Jul 05 2007
Interest rates - the Fed and the Bank of England weigh the risks of boom and bust
The last decade has been good for the world economy, thanks to very low interest rates and easy money on both sides of the Atlantic, and interest rates of around zero in Japan. Even in badly run Britain, where interest rates have been higher than in Japan, the EU or the USA thanks to the public spending excesses leading to so much waste and inefficiency in the growing public sector, rates have been relatively low reflecting the international environment.
As a result there has been a massive expansion of debt. Many companies and individuals have borrowed in yen, paying practically no interest on the borrowings, to buy dollar investments. Clever financiers have developed ever more elaborate debt instruments and packages, mainly in dollars but also in sterling and euros, to sell to these footloose investors using other people’s money to buy their bonds. Investment products have used borrowing to buy more packages of loans to increase the return to the savers.
One of these pyramid structures for borrowing, the so-called sub prime mortgage market in the USA, has fallen badly following increases in interest rates by the Fed. At a certain level of interest rates, the poorer mortgage borrowers with low or irregular income can??no longer keep up the payments. They default on their mortgages. This means the financiers and investors who have bought up packages of these mortgages, and have borrowed more money against the mortgages they hold, have to tell their bank managers the assets (the mortgages) they bought are no longer worth what they paid for them. As this becomes apparent, some have to sell the mortgages on at greatly reduced prices to pay the interest and repayments on their own borrowings. The collapse begins, and can get vicious. If interest rates are hiked again the squeeze will intensify, as more of the original mortgagees will be unable to pay the interest, and more of the investors in the mortgages will be unable to pay the interest on the money they borrowed to buy up ??the mortgages.
So far the general view is that the sub prime mortgage market will continue to be in distress, but these problems will not spread. However, a similar pyramid of debt has been built up around company borrowing around the world. If the Fed, the ECB and the Bank of England keep raising interest rates there could come a tipping point where there was a sharp fall in corporate debt markets just like the sub prime collapse. As interest rates rise so people’s incomes are squeezed. They then spend less, which cuts revenues and cashflow to a whole range??of companies that rely on consumers. As companies find it more difficult to pay their interest on highly borrowed balance sheets, so those investors who have bought the company debt have problems with their bankers.
Today company debt is still expensive in the marketplace. There is little allowance by investors for the risks of higher interest rates and the problems that will bring. There are three possible outcomes to all this:
1. The Central banks back off - no more interest rate rises. The world economy can then probably muddle through, with?? no big increase in debt collapse beyond the sub prime mortgage market.Pyramid debt structures will stay in place.
2. The Central banks literally go for broke and hike rates substantially. They will trigger a major decline in corporate debt as well as sub prime lending. Inflation will be well and truly broken, but so will much else. The worst case would be they do to the USA and the Uk what the Japanese authorities did to Japan in 1990, leading to a decade of recession or little growth.Highly borrowed investment funds will be in serious trouble.
3. The Central Banks tighten a little more, and then switch to interest rate cuts when they see trouble emerging in company debt markets. This is the most likely course they will follow, and will require great judgement or good luck to get it right. If they go too high or leave the switch to lower rates too late they will bring down more of the debt structures just as they have the sub primes.
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John Redwood has been the Member of Parliament for Wokingham since 1987. First attending Kent College, Canterbury, he graduated from Magdalen College...
Looks like rate rises have kicked in at work, they’ve just revised the bonus scheme (which basically amounts to a pay cut). Not all bad news though, to sweeten the deal and not lose a load of staff they’ve dropped all their silly battery hen ‘targets’. Too damn right! I aint no multi-tasker, when their accountants sort out some decent software for me I might spend less time in ‘call work’. If higher interest rates mean I’m not expected to use 5 different outdated and overworked software packages at once whilst trying to have a conversation with someone then roll on higher interest rates!
Seriously though, aren’t interest rates supposed to be set in order to control inflation, not commercial debt markets, unemployment etc? I thought inflation was supposed to be the biggest threat to our economy? That’s what city-types used to tell me when I lived in London. Just because they’ve borrowed too much cheap money, bought too many credit derivatives with it and might get a bad bonus next year surely doesn’t mean the Bank of England should ignore inflationary pressures. I see oil prices are headed up again.
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All savers? We’re globalised, people can get their saving in any currency, even fine wine, art etc. As for negative equity, I told all my homeowning mates when oil hit $78/barrel last summer that they would see 5.5 - 6% interest rates this year and they dismissed me as jealous. Now a couple of them are panicking about selling and have convieniently forgotten I warned them. My family home is owned outright. If the B of E don’t control inflation then this also puts my job at risk, as my employer might decide to scale back UK operations and concentrate on French/German markets instead.
If people prefer to read the Sun and watch Big Brother than read the financial news and look things up, talk to people who know what they’re on about and think for themselves is that my problem? I want inflation under control more than anything. As for the property/finance bubble, bubble’s burst. Would you rather we build up the debt pyramids even more, and that property keeps inflating at 15-20% per year? Will interest rates allow this even? Surely the longer we continue this borrow and spend nonsense the more risk there is of doing a ‘Japan’. I think they’ll peak at 6-6.25 then fall maybe 0.5 then further inflationary pressures will kick in from the world economy (probably the dollar rising and oil prices creeping higher) and by 2010 we’ll have hot more like 7.5/8%.
Reply: I did not express my view on what the authorities should do. I set out three possible scenarios. If they opt to deflate all the debt structures
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Sounds like doom and gloom either way. I might learn to speak Spanish, there’s more to life than money anyway. But thanks for the replies.
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