The Interest Rate Fallacy

08/12/2012 6 Comments

I wrote recently of The Debt Fallacy – the widely held belief that the financial crisis was caused by government debt. If you read it you’ll recall that it’s fairly easy to prove this as a fallacy because figures for government debt are easily available. Nevertheless it’s a myth that is widely believed because the government puts a lot of effort into propagating it in the knowledge that most people won’t actually check.

Another fallacy that the government often uses hand in hand with this is one regarding interest rates. It goes something like this:

Interest rates on UK debt are low because the markets have built confidence in the UK’s economy because of the austerity measures. If the government were to increase public spending, the markets would lose this confidence resulting in the UK losing its AAA credit rating and interest rates on our debt soaring.

This, ladies and gentlemen, is the Interest Rate Fallacy – the widely held belief that interest rates are low because of the market’s confidence in our economy. To show why this is a fallacy is a little harder than it was with The Debt Fallacy because I can’t just download a graph from the IMF website. So before reading on you might want to get a cup of tea and an exciting type of biscuit, such as a Jammy Dodger.

All settled? Then let’s get started. Before we tackle the fallacy we need to look briefly at what government debt is and why people buy it at all.

How does the government borrow money?

The government borrows money by issuing bonds. A bond is essentially an IOU, which anyone can buy. It will say something like, “I will borrow £100 from you for 10 years and at the end of the 10 years I’ll pay you back your £100. As compensation for you not having access to your cash for 10 years, I will additionally pay you interest at an annual rate of 5% for those ten years.”

Why does someone lend money to the government?

Imagine that I have £100 in cash. I could keep the £100 as cash or use it to buy a bond. Cash is good because I can do useful things with it like buy stuff. However, I need to think about my future and if I want to save money for later rather than spend it now then I would be better off buying a bond because I get paid interest as compensation for me not having access to my money. If I want to spend now then cash is good. If I want to save now then bonds are good.

What determines the interest rate on my bond?

The interest rate on a bond is determined by the rate that savers are willing to accept in compensation for not having access to their cash for the period of the bond. So if I want to invest my £100 for 10 years what are the factors that will influence the rate I am prepared to accept?

Probability of default

If I tie up my money with someone for 10 years then it’s quite important to me that they don’t go bust during that time because if they do I will lose my money. If I am lending to someone risky I might decide to ask for a higher rate of interest in order to compensate me for the risk that they might not be able to repay me.

Demand for bonds vs Demand for cash

If I want to save money and everyone else wants to spend money then I can probably get a high rate on my investment. If there are few savers and lots of spenders in the market (i.e. the demand for bonds is low and the demand for cash is high) then the government will need to offer better rates to attract investors. Conversely if there are lots of people who want to save money and few who want to spend, the government can offer much lower rates knowing that there are still lots of people who will invest anyway.

Expected future short-term interest rates

That’s a mouth full isn’t it?

Short-term rates are set (in the UK) by the Bank of England. These rates determine the rate I can get for investing money for a short period of time.

If I am going to invest for a longer period of time, my expectation of what the Bank of England will do with short-term rates in the future is important. This is all sounding a bit wonkish so I’m going to explain with an example. Imagine the following scenario:

  • I live in a country where the government offers two different types of bond
  • One lasts for one year
  • The other lasts for 10 years
  • I have £100 that I would like to invest for ten years

I have a choice:

  • Invest my money once in the 10 year bond
  • Invest my money ten times (once every year) in one year bonds

If I choose the first option then my money is tied up for ten years at the pre-agreed rate of interest. If I choose the second option then every year when I invest my money again I get whatever the new short-term rate set by the government is. Supposing that short-term rates are 2% but I expect them to rise by 0.25% every year. My expectation of what the second option looks like is this:

Year Interest Rate Value of Savings
1 2.00% £102.00
2 2.25% £104.30
3 2.50% £106.90
4 2.75% £109.84
5 3.00% £113.14
6 3.25% £116.81
7 3.50% £120.90
8 3.75% £125.44
9 4.00% £130.45
10 4.25% £136.00

Therefore for me to decide that investing in a 10 year bond is worth it, I need a rate of at least 3.1225%, otherwise I expect to lose money on it.

Conversely, if I expect interest rates to go down then I will be happy with a lower rate for my 10 year investment.

Still with me? Good. Get yourself another Jammy Dodger – you’ve earned it.

Why are interest rates low now?

The government says that interest rates are low because the markets have lots of confidence in our economy because of their austerity policy. Lots of people lap this up as gospel but let’s stop for a moment and think about that. The government is borrowing at the lowest rates in the country’s history at the same time that the economy is in the longest depression in living memory. Would this really be the point in history that confidence in our economy hit an all time high?

Umm… no. So using what we’ve learnt, let’s look at some sensible explanations instead.

Expected future short-term interest rates

Short-term interest rates are very low at the moment. We know why – in reaction to the financial crisis, the Bank of England cut interest rates in an attempt to boost the economy.  (They cut them to 0.5% in March 2009 where they have remained ever since.)

Remember though, that long-term interest rates are determined by what the market expects short-term rates to be in the coming years. One explanation (this is the right one by the way so pay attention) for low long-term interest rates would be that the markets expect The Bank of England to keep short-term interest rates low for the foreseeable future.

Why would the markets expect The Bank of England to keep short-term rates low in the future? Well remember why short-term rates became low in the first place – an attempt to stimulate a weak economy. If the market expects the UK economy to remain depressed in the future they will expect The Bank of England to keep short-term rates low. If they expect a recovery is just around the corner they will expect short-term interest rates to rise and they will demand higher long-term rates in compensation.

Demand for bonds vs Demand for cash

Ok, I said the last one was the right answer but it’s important to consider this point too. The demand for bonds is huge at the moment. Why? Because when the financial crisis struck, people who had spent happily during the good years changed their behaviour dramatically and started saving. We are living in a world of people saving money rather than spending it. Again they are doing that because of a lack of confidence in the economy.

Probability of default

Enough of sensible explanations. Let’s look at a daft one. You’ll recall that people demand higher interest rates if they think that the person to whom they are lending might go bust before their bond matures. Therefore if the markets think that there is a good chance that the UK might go bust within the next 10 years they will demand higher rates for their 10 year bonds.

Let me be absolutely explicit here. There is absolutely no chance of the UK going bust in the next ten years. Despite the least economically competent government that anyone can remember, it is still impossible.

The UK is a large, developed economy whose debt is in a currency that they control. We print our own money – we can’t run out of it. Barring alien invasion, the UK will service its debt next year, the year after, the year after that etc. etc.

What about Greece?

A common comparison, used by George Osborne amongst others, is that Greece has a weak economy that is expected to remain weak but has high interest rates on government debt. They do but there is a difference between Greece and the UK and although George Osborne chooses to ignore it, it is a very big difference. When a country adopts the Euro they give up something very important – control over their currency. The countries that have seen their interest rates rise, Greece, Ireland, Italy, Spain, Portugal all have something in common – their debt is in a currency they can’t control.

But what about Argentina in 1999/2000?

Their debt was in US dollars so the same thing applies. They borrowed in a currency they could not control.

What about Iceland? They weren’t in the Euro and their government debt wasn’t that bad.

That’s true but Iceland’s three major banks had somehow been allowed to build up about €50bn of foreign debt between them. To put that into perspective, that was about 600% (!) of Icelandic GDP. Nice one Icelandic banking dudes.

What if the UK loses its AAA credit rating? Interest rates will soar!

The first thing to mention is that this argument assumes that austerity will prevent any downgrade of the UK’s credit rating. I’ll return to that point though because I want to tell you a few things about credit rating agencies first.

A credit rating agency is a private company that expresses an opinion about a borrower’s likelihood of repaying money they have borrowed from someone else. You will note that the UK currently has a AAA credit rating, which is the highest possible. (Not all agencies use AAA as a code to signify the safest borrower but the UK has the highest rating from all of the major ones.)

For example, the biggest credit ratings agency, Standard & Poors, gives the UK a AAA rating. To understand what that rating means, let’s benchmark it against something else to which Standard & Poors have given a AAA rating.

In the run up to the financial crisis, banks lent money to risky borrowers in the form of subprime mortgages. Those banks would then package up a few thousand of these dodgy mortgages together and sell them on to someone else. Guess what rating Standard & Poors gave to these packages of toxic debt? Yep, AAA!

Reread that last paragraph – the largest credit rating agency in the world gave their highest possible rating to packages of subprime mortgages. I am not a credit rating agency and you are not a credit rating agency but if you and I were forced to form an opinion on the creditworthiness of 2,000 subprime mortgages all mixed together we would probably not come to the conclusion that it was the safest investment possible. The credit ratings agencies did.

If you think I am cherry picking one (albeit hugely damning) example, I’ll give you another. On the 15th September 2008, Lehman Brothers went spectacularly bankrupt. All three of the major agencies rated Lehman Brothers as a low risk counterparty.

So the upshot of this all is that no one actually listens to these people. S&P downgraded the United States from AAA to AA+ last year. Did the markets all panic and think that the US was about to go bust? No. They ignored the discredited opinion of an organisation who thought that subprime mortgages were a good investment and went their about business as usual. Interest rates on US bonds actually went down.

But wouldn’t rates go up if we abandoned austerity?

The last refuge of the “Austerity=Low Interest Rates” cult is always, “Even if your ‘economics’ mumbo-jumbo is right about the reasons for low rates, if we actually took advantage of them and borrowed some more money, those rates would not stay low for long!” I’ll address that now.

Demand for bonds vs Demand for cash

As I’ve mentioned before we are currently in a liquidity trap. In normal times, cutting short-term interest rates stimulates spending. A liquidity trap occurs when we have already cut interest rates as far as they can go but people still want to save. At the moment, no one wants to spend money but The Bank of England have already cut rates to almost zero.

Being in a liquidity trap means that we would need a significant change in behaviour back from saving to spending before it made any difference at all to actual interest rates. The interest rate we would need to get people spending is negative but The Bank of England can’t set a negative rate* so we’re left with demand for bonds far outstripping demand for cash. Being in a liquidity trap isn’t good news but it does at least mean we can increase borrowing without changing the interest rate.

Probability of default

What would happen if the markets thought the UK was about to go bust and everyone tried to sell their bonds all at once? (Yes, I know the idea of the UK going bust is stupid but people use this argument a lot so I should address it.)  Unlike Greece, Ireland, Spain, etc we have a flexible exchange rate. If the markets suddenly decided to start offloading UK government debt interest rates would not actually rise. What would happen is that the pound would just devalue** and interest rates would stay the same.***

Summary

So as we’ve seen interest rates are low because everyone wants to save rather than spend and the markets expect short term interest rates to be low for the foreseeable future because they expect the economy to remain weak.

We’ve also seen that credit ratings agencies’ opinions are not worth listening to. Despite the government claims that austerity is the barrier against a downgrade, I fully expect the UK to be downgraded next year. And you know what? If that happens the markets won’t give a toss and long term interest rates will remain low.

If you have read this whole post down to here then well done – treat yourself to another Jammy Dodger. You know now what determines interest rates on government bonds and you know that it has the opposite to do with everyone being happy about our economy. The sad reason for low interest rates is simply that the markets expect our economy to remain bad for a long time yet.

And to be honest, who could really blame them?

RedEaredRabbit

* They could in theory make interest rates negative but then people would just hoard cash instead of investing it. (You’d get a better return by keeping cash under your mattress than lending it out.)

** Although a devaluation in the pound sounds bad it would actually boost the economy. When the pound is weak then foreign goods and services become more expensive. Also our goods and services become cheaper for foreign investors. This means more money being spent on UK goods and services, both by us and our friends overseas.

*** I brushed over the reason for this because it would have doubled the size of the already too big blogpost. If you’re interested in why this is the case read this.

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The Debt Fallacy

27/11/2012 27 Comments

Because this blog has a strong political theme, it might surprise you to learn that I don’t watch Question Time very often. Partly this is because I’m usually in bed by the time it comes on, but if it were called “Answer Time” and the politicians were forced to give proper answers to the questions I would probably be compelled to stay up late once per week and watch it. Instead it is generally an hour of politicians indulging in their favourite pastime of evading, misrepresenting and misleading and to be honest, I get enough of that already.

Still, I did watch some of it a few weeks ago and noticed that in pretty much every answer the Conservative or Lib Dem gave they managed to blame having to take lots of “difficult decisions”, such as cutting benefits for poor people and cutting taxes for rich people, on…

The mess we inherited from the Labour government

The government seems to believe that this is some kind of carte blanche to do whatever they want without any accountability; a Get Out of Jail Free card that they never have to give back. It isn’t though. It’s the political equivalent of saying, “OH MY GOD, WHAT’S THAT BEHIND YOU?” then running away when you turn around. That particular favourite phrase is not what I am going to spend time talking about because no one believes it anyway. Despite the government’s best efforts, no one is actually dumb enough to agree that they don’t need to be accountable for their policies.

They did come up with another favourite line, however, that narks me even more than this one because a lot of people do actually believe it. When someone mentioned government spending they said something like this:

It was the irresponsible spending of the last government that got us into this mess in the first place…

And the thing that annoyed me more than them wheeling out this spin-doctor nonsense for the thousandth time was that no one else on the panel directly challenged it. If I’d been on the panel, (I was on holiday so they had to go with Steve Coogan as the non-politician), I would have directly challenged it. I would have directly challenged it because it isn’t true. It is a lie and when politicians say it they are lying. This, ladies and gentlemen is The Debt Fallacy, the widely-held belief that UK government debt caused the financial crisis.

Before we delve into what actually did cause the “mess”, let’s see why this is a fallacy by looking at UK government debt between 1997 when Labour took office and 2007 when the financial crisis started. (Source IMF)

National Debt of G7 Countries as % of GDP

National Debt of G7 Countries as % of GDP

Yes, not only was borrowing significantly lower in every single year than everyone else in the G7, it was actually lower in 2007 than when Labour took office ten years earlier. Staunch Conservatives will no doubt be hugely disappointing that there is no marked increase in UK government debt in that graph. Don’t worry, just for you I’ve done another one for just the UK with the previous five years under John Major added in. Now you can see a government who did oversee a marked increase in the national debt. I’m nice like that. Don’t mention it.

UK National Debt as % of GDP

UK National Debt as % of GDP

So you can see why the government’s claim about a debt-fuelled spending binge is a lie. This level of public debt clearly didn’t cause the financial crisis. So what did?

The cause is actually fairly simple. Banks make profits by borrowing money and then investing it. Their profit comes by getting a higher return on their investments than they have to pay on to the people from whom they borrowed the money. For example if I put £100 in a bank account the bank might pay me 1% interest and then invest that £100 in in a scheme that makes them 5%. Simple enough.

Banks though, like any other businesses, want to compete against one another – they want to make the biggest profits for their shareholders and show everyone that they are the best bank. This is what caused the crisis.

Over time, banks became increasingly competitive and concerned themselves more with trying to make the biggest profit and less with the risks associated with what they were doing. With the £100 I put in my bank account they could invest it in something safe and make 5% or they could invest it in something risky and make 10% or 15% or 25%! The more risky the investment the more return it could yield. No bank was going to invest in something risky if its likely return was less than a safer alternative and so risk equalled reward. Competition between banks, all vying for the biggest profits, led to riskier and riskier investments and nowhere was this more prevalent than housing. It became possible for people to borrow crazy amounts of money to buy a house, even if they had poor credit worthiness. This irresponsible lending fuelled housing bubbles all over the world. Here’s how Florida house prices changed in the four years prior to the financial crisis.

Florida House Prices (Q4 2002 = 100)

Florida House Prices (Q4 2002 = 100)

In just four years they increased by almost 80% and people’s wages were definitely not increasing at anything like that rate. In short it was unsustainable. There is a useful principle in economics called Stein’s Law after the late American economist Herbert Stein and I wish more people had paid attention to it in the pre-crisis years. It says simply this:

If something can’t go on forever, it will stop.

Stop it did and we all know the rest. In hindsight it’s easy to look back at this and say that the banks were lending irresponsibly but much harder to say why they didn’t they realise it at the time. The only explanation I can offer is that they were too concerned with out-performing one another and not concerned enough about the risks involved until it was too late. Like a gambling addict who’s had a good night but doesn’t know when to quit, the banks didn’t want to think about Stein’s Law.

Essentially the positions they took on the housing market assumed that:

  • House prices always go up
  • Mortgage defaults are pretty rare

On the first point the banks thought, “Even if this individual doesn’t repay their 120% mortgage, the house will be worth more than that in a couple of years, so where’s the risk?”

On the second point they seem to have committed a really basic error in their probability calculations. Imagine I have lent to 5 risky individuals. The chances of any one of them defaulting on their mortgage is 5%. Therefore the risk of all of them defaulting on their mortgages is:

5% x 5% x 5% x 5% x 5% = 0.00003125%

But those of you who remember your GCSE maths will recall that you can only multiply probabilities together like this when they are independent. For example if the probability of a person having a beard is 20% and the probability of someone being female is 50% the probability of a lady having a beard is not 10%. (Unless of course you work in a circus.)

Similarly, the chances of individuals defaulting on their mortgages are not independent. When an economic downturn occurs, unemployment rises, incomes drop and lots of people all suddenly can’t repay their mortgages at the same time.

Banks, in their bid to out-profit each other, took huge positions on the housing market. They were betting that economies would grow and house prices would go up. It had been so long since the economy had been through a really serious downturn that they had forgotten the lessons of the past. The resulting crisis shows that so confident were they in endless economic prosperity, that none of them had a Plan B in the event of a downturn. The global economy isn’t like that though and if economic history has taught us anything it is that bad things have always eventually found a way to happen and by the time the banks spotted the bubble was about to pop it was too late.

Banks weren’t just lending irresponsibly on mortgages though. People took cheap loans and were able to borrow more than ever before on their credit cards. Banks were so desperate to lend that they offered amazing deals to secure our credit card debts. Fee-free transfers, interest-free balances for 12 months etc etc and the same thing happened – all of a sudden lots of people were unable to make repayments at the same time and the banks had no fallback.

This had a short term effect of making the banks insolvent and governments world-wide were forced to bail them out. While this solved the short-term problem there was another problem that almost six years later remains unsolved.

When economies around the world turned bad, people were left with mortgage debt, loan repayments and credit card bills that were ridiculously high. Those lucky enough to keep their jobs switched overnight from not worrying about their personal debt to worrying only about their personal debt. The thousand pounds they had on their credit cards was no longer something they could kick into the long grass and assume they would just pay it off later. Seeing their friends and co-workers losing their jobs made the risk of redundancy a reality.

This shock led to a very sudden and very dramatic change of behaviour. People moved almost overnight from spending to reducing their debt. Even those who had avoided running up debt became very worried about how little they had tucked away for the hard times and moved from spending to saving.

In the economy your spending is my income and my spending is your income. When everyone stops spending at the same time the consequences can be catastrophic. I say “can be” because a responsible government could plug the gap by increasing public spending but in most cases they didn’t, hence it was catastrophic, hence the depression. (I like saying “hence”. I think it makes me sound all knowledgable.)

So that’s how it happened and that’s the real reason we are in a depression and it had nothing to do with UK government debt at all.

There is a good argument that the previous Labour government should have spotted what the banks were up to and should have done something to address it. Although the banks caused the crisis, the previous government was asleep on the job while this was going on. If the current government were pushing that argument they would have a valid criticism but they aren’t because although it is the truth, it doesn’t pin all of the blame on the previous government.

Politics aside, the years before and since the crisis really are a shameful and embarrassing period in economic history. A first year economics student taking their first macroeconomics module will learn that government spending increases economic growth and that it works best of all when the economy is suffering from a lack of demand. They will learn that my spending is your income and your spending is my income. They will learn that if your spending disappears my income does too. They will learn about economic cycles – the economy will go down as well as up, so plan for it.

Sadly these are lessons that the current government has either not learned or has simply chosen to ignore. Simple enough as those lessons are, it’s sadly far more convenient for them to just propagate The Debt Fallacy.

RedEaredRabbit

Filed under 10 Posts You Should Read, Economics, Politics Tagged with , ,

We need to talk about Europe

08/12/2011 Leave a comment

In the run-up to the last election, much was made of the UK’s poor financial situation. We were told repeatedly  by the Conservatives that after years of irresponsible borrowing, our finances were the worst in the developed world, that we were on the point of bankruptcy and that if we didn’t immediately reduce the deficit then no one would lend to us.

18 months on, we’ve achieved nigh on no economic growth and despite the government’s cuts have continued to increase our debt at more or less the same rate.

This leads me to wonder – if our finances were so bad then and have got worse since, why is it that we can continue to borrow money so cheaply when no one will lend two Drachmas to all of those struggling economies in the Eurozone? Something doesn’t add up.

First, let’s look at whether our finances were really the worst in the developed world. This is a graph of government debt as a percentage of GDP for each country in the G7. The data is taken from the IMF website.

Government Debt as a Percentage of GDP (source IMF)

Government Debt as a Percentage of GDP (source IMF)

You see that orange line at the bottom? That’s the UK. Were we really borrowing so irresponsibly for all of those years under Labour? That’s a matter of opinion but if we’re on the naughty step then it’s pretty crowded.

On a side-note, Japan’s is quite impressive, isn’t it? They seem to be in a Ponzi scheme with their own public but Japan could be a million blog posts on its own so I’m not going down that avenue.

Turning our attention to the Eurozone, you will have noticed in recent weeks that Angela Merkel has blamed the current crisis on the irresponsible fiscal policy of certain member nations – i.e. that they have screwed the Euro by living beyond their means.

Here’s some more data from the IMF website showing some Eurozone economies’ borrowing as a proportion of GDP from the adoption of the Euro up until 2007, the year before the financial crisis.

Government debt as a percentage of GDP (Source IMF)

Government debt as a percentage of GDP (Source IMF)

Ireland and Spain reduced their debt significantly in this period. Italy reduced theirs a bit and although it was pretty awful in 2007, it was even worse when they joined the Euro so I don’t understand the sudden surprise now.

Anyway, it’s fairly clear that while Italy and Greece maintained high levels of borrowing throughout this period, Ireland and Spain did not. Merkel’s claim that each of these nations brought it on themselves purely through their government borrowing is not backed up by the figures. Ireland arrived on the eve of the financial crisis with much lower borrowing rates than they’d had historically but their economy imploded spectacularly nonetheless. Saying that the problems are purely down to fiscal policy is quite bizarre.

Another factor, which Merkel hasn’t wanted to mention, is monetary policy. In the UK when our economy got into difficulty the Bank of England cut interest rates and they have been sitting at a tiny 0.5% for the last two and a half years. Conversely, in April, egged on by Germany, the European Central Bank started to increase interest rates in the Eurozone and perhaps it should not come as a surprise that this coincided with the start of the current crisis.

The fragile Eurozone economies didn’t want higher interest rates but they could do nothing about it. Germany wanted higher interest rates because they were worried about inflation and so the weaker economies had to pay for this through lower growth and higher unemployment.

When the fragile Eurozone economies want to borrow money, lenders look at them and see that they are powerless to control this basic facet of monetary policy and therefore have lower confidence in their ability to respond to changes in their economies. If I want to invest some money shall I do it with a country who can respond to economic problems or one who can’t? Not a difficult decision.

There is though, another branch of monetary policy that is perhaps even more concerning. There is a reason that no one in the market really worries about the UK or the US being able to repay its debt but do worry about the economies in the Eurozone.

If the UK ever gets into a real pickle and needs some more Pounds to repay a loan they always have the option of going to the printer and just printing it. The UK controls its own currency. Ireland doesn’t. Italy doesn’t. Spain doesn’t. If they run out of money they go bust.

In the first recession they have faced, the Eurozone members’ lack of control over their own monetary policy has been a key factor in the crippling of several economies. Angela Merkel now wants to take things further and take away their control over their fiscal policy. Forcing the weak economies into crazy austerity measures will simply lead to many more years of high unemployment and no economic growth.

If it’s that simple though, why would Merkel be advocating a clearly bad policy? The problem Merkel has is that if she did the sensible thing and told the ECB to cut interest rates and buy up lots of government bonds from the weak economies, the German people would get cross and she would not be re-elected. Sadly, these are the things that matter most to politicians.

So what will actually happen? This is my prediction:

  • Germany will implement some rules to restrict fiscal policy of the Euro member states which will keep German voters happy but screw up the weak economies for years to come
  • Having done this Germany will then, finally, allow the ECB to buy up some government bonds, allowing the fragile economies breathing space to avoid short term default
  • The underlying problems will remain

Do you remember when William Hague fought his 2001 election campaign with pretty much one policy? “Keep the Pound,” he bleated incessantly for several months before losing in a landslide against a government who, err, kept the Pound.

He was right to want to keep the Pound though. Ok, he was right for the wrong reasons – nationalism and xenophobia have little place in macroeconomics but in hindsight, I shudder at the thought of where we would be now if we’d adopted the Euro too.

There is a certain romance in the single currency. It feels like it brings us all closer together, working with our neighbours in one financial union and it’s a marvellous two-fingered salute to the sickening xenophobia peddled by Nigel Farage and The Daily Mail.

Sadly, romance and economics don’t mix either and whatever transpires, one thing is abundantly clear – in an era of many bad ideas, the worst one of all was the Euro itself.

RedEaredRabbit

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Debt, Deficit, Default and Bugatti Veyrons

15/08/2011 2 Comments

The other day @WH1SKS tried to bully me into writing a blog post. Normally I don’t give
in to cyber-terrorism but he has big muscles and he could snap me like a twig so I’ve broken the rules a bit.

I have forgotten exactly what the brief said but I think it was something like, “what would happen if the US and Europe didn’t repay their debt?” I couldn’t write it at the time as I had a hangover (because I am cool.)

I don’t have a hangover at the moment (I am still cool though) so I’ve briefly written down my thoughts. I should state that I don’t really know much about this and wouldn’t even have attempted it if @WH1SKS hadn’t made me, so it might be nonsense – these are really just my uneducated thoughts. I do think the US and Europe are very different though so I will look at each in turn….

The United States

The USA has about $14.6 trillion of debt. A number like that is impossible for the brain to comprehend so I’ll tell you what it looks like. The world’s most expensive road car is the Bugatti Veyron Super Sport (BVSS), which costs $2.4m and is 1.19m tall (that’s about $2,000 per millimetre). If you bought $14.6 trillion of BVSSs and stacked them on top of each other they would form a tower 818 times the height of Mount Everest.

(If you then drove them all forwards at the same time the one on top would probably achieve 30 or 40 million miles per hour which would be pretty cool. Still, it would almost certainly end in a nasty accident, so please don’t try this.)

I’ve forgotten my point. Oh, yes. The amount of money they owe is very big. So what would happen if they decided not to pay it back?

Firstly, the US would find it pretty tricky to borrow any money ever again because no one would trust them. You might wonder why this is a problem – they just became better off by $14.6 trillion so who cares? It’s a problem because even with the debt cleared off they would still have the deficit. The deficit is the amount by which their spending exceeds their income and last year the US added 95 Mount Everests worth of BVSSs onto their pile of debt. This means that if no one would lend them any money any more they couldn’t finance their deficit and would therefore need to take immediate action to make the books balance. You are all aware of Labour’s “too much too soon” argument against Conservative spending cuts. Labour’s position is that we are trying to reduce our deficit too quickly and by doing so harming economic growth thus costing us more overall.

When considering the size of the cuts being implemented by the Conservatives this point is debatable. But the Conservatives are not proposing to eradicate the deficit overnight or anything even close.

In our fictional scenario, the US would need to reduce it by 100% with immediate effect. They could do this by massively reducing spending or massively increasing taxes. Either way this would send their economy into a devastating recession, 100 times worse than the last one and they wouldn’t come out of it for a long time. Because the US is so important in the global economy we’d all be back in recession too and again it would be much worse than the last one.

So although paying back 818 Mount Everests of BVSSs it not pleasant it is actually much better than the alternative, so we could therefore say that if a country can pay off their debt then they will do. And in reality the US can afford its debt at the moment without any major risks. It’s a lot of debt but it is a very large economy and the markets are happy to lend it a lot more before they start to worry about its solvency. What the markets were concerned about (and what led to the S&P downgrade) was more a plausible situation in which the US made some interest payments late because its politicians were too incompetent to govern the country properly. The effects of this would have been far less severe than the situation described above where the US outright could not repay any of its debt.

That said it would still cause a major problem. Lenders would be much more nervous about lending going forward, so would require a higher interest rate to compensate for this. More expensive borrowing would slow down the US’s recovery further that alone might not actually be much a disaster were it not for the fact that markets always over-react to everything. The markets would see late payment as bad news and when bad news happens, people in the financial sector all turn into Beaker from the muppets and panic and make everything a thousand times worse.

A banker dealing with bad news
A banker dealing with bad news

So yes, it would be bad for the US to miss a payment but maybe the biggest problems would be caused indirectly by the market’s reaction, rather than from the direct problems of the person who didn’t receive the cash.

That’s America. Let’s move on….

Europe

Everyone has been talking about Greece. Greece’s situation is, I think, a lot worse than what’s going on in the US. Greece’s debt is only (!?) 19 Mount Everests of BVSSs but its economy is tiny in comparison with that of the US and there is a very real possibility of Greece not being able to make its debt repayments. The market realises this and unlike the US no one really wants to lend Greece any more money. This is why they are continually asking for bailouts to keep things going.

If Greece defaults on its debt then it will have serious implications for the rest of Europe. The Greek banks would all fail overnight but it’s worse than that. Most of the major European financial institutions have also lent a lot of money to Greece and some of them will most likely be in trouble. As we saw in 2008 when Lehman’s went bust, a major default causes the banks to completely lose trust in each other. As soon as they lose trust in each other, interbank lending stops and then they get into even more trouble:

  • Bank#1 needs to borrow some money from Bank#2 to pay back a loan to Bank#3.
  • Bank#2 has the cash available but doesn’t know if Bank#1 is ok or not so won’t lend it any money.
  • Bank#1 therefore can’t pay #Bank3
  • Bank#1 goes bust
  • Bank#3 didn’t receive their cash! Are they in trouble now too?
  • No one lends to Bank#3
  • etc etc etc

The other very shaky economies, Portugal, Spain, Ireland and Italy would be hit quickly afterwards because no one is going to risk pumping further money in there.

The European Central Bank would effectively be left holding the bomb when the ticking stopped and would only be able to stop those countries collapsing by printing lots of money (thus screwing the Euro) or by taking significant funding from the more healthy economies (Germany and France) which would screw them up quite a lot too.

The UK would probably be happy that it didn’t join the Euro but its banks would be severely hit and additionally, the EU is the UK’s biggest trading partner, so the UK economy would take a big hit too. I have no idea by how much but it wouldn’t be good.

Markets would react by everyone turning into Beaker from the muppets again.

So, in summary, I think the US is actually ok financially and its problems are caused more by its crazy politicians than by its debt. I am much more worried by Greece, Portugal, Ireland, Spain and Italy, a situation where there I think there is a significant risk of a second global financial crisis.

And if that happens we are not all going to be driving Bugatti Veyron Super Sports any time soon.

RedEaredRabbit

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