Blog Archive -August 2013

23th August 2013
In the last few weeks there has been quite a lot talk about growth in the UK economy but many question it sustainability especially as it coincides with the government's new help to buy or mortgage guarantee scheme. The excitement has been generated by a rise in the GDP figures but analysis of other data can provide a more in depth picture.
In Wealth Creation and Wealth Destruction a correlation has been made between the growth in GDP and the growth in the money in the real economy as opposed to asset economy. With the government following an austerely policy that equates to removing money, growth or otherwise will come from the balance between savings and lending. In normal times bank lending will be greater than savings due to the banks needing to return profits which in turn leads to a growth in the money supply and generally an increase in real growth. If however savings, which for this purpose include company profits etc, exceed lending the economy will contract and this is what has happened over the last few years; banks that have over extended themselves have held on to loan repayments and at the same time reduced new lending. This has been compounded by the corporate sector that is sitting on a pile of cash and seeing a steady return on their previous ventures with no real incentive to make new investments.
This contraction of lending is illustrated in the Bank of England figures for lending. They show a contraction in lending which is consistent with debt being paid off with no new lending. However since June of last year this contraction in lending has started to ease off which also coincides with modest growth in the M4 figures (based on annualised figures moved from contraction to growth around January 2013). So returning to the question of how sustainable the growth is; it probably is real. That easing off in lending contraction can probably be accounted for by many of the fixed term non secured loans (up to 5 years) coming to an end which brings two benefits 1) those who paid off the loans will have more disposable income and 2) those lenders have lost a stream of income and more ready to make new loans. And if anecdotal evidence is to be believed is happening now; a friend was cold-called and offered a non-secured loan at a very competitive rate. This sum of this money will probably lead to a bounce in the economy but growth cannot be assured until the contraction in lending has fully been reversed and that is unlikely to happen for some time whilst those who overextended themselves on mortgages struggle to pay them off in this low inflation period. There is a small contradiction in this arguments and that is that M4 should not grow whilst lending is contracting but this can probably be explained by money that that has been squirreled away being returned to lending; another reason maybe the growing number of pensioner drawing an income from the asset part of the economy. This all suggests very modest growth could be maintained but whether it is sustainable will depend on what this newly released money will be spent on. Currently it would appear to housing following a pent demand during the drought years but the resulting bubble has limited potential as housing is still overpriced for the majority of the population. The alarm bell are also ringing over the number of buy to let montages and this may nip any real growth in the bud as they will push up rents that may absorb this newly released income leading to stagnation at best.

13th August 2013
Another reason why the much touted low interest rates of 0.5% will not deliver growth is a misunderstanding of risk. One can understand the logic; the prospect of cheap money over the long term will give borrowers a sense of stability to make long term investments however most decisions are usually made on how much one will lose rather than what one will gain. This is why sure fire making scheme are always oversubscribed and any project with a genuine risk of failure go unfunded. Coupled this with a relatively low inflation and relatively high profits on current investments and there is no real need for the large corporations to lend or invest in new projects. This is all illustrated by comparing two UK government initiatives, the relative failure of Project Merlin where banks had targets for lending and the current success of mortgage guarantee scheme where a proportion of the mortgage is underwritten combined with a pent up demand.
The success of this latter scheme may be short lived and will do nothing growth in the real economy in fact it is more likely to snuff it out as the interest repayments are likely to outweigh any growth in the money supply. A better course on interest rates would be to raise them. This may lead to a little immediate pain but it would lead to inflation that would allow the economy to rebalance by removing   much of the artificial debt.
7th August 2013
I start my blog when there is talk of signs of improvement in UK economy and the new Governor of the Bank of England makes his first policy statement. So what of it much was made of the forward guidance where the base rate will remain at 0.5% but how will it impact on the economy?
For inflation there are currently two competing forces. Firstly the low rate will also lead to low growth of the money supply, as I explain in Wealth Creation and Wealth Destruction, interest rates and money supply are intrinsically linked. So by conventional standards this will have small inflationary impact. However there is a greater inflationary force acting on the economy and that is a contraction of the material wealth within the economy whilst the quantity of money remains unchanged. So with the statement that inflation is usually defined as too much money chasing too few goods we can inflation even when the money supply is static or even declining and this what is happening now. The lethargic GDP is one indicator of this problem but more telling is Fishers observations of nominal and real interest rates; this states that the interest rate that banks charge can be divided into two parts that covered by inflation and that representing real growth in the economy which has come to be known as the real interest rate. This idea of nominal interest rates being made up of inflation and real interest is observation rather than being contrived by the banks. Again the book I offer an explanation for this relationship but for this argument what is important is that interest rates have been lower than inflation so the real interest rate which can be translated as growth is negative ( in August 2013 the LIBOR  rate was 0.59% whereas the inflation stood at 2.9% or real interest rate of -3.5%). This indicates both a contraction in the real economy but also the possibility of stored inflation which will unleash itself once the economy starts to grow and money that has been hidden away comes back into play. So in economic terms the current policy will lead to more of the same but in the long term inflation will take off  and the longer these low rates are held the greater the impact.
As for growth this is all dependent on the money in the real economy; that in the hands of the ordinary person rather than the investment manager. If the money in the real economy increase so the economy grows and vis-a-versa when the economy contracts and this in turn is linked to lending and saving. So in normal times the growth in the money supply is linked to the growth in the economy of which interest rates are the key driver. Whilst the intention of this policy is to promote growth in itself it will not. However these are not normal times and a lot of money has been hidden away leading to the negative growth we have experienced. The green shoots that we are seeing may well be the result of increased mortgage lending based on government guarantees but how sustainable it is another matter. The new money will expand the economy but if it is a result of rising housing prices then the higher loan repayment may ultimately lead to more being taken out than is entering the economy.