning deregulation. Moving the green belt out just one mile would allow us to build one million houses, after all. And it could add percentage points of pure supply-side driven growth to GDP and living standards.

So here's another lefty myth taking a pummelling

I thought that this was an interesting little snippet of news:

World food prices fell in January to a 19-month low, as costs for everything from sugar to grains slid amid ample global supplies, the United Nations’ Food & Agriculture Organization said. An index of 55 food items dropped to 203.4 points last month from 206.2 in December, the Rome-based FAO wrote in an online report today. The index is down 4.5 percent from a year earlier and is at the lowest level since June 2012.

This is excellent news of course for it means that we're all richer. However, it does rather beat up one of the myths that those on the left have been promulgating over recent years. Here's the absurd grotesques over at the World Development Movement on the subject:

Banks are earning huge profits from betting on food prices in unregulated financial markets. This creates instability and pushes up global food prices, leaving millions going hungry and facing deeper poverty. In January 2014, after four years of our campaign, the EU agreed to introduce new rules to prevent hedge funds and investment banks from driving up food prices.

Do note that those new rules aren't actually in effect yet, let alone resonsible for the falls in food prices.

The WDM's basic claim was that the more speculation there is in futures markets then the higher prices will go. As anyone with any knowledge at all of markets has pointed out, futures markets can only affect spot prices if stocks are rising. When food prices were indeed rising we did see an increase in futures speculation, indeed we did. However, we did not see an increase in stocks: therefore it cannot have been the futures pricing that was driving the spot prices.

We've also not seen a fall in the amount of money being used to speculate in food prices: nor a reduction in the number of trades. But we are indeed seeing food prices fall.

At the end of which there's really nothing left of the case that financial speculation in futures markets increases spot food prices, is there?

No doubt they'll think up some other phantastical claim soon enough though.