Blog Archive -January 2014


26th January 2014

The economy's Catch 22

The increasing congestion on the roads would lend anecdotal evidence to the official statistics that the economy is recovering  But before we get carried away we should wait for the post-Christmas figures to see if this is a sustained growth and secondly whether it will be enough for the corporations sitting on the piles of cash to begin investing although this piece in Saturdays Guardian would suggest otherwise.

Leaving aside its sustainability the current growth has highlighted an interesting dilemma for the Governor of the Bank of England; that of whether to raise the base rate. As has been widely discussed Mark Carney has said that he would not consider raising current base rate from their current low of 0.5% until unemployment was below the 7% mark. With the possibility that this could occur much earlier than anticipated the he has been pulling back from this commitment. Under traditional economic theory the expectation is that growth will lead to inflation but with the latter actually falling the current low rates can continue. The Governor is aware that all this good news is based on rising property prices and has the potential to develop into another bubble quickly. The dilemma is that if he raised interest rates he will chock off growth. But this is countered by a hope that while inflation remains low long term growth will establish itself.

As I argue in Wealth Creation and Wealth Destruction this is a misunderstanding of the economy and interest rates are the root cause of inflation. Whilst productivity is a factor, high interest rates generally lead to high inflation and lower rates to low inflation and thus the current fashion for forward guidance becomes a self-fulfilling prophecy. On these assumptions inflation will continue to remain low in the UK, with poor returns on savings causing a continued rise in property prices. This in turn will lead to more money being sucked out of the real economy from high rents and mortgage repayments (see my earlier post) with a corresponding slowdown in growth; the exact scenario that the Governor is trying to avoid. If on the other hand rates are raised those who have existing loans will be stretched to make the repayments and there is a real chance of those borrowers who are at their limit, the zombies loans, defaulting. Whilst no growth is better than the crisis from mass defaults the economy has got itself into a Catch 22 position. Where property bubbles continue to develop but rates cannot be raised because low economic activity persists.

So how to sort this mess out? In a counterintuitive move I would argue to increase the base rate. With the bulk of lending in variable rate mortgages this would lead to an increase in the money supply which will result in both growth and inflation. With the higher inflation company's profits will decline without new investment. Higher inflation would also reduce individual and corporate or banking indebtedness allowing for higher consumption. Of course for this to succeed personal income need to match this increase. In the long run wages would catch up but to avoid the short term loss and dangers of mass default the government would have to be more proactive by increasing the pay and benefits in their control with the private sector expected to follow. Or measures could be taken to provide a tax rebate equivalent to the increased interest payments for existing loans. There are risks with such a scheme, abuse is one, a second is that all the new money will end up in property again. But for many it would be that inflation persists afterwards however if we accept that inflation is determined by interest rates then all that need to be done is for these rates to fall.


17th January 2014

Missing the point on Growth

On Wednesday the Chancellor, George Osborne made a keynote speech on the dangers of Europe falling behind in the race for growth with China and Brazil and they will eventually be bigger than Europe. The delivery was one of shock and awe but in reality it was statement of the obvious. We are comparing the mature economies of the EU where much of the infrastructure is in place and people live a relatively affluent life style to those of two rapidly industrialised countries that want to bring their population to that western level. By its nature these will grow quicker and when they reach western levels of wealth there output will exceed that of Europe but will it mean that people of Europe will necessarily be any poorer and the answer is no.

This is not even a new argument; similar points were made about Japan, Korea and the other Asian Tigers and did we see any material decline during their ascendancy? Manufacturing jobs did move to these economies but it also heralded a growth in international trade with the West benefiting as much if not more. In fact the experience of Japan and the others are that once they reached similar affluent levels to the west that growth became unsustainable and it all ends with tears typically a property bubble. The same will happen to the BRICs once they have matured. This is not to say that Britain should not be manufacturing more of its own wealth but this can be achieved without the wholesale dismantling of the welfare state or the other benefits we enjoy in the name of competitiveness.

The wrongness of these arguments becomes clear when one looks at an economy in terms other than money. In Wealth Creation and Wealth Destruction I define wealth in terms of time, the time to create and its useful life. The difference between the two represents a product's wealth and the sum of all products is that of an economies. Viewing wealth in this way brings many advantages, one of which is to compare economies. With improved productivity our combined efforts produce more for less with an ever increasing surplus and when treated as whole translates as growth. However there is a limit to how many of a single product can be made; there are only so many TV's we can watch or suits that we can wear, so once everybody has as many TVs or suit that they can use this surplus allows others parts of the economy to expand. It can also be used to fund holidays, pensions, public sector jobs and benefits. Alternatively the surplus is not generated resulting in unemployment.  In the context of international growth the Chinese or Brazilian creating extra wealth for their own consumption does not need to impact on our surplus even if they are making all the TV's. These economies will also reach a point when not all their workers are required to produce demand for wealth and they too will have to choose how to handle this surplus. The problem of international trade that Osborne raises is not to do with benefits or pensions but from the disproportional value given to the same effort in two different economies and the solution is to adjust the exchange rate so they approximately equal.

12th January 2014

A prediction for the 2014 economy

It is at this time of the year that economic pundits make their predictions for the upcoming year and here is my two penny's worth. As always this will be dependent on the money entering or leaving the real economy. This is the balance between savings, pension premiums, loan and mortgage repayments going out of the real economy to the banks and other asset parts of the economy as opposed to the money that returns in the form of new loans and dividend pay outs etc. If the real money supply grows or shrinks by say 2% then generally GDP will follow suit. When economies are expanding the biggest component to this growth is bank lending but changes in government spending can also play a part as do one off event; as Robert Peston points out here that PPI compensation is one giving the economy a £16 billion boost.

With the government determined to cut spending the future of the economy seems to rest on banking activity and the rise house prices with associated mortgage lending seem to support this. However whilst a housing bubble would normally lead to an increase of the available money in the economy the background data tells a different story. The Bank of England's Monthly amounts outstanding of monetary intuitions figures (LPMB6VG) shows a continuous decline in mortgage lending to September of this year when it has started to pick up. This tells us that more people have been paying them off than have been taking out new ones. With the wider lending being a bit more erratic but generally declining as well the growth we have been experiencing has not been coming from increased lending but more probably from the monies that would have previously gone on loan repayments and then there is the £16 billion identified by Robert Peston.

So what will be the impact of this increase in mortgage lending? The government's help to buy scheme will provide a stream of buyers who cannot raise a deposit but can afford a mortgage and with earnings lending ratios being around 3.4 for new lenders it is unlikely to bubble. This all introduces new money into the economy, some £3 billion - £6 billion for November alone. However not all of this will end up in the real economy as the surplus is often reinvested in property. Then there are the mortgages repayments, as already said this should not impact severely on those who have taken out the loan but the effect of rising house prices is not just limited to the buyer but the 3.8 million households who rent from a private landlord, as rents generally follow prices. The nature of the private landlord means that it is highly likely that these rents will be used to buy further property thus reducing the money in the real economy. Such increases in rent will normally be accommodated by growth in the rest of the economy, but with construction and manufacturing sectors stalling in November this cannot be assumed. If the overall reduction in loan repayments was the cause of the economies turn round the consequences of these price increases may undo it.

If these are the mechanism in play then we could expect both a rise in house prices and a fall in GDP. House prices will probably remain high for some time, as there will be stream of buyers who can meet the new criteria and when this dry's up the property market will as always feed on itself as the speculators and 'buy to let' investors carry it onwards. This will all inflate the GDP figures associated with property but we can expect the rest of the figures to decline. This prediction could be undone by companies picking up on the economy's momentum and making real investments but there are probably easier pickings to be made asset part of the economy that will work against this.

There is one easy prediction to make, that inflation will remain low whilst interest rates are also low.