Wednesday, 10 October 2018

The Financial Crisis 10 Years On - And Still The Myths Perpetuate

It’s roughly the ten year anniversary of the financial crash of 2008 - a topic about which plenty of people have opined as though they are expert, in a subject in which they are utter novices (see link at the bottom of the page). One misconception that is still doing the rounds in the notion of bailouts preventing the loss of value. This is sketchy understanding, because the loss of value occurs when people fudge things up with bad sub-prime mortgage loans - a bailout does not prevent the loss of value. The bailout simply shifts the loss from stockholders and creditors to taxpayers.

The other common confusion I keep reading, in relation to financial crash references, is the dubious connection made between interest rates and the amount of money in circulation (see my sidebar on 'interest' for further reading on this). The thing that connects interest rates with money in circulation is the rate of change of the circulated money, not the aggregation of the supply itself, which has a much more negligible effect. The problem (or one of the problems) with an artificially increased money supply is that when prices rise above supply and demand levels, interest rates are inflated too because lenders need to be compensated for the fact that they will be paid back in pounds or Euros or dollars worth less than the ones at the time the loan began.

It is easy to see why if you understand that interest rates are not the price of money. If interest rates were the price of money then more money added to circulation would lead to lower interest rates. But it does not, because when prices are high, your money is not worth as much. The interest rate is the price of borrowing, not the price of money. If lots of people have wealth they would be willing to lend out, that should keep the price of borrowing lower - but this isn’t to do with the aggregate of the money supply in circulation. During the financial crash the mortgage packages were worth less than the buyers thought. This led to a vertiginous drop in the money supply, as banks collapsed and depositors went broke or withdrew their funds from the banking system.

Further reading: previously I’ve blogged in more detail about the financial crisis and the many misunderstandings surrounding it - see here.