Monday, March 21, 2011

On Arguments about Interest Rates

There's an argument that I've heard quite often recently that a major factor in the recent financial crisis was loose monetary policy and low interest rates. This argument is particularly popular among conservative lunatic fringe. Witness Allister Heath (Chair of TPA Tax Comission, daddy is a TPA director) here or Dan Hannan over here as an example of this kind of thinking, there's more in the form of Derek Scott at the Telegraph.

Thing is, I'm not sure that this is entirely resembles what actually happened. A quick comparison of recent and historical interest rates reveals that bank interest rates were not really well below any kind of historical average. Another key point to make is that around 2006/07 mortgages could easliy be obtained at well below the bank base rate.

To foist the blame onto the base rate ignores other important factors. We have for a long time had a financial system that has allowed money to flow freely across borders. This has meant that our banks are free to borrow on the international money markets.

This change has reduced the effectiveness of the bank base rate. While it's true that many mortgages do track the base rate so a rise will squeeze spending among those consumers with tracker mortgages. The effect on the supply of consumer credit will be reduced because banks can seek an alternative to borrowing from the Bank of England at the base rate.

The point I think it's worth making here is that you can't really put the blame on interest rates set by the Bank of England while ignoring the developments that occured in the financial markets.

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