Interest rates and the price of risk

An interest rate is the price of risk. That's an economic truism.

Obviously, with stock market volatility at high levels, and the economy tanking, there are significant risks involved in lending or investing.

Therefore, the interest rate needs to be high.

Oh no it doesn't, say voices including the CBI, estate agents, politicians and rent-an-economists in the national papers. Reducing interest rates is the only way to get us out of recession.

Reduce interest rates, and force the banks to lend, so people can once again borrow stupid multiples of income, pay very little for borrowing it, and send house prices rocketing again so everyone will be happy.

Ummm... little bit of a problem. First of all, now consumer confidence is low and unemployment is rising, it's not going to work. People are cutting back. And the bet they're making is that if they hold back now, the house they're looking at today will cost them 30 percent less next year. Reflating the housing market in this environment? Impossible.

Secondly, though, the banks aren't buying it. The banks take their own view on risk - and have made their own views very clear. They are not reducing mortgage rates. Their view is that the Bank of England can do what it likes to its own interest rate - but they will take their own view on risk, thank you very much, and that view is that it's a bigger risk and they need a bigger price to take it on.

Look at the way equities like BT, Cable & Wireless or Enterprise Inns are trading on yields as high as 13%. Guess what - that reflects the perceived risk. The dividend might get cut. Enterprise might not be able to reschedule its loans. BT might not be able to fund its pension scheme without slashing the dividend. The yield (equivalent to the interest rate) is the price of risk - and it's the perception of risk which determines the yield.

So whatever happens, I suspect the credit crunch is going to continue. Because frankly, why would you lend money right now? Especially if someone's going to use it to buy an asset whose price is going down.