Watching the economic situation pan out is fascinating, hilarious and scary in roughly equal measures. Of course, I could pretend that I could see what was going to happen two years ago, like all the commentators out there. In fact, no, I could see something bad was going to happen but I didn’t know what it would be. Or how deep it would be.
There are a few things that concern me about the way the UK authorities are handling the situation.
Firstly, nationalisation of banks on condition of availability of continued loan funds has a couple of significant implications. This makes it very clear that the government will not allow the failure of a major bank, meaning that in the medium to long term future they are in a position to take on more risk than they have in the past since they know that the government will bail them out if the going gets tough. This has bad implications for shareholders while the executives of the banks are unlikely to suffer significantly because of their risk-taking.
However, in the short term, the government is backing lending to people of poorer creditworthiness (they must be, because the banks would continue lending to people of good credit risk anyway). Which means the government is underwriting loans to people who are (more) likely to default. Effectively subsidising risky ventures that would never receive funding from unsubsidised banks in the current climate.
Secondly setting a low interest rate does a couple of things. It makes people more likely to borrow and it makes people less likely to save. In order for people to borrow the money must come from somewhere. In the fractional reserve banking system it gets created from thin air by a magic multiplication of money from reserves. There are a number of measures of money supply, interesting ones are M0 “bank notes” which is the money made they government and M2, “commercial money” which is money made by the commercial banks through loans based on the fractional reserve system.
There are a number of ways to increase money available for borrowing (which is a close relative of M2), M0 could be increased (print more money), required reserves could be reduced (increase the amount of loan for each pound of deposit), increase the deposits, or many other ways. With interest rates lowered the amount of deposit won’t increase, so there is likely to be an increase in one or other of the money supply figures. This will most likely lead to inflation, since there is more money in the system but the amount of goods in the system remains the same, meaning each good will cost more in terms of pounds but will remain roughly level in terms of time taken to earn the money to buy it.
If I was really cynical, I would tie this information up with Grandis observations about inflation and suggest that the government has a lot to gain by increasing inflation.
Of course, inflation also leads to the increase (in pound terms) of the GDP, which would mean that the government can claim (with a straight face) that it has lead us out of recession (no longer shrinking GDP) although, for a while at least, everyone can buy less with their weekly wages.
No wonder they call it the dismal science.
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