November 11, 2013
Mario Draghi has ensured that the mini-boom in Dublin’s trophy houses will continue for a while. This is what happens when interest rates are cut to almost zero – the people with savings think there is little point saving any more, so they don’t bother any more. They think, what will I put my cash into?
In Dublin, in certain small areas, expensive houses have been rising in price, and it will not be surprising to see the savings of the already wealthy going into houses, pushing up house prices further and make the already wealthy, well, wealthier.
This has been the pattern over the past five years all over the western world, particularly in Britain and America. By reducing interest rates and printing money, central bankers have put themselves on the side of the financial markets. It is not that they love financial markets, but to achieve their objectives they have to go through financial markets. This bizarrely puts central banker and financial markets on the same side, less than six years after excesses in financial markets nearly destroyed the global economy.
It seems that memories are short and both in Britain and the US the central banks have used lower interest rates to boost asset prices. They are hoping that the ”trickle down” effect will drive consumption and spending, allowing the economy to achieve a lift off.
Given that the Irish economy displays many characteristics in common with the Anglo American economies, we can safely say that the same will happen here. The cheap money will encourage the banks to lend against trophy assets again and will encourage people with savings to draw down their cash savings and put it towards buying property, where prices are rising.
This might not be a bad investment decision in parts of Dublin and some other metropolitan areas in the country, but for the most part, interest rate cuts will have am ambivalent effect on borrowing and lending. This is because, while tracker rates will fall in tandem with the ECB rate, this will cause the banks to lose even more money on these trackers. This implies that the banks will have to claw back profits somewhere – and that somewhere may well be on variable rate mortgages.
So the variable rate mortgage holders will end up subsidising tracker mortgage holders to an even greater extent in era of very low interest rates. Similarly, in the rest of the eurozone we are seeing the spectre of deflation for the average guy and inflation for the rich guy.
Cutting interest rates, in the face of deflation on the continent, implies that money will also certainly cascade into financial assets. The banks will make sure of this – and the process will line the pockets of the already wealthy, increasing the divide between the very rich and the struggling poor and, of course, driving a deeper wedge between the haves and have nots.
The cut of the ECB interest rate to a historic low, signals that the Berlin-inspired policy of cutting European budget deficits is not leading to growth but is leading to deflation. Once deflation – falling prices – takes hold it is very difficult to eradicate.
The ECB’s inflation target is 2 per cent per year. Eurozone inflation is rising at only 0.7 per cent. This implies that prices are almost static. Static prices sounds like a good thing, doesn’t it?
If we look at it a bit more closely, we see that if you have static output prices, then you must have falling input prices for sellers of that product to make profit. The biggest input price in the European economy is wages. If you don’t get falling wages, you will get fewer and fewer people employed, this will drive up productivity and thereby, increase profit at the expense of wages.
This implies that Europe will see a return to profitability – yet unemployment is still very high. This will drive up stock markets and make Europeans who rely on stocks for their wealth very rich.
However, by rewarding the owners of capital, stockholders and punishing workers, through lower wages, the people who depend on wages for their income (most people) suffer. In contrast, the people who depend on the return of capital for their income – stockholders and in Ireland, landlords – will do well.
This is what we have seen in the US over the past few years, where the Fed’s quantitative easing policy has made the very rich exceedingly rich, while the income of the American middle class continues to stagnate.
All the while the money cascading into asset markets will push up asset prices and these higher prices, by definition, increase risk because all this new credit is pushing the asset prices way above fair value.
This is the counterintuitive thing about financial markets. Higher prices create higher risk, not lower risk. When prices are rising as they are in stock markets all over the world, people misjudge the risk. The higher prices make them feel not only rich but clever – as if it’s their own genius rather than cheap money that is driving their investment portfolio upwards. This belief in their own genius prompts them to commit more money and then to borrow money to put on the rising stock market.
Look at the chart. It shows what is happening and more to the point what has happened before. It shows the amount borrowed to be put on stock speculation in the US over the past three boom/bust cycles. What we see is that we are now back in dangerous territory.
The more the ECB reduces rates, the more European cheap money will be driving global stock prices. And now that Mario Draghi has opened the Pandora’s box of deflation, we are likely to see a European version of quantitative easing – printing money – some time next year. This will continue to fuel the prices of financial assets up further and further.
We are now in the situation where all the central banks of the world have engineered themselves into a hostage situation. The kidnappers are the financial markets, that threaten the central bankers that they will kill the hostage – the frail recovery – by crashing and bringing down the economies with them unless, the central bankers don’t deliver yet more and more cheap money.
The question now is whether the central bankers will pay the ransom? If they do, prices go even higher, risking crashes in the future. If they don’t they risk a crash now.
My guess is that they pay the ransom now – and worry about the future later. This will keep interest rates down and this is good news for tracker mortgage owners. And even better news for the owners of posh property in the capital cities of the developed world, including Dublin.