Monday 12 July 2010

Here come higher interest rates - and inflation?

An article in yesterday's New York Times - hat tip to Michael Panzner - points out that some $5 trillion in short-term borrowing by banks has to be renewed within the next couple of years. American banks have to refinance $1.3 trillion, but Europe's $2.6 trillion - twice as much in cash terms, and still nearly double the USA's burden in terms of the relative size of their economies (GDP).

Competition among borrowers will strengthen the hand of lenders, so expect interest rates to rise.

In turn, this will hit the trading value of existing bonds (because their income is fixed and so will become less attractive). It will put further downward pressure on house prices as mortgages become more costly and harder to get. And investment banks will be less keen to borrow cash to speculate on the market, so quite possibly shares will fall as debt-fuelled gambling reduces; besides, businesses will find it harder to make a profit if they pay more for their borrowing at the same time as their customers have less money to spend, and the rate of profit obviously impacts on share prices.

From what I read, much of Britain's public debt is in the form of bonds with longer maturity dates, so that part of the government's debt servicing won't be hit so soon as in the USA, where more comes due earlier. But the UK is projected to increase public borrowing for some years yet, so any increase will be funded at a higher cost. And, as I've said before, private debt in Britain is greater than public debt, so the economy is likely to slow as credit cards, variable rate mortgages etc become more expensive and Joe Public trims his personal spending - there is already clear evidence of this in the USA. Expect businesses that rely on discretionary expenditure to be hit particularly hard (except, perhaps, those that service the richer end of the population - inequality has grown in Britain and the USA).

Lower profits mean less tax revenue and more unemployment. Some fear that our governments will be in such a squeeze that they will crack and begin creating money to buy their own debts - bailing themselves out as they did the banks. Inflation is a threat to savers, who for the last 10 years would generally have been better off in cash than in the stockmarket. We could be approaching a turning point. (Contrariwise, Steve Keen thinks inflating our way out can't be done, nor will debt be defaulted or written off - he is predicting another Great Depression - see his last paragraph.)

There's more than one type of inflation. We tend to think of it as higher prices, and certainly there's been some of that, as evidenced by the cost of petrol, food, energy; but the effects aren't universal - my first car cost £6,000 in 1989 and its equivalent today costs the same. We could see price inflation hitting the poor worse than the rich.

Monetarists see inflation differently: they define it as an increase in the amount of money and credit in the economy. If the money supply grows faster than the economy, then in general (in theory) we'd expect an increase in wages and prices. However, since global trade sets the workers of the world against one another, median wages in the UK and the USA have not progressed much for decades. The improvement in standards of living has come from cheap imports, increasingly financed by personal debt.

If the monetary base in one country increases, then normally you'd expect the currency to devalue against that of stronger, foreign economies. But the situation has now become very complicated: many economies are in a similar crisis, so their currencies are falling together against commodities (like gold) whose supply cannot easily be expanded. Other economies (e.g. China) have become dependent on trade with the spendthrift countries, and therefore have a strong incentive to keep down the relative value of their currency, so as not to price themselves out of the market.

Can the show continue forever?

Traditional economists assume that the economy is self-righting, and that debt doesn't matter much because it ripples throughout the system and raises both wages and prices; and currency exchanges will adjust international trade so that it comes back into balance, eventually. Their harmonious conception is now challenged, just as the mediaeval concept of an orderly universe was challenged and replaced with a vision of colliding worlds.

Leading this modern Copernican-style revolution is maverick Australian economist Steve Keen, who models finance in a way that shows the system tends to increasing instability and breakdown.

Yet the economy is not a fixed machine - not even a self-destructive one. Its workings can be changed, for example by the action of governments. As the philosopher Henri Bergson said:

It is of the essence of reasoning to shut us up in the circle of the given. But action breaks the circle.

The economist can suggest what will happen if, if, if. The politician trying to avert disaster and get re-elected will then try something to avoid the consequences of his and our actions. The economy is dynamic, changing and with many intelligent and competing players. It's more like poker than Meccano; perhaps more like war than poker.

UPDATE (13 July): John Mauldin agrees with Keen that deflation seems unavoidable, and predicts that government bonds will increase in value because they are safe. But as I've suggested here, that's the first part of the game; the question is, whether governments will indeed find a way to reflate out of the hole - effectively part-paying-off debt by stealing value from savers. As John Hussman says (my emphasis):

From an inflation standpoint, is important to recognize the distinction between what occurs during a credit crisis and what occurs afterward. Credit strains typically create a nearly frantic demand for government liabilities that are considered default-free (even if they are subject to inflation risk). This raises the marginal utility of government liabilities relative to the marginal utility of goods and services. That's an economist's way of saying that interest rates drop and deflation pressures take hold. Commodity price declines are also common, which is a word of caution to investors accumulating gold here, who may experience a roller-coaster shortly. Over the short-term, very large quantities of money and government debt can be created with seemingly no ill effects. It's typically several years after the crisis that those liabilities lose value, ultimately at a very rapid pace.

For commodity speculators, the second highlighted point is a challenge: wait for the bottom and then ride to the top, or get in now because you may not be able to make the purchases during a really rapid rise (especially if you don't trust "paper gold" and only want the real, tangible stuff)?

So much of what I read among the experts is about timing the market in the short term, which is OK if that's your day job; I don't put myself up against these "gunslingers", as George Goodman (aka "Adam Smith") terms them.

Counter-argument: Charles Hugh Smith says that the rich and powerful simply won't let inflation destroy wealth, since they have most of it.

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