The other main consideration when setting interest rates is employment. Stifling economic activity may have the merit of reducing inflation. This is fine if most working people have jobs. But there is always the risk of overdoing it, of slowing the economy down so much that there is a rise in unemployment. So governments have to strike a balance. Interest rates too low: inflation. Interest rates too high: unemployment.
This may give the impression that it is possible to fine-tune the economy to achieve the optimum balance. If only. In practice, economies respond to changes in interest rates, if at all, in the same way the proverbial oil tanker responds to a tweak to the tiller. The response time can be very long, up to a year; indeed, so long that, by the time any interest-rate changes take effect, the circumstances might have changed so dramatically that the central bankers would have been better steering in the opposite direction. And even if the general course was correct, there is always the risk of undershooting or overshooting. In the UK, the decisions are made by a group of wise persons, the Monetary Policy Committee, which generally changes rates quite slowly, typically by one quarter of one percentage point in either direction. Because these changes are so small, they are generally quoted in smaller units. One percentage point can also be referred to as 100 ‘basis points’ – so in this case the change would be only 25 basis points.
This interest-rate tinkering appeared to work until the financial crisis. After this the situation became so dire that governments desperate to revive their ailing economies slashed interest rates so that they were close to zero – where they have remained ever since. This particular lever thus got stuck and could do little more to stimulate the economy. In fact, banks were reluctant to lend money at any interest rate because of fears that the borrowers would go bust.
The Libor scandal
Banks are not forced to take loans from the central bank. They can instead borrow ready cash from elsewhere, including from each other in what is called the ‘interbank’ market. Ultimately, the rate at which they do so will be set by market forces – by the amount of spare cash the banks have at the time. The actual rate in London, for example, is called the London Interbank Offered Rate – Libor – which is also used as a reference point for banks elsewhere and for credit-card companies. Until recently, Libor was based on a fairly casual reporting system on the assumption that the bankers would simply tell the truth. This was a mistake. In 2008, it was revealed that for many years bankers had often chosen to lie, saying that they could borrow more cheaply than they actually could, so that they would appear to be in a healthier position than they really were – which is fraud. In 2013, the Royal Bank of Scotland, for example, acknowledged that, between 2006 and 2010, 21 traders and one manager had tried to rig Libor. To settle US and UK investigations, it agreed to pay fines of $612 million.4
Lending between banks, honest or not, might seem to cut the central bank out of the picture. But not entirely. The central bank itself also intervenes through what are called ‘open-market operations’. If it wants to reduce the amount of cash in the banking system it has the option not only of increasing the base rate but also of hoovering up some cash by offering to sell government bonds at attractive rates. As will be explained later, a bond is a promise to pay whoever buys it a certain sum of money each year and to return the whole sum after a pre-determined period. Once these government bonds have been sold, they can then be traded on the open market. If, on the other hand, the central bank wants to stimulate economic activity because it is worried about rising unemployment and wants to increase the money supply, it does the reverse. It goes back to the bond market offering to pay whatever it takes to buy back such bonds, thus injecting more cash into the system.
On occasion, however, banks may be so chronically short of money, and nervous that fellow banks might go bust overnight, that they refuse to lend to them at any interest rate. This was the situation following the credit crunch from 2008. Banks hit by losses stemming, among other things, from mortgage defaults in the US, were so spooked that they clung onto the cash they had, so that interbank credit largely dried up. In these circumstances, the central bank can deploy another of its weapons, by acting as a ‘lender of last resort’. If a commercial bank is basically solvent – in that it has sufficient deposits and capital, but just does not have enough funds readily available to pay immediate needs – the central bank can lend it funds and avoid an unnecessary collapse.
Solvents and liquids
At this stage it is worth mulling over what ‘solvent’ means. If you have simple financial affairs and have $20,000 in the bank and total outstanding bills of only $10,000, then you are solvent. On the other hand, if you only have $10,000 but owe $20,000 you are in a less happy position. As an individual, you may not worry about this, on the grounds that you have a job which keeps enough money flowing in to pay the interest on the loans. But technically, if you have no other assets, you are insolvent. This is more of a problem for companies, including banks, which legally are not allowed to continue trading while insolvent. If you are insolvent, then creditors may take you to court to have you declared legally bankrupt.
But being insolvent is not the same as being ‘illiquid’. You might think that being illiquid – which sounds equivalent to solid – is a good thing. But for a bank it can be a problem. Return to the situation where you were declared technically insolvent, but then you suddenly remembered that you owned a house worth $100,000. Immediately you realize that you are solvent. Phew! However, because most of your assets are tied up in bricks and mortar and you don’t have much ready cash, you are considered illiquid. In the long term you should be OK but in the short term you may need to borrow some money to pay your immediate bills, perhaps using your house as security.
Banks too can be solvent but illiquid. They might, for example, lend someone the cash to buy a house and not expect to see all the money back for 20 years. This loan represents an asset for the bank but not one it can use immediately, so if it were faced with a lot of withdrawals it could face a liquidity crisis. While it is still probably solvent, since the loans it made still count as assets, it has nevertheless become illiquid.
The lender of last resort
In this case it may well need to borrow from the central bank – the lender of last resort. The Bank of England took on this responsibility from around 1825. Recognizing the value of having a central bank for these and other purposes, many other countries followed suit. The Banque de France emerged from 1800 and in 1875 the Bank of Prussia became the Reichsbank. The US equivalent, the Federal Reserve System (the ‘Fed’), was created in 1913 following a series of financial panics. The Fed is not just one institution but a system, which includes a central governmental agency in Washington DC, a Board of Governors, and 12 regional Federal Reserve Banks, which perform central banking functions within their own regions. The most important of these is the Federal Reserve Bank of New York which, as well as regulating New York banks, is responsible for the Fed’s open-market operations.
Having a ‘lender of last resort’ offers a degree of security. The downside is ‘moral hazard’ – a situation where people protected from the consequences of their actions are tempted to take greater risks. Bankers, knowing that they have a central bank safety net, may make dangerous bets in search of higher profits and personal bonuses. Even if the bets fail, the bank is likely to survive. Governments will step in because bank failures are dangerous. Politicians fear the fallout from angry small depositors, but also know that the banks are intricately interconnected through webs of interbank lending so that the failure of one bank to repay an overnight loan could topple many other dominoes.
Another concern is that the central banks themselves