The Bank of England cut the base interest rate by 0.25% to 5% yesterday.
So naturally, mortgage interest rates went up. Nationwide, Alliance & Leicester and Britannia all raised the rates on their fixed-rate deals, by as much as 30 basis points (0.3%) in the case of A&L’s two-year fix.
Wait a minute. That’s not supposed to happen. You can just imagine Bank governor Mervyn King standing in front of his giant central banking computer, stabbing desperately at the ‘rate cut’ button with his finger. “It’s broken! The price of credit isn’t falling! What’s gone wrong?”
We’ve explained a number of times that rate cuts just won’t work anymore – see here: Why lower interest rates won’t help homeowners. The central banks let the lending boom spiral out of control long ago. Now that the bust has arrived, they can’t expect to be able to rein it in either…
The explosion of credit in recent years took on a life of its own. At the peak, some banks were lending at below the Bank of England base rate to attract business from private equity clients.
This is now beyond central banking control
And just as the credit explosion accelerated beyond central banking control, now the implosion is doing the same. Even the drastic steps taken by the Federal Reserve are having little impact on the housing crisis there, so a quarter-point cut by the Bank of England can’t be expected to do much.
The infuriating thing is that we now have all these mis-informed calls for more regulation of the financial system. On Channel 4 news last night, a reporter said something to the effect that it was now clear that free markets were not self-regulating, but in fact needed to be overseen more effectively. Capitalism doesn’t work, basically.
Now, I don’t disagree that more regulation is likely in future. Calls for action will be inevitable after the carnage we’ll see as a result of the coming recession. That doesn’t mean I think it’s the right way to deal with things.
What’s caused this seizure in the financial system? It’s got nothing to do with SIVs, CDOs, or sub-prime mortgages. All of those devilish little creations were mere symptoms of one crucial underlying problem – that risk was underpriced by markets for too long. Anyone with any understanding at all of financial history who says that they didn’t know that, is a liar, or naïve to the point of stupidity.
The City and Wall Street understood it. Chuck Prince, former head of Citigroup, even said as much just before the credit crunch brought everything to a halt. His quote, “When the music stops in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing,” sums it up. Everyone knew that the party had got out of control and had to end sometime – and end badly. But until it did, there was fun to be had and money to be made.
The reason risk was underpriced for so long
So the key question isn’t – how do we control SIVs? After all, the huge growth in the use of SIVs came about partly because, post-Enron, the rules governing the use of off-balance sheet vehicles were clarified. That helped companies to understand exactly what they could get away with, within the letter rather than the spirit of the law – another danger of over-regulation.
The key question we should be asking is – what caused risk to be underpriced for so long? And the answer is this – because everyone on Wall Street knew they were too big to fail.
There was always the unwritten promise that the central banks of the world, lead by the US, would step in and save the financial sector from the slightest discomfort. If you still don’t believe me, then let me remind you of one of the most oft-repeated pieces of financial wisdom you’re likely to hear in the US and over here: “Don’t fight the Fed.”
In other words, whatever goes wrong, the Fed will fix it. I hear people talking about the risk of ‘moral hazard’ involved in bailing out Bear Stearns and Northern Rock and it makes me laugh – our whole financial system is built on moral hazard. And Alan Greenspan, as the key central banker of the ‘too big to fail’ era, has to take most of the blame for this, despite his protests in the FT recently.
It all comes down to risk and reward. If bankers make big profits, they get big bonuses. If they make big losses, they don’t have money taken away from them. It’s the same for central bankers. If the economy keeps growing, they are applauded. They are given titles like “maestro” and declared heroes for eliminating boom and bust and creating “the great moderation”. If they take things in hand, like Paul Volcker did in the US, then people burn their effigy in the streets. Which form of popular appreciation would you prefer?
People complain – rightly in many cases – about an undeserving, violent underclass, who take no responsibility for their actions, and whose every misdeed is rewarded with another splurge of taxpayer money, which only encourages further bad behaviour. Well, we also have an undeserving overclass, who behave recklessly with our money, safe in the knowledge that the authorities will ensure their actions have no consequences – for them, at least.
What’s the answer? Scrap the welfare state. If you’re going to regulate anything more tightly, regulate central banks – give them a remit that involves controlling asset bubbles, or at least acknowledging they might exist. Or better yet, just scrap them. Let the market decide what the correct cost of money – the correct level of risk – in the economy is. Markets might not be perfect – but they’re a damn sight better than governments.
Turning to the wider markets…
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In London, the FTSE 100 fell for the third day in a row, ending 18 points down at 5,965. Alliance & Leicester was the biggest casualty of the day. Meanwhile, in the FTSE 250, DSGI (formerly Dixons) took a dive as it issued its second profit warning of the year.
Across the Channel, the Paris CAC-40 lost 37 points to end the day at 4,874. And in Frankfurt, the DAX-30 slipped 50 points to 6,721.
On Wall Street, US stocks were higher. Several retailers issued weak same-store sales figures for March, but retail giant Wal-Mart beat expectations by lifting its forecast for first-quarter profits. The Dow Jones gained 54 points to end at 12,581. The broader S&P 500 climbed 6 points, to 1,360, while the tech-heavy Nasdaq rose 29 points to close at 2,351.
In Asia, Japanese stocks rose, breaking a three-day losing streak, as retailers said they expect profits to rise this year. The Nikkei gained 378 points to close at 13,323.
Crude oil was little changed, trading at around $110.25 this morning, while Brent spot was trading at $108.22.
Spot gold was trading at around $925 an ounce this morning. Platinum eased back to around $2,018, while silver was trading at $17.95.
Turning to forex, sterling was trading at 1.9752 against the dollar, and at 1.2481 against the euro. The dollar was last trading at 0.6323 against the euro and 101.86 against the Japanese yen.
And in London this morning, reports suggest that French power group EDF may bid for nuclear power generator British Energy, though a ‘source’ told Reuters that any bid wouldn’t be more than 700p a share.
Our recommended articles for today…
An economist’s explanation of the credit crunch
– The federal funds rate has lowered and the Fed has removed reserves from the banking system – at the same time. According to textbook economics, this just doesn’t happen. Robert P. Murphy investigates why the credit crunch has upset the world-view of modern economists and explains why having a central bank isn’t going to work in the first place. To learn what the Fed should have done, read:
An economist’s explanation of the credit crunch
How the credit crunch is spreading
– All across the US: families, corporations, local governments and industry are feeling the sting of the credit crunch. What started on Wall St has now spread to Middle America as the downward spiral of reduced consumer spending starts to affect unemployment. Only 16% of US families have booked a summer holiday this year, and as the price of food and fuel rises, Richard Benson shows you what is to come in:
How the credit crunch is spreading