Saturday, 6 August 2016

The Government Is Electricity When It Comes To The Bathtub Of Banking

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.