Wednesday, 23 April 2008

Credit cycle

George Osborne made a speech at Harvard about changing the way we control the economy.  For the last decade or two, the UK and US have tried to control the boom-bust cycle by using one lever (interest rates) to try to control one variable (retail inflation).  When retail inflation goes up, the governments raise interest rates to bring it back down again.  But, Osborne says, there has been a second, hitherto ignored cycle: house prices ("asset inflation") and credit.  House prices and consumer debt has risen while inflation has remained low, and now the credit crunch is in a sense a credit-led-bust rather than an inflation-led-bust.  Osborne suggests trying to control this new credit cycle by controlling how much money banks are allowed to lend as a ratio of their assets.
Osborne seems to have missed a more general point: the credit cycle is partly an artificial problem.  It is precisely because the government (actually the Monetary Policy Committee) frequently changes interest rates that we get credit booms and busts.  The mortgages that are in trouble in the UK got into trouble because of six consecutive interest rate rises.  And the rush for credit was caused by so many interest rate reductions in the years beforehand.  If interest rates were generally constant, it would take a lot of the speculation out of the property market, and house prices would have a chance to settle at a level and growth rate that is determined much more by supply and demand.  Constant interest rates would remove the "fear of missing the boat" that when interest rates are lowered and house prices skyrocket, a house that is nearly affordable today will be far too expensive tomorrow.  And they'd remove the terror of negative equity from house price crashes when rates rise.  It is those sentiments that drive the booms and crashes in the property market.
It also strikes me that for controlling retail demand (in order to control retail inflation), interest rates are a very inefficient and inequitable lever to pull.  They disproportionately affect the people with the biggest mortgage-to-salary ratios (ie, first time buyers), and have fairly little effect on almost everybody else.  Renters don't see rent rises until six months to a year later, and those who have had mortgages for a long time have a much bigger cushion because inflation and career growth have raised their salaries compared to their repayments.
Surely rather than having a massive effect on just a few people, the lever to pull to control retail demand would be one that effects every consumer, not just homeowners with large mortgages?  Perhaps sales tax (VAT) or by varying part of income tax (which could be reflected in the PAYE system very quickly allowing short-term changes)?
Just a thought

1 comment:

Matt B said...

Hi Bill, I'm a long ago work mate, first time poster... ;)

The usual slasdotty displaimer - IANAE (I am not an economist).

Raising & lowering the interest rate apart from inflation control, is also about stimulating/slowing the growth of the economy (although slowing the economy I suspect is all about inflation control). So while having a low inflation rate is good, presumably it can also mean the economy can more easily fall back into recession (jobs being lost etc). Kinda like being skinny/fit is good - but actually having a bit of fat around the midsection can also help if say, God forbid, you end up in hospital due to some mishap.

But I do take your point about rapid rate increases impacting home owners...

So I'd suggest - because keeping the interest rate near a steady level at this stage appears to be an impossible ask - how about the separation of business/investment interest rates from personal/primary home loan interest rates.
Keep the home loan interest rate (for primary residence) relatively steady, while allowing business, investment etc loan rates to vary more greatly.

I haven't crunched any numbers, so this idea is banking on (pun intended) the primary residence mortgages being dwarfed in size by business & investment loans, allowing the interest rate changes to continue to stimulate/cool down the economy as necessary - without the usual home owner heartbreak.