International Political Economy

Leiden University 2011 - Agustin Mackinlay (mackinlaya@fsw.leidenuniv.nl)

Session 2. April 7, 2011
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An Introduction to Credit Markets

The importance of interest rates
Credit, it has been said, is the lifeblood of the modern economy. The capital resources available to entrepreneurs (and therefore job creation), the cost of the public debt (and therefore future tax levels), the value of our homes — all depend on the availability of credit and on the level of interest rates.

Credit is power! In his biography of the Duke of Marlborough, Winston Churchill marvels at the power of the City of London to “manufacture” credit and win the war against Louis XIV. See also Gideon Rachman’s recent book: the 2008 financial crisis will be remembered as the moment when the US finally lost its position as the only global superpower.

Emerginmg powers across the world are taking steps to beef up their financial systems and credit markets in order to provide households, entrepreneurs (and goivernments) with reliable credit instruments. (See DIFC, HKMA).

With that in mind, one remembers US Democratic strategist James Carville famously quipping that he wanted to be “reincarnated as the credit [bond] market because it can intimidate everybody”.

Credit & wage levels. Countries that face a high cost of labor and —simultaneously— high interest rates (cost of capital) usually are in deep trouble: Argentina 1999-2001, Greece 2010. Such situations usually will require new solutions in terms of financial diplomacy.
Long –term interest rates and the Horace Brock Paper

[QUESTION: Who sets interest rates?]

Journalists would have us believe that central banks set interest rates. This is true with respect to short-term interest rates: central banks have a number of instruments at their disposal to set the interest rate at which commercial bank lend to themselves for very short periods of time (usually overnight). 

But you don’t build a factory, you don’t buy yourselves a home on an overnight loan! 

That’s where the excellent Horace Brock paper comes in. Long-term interest rates (10 years or more) are set on the largely deregulated and globalized credit market. The key merit of the Brock paper is that it provides us with a very simple framework to understand how long-term interest rates are set. It is a plain supply and demand framework, much as if we would be analyzing the supply and demand for apples or oranges. True, the paper has aged a bit, but we can update it pretty easily.

[REQUIRED READING! Horace Brock: "Determinants of interest rates", in Boris Antl (ed.). Management of Interest Rate Risk (London: Euromoney Publications, 1988].

An ‘extended’ law of supply and demand

How do we analyze the determinants of interest rate movements in today’s deregulated, globalized environment? What paradigm is most appropriate? We shall argue that the complexities of today’s environment require that we analyze interest movements in what can be called an ‘extended’ law of supply and demand in the credit market. Although this approach is both theoretically correct and intuitively appealing, it is surprisingly unfamiliar to market participants as well as to many who construct forecasting models.

Surprisingly, one reason this is true is that most people do not understand what the law of supply and demand means in a credit (as opposed to a money) market context. In this regard, shifts in credit supply and demand are often mistakenly identified with changes in economic flow-of-funds. In other instances, supply and demand considerations are incorrectly seen as incompatible with more important ‘psychological’ factors. This chapter will clarify the true meaning of supply and demand in today’s deregulated credit market. In doing so, it will demonstrate how the extended law of supply and demand is able uniquely to explain numerous dramatic events in credit markets.

The extended law of credit supply and demand Exhibit 1 [not reproduced here] shows the working of today’s credit market. On the left are those who ‘lend’. Note that the central bank fits in here in a natural way via its open market activities that provide bank reserves to the banking system. As the diagram indicates, it is the banks that provide credit — not the central bank.

How do interest rates change within this framework? They change when the behavior of borrowers and lenders/investors changes. But what do we mean by a ‘change of behavior’? Understanding this concept is the key to everything. The ‘supply schedule’ here can be best thought of as the nation’s aggregate ‘willingness to lend’ schedule (foreign lending is included). This schedule depicts the total amount of funds that will be made available at any given nominal interest rate. Naturally, the higher the interest rate, the more credit will be made available, other things being equal. Hence the schedule has a positive slope. A parallel analysis holds for the demand schedule, although in this case the quantity demanded decreases as the price rises. Equilibrium occurs at the point of intersection of the two schedules.

Changes in interest rates
As the state of the world changes, the aggregate willingness to lend at any given interest rate (say € 500bn annually at a 5% interest rate) will change. It will either increase or decrease. For example, if inflation escalates, people might only be willing to lend € 400bn at the same 5% nominal rate. But as this decrease will be true for any and every level of interest rates, the entire schedule clearly shifts backward. It is this ‘functional shift’ (of the schedule) that causes interest rates to change.+

Why do we emphasize this point? Because it is often misunderstood. For example, suppose you hear that ‘mortgage credit demand has increased’. Does this constitute a ‘change’ that will lead to an increase in interest rates? Not necessarily. If the increased demand is itself simply a response to a lower interest rates, then this increase represents a shift ‘along’ the given demand curve. It is only when demand is greater or lesser at a given interest rate that the entire schedule shifts, and this that interest rates can and do change.

[END OF THE HORACE BROCK PAPER]
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Bank Credit and Bond Markets

Roughly speaking, there are two broad credit channels. Bank credit: depositors entrust their assets to commercial banks, who in turn loan out those resources. Banks make a profit from the difference between the rates they charge to their clients and the rates they pay on deposits. By lending out money to households, entrepreneurs and corporations, banks take on credit risk. It is a highly regulated industry; banks need to hold capital against the contingency of loan defaults! 

A bond is a contractual obligation that is performed directly between borrowers and lenders, that is, without the intermediation of banks. A bond specifies the amount of the loan, its maturity, its interest rate. Bond markets have reached a very high degree of sophistication in most English-speaking countries.