Saturday, 16 April 2011

Rationing is taking place in the UK

Do not underestimate the importance of prices in shaping our quality of life. Countries without them do not prosper. Prices are the key component which co-ordinate supply and demand in an unpredictable, ever changing world. Zero percent interest rates sound great to many, just like having a free bread policy or setting its price below the market level. As previously discussed, it can only lead to rationing which is occurring in the UK today with Mortgages. Its not just backward countries that can experience such a phenomenon.

Interest rates are prices. Unfortunately the government tries to set such prices, usually below the real market level. Well we may like to think that our society is above all that rationing nonsense but that's exactly what is happening in a developed Western country today. 

After the financial crash of 2008 the Government took out large stakes in many UK banks. It also propped up the financial system by slashing interest rates in an attempt to pump liquidity into the insolvent system. It did the job - the losses were stemmed and prices began recovering. The problem was bad assets were not liquidated. Bad loans that were made during the credit boom, again engineered by the Governments loose monetary policy by setting interest rates too low, are still present. These bad loans remain on the Banks books, and they know it. In order to cover against such bad loans (and ensure no more are made) banks they need to preserve capital in order to cover such shortfalls. Viewing housing as a dead duck, Banks demand borrowers to stump up larger deposits, deposits they know people can not afford. They are sitting on cheap money supplied by the Government at very low rates but are too aware of the poison within the system. 

A true free market would clear prices, drive savers interest rates up in order to meet the capital supply and demand imbalances while liquidating bad loans. Its similar to wheat shortages. Bread prices in such a situation would rise, forcing demand to tighten and directing economic resources to find new sources of wheat increasing the supply thus solving such market imbalances.

The free market can't do this with mortgages today. During the credit boom people were given 125% mortgages and interest only payment options. So long as the market went north, banks would have the required equity in a house if repossession was necessary. Now with prices falling Banks are driving up interest rates for people with less than a 25% deposit, the banks safety margin. If you wish to take out an interest only mortgage (which few banks offer) then they drive up rates to deter the buyer and cover the risk that less buffer would be created by the buyer. In these times you need at least a 10% deposit, even then the deals are few and sparse with rates on such products far above the Bank of England's base rate. The Bank of England's artificial interest rates keep the whole system in a zombie state, a la Japan. The commercial banks can access cheap money so existing borrowers with large capital can access it and savers have zero percent interest rates on their savings. There is no incentive to save, repair the capital shortage, as Central bank give out money for nothing. Why pay someone to save and accrue genuine capital when you can borrow from the Central bank for nothing (which incidentally is not real capital, it in fact erodes the value of genuine capital within society).

You can't escape the basic laws of supply and demand by artificially manipulating prices. 

As the market rations mortgages people believe we need further Government interference despite the fact that they caused the shortfall in the first instance. The Governments solution is to take taxpayers money and give it to first time buyers to meet the banks deposit demands. Of course this only makes matters worse. The Government merely diverts economic resources from more sustainable lines of production into the dead duck that is housing. It gives this to people who probably can't afford the house in the first place. It also is completely unfair as it becomes a lottery who wins this money. If further losses are incurred then it is the taxpayer that foots the bill thus creating a double negative.

The solution is to allow prices to do their job. Otherwise rationing is the option and that is the last thing we need.

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