Easing Us Out of House and Home

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ECONOMY…by G. P. Walrus

Quantitative Easing (QE) is a Bank of England policy with the stated aim of avoiding deflation through boosting monetary supply [1]. But what may seem to be esoteric financial voodoo is eroding the wealth of most UK citizens and may end up putting many of them out on the street. In this article I argue that QE will lead inexorably to high inflation, high interest rates and mortgage defaults.

Let’s begin by looking at the nature of the financial collapse. It first manifested itself in the mainstream media, ironically enough, with mortgage defaults in the US. Those defaulting mortgages were part of the toxic debt crisis whereby bad debts bundled up with good debts were given AAA credit ratings and traded electronically round a plethora of institutions, in a game of financial pass-the-parcel.

Each time the parcel was passed, some profit was made. Much of this went into the pockets of individuals as (effectively) cash and the recorded value of the parcel was marked up. In 2007 the music stopped at which point it was obvious that the values assigned to these financial assets were massively overstated. Banks became unable to borrow money, and hence to lend it, because the markets knew they didn’t have the collateral. [2]

This is a very important point. The assets owned by banks and managed funds are worth much less than the values recorded on their books. It is only by the introduction of special accounting rules [3] that banks are allowed to represent these assets at their nominal rather than at their true values. In short, the value of many major financial institutions is not backed by realisable wealth. The stated assets are largely false.

As a simple illustration, imagine I am a bank and have been accumulating gold bars for years through investment and trading with other banks. Suddenly it is discovered that the gold bars we have been happily building up are in fact gold-painted lead. On my books I might have £10bn of gold bullion. What I in fact own is £5bn of lead bullion. Everyone who buys gold now knows about the lead and so I can’t sell it on as gold. A kindly government allows me to keep recording £10bn in my accounts to stop me going bankrupt while we work out what to do about it.

Now here’s a wizard wheeze. I can’t turn the lead into gold but what if the purchasing power of £s dropped over a few years? Pretty soon the £10bn recorded in my accounts would come closer in value to the gold-painted lead I have than the gold I pretend to have, thus substantially reducing the losses I would have to realise on getting what I could by selling the lead. Let’s say sterling devalues by 50%. I still have £10bn on my accounts but I now have £10bn of lead, simply because lead is worth twice the number of £s it used to be. I can now sell the lead at no monetary loss.

Now of course it is much more complicated than this. I don’t need to avoid any loss on my toxic assets I just need to postpone taking the losses until they are small compared with my overall turnover and so can be borne without going bankrupt. With the government guaranteeing all my debts and supporting my cashflow with public borrowing I can’t lose … if I’m a bank.

This is where quantitative easing comes in. Quantitative easing is the process of allowing the banks to circulate more money, created out of thin air, into the economy, by lending to each other and industry and meeting their payment obligations [1]. It is sometimes referred to as printing money but there is no need to print more than a small amount of cash as most transactions are carried out electronically these days.

Because there is more money, but no new wealth has been created, the value of the money is less. This is known as devaluation. There is a global race to devalue currencies [4] because it eases the burden of shoring up defaulting banks. The US is printing money like there is no tomorrow (and maybe there isn’t for them) the UK and the European Central Bank are also playing the devaluation game.

The flip side of devaluation however is inflation. The price of reducing the purchasing power of your currency is that imports become more expensive. The UK has higher imports than exports and this deficit is set to increase [5].

As a result, prices will rise as a direct result of QE (this is one of the explicit aims of the policy). Inflation is already hovering over 3% [6] (there are various measures but a general upward trend). Investors who can move their wealth around are buying up primary inflation-proof assets such as precious metals: gold, silver, platinum and palladium have all risen dramatically in price since the financial crash [7].

As inflation rises, those who make money by lending money must start to raise the interest rates they charge. Otherwise inflation will erode the profits they make. I lend you £100 now and get £105 back in one years time. but, after inflation, that £105 only buys what £103 did one year ago so I have increased my capital by only 2% in real terms as opposed to 5% – a 60% drop in profits! With higher rates of inflation I could be making losses. Some readers will, like me, remember the 70s, where inflation got as high as 29% per year. Strangely enough, we had just decimalised the currency and brought in a huge devaluation on the back of it. Houses used to cost a few thousand pounds back then…

Anyway, inflation leads to higher interest rates which means that ultimately mortgage payments will also rise. It is not clear when this will happen and the effect takes time to come through as people move on/off fixed rate deals [8]. The standard variable rates and fixed rates on offer will show a rising trend over time. Incomes will rise in line with inflation (maybe with some lag due to the poor jobs market) but interest payments on mortgages will rise much faster. An increase in mortgage interest rates from say 3% to 4% represents a 25% increase on the monthly interest payment. It is interesting, is it not, that the government has already moved to place a cap on the level of housing benefit that can be paid to cover a mortgage [9].

If your mortgage is small compared to your income, you may shrug this off with a little belt-tightening elsewhere. But there are many many UK households who are badly overstretched on their mortgages [10]. The hike in interest rates which is the inevitable consequence of inflation driven by quantitative easing has the potential to bring about defaults, foreclosures, downsizing and homelessness on a massive scale.

Is there any hope that the banks will show the same mercy to mortgage defaulters as they, the banks, were shown in the financial collapse? I wouldn’t bet the house on it

[1] “Quantitative Easing Explained: Putting More Money into our Economy to Boost Spending” Bank of England, http://www.bankofengland.co.uk/monetarypolicy/assetpurchases.htm
[2] Nicole Gelinas, “Can the Feds Uncrunch Credit?”, City Journal Vol.19 No.1 Winter 2009, http://www.city-journal.org/2009/19_1_credit.html
[3] Yalman Onaran, “Bank Profits from Accounting Rules Masking Looming Loan Losses”, Bloomberg, June 5, 2009, http://www.bloomberg.com/apps/news?pid=newsarchive&sid=alC3LxSjomZ8
[4] Tom Stevenson, “It’s every nation for itself in the devaluation race”, The Telegraph, 20 November 2010, http://www.telegraph.co.uk/finance/comment/tom-stevenson/8082244/Its-every-nation-for-itself-in-the-devaluation-race.html
[5] Ken Coutts and Robert Rowthorn, “Prospects for the UK Balance of Payments”, Civitas, March 2010, http://www.civitas.org.uk/pdf/RowthornCouttsBalancePayments.pdf
[6] Office of National Statistics, http://www.statistics.gov.uk/cci/nugget.asp?id=19
[7] “Precious metals rise with silver outperforming”, International Business Times, 19 November 2010, http://www.ibtimes.com/articles/83817/20101119/precious-metals-rise-with-silver-outperforming.htm
[8] Ian Pollock, “What will happen if interest rates start going up?” BBC, February 2010, http://news.bbc.co.uk/1/hi/business/8493097.stm
[9] Samuel Dale, “Emergency budget: housing benefits capped and cut”, Mortgage Strategy June 2010, http://www.mortgagestrategy.co.uk/economy/emergency-budget-housing-benefits-capped-and-cut/1013864.article
[10] Jill Insley, “Debts leave 3m Britons struggling to pay mortgage, says Shelter”, The Guardian, 11 November 2010