Wednesday, 9 April 2008

Tomorrow and Tomorrow and Tomorrow..

How brave will the Bank be?

The Bank of England is facing that tough decision time again. How much to cut the Interest rates.
5.25% now, and judging by the caution shown over the last 6 months another 1/4 % seems likely.

But it is enough? Should Mr Brown use his 'influence' over Mr King at the BOE to cut the rate further.

Inflation, the big worry, is being held by the absence of credit and higher mortgage payments anyway isn't it?

The Times and The Telegraph are not convinced any cut is on the cards at all. Most other papers are going for an Evens bet on a cut.

Politically a full 0.5% would boost a Prime minister who really needs to look more decisive and in command, and heal some of the latest backbench anger at the 10p rise hitting low income earners.But is it wise?

Place your bets now


Anonymous said...

They might as well cut it to 0%. It's heading there anyway and it will make the bank cronies more money, faster.

James Higham said...

Yes, as Matt said - the gutless way.

Old BE said...

If my own finances are anything to go by, I am in full-scale retreat and anything frivolous is off the menu. The Bank should cut rates by 0.5 points and signal that it is prepared to do so again soon if things don't turn round.

The credit/housing crash will soon start impacting on employment and then the circle will become vicious.

Inflation is better than depression...

Unknown said...

No cut at all would be most sensible - you only have to look at the Interbank Rate to see that lowering the Base Rate won't make any difference to the rate on the street, but will impact badly on the price of sterling and hence inflation.

But will the Governor & Bank of England hold firm against an increasingly desperate Chancellor?

Old BE said...

WG - this is what perplexes me. I thought that Bank's job was to pump (or not pump) enough cash around to keep rates at the level that they set every month. Surely if market rates are above the official rate the Bank needs to be pumping more cash around. If market rates were closer to official rates we probably wouldn't be having this drought that is now affecting mortgage holders. Mortgage rates have detached from the base rate quite spectacularly. Surely the Bank needs to be addressing this by lending the banks more cash?

Anonymous said...

No Cut: 0.2
0.5% Cut: 0.3
0.25% Cut: 0.5 penny's worth.

Mark Wadsworth said...

Cut! Cut! £ will fall, my FX account will rise (relative), inflation will rise, house prices will crash even further, and I can buy back even more cheaply than otherwise (having sold to rent recently).

And it will have bugger all impact on mortgage rates or house prices - see USA, where prices are trundling down at 10% a year for nearly two years.

Old BE said...

I see they went for the vanilla option of a cautious quarter point. Let's hope this is part of a cutting trend.

MW - how does a cut increase the chance of a house-price crash?

Anonymous said...

Blue Eyes- The vanilla option indeed.
Probably correct for now, but I feel it will cause some pain later when they look back at options that should have been taken earlier.

wildgoose - Blue Eyes -The question is how does a government force a market to lower their rates if they don't wish to. Lend them long term loans against their known/unknown sub-prime assets or is there some legislation in the offing?
Or could we all have a Bank of England loan and mortgage?

Unknown said...

The Credit Crunch is what happens when the expansionary effects of fractional reserve lending goes into reverse.

If £5 of assets can support £100 of loans, then £4 of assets can only support £80 of loans.

If the £5 of assets turn out to be worth less than £5 then they have to rein in the amount of credit they are making available.

And as people take fright at the economic outlook they stop spending and start paying off debts.

The first part depresses the economy further, possibly causing additional loan defaults which hit the banks asset base.

And when people pay off debt they take money from a deposit account and pay off money in a loan account. The numbers cancel out, but the banks have lost both the money on deposit and also the valuable interest-earning loan (which has probably been securitised) - another restriction to their asset base (and to what they can lend).

In other words, a nasty deflationary spiral.

And yes I know this is a simplistic description of what is happening, but I'm not convinced that the majority of our MPs even understand what is happening at this simplistic level.

Anyway, given that this is what is happening and why, lowering rates will have little or no effect on the retail market. It only serves to remove later maneuverability and weaken Sterling thereby importing inflation and weakening the real (after inflation) interest rate even further.

Raising rates of course would just add to the economic pain, probably causing more defaults. And the howls of ignorant protest this would cause makes it politically even less of an option.

So my preference would be to keep rates on hold and try and weather the storm.

Caveat: I am not an economist, I just claim a modicum of what we Yorkshire folk call "nous".

Anonymous said...

The french call it we. Which ironicly enough is what a large proportion of them smell of.

Anonymous said...

I’ve been thinking about this for a while: say Bank A has £1m of deposits and loans out £20m based on that. What happens if someone doesn’t pay back their loan? If there is a default rate of 5% and loss given default is 100% do they lose all the money they have deposited (less interest)?

How do they create the extra £19m to loan out? Is it just loans from other banks? Surely it can’t be. Are they just allowed to create it?

Old BE said...

Thanks WG but I'm still a bit unsure as to how it works. Surely a bank can't lend more money out than it has cash in its vault (even if that cash is itself borrowed) or am I missing something. You will be glad to hear that I will never be an MP - too ignorant!

Schadenfreude said...

wildgoose: whilst your analysis is fundamentally correct, it is actually slightly worse than this. The banks are constrained by Basel I rules not to create more than £12 of debt "funny money" for every £1 they have on deposit. The banks got around this by shifting the debt off-balance sheet into something called credit derivatives which they sold on to people that weren't banks. As a result the banks bent the Basel I rules and in the case of Citicorp it now has £42 of debt for every £1 on deposit.

Now there is no market for credit derivatives any more so the banks can't create any more debt and stay within the Basel I rules. In fact they are having to take some old debt back onto their books, and this means they have to get people to pay back some of the debt early. The banks borrow short, multiply what they borrowed 42 times then lend long. Problem is that when investors want their money back the banks have to call in some of their long term credit. They are doing this in the US by repeating what they did in the Great Depression - they are forcing good debtors out of their homes whilst there is still some equity in their properties!

Imagine if you woke up in the morning to see a For Sale sign in your garden. And then HSBC phones up and says "sorry about that but we need the money". Not nice.

Thing is the debt goes around in circles. Imagine a local house builder builds a house. He needs an advance from the bank to pay for materials etc. So he has that advance and he has to pay interest. And this is all bank "funny money" created from thin air. But he can pay this debt off when he sells the house. And the homebuyer will pay off all that debt from the house builder with a mortgage, which is yet more funny money created from thin air. And the home builder needs a mortgage too - which is yet more funny money. And the whole lot is just going round in circles. You can't tell the difference from funny money and real money - it looks the same and works the same. But eventually there is so much debt in the system that it just can't go round in ever increasing circles anymore. Once the merry go round of debt stops the debt acts like a black hole sucking up all the real wealth to the benefit of those that ultimately hold the collateral. And usually those that hold all the collateral are the super-rich, since they are the only ones that were in a position to advance the real money in the first place, upon which all the funny money was built. So after a lifetime of work we end up with nothing because the super rich have got it all. Just as it has been throughout history. Happens every 100years or so, so nobody remembers well enough to see it coming.

The debt spiral is coming unravelled now. You can tell because the economy just can't handle high interest rates without grinding to a halt. Anything over 5% is really hurting. The sheer magnitude of the total debt in the system means the interest cannot easily be paid out of total GDP. Same happened in Japan - haven't been able to handle interest rates over 1% there.

Teach you children and your grandhildren and your great grandchildren to avoid debt, even mortgage debt, like it had bubonic plague.

Schadenfreude said...

@blue eyes/anaonetta: sackers could give you a thorough explanation on his bearwatch blog, but yes, banks of all kinds are allowed to create DEBT out of thin air. It isn't money as such, it is debt. However, the debt created can be traded the same way as money between banks so it looks to you and I just like money.

Imagine you get paid by your employer. You get a bank statement showing how much you are paid. THIS DOES NOT MEAN THERE IS X AMOUNT OF CASH IN A VAULT SOMEWHERE WITH YOUR NAME ON IT! It only means that the bank will pay out some cash equivalent to the amount on your statement, if you ask it nicely. However, it will only do this if it has enough cash available to do so, and if everyone took their deposits out at the same time IT WOULDN'T BE ABLE TO! Consequently the banks try very hard to stop you taking large amounts of cash out - you need all sorts of ID to do it (but almost no ID at all to take out DEBT on a credit card over the phone!).

So your bank statement isn't telling you what you have in the vault. It is an IOU for your cash that the bank has ALREADY SPENT ON ITS OWN PROJECTS!!!!

So what does the bank spend this cash on? Well the bank is allowed to create debt from thin air that looks a lot like cash. This is called fractional reserve banking. It is money from thin air. How it does this in actuality is complicated (there are detailed descriptions on the web) but essentially it all boils down to the fact that the banks are allowed to create a lot of money relative to what they are holding on deposit. In theory it is limited by banking regulations (known as Basel I) to 12.5x what they have on deposit. In practice the banks can get around Basel I rules by putting the debt into a package called a credit derivative and selling it on to someone that isn't a bank and therefore doesn't have to comply to Basel I rules. This means banks can create as much debt as they want, as long as they can shift the debt off their books.

This debt then circulates in the system rather like money. But if everyone with a debt advance took out cash, and everyone with a deposit took out cash the bank wouldn't have enough cash to go around.

Back in the old days the banks used to do this with gold. People would give the banks their gold and the bank would give them back a convenient, lightweight, tradeable IOU - a bank note. In theory the bank notes = the gold on deposit. But the banks sold a lot of the gold put on deposit and issued more IOUs than they had gold! Everything went well as long as no-one asked for the actual heavy and inconvenient gold! As long as the economy was doing OK they didn't actually want to carry all that gold around. But when the economy goes bust (actually due to all the dodgy IOUs created masquerading as real wealth created) everyone wants the actual physical gold. Problem is the bank knew it didn't have enough gold for everybody so it locked its doors. People then shot their way in to get the gold only to realise it wasn't there. Then they shot the bank manager....

Obviously if you create more and more debt and circulate it as cash, but the real wealth (food, housing etc) is the same then you are just asking for trouble. Thing is these things unravel very slowly so nobody realises until its too late. Nobody ever really takes control. Thanks to the internet maybe we will learn NEXT TIME! Assuming civilisation survives THIS TIME! (Last time it happened, it led to WWII...)

Anonymous said...

So if the bank doesn't sell on my debt, does it lose anything if I default?

Schadenfreude said...


That's a bit more difficult to explain, but lets say you've bought a house. You take out a mortgage (i.e. funny money debt) to pay for it. The house builder gets paid with funny money but thinks its real. The bank lets him pretend its real. As long as you eventually replace the funny money with real money everything will be OK (sort of). If you default then the bank has paid funny money to the housebuilder but in principle this can be swapped with real money by the housebuilder at any time. The bank can shrug this off for just one defaulter, but if there are many people defaulting on loans then the bank is in trouble. So is the housebuilder, in principle, unless his "deposit" in funny money is covered by the government guarantee.

So the bank will come after you if you default.

Anonymous said...

A 0.25% drop was the right choice as inflation is still looking high, but it should come down once input prices fall (which apparently they will!).

Mark Wadsworth said...

Blue eyes - to answer your question, a weaker £ will lead to inflation (agreed?). In the short term, higher inflation means people have less money to spend on housing (so prices fall!) and also means that mortgage interest rates are higher (so prices fall!).

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