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Time to lower interest rates

August 20, 2011

Dear Sir,

Most people in Bermuda know at this point that all is not well in the local and world economies. The problems are bad and getting worse. China and India alone represent about 40 percent of the world's labour and they are willing to work for about 1/10th the wage in the West. Shanghai has a minimum wage of about $2,000/year and this is at the top of the heap in China.

The impact of this cheap labour is seeping through to the West and is leveraged by the fact that the West is over-indebted. It is no longer just the goods producing sector but also the service providing sector that is having an impact on aggregate demand and wages in general. Investment bankers in India are much cheaper than those in the likes of New York and London, accounting, back office, you name it, there are cheaper places for highly productive labour.

Consumption, or retail sales make up about 70 percent of the US economy. There is a negative feedback loop that is in a spiral and looks to get worse. In Bermuda there have been 38 consecutive months of falling retail sales and on an inflation adjusted basis these annual declines are averaging somewhere in the six to ten percent region. In order to maintain margins, companies look for higher unit productivity levels through layoffs. These layoffs lead to lower aggregate income levels which feed back into less consumption which leads to lower top line revenues and more layoffs ensue.

The West has been desperately lowering interest rates to try to offset the pressure on margins. Japan, America and the Switzerland have their rates virtually at zero while Europe seems very likely to back off from their ill timed move to 1.5 percent. Bermuda still has base rates at 3.75 percent with the average Joe paying a seven percent variable. Thirty-year fixed rates in the US are flirting with the four percent level.

Bermuda has had a bit of a cushion because the insurance sector has not been highly correlated with the capital markets but the rest of the local economy is being hollowed out. Too much money is flowing to the banks at the expense of the main street economy. People pay their mortgage at the expense of discretionary spending in the broader economy. My belief is that there will be a break soon and more companies will go belly up and the banks' problem loans will again swell.

Banks are not the core of an expanding economy, but they do feed growth through credit creation when aggregate demand and opportunity exist. Let us face it, the credit bubble has popped and people are trying to work off the over-indebtedness. This is generally a good course of action but there is a confluence of events now that means that the banks need to be proactive and get in front of a potential much larger crisis.

If the banks don't take a smaller share of total income, the problem could move from a liquidity issue to a solvency issue. With around $8 billion in loans, a 25 percent drop in the price of real estate could lead to a solvency issue with the banks. I keep hearing that the banks are willing to work with individuals on a case-by-case basis, which is good, but I feel that not looking at the big picture is convenient to their quarterly earnings but potentially catastrophic to their longer term situation.

We need stimulus in the domestic economy and it isn't going to come in any major way from Government outlays. We have a structural budget deficit due primarily to excess spending in general and a bloated civil service. Government employs more people than other countries, which leads to about $75-$90 million dollars/ year in deficit spending. This structural deficit is social welfare of sorts at the moment and until this is corrected through attrition and higher productivity, Government spending is tapped out. This leaves lower interest rates as our only viable tool for stimulus at the moment.

Traditionally, bank profits in Bermuda fed back into the local economy through dividends and retained earnings. This has all changed drastically in the last decade as dividends and retained earnings go overseas to our bank shareholders. With total Debt/GDP levels well above 100 percent and the nominal economy at best about zero percent, then these interest payments are further shrinking the nominal economy by six percent to seven percent.

This is an unsustainable situation and until we nurse the nominal economy growth back up to the area of the nominal interest rate then we are going to have crisis potential. We need to lower the hurdle rate through lower rates which in turn can stimulate the nominal economy and keep the system afloat.

We never hear what the bankers are discussing about these risk dynamics behind closed doors. They seem to be fighting the wrong war. I think they say they need to get fat because they will cap rates when rates eventually move higher. My point is that things are not what they used to be and there are huge deflationary forces that need to be addressed or the floor might drop. In my view, the banks should address these potential solvency issues and then they can get back to the upside threat of interest rates when the facts change. Can we at least hear from the banks?



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Published August 23, 2011 at 10:00 am (Updated August 23, 2011 at 10:22 am)

Time to lower interest rates

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