Secrets behind interest rates

Last week the Bank of England caught the City by surprise by raising the Interest Rate by a quarter of a point. Not long ago, before Christmas, it also surprised the City by not increasing the interest rate.

This behaviour might be rooted on the “Expectations Theory”. According to this theory, people have some expectations about what somebody else is going to do, and they would act as if those expectations were going to be true. So perhaps the Bank of England was playing with the expectations in order to make them behave as if there were an increase in rates.

What is this behaviour?

Changing the interest rate in order to affect the economy is an idea developed by Milton Friedman. He observed that periods of speculation or situations where there is too much money in circulation lead to increase in prices, what we call Inflation. If the situation gets out of hand, it all can end up in unreal prices. A mix between people not being able to consume anymore because of high prices and a sudden selling frenzy of assets which people think overpriced can trigger a crash, which is followed by a crisis.

In order to avoid it, the Central Bank increases the interest rate. This, on one hand, makes credit more expensive, and people less willing to get them and therefore, less money will be available to keep prices rising.

On the other hand, those who have money will find more attractive keeping it in the bank to get higher interest, with the result, as well, of less pressure on rising prices.

Let’s suppose you expect the Central Bank will increase the Interest rate. You will hold your hand before asking for a credit (above all if rates are variable), or will keep the money just in case you need it in future, because it is better to keep yours than to pay the higher interest in some months. As a result of your expectation, there is less money changing hands. Exactly what the Bank wants to achieve by raising the interest, but without doing it.

Now, the economic data is saying that inflation nearly reached 3% in december, that property prices keep on growing, and growth is expected to be 3%, very high for a developed economy. Facing this data, the Bank could not waste any time and decided to increase the interest to “cool down” the economy.

The other aspect that must be considered when talking about interest rates is the currency exchange, but all the analyses seem to point that it was not relevant in these two decisions.

Why David Beckham’s salary is not an exaggeration

All those who like or just enjoy a bit football (or soccer for this matter) must have noticed that David Beckham has been signed for £128 million. Or in other words, $1 million a week. Excessive as it looks, this amount of money might actually make economic sense.

LA Galaxy, the club that is signing him, is a company. Hence it must have enough revenues to cover its costs. And these costs will rise considerably from April when Beckham starts playing. They must have a plan.

Although his right leg was still one of the best in Europe, Real Madrid, his present club was not signing him from Manchester United to become the new superstar. Beckham had to become a living advert. And he did. There were record sales of shirts, the team got exposure in the whole world. Everyone wanted to see Madrid playing to see Beckham.

LA Galaxy is signing him after a bad performance in the World Cup. He went to Real Madrid to win trophies, and to date, he has won nothing at all. But he is not being signed for being a quality player. He is being signed for being a celebrity-player.

He will boost the name of LA Galaxy around the world (very few people in Europe knew the name of this team until one week ago and now it is everywhere). Thousands of fans will be willing to see him playing, which will fill the stadium. In a moment where the fan base is still being built, this might attract some fidelities to Galaxy. The merchandise sales will soar. There will be a demand to watch the games all over the world, which will turn into TV rights sold. And in a advertising-driven-economy as the USA, advertisers will be pouring millions on the team. Not to mention, obviously, that with such player, LA Galaxy increases the chances to win the championship. And this will attract more fans, more attention, more advertising and more money.

What is hard to comprehend is the amount of money that he will generate now, and above all, in the future. This revenue will make the signing amount small. In that case, if Beckham is generating more money than what he costs, the signing amount is not exaggerated.

We could discuss if it is fair that a single person receives such an outrageous amount of money. That would put us in the realm of ethics, which are not strange to Economics. But leaving ethics aside, it is clear that Beckham is being paid in accordance with his contribution to the revenue of the company, and that is perfectly economics.