Worried about a potential nose-diving economy that is very unlikely to materialise (and long-term almost certainly won't), the quasi-governmental Bank of England’s basic rate is being lowered from 0.5% to 0.25%, with the actual UK government — driven here by Theresa May and Philip Hammond - favouring a scheme to force the banks to pass on lower interest rates to businesses in the hope of injecting new lifeblood in the small business sector and a borrowing system that favours them.
This is a big mistake
because it treats both risk factors and interest rates as though they are mere
numbers without important supply and signals attached to them. Generally, if
savings are in scarce supply but there is a high demand for borrowing, then
interest rates will rise.
This will reduce demand
for borrowing (because with compound interest borrowing is expensive) but it
will also increase the incentive for savers (because people who save will get a
better return on their money).
As more money is saved,
more capital becomes available to be loaned out, and the price (that is, the
interest rate) will fall, making borrowing more enticing, and increasing demand
for loans. Just like with any consumable good - cars, garden plants, laptops
and oranges, the price of borrowing fluctuates in order that as closely as
possible it matches savings supply with the credit demand.
Consequently, interest
rates provide signals regarding the extent to which people are willing to forgo
something in the present for something more desired in the future. So interest
is basically a tax on borrowing, and factoring risk is an evaluation of the
probability of a borrower defaulting on a loan.
There are two principal problems with the government's approach to this;
one to do with artificially adjusted risk and the other to do with artificially
adjusted prices of borrowing.
To take the second one
first, when interest rates are lowered a lot of keen borrowers come along to
capitalise. To satisfy this demand the Bank of England must increase the money
supply, which drives up prices.
As people are borrowing to
consume goods, not to store money, they will need more money, which the Bank of
England must respond to with a further increase in the money supply, which
further drives up prices, and round and round we go.
And when we have
artificially adjusted risk, businesses are started up without the requisite
risks of their failure factored in to the terms of the loan. A scheme that
artificially favours small businesses avoids the mild deflation that brings
about the healthy bankruptcy of insolvent businesses and the roadblock to
future insolvent ones starting up in the first place.
Suppose a
magic genie appeared to you and told you tonight's winning lottery
numbers. One thing you wouldn't do is announce those numbers to everyone you
know. Knowing they are worth a fortune to you, you'd select those numbers on a
ticket, pay your £1 and become a millionaire at the weekend. If you can
make a logical connection - this makes matters clear on why governments
pressuring banks to loan to small businesses is a bad idea.
This harks
back to the crazy days of Ed Miliband who very much wanted to
establish a network of regional banks to lend to local businesses, based
on supposed findings from the Small Business Taskforce that
innovation is being inhibited due to the lack of bank-lending. Because of
the drop in bank-lending, his party, along with the Liberal Democrats, were
keen to drive banks into a greater state of lending. This was a terrible idea
then, and it still is now.
If a
prospective business has the qualities to make it lucrative for investors then
a bank will miss an opportunity to profit by not lending to the
business. The obvious corollary is; if after an assessment a bank is not
wilfully invested in a prospective business, it must believe that the project
lacks the qualities to make it a lucrative, profit-making venture. Hence,
when politicians pressurise banks to lend to businesses they are often forcing
them to invest in projects they believe to have a low chance of engendering
profit.
If you take
the logic to its natural level, by proposing legislation that imposes
compulsory lending from banks the government forgoes a great opportunity to
make a profit by not capitalising on these opportunities themselves, rather
like how a man who knows next Saturday’s wining lottery numbers forgoes a
greater profit by telling everyone the numbers ahead of the draw.
Instead of
passing any such legislation or temporary duress, the government could hire
people to invest in all these innovative schemes and channel the profits into
good and profitable services for the benefit of the taxpayer. That it
doesn't, suggests that the government doesn't think these prospective
businesses are worth investing in after all - which makes it crazy that they
should force banks to do so.
This also
makes it clear why not only is government interference in the markets
often harmful - it also demonstrates why governments loaning to businesses that
can't get a loans from the bank is unwise. What ought to be obvious is
that if a bank isn't lending to a business it must think it has better ventures
in which to invest. Alas, this seems not be obvious to a number of our
politicians.
Take
Hopeful Harry who has been refused a bank loan for his prospective retail
business. What are the chances that Harry knows better than the bank
about how to invest their money? Very small; after all, as far as Harry
is concerned the only perceived use of the money is to have it invested in his
business. But as far as the bank is concerned, it has knowledge of all the
alternatives that Harry doesn't know about, making the chances of Harry's
business being the best prospective investment vanishingly small.
If Harry
has approached numerous potential investors and been turned down, it would be
economic madness for the government to invest in Harry's business on the back
of this. In loaning to Harry - and businesses like his - the government
has harmed society because it has invested money in ventures that are less
conducive to success than the alternatives.
An economy
in which investors are risking their own money has greater invectives for
profit and economic mobility than when a government is risking the taxpayers'
money. Green tax breaks and eco-subsidies are not all they've
cracked up to be either, as they interfere in the free market by gearing
entrepreneurs towards ventures that factor in government subsidy rather than
assenting completely to the mechanism of matching supply to demand.
When
politicians tell you that the financial crisis occurred because banks were left
to their own devices, they are speaking the opposite of the truth - the
incentive to gamble is usually (and was in this case) greatest when excessive
risks are not met with collapse but with government
bail outs.
I'm not
saying that when the public's money is at risk the State shouldn't have safety mechanisms in place - but the financial crisis largely came about because
there were too few incentives to stop banks taking risks. Prior to the
financial crisis banks were taking so much risk precisely because they were
bootstrapped by government subsidies to the tune of hundreds of billions.
When the likes of Cameron,
Osborne, Cable and Miliband complained about how irresponsible and greedy the
bankers were - they were without perhaps knowing it also complaining about how
much the bankers responded to government subsidies. That is like a man
who has paid a tattooist to tattoo him complaining that the tattooist has
ruined his unblemished skin by indelibly marking it with the design.
A healthy bank will
protect everyday citizens' savings that are tied up in their accounts and offer
customers security against the loss of their savings. Consequently, depositors'
concern about the security of their money and their discernment in choosing
with whom to deposit and invest is a necessary part of a well functioning
competitive banking system.
It’s the removal of this
that contributes to the banks’ propensity for excessive risk – for if customers
deposited their money based on knowledge of a bank’s history of sound and
consistent investment, then all the better for them and for the banking market.
And an important part of
this security of borrowing and investment is bound up in the fact that as near
as possible banks must allow interest rates to find their level by the
mechanisms of supply and demand, and they must only loan to businesses that
they've assessed as being highly probably solvent in the next few years and
(hopefully) decades henceforward.
