In recessions, the Bank of England cuts base rates to spur growth. It believes lower interest rates will boost bank lending, as do most economists. The theory goes that banks become more willing to lend because their costs are lower. And because prices are lower, loan demand rises. So everybody's happy.
But professors Joseph Stiglitz and Bruce Greenwald of New York's Columbia University say most economists are wrong. Why? Because interest rates aren't the only costs that banks have to consider. If a borrower defaults, the bank must write off some, or all, of that loan. So write-offs are costs too. These are ignored by central bankers, yet Greenwald and Stiglitz say default risk is more important than interest rates for four reasons.
First, interest rates might fall during slowdowns. But slowdowns also cause bankruptcies and defaults to rise. Higher write-offs push banks' costs up by more than falling rates reduce them. That makes them less willing to lend.
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Second, banks don't cut loan prices much (except where they have to, such as where an existing mortgage is linked to the Bank of England rate). This happens for exactly the same reason their costs haven't fallen enough to justify it. So lending overall doesn't get any easier.
Third, borrowers also know that default risk rises in recessions. So many don't want to take on even more debt. Thus loan demand does not rise when interest rates decline; if anything, it falls.
Finally, a higher proportion of loan applications come from inveterate optimists and frauds. Bankers can't spot all of them. So default risk is even worse than expected.
On top of that, recovery rates from those borrowers who do default tend to be lower during recessions meaning lenders get less of their money back. Also, many loans are secured on property, and its value also falls in recessions. Thus even though a banks' funding costs might fall when interest rates are cut, the rising risks involved in lending during a downturn outweigh the potential rewards to be had.
By the same token, raising interest rates won't slow the economy either, at least not at first. If the economy is booming, default rates are falling even as interest rates are rising. If property values are rising fast too, write-offs are lower. So there's no reason for banks to rein in lending.
Recent evidence certainly seems to support the Stiglitz and Greenwald theory that interest rates simply don't work very well as a monetary policy tool. Recoveries from the last few recessions have all been much slower than expected. Yet they were faster in the 1980s recession and before. Lowering interest rates seemed to work to reflate the economy back then. Why?
According to Stiglitz and Greenwald, the answer, in a nut-shell, is technology credit cards, call-centres and internet banking. Before their invention, you'd have to visit your branch every payday to transfer your money to an interest-bearing savings account.
That was worth doing when interest rates were high. But you didn't bother if rates were low. Your money, therefore, lay dormant in your current account earning little or no interest. That was free money to the banks. Consequently, their borrowing costs fell faster than the base rate. That helped compensate for higher default risk.
These days, we can transfer our wages into a savings account via the phone or internet. And we don't need to withdraw cash for short-term spending we can use credit cards. So it's much easier to make the most of our savings. In fact, the lower the rate, the harder we're prepared to work. As a result, banks' borrowing costs fall less quickly than the base rate. So they don't have any offsetting compensation for higher default risk, which means they become less willing to lend.
It's a vicious circle. We need bank lending to stimulate the economy. But banks won't lend and customers won't borrow unless bankruptcy risk is falling. That only happens when the economy is growing. This means there's little choice but to wait for the economy to heal. Indeed, there's a strong case for getting the pain over with quickly.
So what can we do? The best solution is for the Bank of England to prevent credit-fuelled bubbles in the first place. Rather than avoid recessions, it should encourage frequent, mild slowdowns to remind us all of the danger of excessive debt.
Now that we're here, the Bank is printing money to buy gilts. I'm not in favour of printing money. It robs savers and taxpayers. But if the Bank must print money, the Stiglitz-Greenwald theory suggests it can only succeed in one of two ways: it must reduce default risk, and so encourage the banks to lend; or it should lend directly into the economy itself.
The Bank would argue that it can't take these sorts of risks but at current yields, the Bank will suffer losses on its gilts when it sells them. So how can it argue against taking credit risk by lending directly?
But no doubt the Bank will keep buying gilts, praying that the only reason it hasn't worked so far is that it hasn't yet bought enough of them. Yet it can't work. So we're more likely to see higher inflation than sustainable recovery. What should you do? Buy gold.
Simon writes the True Value newsletter. Contact 020-7633 3780.
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