Tuesday, 25 November 2008

Forced bank lending the latest instalment in Labour’s doomed spiral of intervention

Alistair Darling appears set to commit an 80 year old mistake. In his misguided attempts to control the UK economy and force businesses to conform to New Labour’s agenda, he is again going to intervene between banks and their customers.

He has already intervened countless times over the past year, but this latest intervention is pitifully predictable. Indeed, as was explained 80 years ago, it was inevitable that his previous interventions would have unintended consequences that would be the opposite of what he intended, and that to counter those consequences he would be obliged to intervene again and again to ever greater degrees.

Published in 1929, just as another depression was about to rock the world economy, Ludwig von Mises’s Critique of Interventionism demonstrated that as soon as politicians began to intervene in the economy, they would have to continue to do so until ultimately the entire system came under their control. According to von Mises, interventionism was simply unsustainable: either one accepted the laws of economics or one was forced to implement socialism.

We can see how this works if we consider price controls – an example that has striking relevance to Mr. Darling’s current dilemma.

If government tries to fix the price of a commodity, it will not be able to sustain prices below those that the unhampered market would set. This is because with price controls:
"Sellers are forced to sell their goods at lower prices, so that proceeds fall below costs. Therefore, the sellers will abstain from selling and hold on to their goods in the hope that the government regulation will soon be lifted. But the potential buyers will be unable to buy the desired goods."
The result, therefore, will not be the increasing availability that the government sought but a reduced availability of the good resulting from suppliers having no wish to supply at such a low price. To raise supply to the level the government desires at the price the government has mandated, it must therefore intervene again to force suppliers to supply the good: “…it tends to supplement the price ceiling with an order to sell all goods at this price as long as the supply lasts."

However, as the good is now on sale for below its real value, far more customers will emerge than would do so if the good was priced naturally. And since the price is "below that which the unhampered market would set, the same quantity of goods faces a greater number of potential buyers who are willing to pay the lower official price. Supply and demand no longer coincide; demand exceeds supply, and the market mechanism, which tends to bring supply and demand together through changes in price, no longer functions."

There is still not enough of the good to go round, but now it is not because of suppliers reticence but excess demand caused by under-pricing. Government has prevented the price mechanism from operating to prioritise this demand. Therefore another means must be found to decide who gets what, which leads to the third wave of intervention: Rationing.

"Of course, government cannot be content with this selection of buyers. It wants everyone to have the goods at lower prices, and would like to avoid situations in which people cannot get any goods for their money. Therefore, it must go beyond the order to sell; it must resort to rationing. The quantity of merchandise coming to the market is no longer left to the discretion of sellers and buyers."
But why, if the price is below that at which suppliers can make a profit, would they produce the good at all? Only if the government intervenes to force the production of the good. Consequently, the fourth intervention takes place:

"When that is exhausted the empty inventories will not be replenished because production no longer covers its costs. If government wants to secure a supply for consumers it must pronounce an obligation to produce."
And how can this be achieved when costs are below prices? Only by driving down costs, which requires government to intervene to set the prices of the factors of production that go into producing the good. Ergo, "it must fix the prices of raw materials and semi-manufactured products, and eventually also wage rates, and force businessmen and workers to produce and labor [sic.] at these prices."

But what, you may ask, has this to do with Mr. Darling? If one considers money and borrowing to be commodities, the answer is everything.

Government has long been intervening to keep the cost of borrowing below the market rate. This is the role of central banks: they enable governments to control the supply of money by forcing lending rates down below the market rate, so stimulating artificial and unsustainable booms that keep the voters sweet until the next election. The Bank of England did this again last month. Under normal circumstances, a “credit crunch” should result in an increase in the cost of borrowing. This would result in more saving and less borrowing until a new equilibrium was reached. However, the government has intervened to keep the cost of borrowing low.

As von Mises predicted, however, this has had unintended consequences. The government may have wanted low interest rates, but the banks were still inclined to set interest rates based on risk: as default is more likely now than it was a couple of years ago, the cost of borrowing is raised to take an actuarial account of risk. Also, as the banks have limited capital, they are bound to lend to the most profitable borrowers: those who will pay higher rates. So inevitably the government is again inclined to intervene to force banks to lower rates.

The predictable result is that banks won’t lend. They’d rather buy government securities or look abroad for more valuable investments than lend to businesses and householders at rates that are no higher than inflation or make a tiny real return but involve huge risk (companies will go to the wall; mortgagees will default). So the third intervention comes, as Darling forces the banks to lend.

Not to everybody, mind. Already the rationing is appearing: the BBC suggests that the intervention will be for favoured groups, which at this stage consists of “Small businesses” (which means it might be time to sack that 50th employee and cut one’s borrowing costs!).

One can only begin to guess at what the unintended consequences of this latest intervention will be. However, the two things of which we can be sure are that further interventions will inevitably follow as long as Labour ministers believe that they can over-ride the laws of economics, and that these interventions will continue to have unintended and negative consequences for all of society.


Kit said...

The government, via the FSA, increased the banks capital requirements thus reducing the amount the banks have available to lend. I think Labour call it joined-up government.

Kit said...

For any Hayek fans this worth a listen:


It could have been recorded today rather than 1975.

dreamingspire said...

I submit that comparing the supply of produceable goods with the supply of a non-physical item, namely money, is fallacious. In general government doesn't control the supply of goods, but it does control the supply of money - first by using money that it has (which is where we are now) and later by "printing" it (which is where I hear in the news this morning the USA may soon move to). The argument is then about how that money is used.
And I further submit that, by increasing the cost of money, the banks are increasing the risk of default. When I was running a business I used to point out that it is not paying the interest that is the real problem but repaying the capital - but that was in a time of quite low interest rates, even for personal borrowing, yet there were still businesses squealing loudly when bank rate went up 0.25%.

Tom Papworth said...

"In general government doesn't control the supply of goods..."

Ah! But they would if they could ;o)

On a more serious note, I will admit that the analogy is not perfect, but it serves a purpose in demonstrating the general principle, which is that government intervention always has unintended consequences which require the government either to accept market forces or to intervene further until eventually the entire system comes under their control. This is clearly happening in the banking sector too even if money is not quite the same kind of good.

The argument remains whether government is better placed to direct the economy than are the individual actors themselves. I would contest that the answer is patently in the negative.

"by increasing the cost of money, the banks are increasing the risk of default"

That does rather fly in the face all acturial accounting. Interest rates reflect risk, which is why the Bank of England rate is lower than the LIBOR rate, which is lower than the mortgage rate, which is lower than the credit card rate.

dreamingspire said...

"That does rather fly in the face all actuarial accounting."
If my costs rise, then the risk of my business failing rises. Raising the interest rate on my borrowing is a rise in my costs, just like any other. Take two businesses with borrowings: if my bank doesn't pass on the recent base rate fall, I become less able to compete against a business whose bank does pass on the rate fall. If my bank decides to actually increase the rate that they charge me, its even worse. Actuaries take note, please. Of course you could argue that the actuaries are in the business of making some businesses fail because today's reduced market cannot sustain all of them, and that socialist policies just grind everything down. Could there be a real third way down the middle? An equitable market? As I have posted elsewhere, free markets are metastable, so the battle is to manage them.
If a credit card company (actually a bank) raises credit card interest rates when base rate falls, that's really cruel. Socialists take note here: banks are there to help themselves, and presumably the actuaries are there to help the banks.

Tom Papworth said...

I understand your point about costs, but that does not change the fact that interest rates factor in risk. This isn't about being "cruel"; it is a sensible and logical reaction to increased risk of default.

To suggest that it is a conspiracy is just daft. It doesn't need actuaries to bankrupt businesses that should never have been borrowing such large sums - and never would have done had government not artificially kept interest rates low for the past decade.

"Could there be a real third way down the middle?"

No. That is the whole point of Mises book. Intervention must either be abandoned or must proliferate until socialism is implemented.

"Socialists take note here: banks are there to help themselves, and presumably the actuaries are there to help the banks."

Er.... Yes. Just as you set up your business to help yourself, and employed staff to help your business. That's kind of the point.