Friday, July 20, 2012

LIBOR re-visited

We've all heard this story before.

If you drop a frog in a pot of boiling water, it will of course frantically try to clamber out. But if you place it gently in a pot of tepid water and turn the heat on low, it will float there quite placidly. As the water gradually heats up, the frog will sink into a tranquil stupor, exactly like one of us in a hot bath, and before long, with a smile on its face, it will unresistingly allow itself to be boiled to death.
(This version is from Daniel Quinn's The Story of B)

Only problem is... the story isn't true. Frogs will jump out either way. Nonetheless, it serves as a powerful metaphor. We all understand its underlying meaning.

Here's a slightly different story (There are a lot versions of this story. Here's the link for the one I used.):

It is the month of August; a resort town sits next to the shores of a lake. It is raining, and the little town looks totally deserted. It is tough times, everybody is in debt, and everybody lives on credit.

Suddenly, a rich tourist comes to town. He enters the only hotel, lays a 100 dollar bill on the reception counter, and goes to inspect the rooms upstairs in order to pick one.

The hotel proprietor takes the 100 dollar bill and runs to pay his debt to the butcher. The Butcher takes the 100 dollar bill and runs to pay his debt to the pig raiser. The pig raiser takes the 100 dollar bill and runs to pay his debt to the supplier of his feed and fuel. The supplier of feed and fuel takes the 100 dollar bill and runs to pay his debt to the town’s prostitute that, in these hard times, gave her “services” on credit. The hooker runs to the hotel, and pays off her debt with the 100 dollar bill to the hotel proprietor to pay for the rooms that she rented when she brought her clients there.

The hotel proprietor then lays the 100 dollar bill back on the counter so that the rich tourist will not suspect anything. At that moment, the rich tourist comes down after inspecting the rooms, and takes his 100 dollar bill, after saying he did not like any of the rooms, and leaves town.

No one earned anything. However, the whole town is now without debt, and looks to the future with a lot of optimism.

Okay, as you might've guessed: this story is fictional as well. It makes no attempt at hiding that fact. It's a little harder to understand, but it again provides a powerful idea that is economically sound. The power of cheap money and easy credit, aka stimulative monetary policy. 
Money needs to be cheap, so home buyers can buy homes, businesses can expand, and investments for the future can be made. Every central bank in the world has made it their policy to lower interest rates and expand the monetary base. As the monetary base expands, so does the economy. A rising tide lifts all boats.
Here is the problem: Despite all these efforts, it isn't working. Money still isn't cheap. Banks and businesses are hoarding money to protect against future uncertainty. They need liquidity to handle another crisis, if it were to arise. So they don't lend, they don't invest, they just sit on it. Waiting. Waiting for a better economy to arrive. One that isn't so unsure of itself. But no one knows when this is going to come. It's a global crisis of confidence for good reason. 
As banks want to sit on the free (or practically free) money given to them by central banks, the only way to entice it out of their hands is to offer them a much higher interest rate than what the central bank has already given them. The bankers are saying pretty clearly, "It's not worth it to us to lend out money at 2 percent, but we will accept the additional risk for 5 percent. If you can give me 5 percent, then you have yourself a deal. " As such, it is the deal for banks to lend money to other banks. Interbank lending rates (LIBOR) go up, despite everyone wanting them... no, needing them... to go down. 
If you a central bank and you see this, how do you keep interest rates low? Lie. Or, better yet, get others to lie for you. Or, best yet, if they are lying on their own already, just go ahead and let them. Tell everyone that LIBOR is really at 2.00 percent instead of 5.00 percent. They will believe you. Interest rates will stay low. Everyone will be better off for it. 
It's not true, but the idea is more powerful than the reality.

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