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
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
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.