17 May 2011

What should the interest rates be?Warren Buffett offers many great quotes, one of them is:

“Managers thinking about accounting issues should never forget one of Abraham Lincoln’s favorite riddles: `How many legs does a dog have if you call his tail a leg?’ The answer: `Four, because calling a tail a leg does not make it a leg’.”

 This quote has many applications, including that of UK debt which officially stands at some GBP 1 trillion, and unofficially if you take into account all the pension fund obligations, bank obligations, it is closer to GBP 8 trillion 

 http://www.financewithvision.com/research/market-commentary/22-january-2011

 what once again we reiterate means, that the only way out of this mess is through inflation.

This riddle also has a great application to finance and economics, for where as finance should be like  simple maths, economics often is debated as social science, with no right or wrong answers.  This poses a problem for me, as I am about to try to write a comment on Central Bank Rates, and I am looking for an answer.

 Someone asked me recently if I think that it is good news for Poland that it raised its rates to 4.25%, where most of the Developed World has them close to 0 - 1% mark.  It is true, Poland, like China, India, Brazil and many other "EM" countries is raising interest rates to combat growing inflation.

 My reply was very simple, that Poland and others are in very fortunate position to be able to do that, as frankly UK, EU, USA and especially Japan could not dream of rates at these levels due to their out of control debt problems.  Its simple maths:  

1. on average a state budget as % of GDP is 50% (unfortunately lately more)

2. if we assume that UK, EU and USA have 100% debt to GDP, it means that for each 1% interest rate, UK needs to spend 2% of its budget on its debt servicing (in Japan this figure is 4%).

3.  this means that by definition UK cannot increase rates, as it has fallen into a massive debt trap - and frankly you do not need to have a Noble prize in economics to understand this.  

This means that even if UK is in need to combat its 4.5% inflation (announced today), it can do nothing about it, except maybe a small rise for “show”.

Indeed there is another even simpler logic to this.  High interest rates are designed to stop excessive overheating and borrowing, but who is the biggest borrower today in the  UK or USA?  Well the government is, so clearly high rates are a direct hit into the government interests.  China, India and other countries are in completely different position, as especially in China the Government is a net lender.

This is why I also significantly question the independence of Central Banks, as telling the MPC member in UK that your job is to keep inflation down, is simply not realistic.  Indeed I actually feel sorry for all the MPC members who sit there and their only dilemma is:

  - should I do what I was hired to do, and raise rates to 5%, and bankrupt the country as it will mean that its deficit will go up fro 10% of gdp to 20% of gdp?

  - or do I do what is economically right, and keep rates down, print money via QE like crazy, get reelected into the MPC, get awarded a praise for doing a great job (like Alan Greenspan), and hope for this game of Monopoly to restart -  but ideally after I leave the MPC.

Now Central Bankers in India, China, Poland and half of the EM that is raising rates are lucky enough not to be in this position, meaning that they can actually do what they think is right, and not what they have to do.   This is a short answer to the question, that yes I think that it is very good news that Poland is in position to increase its interest rates, and still have growth.

In fact setting my own nationality aside, I think that Poland is an example of the country that due to its size, and fairly low dependence on foreign sector, has managed to create its own little well functioning economy, with own supply and own demand, own savings and investments. Not export orientated like China, not Import orientated like USA, it is just right.

So now that we answered the question that it is good news, lets try to work out what is the right level of rates?

This is not easy.  Generally rates should follow the inflation level, and I even think that ideally (where possible) we should replace all MPC like bodies with the set rule that the Interest Rate should simply follow the Inflation rate from the previous observation period.  This way, the mechanism will correct itself automatically, savers will always be paid how much they lose, and no stupid macroeconomic policy will lead to the problems that USA, UK, EU, and in essence we will take the power away from people to make mistakes.

Now this logic has three key faults:

1.  rates should never be at 0%, even if inflation is 0%.  Zero rates make money as product underpreciated.  Imagine how much water you waste because it is free, and imagine how you would treat it if you were paying for it meter by meter.  Money is no different.  IN fact money is so important that it should never be free, and hence I think that there should be a respectable minimum interest rate, which I admit that in the totally arbitrary way I set at say 3%  (other views are welcome here). Indeed one such view is that optimal level of inflation is at about 3% to correct the issues of sticky wages and sticky house prices, and if we apply this rule, than rates should also be at 3%.

2.  inflation itself is a misleading indicator, as in reality what you want to track is the increase in the money supply, as inflation sometimes is very real and not related to the problems the country is facing.  Indeed current inflation in the “developing countries” is commodities based, and one cannot really fight it, as it is not driven by money supply, but by the basic laws of supply and demand, ie, everyday there are more people in the world, and importantly more affluent and aspiring people, and there is the same amount of land, and even less oil in the world, so it is no brainer that the price of oil is going up on the daily basis and will continue to go up.

3.  the real big picture.  Though ethically questionable, is there anything wrong in running a huge deficit, so that US citizens can buy cheap TVs, cars, import everything for 1/3 of its fair price, and basically live of the wrong export focused policies of the likes of China, SE Asia and Middle East?  At the end of the day, as long as US citizens will be able to appreciate how lucky they were during the last few decades and smoothly revert to normality, cut consumption, accept driving 10 year old cars, than who is a real loser here?  Twenty years of hard work for 2 trillion of worthless dollars.

It takes a very cynical approach to think this way, but frankly speaking, if I would be an Abu Dhabi citizen, each with approx USD4m of savings in the SWFs, I would be concerned, not only about USD, but also about GBP, EUR, JPY and other major currencies.  Perhaps it would be better to pump less oil?   No wonder last week Abu Dhabi's IPIC became a biggest single investor into Glencore IPO taking nearly a billion of it.  Frankly if I would be them, I would have bought the company outright.

Coming back to the issues of inflation… I am afraid that UK should just get used to it, though frankly part of it is also due to food inflation and not only the effects of Quantitative Easting.