The low inflation trap

Dec 18 2013 07:42
*Edward Ingram
SAFE financial contracts, if they existed, would benefit everyone. They would benefit all of the mainstream financial institutions and governments as well as all of the people, because everyone could then plan ahead without worrying about interest rates and inflation.

Inflation becomes easier to manage and the wealth that you have does not move from you to others that have not earned any of it when you borrow or invest.

I am taking two weekly columns to cover this topic even lightly; the first part follows below.

The reasons why they don't exist

The reason why these financial services do not exist is not known. Opinions vary. Here are some of them:

• The mathematical theory has never been worked out – till recently. It is available on one of my websites. It was also featured in a discussion on the world’s premier Risk Management Website’s almanac of best contributions in 2012 – See the GlobalRisk Community (the link requires membership).

• Too much profit is made out of everyone else’s misery and difficulties and the confusion that exists, and those that have the power to influence or to change that are paid by those that are making those incredible profits.

• People are just used to doing things in the traditional way – counting the money and repaying the money and generally ignoring inflation; or they are trying to keep pace with prices instead of incomes. See last week’s essay.

• Economists at central bank level are the ones that are trusted to steer an economy away from and out of any difficulties - but they have not done so; and by their own public admission they are ignorant in some (to them) unknown way.

I strongly suggest that they look at how financial services for savings and loans betray the people’s trust, and put that right. Then most of the problems which they claim not to understand will vanish and, most importantly, confidence will return.

• A friend of mine who has had experience at a very high level in the educational world tells me that if a proposal is made which may make the powerfully entrenched people at the top feel vulnerable, they have a list of more than 20 ways which can be used to delay or prevent these changes from taking place.

Their fear is based upon the fact that they have spent a lifetime getting to where they are, they understand things the way they are, and any change would make them very vulnerable.

Well, you can take your pick. For my part, all I can do is to show what kind of financial services we could have. It is not for me to make it happen.

However, there is a growing support base from professors, actuaries, and others like retired bankers who are less vulnerable; and one American has started an internet petition to have these new financial services brought before the United States Congressional Committees and President Obama.

The low inflation trap

In my first essay in this series I showed a table which explained how mortgage finance has brought much of the financial world crashing down, not in the high inflation nations but in the low inflation ones. This was not just through the subprime and other issues, but because of the sensitivity that mortgage finance has to interest rate changes.

Here it is again:

The Fed was heading towards a 4.5% interest rate hike needed to curb inflation – implying around 8% for mortgages. It seems that they did not have a copy of these tables! They could not have understood how sensitive mortgage costs are to interest rates.

This table explains the troubles of the construction sector, and why so many people have their homes repossessed even in normal times when interest rates rise. And the same interest rate sensitivity issue applies to government and other bonds. It is this sensitivity to an interest rate increase which is preventing a speedy economic recovery right now.

Taken together, these two sectors of the economy are blocking the way forward for many low inflation countries, slowing the recovery and perpetuating low interest rates for years to come. Cheap money is abused money. This is not a good way forward.

It is called the Low Inflation/Low Interest Rate Trap. In brief, because of the sensitivity of these financial services to interest rate changes in both upwards and downwards directions, low interest rates inflate the price of almost all investments making debt repayments unsustainably low and likely to blow the roof off when interest rates rise.

The alternative is to redesign these two financial services, and so eliminate the problem.

Are there safe alternatives?

This topic will be discussed in Part Two next week.

 - Fin24

*This is a guest post from Edward Ingram, a leading specialist in mortgage finance and macro-economic design for sustainable growth who is involved in studies in macro-economic reforms.

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