Keith Hudson
<<<< CONSUMERS FIND THERE IS NO FREE LUNCH
Ed Crooks
When lenders are virtually paying you to take money from them, it is hard to see the down side. But low interest rates have a price, in terms of the potential misallocation of resources. Money is cheap for consumers today, just as it was cheap for dotcom
companies in the late 1990s. And, just as with the dotcoms, the hangover from the cheap-money party could last many years.
The worldwide cycle of rate cuts kicked off by the Federal Reserve in January 2001 was straight out of the policymakers' play book. Determined not to make the mistakes Japan made a decade ago, central banks have attempted to hold up domestic demand. In the case of consumer spending they have been remarkably
successful.
In the US, for example, private consumption grew by 2.5 per cent in the recession year of 2001, compared with a fall of 0.2 per cent in 1991, the worst year of the previous recession. Similar healthy growth rates were recorded in many other economies, from Australia to Spain to the UK. But consumers have been able to
keep spending only because they have kept borrowing. Low short-term rates have been reinforced by lower long-term rates, encouraged by fears of deflation and rhetoric from central banks. Increasingly deregulated and competitive financial services industries worldwide have made it possible for consumers to load themselves up with debt.
In the US and Europe the burden of household debt relative to income has risen to record levels. Across the Group of Seven large economies, the ratio of household debt to household income has risen to 105 per cent, up from about 90 per cent in the 1990s.
To the extent that it is a rational response to lower real interest rates or more stable household incomes, this build-up of debt need not be a problem. But if consumers begin to worry that they have borrowed too much, the cuts that have not hit over the past couple of years will turn out to have merely been deferred.
The worst-case scenario would be if there is sustained deflation. If prices and wages are falling, the burden of households' debts rises and they have to cut their spending. "Debt deflation" is the classic case in which falling prices are economically damaging: the bigger the debts, the bigger the threat.
Short of that, however, the build-up of household debt could still bring weaker growth for many years if consumers decide they have to bring down their debts relative to their incomes. In particular, many economists, and some authorities including the Bank of England, worry about "money illusion": consumers may have built up debts because they have been focusing on low nominal rates of interest, not realising that low inflation means that real interest rates will not be as low by historical standards.
Perhaps the most worrying consequence of low interest rates is its effect on house prices, which look likely to be to the early years of the 21st century what equity prices were to the last years of the 20th.
Worldwide, house prices rose 6.1 per cent last year, according to The Economist's index. Low interest rates are neither the sole cause nor any guarantee of a housing boom: Germany has its lowest rates for a century, but a flat housing market. But low short- and long-term rates have brought cheap mortgages that have undoubtedly helped fuel the housing markets in many countries.
The International Monetary Fund has concluded that housing booms have been followed by busts 40 per cent of the time. which does not sound like reassuring odds, particularly as the effects of house price crashes tend to be more serious and more prolonged than the effects of equity price crashes.
A reassuring observation from the IMF is that house price falls are often associated with rises in interest rates. While low rates last, prices have some support. But if housing markets are naturally volatile, it is possible that some could simply topple over.
Just as there is no such thing as a free lunch, there is no such thing as free money -- as the world's over-burdened consumers may yet discover.
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Keith Hudson, 6 Upper Camden Place, Bath, England
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