Unless you’ve been sleeping under a rock, you’ve probably noticed something unusual this recession – high unemployment and higher home prices. Odd, right? Usually when people are at risk of losing their jobs and business, their cost of living doesn’t rise. Free markets tend to manage risk this way, choking off credit as economic risk increases. Not this time.
Instead of crafting a market-based response, central banks decided to control markets. It didn’t matter what the market did, a small group of bankers decided they knew what it was going to do. Instead of responding to what was happening, they set out to stop a doomsday vision they dreamt. Capitalism was no longer in control, but the state was. At least when it came to investing.
Interest Rates and The Cost of Borrowing
First, let’s just run down the basics. In free markets, the cost of borrowing is tied to supply and demand. Investors scramble to lend money when risk is low, and has a high prospect of reward. This tends to make lending rates cheaper, as well as makes it easier to borrow more money.
If everyone wants to lend you money, you get them to compete by lowering the cost. This is why Zuckerberg has a mortgage – his mortgage rate was less than inflation 10-years ago. He doesn’t need a mortgage, or thinks his house is a wicked investment that’s going to beef up his portfolio. Lenders know there’s almost zero chance he won’t pay the bills. He borrows for free, when everyone else is paying 4x the rate. This is very different from when you and everyone you know can borrow at an inflation neutral cost, but we’ll circle back to that.
When risk is higher, fewer people want to lend money. Less capital to lend, means the borrower needs to give enough incentive to lend. This results in higher rates, as well as lowers the amount of money that can be borrowed. Think subprime lenders, that will lend if you’re rejected from a bank, but they are far from cheap.
The free market manages borrowing well this way. Demand to lend money increases when there’s less risk, dropping the cost of borrowing. It also increases leverage. Demand to lend money decreases as risk rises, increasing the cost of borrowing. It also decreases leverage. It’s a simple, but efficient system.
How Central Banks Broke The Model
When the pandemic started, borrowing rates began to increase. The market basically said, “you know what? We really shouldn’t lend the maximum amount of money to people as the economy goes down the drain.” It exposes both the borrower and the lender to a problematic situation, so both parties tone down. Great success. The free market was working to contain a predatory situation.
The free market didn’t last long though, as central bankers planned a recovery before a drop. They imagined a risk event, decided it was over, and then started the recovery. They slashed interest rates, and when investors wouldn’t accept low enough yields, the state began to compete with investors. Investors wanted a premium for risk? Not today, the state was willing to buy the debt they also guaranteed. Investors with a lot of money, still can’t compete with an organization that has a money printer.
The argument for easy money for the government is a no brainer. Of course they needed cheap debt. How much, is a more difficult argument. Mortgage rates need to be the cheapest possible? Not valid, and doesn’t make sense in basic market theory. Flooding the mortgage market with cheap and unrestricted lending at all time highs was not meant to manage the economy. It was meant to prevent home prices from falling.
This may have been the dumbest thing they possibly could have done. Throw billions at fixing a problem that hasn’t occurred, and you’re not sure will. It was the central bank equivalent of giving an adrenaline shot to someone today, because you’re pretty sure they’re going to go into cardiac arrest next month. Not only does it not fix the problem, it causes a whole other set of problems.
Cheap Money Causes Bubbles
“I will go to my grave believing that the financial crisis happened because of bubbles created by easy money,” once said billionaire Stanley Druckenmiller. How cheap is too cheap? One of the most common things I hear is, rates are so low, you can’t lose.
The perception from many homeowners is inflation will wipe out the debt they have. “I’m borrowing at 1.5%, and inflation is going to be at least 2%. I’m getting paid to borrow!” I hear some variation of that from investors a few times a day now, and it’s technically right. The cost of debt is inefficient compared to inflation. The real value of your mortgage debt will go down if you borrow at a rate lower than inflation.
However, buying a home because rates are cheap is a crowded trade, especially in Canada. Yes, the inflation adjusted value of the mortgage debt will wear down. The problem is you’re probably not Zuckerberg, doing this when other people can’t. If everyone can do it, it drives home prices higher. The general market thinks they can buy a home at any price, and it will be cheaper due to inflation. Most aren’t considering the possibility they have overpaid for an asset.
Maybe a 3-season cottage that can’t be used in the winter, without a water hook-up in rural Ontario is worth a million. Maybe it isn’t. If it isn’t, a 0.5% real decline on your mortgage doesn’t exactly compete with a 10% or greater drop on the total value of that beauty. Back to killing capitalism though.
Capitalism Doesn’t Exist When The State Determines Risk Levels
Monetary stimulus is needed in a downturn, and no one here is saying otherwise. A temporary injection of liquidity goes a long way in stopping a crisis. However, it needs to be a market based response. A small group of bankers creating a doomsday scenario in their mind, and crafting a response to something that hasn’t happened, isn’t market based. It’s something that happens in a non-market, planned economy – typical of communist countries.
Capitalism doesn’t exist without competition and risk. If central banks eliminate competition and risk, they set a dangerous precedent. Participants think free markets no longer apply, and downsides don’t exist. If they’ll send home prices up double digits during a recession, surely they’ll always prevent prices from falling.
After all, they already said they would keep rates low for a predetermined amount of time. They also said they would work to suppress the yield curve, and future borrowing costs. None of these messages from the central bank indicate they plan on listening to the market for the foreseeable future. The rules of capitalism no longer apply. Risk off. Mortgage on.
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