A couple of notes. As I wanted to put the predictions on record before they occurred, I rushed the writing of the essay, so there are several errors and omissions. Of particular note is that I forgot to mention that UK investments have turned the corner, such that UK Plc's overseas investments no longer generate a surplus. I am aware that there are many other problems. However, I have published it as it was sent, so that you can judge the accuracy of the predictions, without me giving the benefit of hindsight. Why read it? I have also predicted that the UK economy is going to get much, much worse. I have predicted that what will happen shortly will be the worst disaster to befall the UK since WWII.
Where’s the Beef?
I am sitting in
The majority of mainstream economists have remained convinced that some kind of economic miracle has been taking place in the
The balance of trade has been in the red for so long that we have come to accept that this is perfectly normal. We achieve growth without either producing more goods for internal or external consumption. Our production of commodities such as oil are in decline. We claim that services have taken up the slack, but we are unable to locate the source of the real wealth that has spurred the growth, and we can not claim that our export of services is sufficient to explain our apparent increase in wealth.
So how has the
Finally, I would like to make an apology. This is written in haste, and I have had to balance time constraints against rigour and writing style. With the storm approaching, and my desire to write this before the storm breaks, I have rushed this essay. There are not the number of references that I would like, and in places I do not provide comprehensive figures which might help support my case. There are many moments of clumsy writing, though I hope not clumsy at the expense of the overall argument. Many of the arguments are not as detailed as I would like.
1. A funny view of wealth
I am going to start by looking at the world from the point of view of many modern economists. Whilst none of the economists would accept that what I am about to portray is their belief, when you look hard, you will find that this must be their basic belief. If not, then they have no justification for their pronouncements of success for the
Imagine a family living in the
Next door to the
The Jones family, have less income than the
Which of these two families is the more wealthy family?
The answer largely depends on whether you are an economist who has been a cheerleader for the boom of the last ten years, or whether you are a person grounded in the real world. The
The following chapters will take a look at the
In the following two sections I will introduce some of the unusual recent influences on the
2. Forever Blowing Bubbles….
All over the Western world there have been prophets of doom, prophets who predict the end of the long house price boom. Each prediction of the ‘end’ or ‘the impending housing crash’ has been disproved with time. All such prophets have, time after time, been proven wrong (including this author, who predicted a crash as early as 2003). There is even a website dedicated to housing ‘doom’ in the
It seems worthwhile to ask what the doomsters actually got wrong, if they have gotten anything wrong at all. So what are the arguments for why house prices are overvalued?
Valuing Property - What is ‘Value’
Let’s start with the idea of value. How do we value a house? The first point is that there is a market value, which I will define the value that someone is willing to pay for a property in real time today. If we use this, then house prices can never be over valued or undervalued, as they are always correct. However, this is not much use to us if we are trying to decide whether there are risks that house prices will rise or fall.
Valuing Property - Incomes
One way of looking at house prices is to compare them to incomes. As people get richer, they can afford to spend more money on property. This is not, however, a straight line relationship. As people get richer, they have greater potential for discretionary spending, as the proportion of their income needed to service basic items such as food, heating and so forth reduces. Housing is an essential and might not be called ‘discretionary’ spending, as we all need housing, but how much money is spent on housing over and above ‘putting a roof over your head’ does have an element of discretion. It is very similar to the student who goes to a cheap pub to eat whilst he is relatively poor, and the same student after graduating and starting a career in banking going to a trendy expensive restaurant. A person needs to eat but, in both cases, has an element of discretion over how much to spend on this necessity. In housing we can see the same mechanism in the first time buyer trading up in to a better house. For this reason, that housing is in part discretionary spending, we can see that spending on housing might increase faster than incomes.
Valuing Property - Supply of Housing
Another important factor, if not the most important factor, in the determination of house prices is supply and demand. In a perfect economic world, supply and demand would match. In the same way that we are never short of washing powder, we would never have a shortage of housing. After all, we never hear of a boom in washing powder prices because of scarcity. The reality is that, in the
Value of Property - Supply of Finance
One of the common errors in considering supply and demand in relation to the housing market is to forget the importance of supply of finance into the housing market. The
Increases in income multiples. Even a few years ago 3 times earnings were considered the maximum, but recently some lenders have offered up to six times earnings. This leads to a situation where people can now borrow ever more money in relation to their income. This process would be quite logical if the increase in multiples related to the increase in income available for discretionary spending, but the level of the increases have outstripped this.
No deposit, 100% mortgages. One of the reasons for deposits is to offer the lender an assurance that, if the borrower fails to pay the mortgage, there is sufficient equity remaining in the property for the bank to recover their money after the costs of recovering and selling the house. In a situation of continuing house price rises, this may not be deemed necessary. However, such a risk is built on an assumption of no end to house price rises, a very high risk strategy. Another reason that is implicit in the idea of a deposit is that the buyer is also risking their own money in buying the house as, in the event of foreclosure, they are likely to lose a substantial sum of their own money. Removing this risk means that the borrower has less to lose in the event of financial problems, removing an incentive to find every means available to keep paying the mortgage. Again, lenders are taking a greater risk in their lending.
Self Certification. Several news reports have showed that self certification has been used by mortgage brokers to secure mortgages that would otherwise be impossible to secure on the genuine incomes of the applicants. This is why, before the current house boom, it was necessary for applicants for mortgages to prove that they were in receipt of the income that they were claiming. The question that self certification raises is why it is that lenders have relaxed their checks? They might claim that it makes the applications process faster and less complicated, but set against the risk of future inability to pay, surely this is a poor trade-off. The cynical view might be that the lenders were intentionally relaxing their lending criteria through a backdoor method.
Affordability based decisions. Some lenders started to review the overall position of the applicant’s finances, rather than looking at income. This, at first sight, appears to be a rational approach. However, the criterion for affordability was based upon an assumption of continuing relatively low interest rates, an assumption that was to lead to the lenders taking very high risks as, if interest rates rose considerably, what was affordable would no longer be affordable.
Interest only mortgages. The trouble with this kind of mortgage is that there is no provision, whatsoever, for the repayment of that actual mortgage itself. Traditionally the lender would require that the borrower demonstrates that they have made an investment plan to eventually repay the mortgage, but this requirement is removed. No doubt lenders will claim that their expectation is that the borrower will take out such an instrument, but the cynical point of view would be that they are just using a ploy to allow borrowers to borrow more money.
So what is the result of these new ‘relaxed’ lending policies on the housing market? The most important effect is that there is more money available to more people, in ever more risky loans. This additional money is then available within the house market and, where more money is chasing a limited supply of assets, the prices of those assets will inevitably rise.
A Small Diversion - Affordability
It is worth taking a small diversion at this stage, regarding affordability. One of the big arguments for relaxation of the lending criteria has been that, in a low interest environment, that housing becomes more affordable. This is one of the great myths of the housing boom and needs to be put to bed once and for all.
The argument goes that, in a low interest environment, the cost of servicing a mortgage has gone down significantly in comparison with a high interest environment. At first sight this is an appealing notion, and appears to be perfectly logical. As interest rates go down month by month, we can see the month on month cost of a mortgage go down.
However, there is an important element of the cost of a mortgage conveniently forgotten in this rosy picture, and that element is inflation.
The best way to illustrate the importance of inflation is to take a trip back in time, for example to the 1970s, when both interest rates and inflation were high. During this time we could see the picture of the young couple buying their first house. In the classic picture of the time, the couple would struggle to save up to put the deposit on the house then, once they purchased the house, they would struggle with the repayment of the mortgage under burdensome interest rates. At first site this picture of struggle appears to support the arguments of low interest rates providing greater affordability, but it is when we see the same couple a few years later that we see the problem in the argument. It is then that we can see that the key to affordability is not just interest rates, but also inflation.
All of the time that the young couple have been struggling to pay the mortgage, something else has been happening too. The high rate of inflation has meant that the value of their debt has been eroded by inflation. As such, after a few years of struggle, the couple will find that their debt becomes easier and easier to service, and the proportion of their income required to service the debt declines year on year, as their earning are rising in line with inflationary pressures. As this occurs the percentage of their disposable income needed to service the mortgage is declining such that, as time progresses, they are left with more and more disposable income.
It is at this point that we should note that there is a relationship between inflation and interest rates. In periods of high inflation, interest rates climb, and in periods of low inflation interest rates drop. So what does this mean in relation to mortgages? It means that one effect offsets the other. Whilst in the real world, the relationship is not perfect, the relationship does exist .
Once we take low inflation into account, which has been the current situation, we then see that, whilst a higher mortgage looks more affordable in principle, in practice it is not actually much more affordable than in the past. What has actually changed is the profile of the payment of the mortgage, not the amount of the mortgage that is finally paid. In the high inflation and high interest example, the mortgage payment is front loaded, with very high initial payments quickly switching to lower and lower payments. In the low interest low inflation scenario, the payment of the mortgage is easier at the start, but only because the cost of the mortgage repayment is spread more evenly through the lifetime of the mortgage.
In this environment, there is no particular problem if, for example, the three times earnings multiple is used in both cases, as the final amount that the borrower pays will remain similar. The real problem arises when the false notion of affordability comes into play in the form of higher multiples of income. In this case the real cost of the purchasing the property for the borrower has increased as, over the lifetime of the mortgage the borrower will end up paying more money than in the past as a proportion of their income.
As mentioned earlier, the relationship between inflation and interest rates is not perfect, but to ignore this in considering ‘affordability’ of housing is, to say the least, rather odd. All of the major mortgage lending institutions employ economists, and it only seems reasonable to assume that the economists were aware that the affordability argument has this rather important problem. This raises a question as to why the lenders continued with an argument that was problematic? A cynical view of this would be that they sought to persuade people into accepting greater levels of debt than was actually necessary, in order to expand the size of their lending portfolios.
Supply of, and Demand for Housing
Classical economics points to supply and demand as one of the key factors in the pricing of assets, and this mechanism has been proven time and time again. Analysts of the
However, it is only recently that the real issue of importance for demand has started to fully come to light. It has become apparent that the demand for housing has seen a massive increase in the last few years, and this increase is a direct result of massive net immigration into the
What we can say from knowing that there has been ‘a lot’ of immigration is that, in conjunction with the changes in society, there has been a significant increase in demand for housing overall. How much additional demand is currently unknown and therefore it is difficult to make any rational calculation of how much prices may have inflated as a result. Perhaps one of the most important points to note from this is that current house prices must at least be dependent on the immigrants remaining in the
I have emphasised that the scale of immigration has only recently been coming to light, as I believe that this is why many analysts have wrongly predicted a house price crash over recent years. Whilst they were aware of immigration, they had no idea of the scale of the net inward migration.
Buy to Let
It is impossible to view the
A report by Bradford and Bingley illustrates some of the drivers for the fever for buy-to-let. In their report they point to a rising population of students and the net inward migration as factors that are driving demand for rental properties. Despite this there have been several reports that demonstrate that many buy-to-let landlords are still making a loss on their investments in property. One of the questions that this raises is; why exactly do landlords continue to invest in the sector? The only rational explanation for this is that they are hoping for continuing appreciation of the assets to provide a long term profit.
According to Mintel, there is also a view that is widely held that ‘bricks and mortar’ when compared with other assets are relatively safe. As such some landlords are using the investment in property as a substitute for pensions and other long term investments. What this means in practice is that money that would have previously been invested into pension funds, unit trusts and other forms of investment is now being diverted into residential property.
This must be having an impact outside of the property market. Where a pension fund would largely invest in the stock market or in new business, and therefore be used to invest in the development of economically productive organisations, the investment into housing represents no long term gain for the economy overall, as the investment is largely used to secure and maintain an already existing asset, without major improvements in the productivity of the asset. The only benefit to the economy overall in the switch from purchase of a home, to rental of a home is the allowance of greater flexibility of labour, in that it is often easier and cheaper to move from a rented house than from a purchased house. Most importantly the buy-to-let market is not a stimulus to new housing development, but an exploitation of the conditions of restricted supply, usurping individual buyers who would otherwise be better able to buy the asset. This is not supply and demand, but utilisation of a supply constraint to extract profits (however hypothetical they are becoming) without delivering any additional value to the purchaser of the property, except flexibility in some cases.
Whilst some people welcome the flexibility, many people do not and would prefer to purchase a property if they had sufficient funds. However, the inrush of buy-to-let money has (almost certainly) been one of the drivers of price inflation, in particular at the lower end of the market. If supply were meeting demand, prices would certainly be lower, and many existing tenants would likely switch to home ownership.
Is Buy-to-let a bubble?
As in all classic cases of bubbles, the bubble is (in part?) growing on itself. The more people funnelling money into the buy-to-let market, the greater the growth in the value of the asset, and the greater the growth in the value of the assets, the more people invest in the hope that the asset will continue to inflate in value. At some point the investors must actually achieve sufficient return on the asset in order to justify the asset. What happens when the asset finally stops inflating, such as the famed South Sea Bubble, or Tulip Mania? It is at this point that the bubble pops, normally very painfully for the latecomers to the investment.
In the event that the current level of house price inflation is unjustified (which is the argument being proposed), this may well represent a disastrous misallocation of resource. This is, after all, allocation of resource that could have been invested into developing businesses, or promoting the development of new businesses.
The aforementioned Bradford and Bingley report goes to some lengths to emphasise that the buy-to-let market is not a bubble. However, in the event of falling prices, and poor rental yields, there is a real question over whether the buy-to-let market can be sustained. This is not an original thought, and it is a subject that is being asked by many analysts who are cynical about the prospects for the property market. The big question that this raises is the big question for the housing market overall. What will be the final impetus to the bubble popping?
There is also another very worrying aspect to the buy-to-let bubble. The worry the bubble raises is why it is that there is so little confidence in investing money in the stock market, investing in new businesses, or all of the other alternative investments? Something has gone badly wrong with the investment market for so much resource to have been allocated to the housing sector. What we are viewing is a loss of faith in the ability of business to provide decent returns, and that does not bode well for the health of the business sector, and does not bode well for long term economic growth.
There is another important aspect of pricing within markets, the idea of market sentiment. This might reasonably be described as the ‘herd mentality’ which is a situation where the majority of people will follow what the majority of other people are doing. This has already been referred to indirectly in discussion of the buy-to-let market. In the
Set against such negative sentiment is the reality of the increase in demand. Where does this leave the market? In order to discuss this it is necessary to actually view the causes and impact of net immigration, which is the subject of the next chapter.
Immigration and the UK economy
Immigration is a matter that is discussed with extreme care because of the potential for the issue to become entwined with racism. This sensitivity has developed to such an extent that it has become, in polite circles, almost impossible to discuss anything but the positive impacts of immigration. This has stunted debate, and prevented a rational analysis of the economics of immigration. This section will look at immigration with no such constraints, and will try to examine immigration from an economic point of view.
Sources of Immigration
Immigration into the
The aim in this section is not, however, to review how people immigrate into the
Before looking at immigration it is worth noting that, as is pointed out elsewhere there is a major controversy over the statistics for immigration. For the purposes of this section we will note that the immigrants into the
Immigration and Wages
There are some people who argue that immigration does not have an impact on wages. This argument may have some validity if the scale of immigration does not lead to any significant increase in supply of labour in any particular labour market, such that the increase in overall numbers is negligible. However, in the case of mass immigration, as has occurred in the
It seems faintly absurd that this needs to be explained at all. Any reasonable grasp of economics will indicate that, all things being equal, an increase in supply relative to demand will lead to downward pressure on prices. A decrease in supply relative to demand will lead to upward pressure in prices. Few would argue that, if the supply of steel increases relative to demand that there will be no downward price pressure, and few would argue that if steel supply decreases relative to demand that there will be upward pressure on prices (all things being equal). These are widely accepted principles in economics but, despite this, some people still argue that increasing the supply of labour has no negative effect on the price of labour. Apparently, when the word immigration is mentioned, the laws of economics are abandoned, and economists scrabble around trying to redefine the laws for this special case.
One of the reasons for such a fallacy is that some studies have shown what appears to be large scale immigration into a particular area whilst seeing no fall in wages. This suggests that immigration does not have a depressive effect on wages. The only trouble with such a suggestion is that it ignores the possibility of an upward pressure on wages due to supply constraints. The influx of labour may not make wages fall, but it may prevent them from rising. In this case, the increase in supply has a negative impact on the workers who would otherwise be wealthier as a result of wage increases.
One of the arguments for immigrant labour is that it is addressing shortfalls in the
Economists such as David Card point out that, in the
If we accept that hiring an immigrant worker can lead to a British worker remaining economically inactive, the calculation to the cost of the economy of the migrant labourer might be expressed as the weekly cost of benefits minus the tax input of the migrant labourer who has been substituted for the British worker. In nearly all imaginable and realistic cases the tax will be insufficient to cover the benefits given to the British worker leading to a net loss to the state, and therefore a very substantial net loss to the economy.
What of the skilled immigrant worker? How does this worker impact on wages? Here the argument is similar to the unskilled labourer in that, if there is an increase in supply, there will be a negative impact upon wages for native workers, with a likelihood of reduction in wage levels, or a reduction in the rate of increase in wages. However, in this case, it may be that there is a genuine shortage such that organisations are completely unable to satisfy their requirement for skilled labour, regardless of the wages that they are willing to provide, and there may be a time lag in training new workers that will prevent current demand being met. This could have a negative impact on certain sectors of the economy where the labour is needed, leading to an overall negative effect on the health of the economy overall. In this case the jobs that are undertaken by the skilled migrant labourer would simply not be done without the migrant. It might also be argued that the skills are provided very cheaply, as the immigrants already have the necessary skills with no need to invest in training.
To consider the impact of immigrant skilled workers it is worth considering one of the most discussed examples, the shortage of plumbers that has been resolved with the immigration of large numbers of Polish plumbers. Prior to the arrival of the Polish plumbers the problem had become so severe that the subject was becoming a matter of (at least middle class) humour. Whilst the shortage was leading to expense and inconvenience for consumers, it was also probably more than a matter of inconvenience for industry, where plumbing problems were no doubt going unresolved, systems not being built, or being built late, built to poor standards amongst many other problems. This might lead to the conclusion that the introduction of Polish plumbers brought a real benefit to the economy by filling a very real skills shortage, and a skills shortage that was having a negative impact on the well being of the economy overall.
It would be difficult to argue against the idea that, in the short term, the Polish plumbers offered real economic benefits. However, it is in the long term that the fabled Polish plumber looks a less attractive a proposition for the economy. In order to see why this is the case it is necessary to view the situation prior to the arrival of the Polish plumbers. The cost of plumbing was (inevitably) rising due to the shortage of skilled workers, and the competition for skilled workers was leading to increases in the wages of plumbers. The rising wage levels meant that plumbing was becoming an increasingly attractive area of work, and was attracting new entrants to the trade. This suggests that, given sufficient time, supply and demand would have resolved the plumber shortage without any intervention, or any need for external labour. When considering the impact of migrant labour on plumbing, it is possible to suggest that the introduction of immigrant plumbers provided an alternative to this solution, by the substitution of labour from another market.
This substitution of migrant labour for training native labour has the self evident effect of removing the demand for native labour to be trained, and therefore has the potential for a situation in which a labour market can become dependent on immigrant labour. In a case where the migrant labour is temporary, this might be considered a serious problem on the grounds that it is quite possible that the problem will re-emerge some time in the future, once the immigrants return to their home countries. The alternative is to have a continuous flow of immigrant plumbers into the market place, thus the dependence.
Perhaps the most important point, when considering the case of the plumber shortage, is that plumbing is an area of work that, had the financial incentives continued growing, might have provided sufficient incentive to motivate the economically inactive to have chosen work over benefits. By introducing the immigrant labour wages ceased to rise, or dropped, and the result was that the incentives for entry into the trade were reduced, thereby helping to maintain people in economic inactivity.
This is not to ignore the problem that, had it not been for Polish plumbers, there would have been a shortage of plumbers for several years, whilst sufficient entrants to the plumbing labour force were trained in the necessary skills. However, if designing a better ‘plumber policy’, one free from constraints, this shortage might have been addressed by a transitional arrangement where the immigrant plumbers were permitted to remain in the UK for a fixed period of time, with a period of phasing out the immigration. Such an arrangement would need a clear end date to ensure that the market was prepared, by commencing training ‘native’ plumbers. Of course, the reality is that such a scheme would not be enforceable under today’s immigration constraints, and can only be a hypothetical solution to skills shortages.
Having dealt with skilled workers it is also necessary to look at the impact of highly skilled immigrants on the labour market. If we take the example of an immigrant working as a merchant banker in the city of
In addition to the immediate financial benefit of ‘high skills at low cost’, these highly skilled workers may be able to add significant value in the sectors in which they work in other ways, such as their ability to introduce new ideas, new methods, and a host of other benefits, which are related to the combination of high levels of skill in conjunction with their experience of their own home country systems. Furthermore, just increasing the level of high skills, for example taking the case of scientists, will have potential to increase the potential for improvements in technology, process, and other economic enhancements through the sheer presence of numbers. More highly skilled people, increases the prospects of more innovation, more new companies and so on.
There is a simple initial attractiveness to this argument but the situation is very much like that of the plumbers, but with considerably longer time scales to develop the necessary skills. However, the case of skilled workers differs from plumbers in one respect; it is an area in which the immigrants are not a substitute for the economically inactive, as very few of the economically inactive would have the qualifications or potential to undertake this kind of labour. As such it would be difficult to argue that there should be restrictions on such highly skilled workers coming to the
There is a more worrying underlying question to ask, as follows; ‘Why it is necessary to import such talent in the first place?’ This will inevitably lead to the follow on question of what it is in the infrastructure of the
The upward pressure on wages resulting from immigration
Whilst supply and demand tells us that immigrants will inevitably have a negative impact on wages in the job market in which the immigrants are working, there is the possibility that immigration may create an upward pressure on wages elsewhere. This will occur in situations where a company can lower the wages of workers, and therefore cut costs of their business as a result. In these cases the company or organisation will free up more cash, and some of that cash may be channelled into the remuneration of other people within the organisation, such as senior managers or business owners. A good example of a formal route for such a process would be in the provision for bonuses based upon profitability.
Whilst such an increase in remuneration may be a positive for those in receipt of them, it is unlikely that this has any positive benefit to the economy overall, as the increase in remuneration is a transfer of money from non-immigrant workers to the recipients, rather than the generation of ‘new’ money through, for example, more efficient production methods. In short it is a case of an increase in wealth differentials between managers/owners and workers, rather than the generation of new wealth.
Remittances and Repatriation of Funds - the Missing Argument
The issue of remittances and repatriation of funds is not heard in discussion of immigration, and yet may be one of the critical factors in considering the economic benefit of immigration. It is not clear whether this is not mentioned because of ongoing sensitivity about the subject of immigration, or whether it is because economists have just simply not considered the issue. As a consequence there is little solid evidence that can be provided and this section is therefore even more speculative than other areas of this discussion, relying on a combination of reason and guesswork.
Note 1: I define ‘remittances’ here as money which is sent by the immigrant to their country of origin to help their family or friends with financial support, and ‘repatriation of funds’ as the situation in which the immigrant returns to their country of origin taking with them their savings and investments that have been accumulated as an immigrant worker.
Note 2: I have written to the ONS to request information on the way that they collect information on migrant transfers (these show up in the balance of payments statistics). Their first answer they gave suggests that no account is taken of remittances whatsoever, and that inwards and outward flows of money of inward and outward migration are based upon the passenger surveys at landing/departure points. This method of calculation requires accurate numbers for migrants (non-existent) and the co-operation of migrants who need to volunteer their financial affairs at the time of embarkation/disembarkation. At first sight this appears to be a poor method of calculation, and my follow on questions to my initial enquiry to the ONS remain unanswered. My suspicion is that they are painfully aware that their methods are probably not much better than wild guesses.
These can be anything from a City of
The important aspect of temporary workers is that, on leaving the
If we return to the example of the Polish plumber discussed earlier, we can make some ‘back of a cigarette packet’ calculations for the temporary worker. We might surmise that the Polish plumber has decided to work in the
If we take the case of a skilled financier earning £150,000 per year in the city, it is very likely that after a two year contract in
Permanent Immigrant Workers
For immigrant workers coming from developing economies, one of the attractions of working in a developed country is the ability of the migrant to earn enough money to help support their family in their home country. One example of this is the
There may be many kind of remittances, from fixed monthly payments to the family, or providing one off payments to educate a relative, or to help a family member start a new business. The key point to consider in all cases is that this is cash leaving the
No speculative figures are supplied here as such figures would be even more speculative than the example given in the case of the temporary workers. However, it is possible to assume that the numbers, when viewed over the immigrants lifetime, might be very large indeed, in particular in the case of immigrants who are successful and therefore earn large amounts of money.
Close ties with country of origin
In addition to taking cash sums out of the economy, there is also the possibility that immigrants will be more likely to have a negative impact in other ways, when compared to a person of equal economic status who is a native worker.
One obvious example is that of return visits to the home country. This can be seen as being equivalent to a native worker taking a holiday in another country. Cross border tourism is an industry that sees large amounts of cash being transferred from one economy to another, and is therefore an equivalent to an import of a good. The question that is raised with the immigrant worker is whether the frequency, cost and duration of their trips is greater than that of a native worker who is of equivalent economic status. In this case it might be reasonable to suppose that the immigrant worker (including temporary workers) is more likely to travel out of the country, thereby removing greater cash sums from the economy.
Another area which might see a negative impact is in the purchase of goods and services. There may be a tendency for immigrants to prefer to purchase products and services that originate in their county of origin, for cultural reasons and for reasons of familiarity. An obvious example of this is the introduction of Polish products into supermarkets based in areas with large numbers of Polish immigrants, or the many Asian supermarkets that largely stock products from the Asian sub-continent.
Once again, the impact of this skew towards buying goods from the country of origin is not measured, and therefore the real value of the resultant rise in imports is unknown and uncalculated. It would, however, be reasonable to speculate that an immigrant, when compared to a native of the same economic status, is more likely to purchase greater numbers of imported goods, with the negative impact this has on the balance of payments.
So what do remittances and repatriation of funds mean for the
It is here that the question becomes very blurry, as the figures are not known. However, if we were to take the example of Central European temporary immigrant workers and make some assumptions, the figures become rather disturbing.
If we imagine that there are 500,000 Central European temporary workers, and we assume that they will be staying in the
However, when we look at this loss, it is even more severe than it first appears. When a person earns money and spends the money in the country in which it is earned, the money recycles through the economy. Even when a person uses some of their cash to buy an imported good, such as a television, a substantial proportion of the money remains in the economy. In the case of the television there is the
In the case of remittances, it is far more difficult to make a calculation of the impact upon the
The Pensions Argument
One of the arguments for immigration is that immigrants add to the labour force, and often immigrate when they are young. This influx of younger workers is seen as a solution as it will maintain the young population at a higher level than would otherwise occur, thereby ameliorating or solving the problem. Furthermore, some studies show that immigrants have larger numbers of children, thereby raising the birth rate and counterbalancing the decline of the birth rate of native people.
The first problem with this argument is to return to the argument about economically inactive native workers. If the cost of immigration is the retention of these workers in inactivity, then the immigration is just substitution, and substitution at great cost.
In the case of skilled workers who are immigrating permanently this is a different argument, and a case may be made for such workers, provided that, after remittances and other factors, they present a net gain for the economy. However, even in this case there is a fundamental problem in the infrastructure (and society) that is being solved by the immigrants from other countries. The first problem needing to be answered is why individual
Cheaper Goods and Services
It could be argued that the downward pressure on wages results in cheaper goods and services. For example, if you have low cost fruit pickers, this will make a kilo of strawberries cheaper, thereby offering a real benefit to all of the people who eat strawberries. This appears to be an economic benefit offered to the
However, if you consider that the immigrant labourer is helping to keep an economically inactive person inactive, then the situation looks rather different. This is because, what the person saves in the price of strawberries, they will pay in taxes to support the economically inactive person, and the higher tax will outstrip the cheaper strawberries creating a ‘dis-benefit’.
In addition, if wages are negatively impacted by an immigrant, the consumer of a good or service that utilises the immigrant labour may feel the benefits of the cheaper good or service, but the benefit is a transfer from the native worker whose earnings are lower than they would otherwise be, to the consumer. There is no net gain but a transfer.
Outward Migration (Emigration)
In viewing outward migration, once again, we encounter the problem of the lack of accurate statistics and we therefore will again need to speculate and reason in place of using research. Whilst passenger surveys may give an indication of numbers and financial information, they are also likely to be very inaccurate. Lacking any other statistics we will at least use the recent ONS statistics for the outflow, a number of just over 200,000 individuals in the last year, and 800,000 have people have left and not returned since 1997.
Who are these people that are leaving the
Another group that are emigrating are highly skilled
The systems for these ‘immigration’ countries are heavily biased towards immigrants who are graduates and postgraduates, and also heavily biased towards people with experience in careers with specialist and ‘in demand’ skills. If we look at the example of
The final category of emigrant to consider are the entrepreneurial business people, a category that would be impossible to quantify or identify. For this there are no statistics, and no way of determining the numbers or any sense of value of the loss. However, a visit to South East Asia will quickly show that there are large numbers of just such individuals, who can often be found in cities such as
There is one category of immigrant into the
The first thing to conclude from this review is that there are some aspects of immigration that need to be studied as a matter of urgency. Without more information the economic consequences of immigration will remain unknown.
The second conclusion is that the immigration of all types of unskilled workers is almost certainly going to have a significant negative effect on the economy. We can also view the case of the skilled worker as a negative in general, but an occasional necessity for a short duration. With regards to the permanent immigration of skilled workers, this is likely to be a negative, in particular due to the negative impact of remittances and the particular skew of the spending. However, this would need to be looked at further in more detail to draw any firm conclusions.
As for highly skilled immigrants, short term immigration may be necessary for a period, though for longer periods than skilled workers. However, if this is necessary question need to be asked about why the
The last point to make is that, even if the negative economic impacts of migration are understood, there is little that can be done to reverse the current patterns of migration without significant changes to the structure of
Where’s the Beef?
For many years now it has been widely promoted that the
Wealth creation in a broad economic sense is a difficult concept to pin down. When we look at a country, it is possible to have an appearance of growing wealth but, at the same time, have a real reduction in wealth. In the following sections, the possible sources of wealth creation will be detailed.
One of the most obvious sources of wealth is the extraction of commodities, whereby the extraction process adds value - or put another way - creates wealth. This process leads to real output and, provided that the extraction cost is lower than the selling price then real wealth is generated. In the case of the
It will come as no surprise to most people that manufacturing is a significant source of wealth. According to an EMEA report, gross added value from manufacturing in the UK saw a rise in the mid-nineties, followed by a decline in the early 2000 period, a decline that led to the added value falling back in 2005 to where it had been in 1999. The same story can be said of actual manufacturing output, which has followed a similar pattern. What is certain is that, manufacturing remains a source of added value in the UK economy, but that the amount of added value that manufacturing contributes may be in long term decline, or at best static. Furthermore the
When an overseas tourist arrives in the
I have already started mentioning the balance of trade, a balance that year on year is negative. This apparent ongoing negative balance started as a source of major concern to both the public and economists alike. As time has gone by, and no economic crisis has occurred, the sense of alarm has diminished. One of the explanations for why there has been widespread acceptance of the negative balance has been that the negative balance has been counteracted, in part, by the inflows of investment into the
Few people argue that money being invested in new businesses does not offer benefits for an economy, in particular where the company introduces new products, technologies, processes or systems of management. Unfortunately working out which investment is positive for the
In the case of one company buying another, is the intention to bring some added value to the company, such as the introduction of new management systems or technologies, or is it to gain market share through accessing the distribution system, or the technologies of the purchased company? Will the company purchasing the other company create new wealth for the UK by producing more, producing more efficiently, allowing others to produce more (or more efficiently), improve balance of trade through export of goods and services, or will it just operate as a company that provides goods or services that provides internal transfers of wealth? If it is the latter, then it will repatriate some of those profits to the home country, and in doing so reduce the net wealth of UK Plc.
For a moment it may be worthwhile to look at what is seen today as a rather quaint concept, the ‘Buy British’ campaigns that some people may remember from the 1970s. This is an important concept as it will later have relevance to how we may see wealth creation in the context of inward investments.
We smile as we say it…
The ‘Buy British’ campaigns are now a curiosity of history, and most consumers in modern
If our consumer were to follow the slogan, and buy the British hi-fi, they will effectively be foregoing an increase in their wealth, as they will need to spend more money for less features. The principle here is that their money will not go as far, which surely means that they are less wealthy. This will help the British hi-fi manufacturer, as the company that would otherwise not be able to compete with the Japanese manufacturer. The consumer will have made a small contribution to the survival of the British manufacturer, a contribution that is based upon sentiment rather than the merit of the company or the product of the company.
Is this sustainable in the long term? The answer is, of course, ‘no’. The Japanese company is presumably a better company as it is able to provide a better hi-fi at lower cost, and will presumably continue to develop attractive products. In the short term the purchase may help the British company by giving it a breathing space. If it is a good company it will use the time to respond to the challenge posed by the Japanese company, improving the business such that it will be able to compete in the future. If it is a bad company, it will see that sales are still high, and take a complacent approach, and fail to respond to the Japanese threat. After all, the signal from the market appears to be positive towards their product, as they are maintaining their sales. The trouble arises, in the case of such a complacent company, when the consumer eventually starts losing so much wealth by buying the British product that they will eventually switch to the wealth creating Japanese product.
Alternatively, what would happen if the consumer follows their immediate self interest, and buys the Japanese hi-fi? The first point is that the consumer will have become, at least in the short term, wealthier, as the money that they have used to make the purchase has purchased more and better than the same money would have purchased if the only choice had been the British hi-fi. This is a real form of wealth creation for the individual, as they have just found that their purchasing power has been increased such that, for example, they can afford Dolby sound, whereas before they could not have afforded it.
So, when we look at it from the point of view of this individual consumer, it appears that ‘Buy British’ never did make sense.
The problem arises when we look at the situation not as one consumer, but consumers collectively, that self interest suddenly looks different. At this point, we see lots of British consumers choosing the Japanese hi-fi, and start to see that the British company will very quickly find that sales are declining, and will eventually be forced to shut down (assuming that it fails to rise to the challenge, which is what happened in many cases). At this point, the rational choice of each of the individual consumers will have a long term effect on the wealth of UK Plc. Once the
There are further consequences. The end of the manufacture of hi-fis may also impact upon other suppliers, such as component suppliers. It may be that they specialise in hi-fi components, in which case they may disappear, or it may be that they will become weaker, and lose economies of scale. This weakening may create further opportunities for foreign companies to enter the
To create a simple illustration of this, imagine that our imaginary purchaser of the Japanese hi-fi is a pub landlord who lives in the town that manufactures the British hi-fi. He buys his hi-fi, and benefits from the increase in wealth that it provides. On the other hand, a few years later, the British hi-fi company shuts down, and he notices a small (but not insignificant) drop in the sales at his pub. The drop in sales at his pub are not the only thing he notices, as he is also paying more local tax, which is helping to support the increase in the numbers of people on housing benefits. Once again, this is a massive simplification, but I hope that it illustrates the principle. The principle is that when a foreign competitor moves into a sector and removes British companies (or takes away market share), there is a trade off that is being made by consumers. On the one hand, they become wealthier as individuals, as they are able to purchase more or better with their money, but on the other hand they weaken the overall economic circumstances in which they operate. Whilst campaigns such as ‘Buy British’ are doomed in the long term, there remains an interesting rationale for them, in the sense that such campaigns are a recognition of the cost of using foreign companies for goods and services.
If we return to our imaginary consumer, the difference in price between an equivalent
Is this an argument for protectionism or ‘Buy British’? It is not such an argument, as the case given illustrates that, in the long term, a company or industry that fails to compete on its relative merits will, in any case, decline in the long term. If an industry is protected from competition by a slogan, or tariffs, then this will engender complacency, and there will be a spiralling loss of wealth to individuals, as they will not have access to better products at keener prices.
The reason for this diversion is to understand that, when looking at different consumer decisions, there are trade offs in wealth that may not be entirely obvious. This is very important when considering foreign investment into the
Transfer of technology, management systems and processes
One of the oft cited examples of a benefit to the
We can see this process in the example of Japanese car manufacturers, as they have introduced many new innovations into the
Another example of positive inward investment, is that of a company such as Microsoft setting up a Research and Development centre in the
However, not all investments offer such dramatic benefits and, where they do, the question then arises as to at what point they offer diminishing returns. In the case of the Japanese automotive innovations, once the innovations have already been widely adopted, will the opening of another Japanese automotive plant add anything new, or will it just offer more of the same? The answer is that any company that invests into the
So far the examples have only examined one side of the balance sheet, but it is vital to remember that this is not a one way street, in particular where the economy in receipt of the inward investment is at a similar (or higher) level of development. In these cases the innovation will not only flow inwards as a result of the inward investment, but will also flow outwards. A good example is that of the Japanese company that purchased Pilkington glass, a purchase which will lead to the diffusion of Pilkington technologies into the Japanese company. In fact, in most cases, the process of learning is likely to be in both directions, such that the calculation of the benefits for UK Plc is never as simple as it first appears. Returning to the case of the Microsoft R&D centre, it is very probable that some of the ideas and innovations being developed in
The situation is therefore not as simple as it first appears when considering the long term wealth of UK Plc, as the calculation of the benefits of the inflow of ideas against the outflow, are not easy to identify. Does the hiring of a
The assumption that inward investment brings positive gains for an economy through the introduction of innovation is widely held, as it at first appear to be a perfectly logical proposition, but it is a position that just looks at the positive inflow of innovation, instead of the inflow and outflow, and the opportunity costs. For example, when a foreign company takes an innovation out of the
Repatriation of Profits and Support of Head Office Facilities
Whenever a company invests in another country, their aim is to make a return on the investment. This can be neatly summarised as wishing to extract greater wealth from the country that is the target of their investment than that which they put in. An investment is intrinsically established with this intention and this is simple and vital concept to grasp. All companies that are investing in the
In addition to the intention to extract wealth from the
The exception to this situation is where a head office uses the
Licensing, franchising, and other transfers
When a company invests in the
It may also be that the company has its own in-house manufacturing systems and equipment, and these will be transferred to the
If we take the example of franchising, the investment is even more heavily skewed towards the country of origin of the inward investor. In cases, such as McDonalds, the investment into the
In the above cases it is possible to see examples where the profits, relative to the level of investment, may be particularly high. In these cases, there would need to be a very significant benefit to counterbalance the outflow of money that follows the initial investment, such as balance of payments benefits through export, in order for UK Plc to see a net gain in wealth from the investment.
Inward Investment for the Manufacture of Goods
Across the world there is intense competition to attract manufacturing companies into countries or regions, in particular when the goods are both for internal and export markets. The most obvious benefit is that of export, which translates into a net flow of wealth, from the country that is the recipient of the export, into the exporting country. When an export oriented manufacturer sets up in the
Furthermore the manufacturer will spread benefits even further through the recycling of their wealth to other
The negative side of the equation is when the manufacturer is displacing a
The Use of Country of Origin Suppliers
When a company invests in a particular country, they will often import managers and practices along with their investment wealth. This will often result in the company importing its current supplier base, such as component suppliers, support services and so on. This process can have a variety of implications for the long term wealth of the country in receipt of the investment.
For example, if a
Alternatively, it may be that the volume of business is sufficient to provide an incentive for the speciality chemicals company to set up its own operation in the
The entry of the speciality chemicals producer then may lead to the entry into the UK market of companies that support their operations, for example in the provision of base chemicals. What started off as one company investing in a market will actually probably commence a chain reaction of activity from more new entrants into the market.
The question that arises from this is whether this is of benefit to UK Plc. It is here that the questions start to become complicated. In the example, if the
In short, the investment of one company into the
There is only one certainty that can be taken from the example that is given above, and that is that it would be wrong to assume that the investment into the
So Inward Investment is not all Good?
Perhaps the most dramatic example of inward investment not being ‘good’ can be found in the sale to foreign companies of utilities such as electricity generating companies. The only possible argument for this kind of investment being ‘good’ for the economy would be that the foreign utility companies will be able to offer improved management of the utility, as they are very unlikely to be bringing any new technologies that are not already available to UK utility companies, and unlikely to be bringing any new processes, and so on. In the case of utilities, the outflow of wealth to the country of origin of the holding company will be very substantial, and the improvement in management would have to be quite astounding for UK Plc to see any gain from this inward investment. It is unlikely that any rational person would say that it would be possible for management improvements to be sufficient to justify the sale of an electricity company, when compared to the outflow of wealth from the
This raises the question of why the
The point in discussing inward investment in such detail, and challenging the assumption that inward investment is good for the country is vital when considering the ongoing balance of payments deficits.
Another important method of generating wealth is the development of services. This is a more difficult area to explore. The most simple way that a service can clearly generate wealth is through the sale of one individual to another. In this case there is a transfer of wealth from one person to another. Examples of this might be the case of the taxi driver, the photographer, and so on. The same process occurs when an individual or company, such as an accountancy firm, or a consultant, or cleaning services company sells their services to another company. In each case the service provider has wealth transferred from the recipient of the service to the provider. So far so simple. This is a process that is occurring within all economies on a daily basis. The growth in services is widely seen as ‘the engine of growth’ in the
Before going on to more detail it is also worth noting that export of services has seen increases over recent years and has a positive trade balance. For example, in 2004 the surplus reached £20.2 billion. This export of services is a real net gain for the
However, before looking at services it will be valuable to take a detour into the source of money into the economy, and to look at borrowing in particular.
Consumer Borrowing and Transfer of Wealth
To illustrate what is occurring when an individual consumer borrows money, this section will use a person (Mr. Smith) who uses a credit card to pay for a meal at a restaurant. He needs to use his credit card due to his habit of overspending each month. When Mr. Smith pays for his meal, some of that money to goes to the restaurant, and some to VAT (ignored hereafter), and a debit (a debt) will appear on the credit card such that Mr. Smith will now have to pay the credit card issuer (a bank) for the meal in the future.
Does this transaction add to the wealth of UK Plc? In borrowing the money, the bank that lends the money will (presumably) be making a profit on the transaction, the restaurant will (presumably) be making a profit on the transaction. Both of these organisations have provided an added value service. On the other hand, the net worth of Mr. Smith is negative as a result of the transaction, and he is actually less wealthy as a result. How does this transaction of ‘going to a restaurant to buy a meal’ impact UK Plc?
If the bank has used the funds of savers in the
What if the money that provides the loan has been borrowed from outside of the
It could be argued at this stage that the overseas lender only has a very small amount of the total transfer of the wealth, and that the majority of the wealth goes to the restaurant owner. This is largely correct. However, depending on the status of the individual and the type of loan, the final interest that is paid on the loan might actually be very high, and translate into a large sum of money over the period of the loan. Some of this interest is profit for the UK bank, and some of the interest is profit for the foreign bank. If we say Mr. Smith is an overstretched credit user, with a moderate credit history, and give him a £500 balance on this credit card, an 18% interest rate, and ongoing minimum payments of 5% of the balance, this £500 will cost Mr. Smith a shocking £214 over the life of the loan. This is not an atypical profile for a heavy credit card user with a moderate credit history, but better and worse examples can be created in any number of permutations. In this case a £50 meal will see a transfer in wealth of £21 to the banking system from the restaurant goer, a significant loss of wealth to the individual, and a significant transfer of wealth to both the UK bank and the overseas bank. Different profiles will produce different results, and the example given is just to give a sense of the potential scale of the transfers. In this case we might hazard a guess that Mr. Smith has just transferred as much as £8 of his wealth to another country, in order to pay for a £50 meal, a meal that might otherwise have seen no transfer of wealth outside of the
This is a very expensive transaction for both Mr. Smith and UK Plc, and has a negative impact on the overall wealth of both.
Let’s take the case of Mr. Smith using mortgage equity withdrawal to pay for the restaurant meal (and presumably other items). Surely the wealth of Mr. Smith remains neutral? He has not increased his net debt as his asset (his house) has increased in value, and he is therefore just spending the increase of the value of the asset without actually increasing his overall level of indebtedness. On the contrary, in this case, his debt has still increased in real terms, and only ceases to be an increase in debt when the value of the asset is actually realised. In particular, the interest paid on the loan made for equity release will, over time, erode the gain in the value of the asset. In addition, until the gain from the asset is realised, there is the real prospect that the appreciation of the asset may be reversed, thereby decreasing the wealth of Mr. Smith by the amount of the decrease, and also by the requirement to continue paying interest on the additional loan.
In cases of equity withdrawal, just as with the standard loan, it is also necessary to look for the origin of the finance for the loan. If the equity release is being financed from non-UK sources, then there is, once again, a loss of wealth from the
Does the same principle apply when Mr. Smith purchases a product, if he has purchased the product with borrowed money, sourced from another country? The situation is, of course, the same. The real difference here is that the transfer of wealth from UK Plc will be even larger when the product is an import. In addition to the transfer of wealth overseas from the debt interest, there is also the transfer of the cost of the good (calculated as the cost before added value services such as promotion, distribution and retailing which may be
Above is a micro picture of what is happening in the UK Economy. On a larger scale the
Perhaps the most interesting question to ask about such debt, is where it is actually held. The
So where is the beef?
We will now return to Mr. Smith and look at him in a bit more detail. Mr. Smith has always been confident that he is in a financially sound position. He has purchased a house and, in the time that he has owned the house, he has seen a big increase in the value of his asset. This is one of his sources of confidence, as he can see, year on year, he is accumulating financial reserves. On top of this he has a job that pays well, and he sees a small pay rise every year. The only trouble is that Mr. Smith works hard and feels that he should enjoy the good things in life, so that he quite regularly borrows money to finance a better quality of life - so that he can go to good restaurants, buy nice things and go on holiday on a regular basis. Over the years he has borrowed more and more money through bank loans and credit cards. When he started, the payments were not too bad, but now he is noticing that he is struggling to maintain payments. He is a bit nervous as he has just had to take out another loan to pay his overdraft, which has occurred because his debts and expenditure keep on pushing him into the red. He has felt okay about this situation overall, however, as he has the increase in value of his house to bail him out if need be.
Eventually, he will use the equity in his house to bail himself out, by using equity release to pay of most of his debts, and also taking a bit more to buy a new car. His mortgage payments have increased, but the amount of debt repayment is once again manageable. He feels content and is enjoying driving his new car.
Everything is looking good for Mr. Smith, until he starts to notice a new trend in the newspaper he reads. He is starting to see commentators talking about a ‘credit crunch’ and a slow down in the housing market. He is not too concerned though, as his house has gained in value by such a large amount, that he has a big cushion.
Back to Services - the ‘Engine of Growth’
Why the detour into lending in the middle of a discussion about services? The reason is quite simple. Services have been promoted as the engine of growth in the
The real question here is, where has the money for such expansion originated from? The answer is long but not overly complicated.
If we go back to Mr. Smith in the restaurant, we can see that he has borrowed money to finance his restaurant visit. In doing so he has decreased his wealth in order to fulfil a short term need. This is, partly, what wealth is for, but this is Mr. Smith’s future wealth that he is spending. This borrowed money that Mr. Smith has spent in the restaurant will then recycle throughout the economy in many ways. The restaurant owner will be a little wealthier, and will then spend some of the money on buying goods and services, the restaurant staff likewise, and so on. Furthermore there will be suppliers to the restaurant who will also be beneficiaries of the spending of Mr. Smith, as his consumption of foods will mean that the stock will need to be replenished, and the process of cooking will require energy, and some of his money may contribute to decorators, maintenance people and so on through all of the restaurant support services. We can then see the same process with each of these support services spending their small share of Mr. Smith’s transfer of wealth in a host of different ways, each further helping to support another layer of businesses.
It is only when we look at lots of versions of Mr. Smith, all borrowing money, all of which dissipates through the economy in a myriad of ways, that we can see what a dramatic effect this has on the economy. Throughout the
This is all well and good, provided that Mr. Smith keeps on borrowing and spending. The
The reality is that the
This then raises the question of how so much debt has been accumulated. One of the core problems has been the oversupply of finance which has led to a credit bubble. Just as in the mortgage markets, if too much money is chasing too few lending opportunities, then it is inevitable that the money will eventually be misallocated. This misallocation can be summarised as ‘cheap and easy’ credit. This finance has been flooding into the
One of the problems at the heart of the credit bubble is that the risk has been separated from the lender, who can lend with impunity, whilst packaging the debt into financial instruments that can then be sold to third parties. This would appear to be a wonderful way to make money for the banks undertaking this process, but the problem is that, as fast as one division was selling the debt through the front door, another division has been buying similar debt through the back door. This is to massively simplify the mass of transactions that represent debt markets, but the principles are simple and clear. If you separate the issuer of borrowing from risk, then the lender will issue debt that is of much higher risk. The whole situation has been further complicated by the
It is very easy to enter into the technical world of banking, and become bogged down in statistics, figures, yields, and all of the jargon of modern finance. What many of the specialists fail to see is the real people behind the jargon, the Mr. Smiths of the world, all of whom, with a false confidence, continue to borrow ever more money, sacrificing ever more of their future wealth, in the belief that the situation is sustainable, that somehow they will muddle through in the end.
The simple truth has always been that, eventually, the credit boom had to stop. People can not continue to finance themselves on credit forever, and when the credit stops and the payback begins, all of the spending from the influx of credit into the economy will disappear. Mr. Smith will stop his restaurant dining, and the restaurant owner will see a real and sustained drop in sales as millions of Mr. Smiths finally tighten their belts.
The knock on effect on the economy of such belt tightening will be profound. For all of the debt that has been accumulated, there will be a continuing outflow of wealth out of the
So what else will happen when all the Mr. Smiths stop spending? Let’s imagine Mr. Smith is manager in a mobile phone shop. He makes a reasonable living from selling the phones and thinks that his job is rewarding and secure. The trouble is that, just as he is tightening his belt, so are many others. In the modern world a mobile phone is increasingly an essential of life, so sales in Mr. Smith’s shop will continue. The trouble is that the latest model no longer looks so essential to all of the other Mr. Smiths in the economy - Mr. Smiths who are busy tightening their own belts. Sales of phones are starting to drop in Mr. Smith’s shop, and Mr. Smith is becoming slightly edgy about the job, and reducing his own spending further. As time goes on, he notices that there are also belt tightening measures from his head office, and then the request that he lay off one member of staff, then another, then another. Mr. Smith tightens his belt even more, and across the service industries the same is happening. It is the start of the downward spiral.
The downward spiral is where the cheap credit stops, the repayments begin and the saving starts. As the economy turns down, the fears of individuals increase, and as the fear of individuals increase, their spending drops, and as their spending drops, the economy turns down further, and as the economy turns down further the unemployment rate goes up, and as the unemployment rate goes up, the defaults go up and the banks tighten credit further, reducing spending further, and increasing and leveraging the downward spiral. And so it goes on, and on, into full blown recession.
The result of this downward spiral will not be a pleasant experience for the
The ‘City’, the Jewel in the Crown of the
There is no doubt that the City of
The same economist report goes on to say that the City has now suffered a setback, in part because of the ‘Credit Crunch’, and in part because of the Northern Rock scandal. The overall conclusion of the report is that the City will be going through a period of difficulty but will, in the end, bounce back. There is no doubt that the City remains the jewel in the crown of the
So far, so good, but there is one question hovering above the apparent massive growth in the City. That is the question of how much of the growth is built on servicing the consumer debt of the
In the same issue of the Economist as the report on the City of
How will this effect the City of
In this context, the continuing confidence in the City of
The Credit Crisis and the Impact on Businesses
The reports of the difficulty of small and medium sized businesses (SMEs) obtaining credit have already started. As banks have become more fearful of lending to each other and individuals, the effect has also spread to small business. At first site this appears to be a matter of technicality, that the money is no longer available, and a matter of sentiment, that there is fear in the markets. It may be, though, that the financial services sector are simply following a rational course and are just running for safety, as they must be aware of the risks of lending to small businesses when there is a prospect of a severe downturn in the economy.
The results of tightening credit in this sector will be twofold. On the one hand companies that need money for expansion will not have access to credit, or will have to pay a premium for the credit that they receive. This means that there will be a slowdown in the expansion of SMEs. The second impact will be that companies going through a difficult period, will be very unlikely to receive the support that they need. In a period of a downturn, this will be likely to push many companies over the edge into bankruptcy.
Once again this activity will see feedbacks into the economy, with less growth, and increasing numbers of bankruptcy, there will be a growth in unemployment. The growth in unemployment will then have a knock on effect of reduced consumer spending, which will then feed into tougher conditions for the
The only way to stop the downward spiral will be for the
- Increase productivity - there is currently no sign of a productivity miracle on the horizon so this is unlikely in the short to medium term.
- Decrease the costs of inputs relative to competitors, with the only realistic option being the reduction of wage costs. The minimum wage will be likely to limit the depth of such a reduction, though will not prevent it entirely.
- Reduce the costs of doing business through changes to the system of taxation. The problems with this option are dealt with elsewhere
- Reduce the cost of doing business by reducing the regulatory burden. The
economy has less and less freedom in this respect due to membership of the European Union, but that is not to say that some reforms could not be undertaken. UK
- Allow a significant devaluation of the currency, which will allow exporters to become more competitive, but at the cost of reducing the relative wealth of UK Plc.
Of all the options the last is the most realistic. The fall in the
The Exchange rate of the £GB
For a long time the pound has managed to defy the gravity in the face of negative balance of trade, in part due to the inward investment into the UK. It is worth remembering that currency, like everything else, has its worth dictated by supply and demand in the long run. The simplest logic would therefore say that, if you are importing more goods and services than you import, then the currency will weaken. Although this seems apparently reasonable, it has not been reflected in the real world, and there are several explanations for this.
It has already been mentioned that inward investment can overcome the effects of a negative balance of trade, and the
There is also the matter of sentiment, and it is very likely that sentiment will turn against the
The upside of this will be that the £GB will make exports of goods and services more competitive relative to other countries. The downside, as has already been pointed out, is that this would represent a substantial loss of wealth for both individuals and the country (an obvious illustration of which is that a person will have to pay more for an imported good than they would otherwise have done).
Another source of money entering the
It now seems to be entirely acceptable that this situation exists. ‘Excessive debt’ is seen as being 60% of GDP, so that governments can claim that they are within acceptable boundaries when they report such debt. If an individual (excluding mortgages which are at least in part backed by a saleable asset) were to be so in deep debt it would be viewed as both dangerous and irresponsible. One way that government has overcome this objection is by claiming that the debt is due to ‘investment’.
In the context of government it is very difficult to see exactly where the difference in investment and spending starts and finishes. For example, does borrowing to build a new hospital count as spending or investment. It could be argued that the hospital improves health outcomes of individuals, and therefore enhances the ability of such individuals to be productive in the economy. On the other hand, how does this account for the cost of a pensioner, who uses the hospital? The pensioner is no longer productive in the economy, except through spending pension money, and therefore the ‘investment’ made in treating the pensioner is not an investment but spending.
By contrast, if we look at a business investment, it is normally possible to write a plan which (whether right or wrong) clearly lays out exactly what return is expected on the investment, and has relatively visible ways of measuring the success of the plan. The same might be said of an individual investing in education such as an MBA, where they can commence with an expectation that their investment will yield a return in being able to achieve a measurable higher salary. In both these cases there is no certainty of a return on the investment, but the outcome of the investment will normally have a clear and measurable expectation.
Does this mean that government should not borrow for investment? This is a difficult question, but certainly much of government ‘investment’ is difficult to separate from spending.
Another example of such complexity is the Private Finance Initiative, which combines borrowing, with spending, and thereby is a method of borrowing money without it appearing on the government balance sheet. How much of the finance is borrowing, how much is investment and how much spending? There is potential for a wide range of interpretations, more so than our earlier example of the government directly borrowing money to build a hospital. Even the ONS admits to the complexity of such calculations, by saying that ‘The complexity and variety of PFI schemes poses significant measurement challenges, but ONS and HM Treasury have established that the audited accounts of central and local government and public corporations can be drawn on for the purpose of estimating the finance lease liability.’
The purpose here is not get into the rather arcane and detailed questions of PFI, and how to calculate government borrowing but to point out that government ‘investment’ is not necessarily always ‘investment’ in the sense that it offers real prospects of a return to the economy. As such, if the government borrows, it would be wiser to default to the position that the government is borrowing for spending rather than investment.
It is also an interesting question as to whether the government should borrow at all (except in the situation of national crisis) as there is a facility to adjust taxation to meet all current spending requirements. It could be argued that a company has the same facility, or an individual, but we would once again get into the deep waters of calculating what is an investment, and what is spending, a near impossible task to achieve with objectivity when looking at government investment. For example, no one has ever come up with a reasonable and objective way of assessing the benefits of ‘investment’ that the
In summary we have a government that is borrowing heavily in a period of what appears to be strong economic growth. Some of that borrowing, may create a return, as some of it may be going towards genuine investment. The more the government borrows, the greater growth in the
My suspicion, and it is no more than suspicion, is that the government is actually borrowing to finance spending, as the public sector has grown strongly over the last few years. By spending, I mean that the government is not expecting any kind of measurable return on the borrowing in economic terms. Whilst the spending may enhance the quality of life of individuals in the
The question of how the government is spending money is not a matter of small concern. In particular, if the government is borrowing money for spending, then the question of how, and when it will be paid back looms large. This question becomes even more pertinent if the
In the event of a recession or depression, the government will have a very difficult choice. It might choose to borrow more, and use the money for spending, or it will need to cut back on spending and, one must assume, investment will also be cut, as the two are difficult to isolate from one another. This effect is double blow to the economy, as the quality of life will fall, along with the potential to make long term improvements to the infrastructure that supports the economy. Furthermore any cut in expenditure will also filter through the economy in a myriad of ways, such as increases in unemployment. If the government cuts back it will act as a downward lever on an already sinking economy.
Does the government have the option of borrowing through a recession? It is, of course, possible that this can be achieved. However, the cost of the borrowing is likely to be high, as during a time of difficulty the ability of the government to pay debt will be worse than during a time of economic growth. Most importantly, this additional debt will go primarily towards spending, and will therefore need to be paid back in future with no potential for a return on investment to be used to pay back the debt.
So what can government do when it has seen debt increase during ‘the good times’, leaving it little flexibility to borrow in the bad times. I am not sure there is any answer that does not contribute to levering the economy further downwards in the short term, or creating long term and expensive liabilities in the medium and long term.
So what actually will happen to the
The first signs of what is about to come are already apparent. At the time of writing this there are the first discussions of a recession for 2008.
However, I would argue that recession is not the correct word for what is about to happen, and would suggest that a more accurate description is economic crisis. Up to now I have been describing some of the problems in the
I have already described the downward spiral of consumer spending, and the knock on effects on the
The first prediction is that this Christmas will see very disappointing sales in the shops, and poor sales for services such as restaurants and other entertainments. As Christmas ends and the heavy discounting of the New Year sales starts, panic will set in and the real depth of consumer fear will become apparent in a slew of profits warnings. As the new year starts, the service sector will start a review of their cost base, taking into consideration their poor performance over the critical Christmas period. The reaction of most companies will be to commence plans for staff layoffs.
These layoffs will commence from a trickle at the end of January and will rapidly accelerate to a deluge in the following months. Consumer sentiment will drop to all time lows. Credit defaults will start to rise rapidly, with the rise in defaults lagging the downturn by about 3 months.
The slow fall in house prices will accelerate into a full blown crash, with February or March being the months where the falls really start to accelerate. In the six months that follow prices will drop by an average of 20 - 25%, as buy to letters panic and sell into a falling market. In part this will be a response to the fall in house prices, in part it will be due to increasing difficulty in renting their properties (though this factor will lag the price drop).
As the labour market tightens there are many possible outcomes for what will occur with the temporary migrant workers. Inevitably, as jobs become more scarce, the inflow will diminish and reverse into an outflow. How many will choose to remain, and how many will choose to return home is an important question that only time will reveal. It may be that, if many media reports are true, that many employers will retain the migrants rather than
After about six months the rate of the fall in house prices will decline, as some individuals start to imagine that house prices are now at the bottom. They will, unfortunately, be mistaken. Prices will continue to drop a further 20% over a period of a further year, at which time they will bottom out and stagnate for another one to two years. The real fall in house prices will be over 45% during the period of economic contraction (the IMF estimates an overvaluation of 40% and the drop will overshoot this).
There may also be other negative side effects of the contraction, though these are more difficult to predict. It is likely that, as gloom deepens in the
All the while this is happening the government will fall into crisis. With a falling pound, an economy collapsing around them, and an already overstretched borrowing position, they will be faced with ever more expensive borrowing, meaning higher interest rates, or massive cuts in public expenditure. There will be no room to manoeuvre. The only solution will be to cut back on expenditure. Continuing to borrow will be too expensive, and would destroy the value of the pound, as well as creating an even deeper crisis of credibility that the
The situation overall will be a massive contraction in the
Up to now, this discussion has avoided the social effects of the coming crisis. Of a certainty, society in the
It would be nice to end this conclusion with a sunny and positive note for the future, and to say that the
 The argument here is inspired by an article published in the Economist magazine several years ago. I do not have the reference for it here, but would nonetheless like to acknowledge their contribution.
 See The Scottish Government, Scottish Economics Report - June 2006, Chart 2.8: UK Interest Rates and Inflation, 1998 - 2006, as an example.
 I am sure that someone must have made this calculation, but I have not seen the results. As such I am just talking about broad principles here.
 Appleton Estates, 11 September 2007, retrieved 17 November 2007, from www.appleton-estates.com
 Bradford and Bingley, Myths about the Buy-to-let Market Undated, retrieved on 17 November 2007 from www.bbg.co.uk
 Low Rental Yields Bar Investors from the Buy-to-let Market, 8 November 2007, Lorna Bourke, Citywire, retrieved 17 November 2007 from www.citywire.co.uk
 Buy to let Market: The Number of UK Property Tycoons set to Double by 2010, Mintel, Market Research World, 17 November 2007, retrieved 17 November 2007 from www.marketresearchworld.net
 Emigration from the
 Lowenstein, R: The Immigration Equation, 9 July 2006, The New York Times, retrieved from www.nytimes.com on 18 November 2007.
 If we imagine a person who is on a hypothetical benefit of £100 a week, and they accept a full time job paying £140 per week, their hourly rate of pay then becomes £40 divided by 39. There are many forms of benefits and therefore many different scenarios that could be explored. I have chosen a hypothetical example as this is the simplest way of explaining the principle. It is also worth noting that, even if not actively calculating their real wage, people facing the benefits or work choice will be very likely to have a sense of what the relative rewards are in each case.
 If they are entitled to benefits and they utilise this facility, very few people would (I hope) argue that they are anything but a negative for the
 I seem to remember a newspaper publishing the story of a lecturer from a college of higher education giving up lecturing to go into plumbing as the wages were so much better.
 It should be added that there is a significant risk in investment in people, as they do not all succeed in their training, some will die or be incapacitated, some will not follow the career direction their training suggests, and others may immigrate into another country. In all of these cases the investment of the state, or other institutions, into their education is a waste.
 The same arguments might be made for unskilled and skilled migrants. However, there is an assumption that, rightly or wrongly, that more skilled people are more likely to have far higher potential for positive impacts. It is an assumption that seems perfectly reasonable, as highly skilled people are more likely to intelligent and hard working (as highly skilled people are likely to be where they are through either significant effort, greater intelligence, or a combination of both - notwithstanding that some highly intelligent people do not have opportunities to excel).In addition they already have skills that will allow them potential to utilise their strengths. In short they are more probable candidates to add significantly to economic well being, whereas the unskilled, and skilled are far less probable. This is clearly an area where that could produce significant debate, but I agree with the assumption that highly skilled workers are more likely to generate wider economic benefits for the reasons outlined, as this seem to me to be entirely rational .
 Emigration Soars, The Telegraph, 16 November 2007, Retrieved on 7 December 2007 from www.telegraph.co.uk
 Immigration Trends 2004/5, New Zealand Immigration, retrieved from www.immigration.gov.nz on 7 December 2007
 Settler Arrivals 1996/7 to 2006/7, Australian Government Department of Immigration and Citizenship, retrieved from www.immi.gov.au on 7 December 2007
 The Economist, North Sea Oil: When the Wells Dry Up, 12 July 2007, retrieved from www.economist.com on 19 November 2007
 The one positive point is that the experience in this sector has led to the development of a specialised industry, deep sea oil extraction, which has ongoing potential for export.
 UK Manufacturing in Transition, EMEA, Undated, Retrieved from www.emea.info on 19 November 2007
 Bank of England Inflation Report, 2006, PowerPoint Presentation, retrieved from www.bankof England.co.uk on 30 November 2007
 ‘The Pink Book, ONS, retrieved from www.statistics.go.uk on 7 December 2007
 National Statistics Online, International Travel, Retrieved from www.statistic.gov.uk on 1 December 2007
 Bleak House, 29 Nov. 2007, The Economist, retrieved from www.economist.com on 30 November 2007
 Economist, The City of London’s Fall, November 29 2007, retrieved from www.economist.com on 1 December 2007
 Economist, Card Sharks, November 29 2007, retrieved from www.economist.com on 1 December 2007
 The Sunday Times, The Gathering Storm, 2 December 2007, retrieved from www.timesonline.co.uk on 2 December 2007
 ONS, Government deficit and debt under the
 Including finance lease liabilities in public sector net debt: PFI and other, Adrian Chesson and Fenella
Maitland-Smith Office for National Statistics, November 2006, retrieved from www.statistics.gov.uk on 10 December