Low Inflation Trap

This page has been updated and move to the main blog.

A recent comment from a reader - name withheld pending permission to reveal it:
Dear Edward, 
This is by far the most interesting piece that I have read so far. Indeed, the house price problem is one that governments and central banks have to grapple with, particularly the EMU countries where the financial structures are so different leading to some of the major problems in those economies. I did want to structure my PhD thesis along these lines,...


When interest rates get too low, property prices swell, forcing people to borrow more if they want a house to call home.

In a recession after the bubble has burst, and property prices have crashed, governments and central banks try to stimulate demand by lowering interest rates further.

But when recovery sets in nominal interest rates start to rise. This makes the cost of a mortgage increase dramatically – far more than the accompanying increase in average earnings, and thus much more than the percentage increased demand related to rising incomes, diverting spending into faster mortgage repayments.

This also undermines property prices and the wealth that is stored there, reviving bad memories again and slowing consumer spending through what is known as the ’wealth effect.’

This is further re-enforced by the effect on the value of fixed interest rate bonds. Any recovery from slow growth feeds through to a raise in interest rates and a discouraging scenario that begs for a return to the prior condition of slower economic growth followed by lower interest rates.

In Adam Smith’s Wealth of Nations, the increased mortgage costs and bond servicing costs should be proportionate to the increased spending and increased incomes as the economy recovers. But what we have is from mortgages is a disproportionate response that creates a negative feedback loop that is directly caused by the response of people to the unstable behaviour of the mortgage cost structure. Then there is the unsafe behaviour of fixed interest rate bonds whose value rises and falls disproportionately fast as well.

Raising the interest rate by 1% in an environment where long dated bonds are offering a yield of say 2% may trend that yield towards 3% and thus (in simplistic terms) halve the current capital value. The figures can be argued with and rightly so, but the multiplier effect on the value cannot be argued with. And the wealth effect and the effect on balance sheets is significant.

These forces act against any economic recovery, by making it extremely uncomfortable as asset prices drop and  new borrowing costs rise dramatically. Where variable interest rates have been used the dynamics of cost and diversion of spending from consumption can be even more dramatic. Is this the kind of instability that we wish to live with?

This is what engineers call negative feedback. It is used in order to moderate changes and to home in on in a target, which in this case is slow economic  recovery or slow economic growth.

This is what Edward calls a Low Inflation Trap. This will slow economic recovery significantly and unless we change these debt structures a repeat performance is likely. In fact both the Austrian School and a paper by Claudio Borio at the Bank for International Settlements point out that this rapid swelling (Edward calls it geared swelling relative to all other prices) has been the fore-runner of many an economic crisis for centuries past.

It is time to address the problem.

That is why the main website:

is now devoting pages 1 - 10 to the agenda for a commission of enquiry with an outline of a forthcoming book placed on the Home page.

Please pay particular attention to the IMPLEMENTATION page. It can be done.

The Home page points out:
Packaging the products is easy. Mortgages cost less wealth every year so rentals will cost more than mortgages after about a decade into the contract. See illustration sketches below.

Bonds will be index linked to GDP so the share of GDP that you earned as income and saved by investing in bonds will be preserved. You deserve that. It costs nothing to preserve wealth other than admin costs. 

The lead-in is easy: keep mortgages the way they are now but add an escape hatch whereby if they become too expensive as interest rates rise, the borrower can chnage horses. This buys time for the banks to re-organise and increases the public's trust. Funding is easy for the banks - property values stay inflated for the time being so they are safe and people feel safe and they can raise funds for lending linked to average incomes growth rates or to GDP. We get a soft landing and we create the confidence needed. Mortgage sizes are very inflated just now. The authorities have to allow them to reduce in an orderly fashion relative to incomes as incomes are growing. We get back to mid-cycle conditions this way, and thereafter we stay there. Property values are now safe and 100% mortgages are safe too. Savings and pensions are now safe. WE may get to have more of them.

Governments can buy back their unsafe bonds at a value that investors will not be able to refuse because by indexing to GDP the value will be safe. A bit of inflation will help them to do that and at the same time they will be able to cut their debt/GDP ratio by buying their debt cheaply under the threat of inflation. Thereafter, their borrowing costs will be about 1% p.a. and the economy will grow having shed the unstable wealth everywhere other than in equities and other forms of gambling."

In the mathematical studies of Mortgage Theory on the 
pages and again in the 
pages you can study how we can 'stretch' the ILS Mortgage Model in order to prevent property prices from falling in money value, allowing incomes and interest rates to rise without causing any serious discomfort as economic recovery sets in.

Doing this ought to overcome the main problem, thus enabling economic recovery to continue unimpaired and without any need for major interest rate subsidy, however created (by Quantitative Easing, or otherwise).

And this site you are on

gives practical descriptions of how all parties concerned in the behaviour of an economy can adapt.

For a fuller explanation of the LOW INFLATION TRAP with tables and illustrations,
Try the QE2013 Blog  

This is a fully illustrated essay on the situation that we are currently in and how the new ILS Mortgage Model would provide a solution. The provisions made, should hyper-inflation occur, are also outlined based on experience in Zimbabwe.

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