La Crisis

Everybody seems to be getting bored with our current economic problems.  However, it is important to recognize the reasons for the crisis and also the realities of our situation in order to take action to correct it.   At present, at least in public, we are in denial, and many think that the problem will resolve itself with time.  That may be true but at what cost?

Apart from the obvious problem of overvalued real estate, too much emphasis on short-term profit, over-reliance by local government on property taxes, etc., I see interest rate policy as being at the heart of the problem.  How so?

In my view, nobody benefits from low interest rates in the longer term for the following reasons.

Savers:
In times of low interest rates, savers invariably receive interest lower than the average inflation rate (3%). In addition, they have to pay tax on this unearned income.  So, without spending any of their income, their capital is eroding at an alarming rate.  

Personal Borrowers:

Low interest rates make property ownership more affordable in the short term.  Very quickly, prices start to increase forcing new entrants to borrow larger amounts of money to fund their purchase.  This means that they are spending a larger percentage of their income on their homes and, when interest rates rise, their situation becomes perilous.

Corporate Borrowers: 

It is hard not to understand corporate borrowers taking advantage of low interest rates.  If their borrowing costs are 5% (cost of funds plus lender's margin), their net interest cost, after tax, is equal to average inflation therefore, they are paying zero or negative interest on an inflation adjusted basis.  The problem is that this situation encourages companies to borrow too much.  The companies that are doing well even during these times are mainly those who do not rely on the banks for funding or have not over borrowed.

Banks:

Low interest rates are bad for banks.  Commercial banks make their money in three ways.  Interest margin on loans, fee/transaction income and interest margin on resources.  If the margin on resource income is lower (as at present due to a lower return on "free" deposits), then the bank must improve its return in the other areas to maintain profitability and keep shareholders satisfied.

Banks have been increasing their charges, both normal and penalty, at an alarming rate.

On the lending side, banks also need to improve their income.  With margins being squeezed due to competition, banks have been gearing up significantly and utilizing the markets to source funding.  This is invariable a disastrous strategy.  Although they are not mis-matched on an interest basis, they are funding very long-term mortgages (up to 40 years in some cases) on a short-term basis.  In such a situation, there is always the potential of a liquidity crisis.

And, let's not forget the potential for bad debts.  Perhaps the Banco de España needs to start fulfilling its role properly as the overseer of the banking sector.  It is worth investigating the rather large property portfolios acquired by the banks from their clients and which are not being released onto the market thereby creating an artificial shortage of housing and the consequent effect on property values.  The absence of control of interest rate policy makes things difficult for the Banco de España in helping to control the situation, but not impossible.

Banks are funded by their clients and the inter-bank market, not in any meaningful way by their shareholders.  When banks lend to companies, they are not too worried about those companies' shareholders - they put themselves first in line when things go wrong.  Perhaps they should also put us first when we lend to them (by way of credit balances in our accounts) rather than their own shareholders.  A nice thought!!

Interest Rate Policy:

Some years ago, we were told that low interest rates were desirable to encourage investment in the production process, especially in Germany.  This in turn would stimulate economic growth in Germany which would pull us all along to a more prosperous future.  Actually, Germany has never been an engine of growth for the rest of us (that's the USA) rather, they have been a significant exporter of inflation over the years.

My view is that this idea was a great lie.  Low interest rates were desirable to stimulate spending (usually on products from the Far East) as a means to fund (via taxation) European expansion to the east.  Not necessarily a bad idea but why the rush?

Low interest rates have been the basis of the problems in Ireland and Spain.  I have no doubt that, should the ECB decide to raise interest rates in the future (probably this year to stop inflation in Germany and France), not too much consideration will be given to the effects on the economies on the periphery of Europe so, in this scenario, I can see our problems here in Spain getting worse, not better, over the next few years.  Perhaps interest rates will not rise while Zapatero holds the European presidency.

Summary:

The question of interest rates is only one of the problems.  There is a need to address many issues such as the high cost of moving home here in Spain due to taxes and the ridiculous situation where a Notary is required (at enormous cost) to witness signatures for these transactions.   Only when action is taken on such fundamental issues will our economy move forward.