Wednesday, September 14, 2011

The UK Economy - A Review

It might seem odd to be writing about the UK economy as the Euro area crisis is drunkenly lurching forwards. However, the European crisis is now at a stage where past policy has set in place a structure which is now dictating events in the face of new policy provision. The reactions to the crisis will have an impact of some kind, but the choices on the table are constrained, and can only shape the direction of the crisis, rather than resolve the crisis in a positive way. Time and events allowing, I might return to this subject again, but for the moment, I thought I would fulfill my promise to review the UK situation.

The first and most important point in a review of the UK is to understand the situation of UK debt. The lessons being taught in Europe apply just as much to the UK as they do to the troubled states of Europe. I have already cited this before, but a paper from the Bank for International Settlements tells the story. At present, the corporate, household and 'public' debt (debt accrued in the name of the government but to be paid by individuals and businesses) as a percentage of nominal GDP in 2010 was 323%. The table shows the steady accumulation of debt since 1980, when the same figure was at 160%. An interesting comparison can be found in France, which is threatened with the spread of the Euro crisis, at a near identical 322% in 2010, or crisis-hit Spain at 355%.

There has been lots of publicity about the government 'austerity' measures which are supposed to address the problems of government debt. However, as yet, there is little sign of austerity, with government debt accrual continuing at a blistering pace. This chart from the UK Office for National Statistic using the troublesome measure of net debt to GDP is nevertheless indicative of the current position.

This is a quote from Liam Halligan at the Telegraph a short while ago:

What does surprise me, though, is that despite the broad support the Tories have received since taking office, and despite endless rhetoric about “living within our means”, UK fiscal policy is actually becoming more profligate. Far from insulating ourselves from systemic dangers, we are making the UK even weaker.

During April and May, the first two months of this fiscal year, the Government borrowed £27.4bn according to figures released last week, up from £25.9bn during the same months in 2010. That’s right, we’re borrowing more – despite all the Treasury’s tough talk.

He is absolutely correct, and the situation is not going to get better, but is going to get worse. Unemployment is on the rise, and is going to get worse:

The relentless rise in government spending has, so far, managed to hide the unemployment by using borrowed money to increase activity (and thus employment) in the economy. The problem faced by government is that, as they decrease the rate of borrowing increase, unemployment will rise, and tax receipts will fall while expenditure goes up, and activity in the economy will fall. It is a situation described by Ambrose Evans-Pritchard for Greece:

Let us be clear, the chief reason why Greece cannot meet its deficit targets is because the EU has imposed the most violent fiscal deflation ever inflicted on a modern developed economy - 16pc of GDP of net tightening in three years - without offsetting monetary stimulus, debt relief, or devaluation.

This has sent the economy into a self-feeding downward spiral, crushing tax revenues. The policy is obscurantist, a replay of the Gold Standard in 1931. It has self-evidently failed. As the Greek parliament said, the debt dynamic is "out of control".

It is a fascinating analysis, in how right it is - and how wrong. Yes, if governments borrow money, tax revenues are supported, as more people are employed. But....but in order to have that employment, a government is borrowing money in order to get x% of that money back in tax revenues. The more money that is borrowed, the greater the tax revenues from the economy, but it is a recipe for disaster. In the end, the government is borrowing money to pay itself back a small percentage of the borrowed money. It is a simplistic and extremely foolish way to run an economy.

To try to illustrate the point, imagine that you have a reasonable job, but are massively in debt, and with your expenditure exceeding your income. In order to continue forwards, you borrow more to spend, but also use some of the borrowed money to repay past borrowing. You appear to be ok as you are still paying your debt, but all the time the total net debt is increasing. As soon as you stop borrowing, you will need to reduce your spending, but also reduce your spending further in order to pay the debt that you were previously paying with further borrowing. It is a double whammy. In the case of governments, the repayment of previous borrowing with new borrowing is achieved indirectly through 'creating' employment with borrowed money, then retrieving a percentage of the income from the employment to use to pay for previous borrowing. What governments in this situation are really doing is hiding unemployment with borrowing and artificially bolstering tax receipts with money that was borrowed in the first place.

The UK government faces the problem that, if spending and borrowing is cut, unemployment rises, and as unemployment rises, tax receipts fall. This fall is both from less employment, but also from businesses who see their activity and profits fall as there is less spending in the economy due to lower employment levels. As government tax receipts fall, and unemployment rises, the economy contracts, and as the economy contracts, GDP appears to fall (appears, as GDP measures the activity in the economy that is resultant from borrowing), and as GDP contracts, bond purchasers become more nervous. Nervous bond purchaser then raise the cost of borrowing in response to their nervousness, and in doing so make the servicing of the extant debt pile more expensive, creating further problems for the government in cutting expenditure, as resources are transferred from spending towards higher debt repayment.

It is a relentless downward spiral. However, the option of continuing to borrow to support tax receipts, as explained earlier, is simply a self-defeating self-delusion. In the end, the only way ahead is to find the real rate of employment in the marketplace without borrowing, and the real rate of tax receipts, and real national income. The problem is that, in doing so, there is a risk that the scale of the contraction might just swamp the government finances and see shocking rises in unemployment (with risk of serious political/social instability).

In the meantime, the Office for Budgetary Responsibility (OBR) lives in its own fantasy land. Their March report notes that their previous prediction for economic growth was overdone, and that the high inflation was unexpected. Nevertheless, they predict growth of 2.35% to 2013, and 2.1% after. Curiously, their fan chart of the possible GDP outcomes does not include the possibility of a decline in GDP, despite the huge uncertainties in the UK economy itself, or the broader instabilities in the world economy. It is within this context that we must examine their forecast for the fiscal situation, with deficits falling steadily to 1.5% in 2015-16, and also a significant decline in unemployment. In other words, their predictions are premised upon a significant economic recovery, which would presumably be the same economic recovery we have been told about for the last few years. The question to ask is; what has really changed?

In terms of the world economy, although I do not have the space to detail it here, it has become ever more unstable, and there is certainly no sign of a sustainable recovery. Instead, with the Euro crisis currently at centre stage for example, the risks are strongly on the downside (see chart below which is 2009-10 exports). With the Euro area representing our major trading area, the risks inherent in the Euro crisis for the UK are rather obvious.

The answer of many is that, even as government contracts borrowing, there should be a period of so-called monetary easing. The benchmark interest rate has already remained at record lows for a long period, as can be seen in the chart below:

Despite such low interest rates, which in 'normal' times would see a boom, the UK economy is barely moving. The result of the low interest rate target is that variable mortgages are currently averaging 4% (compared with 6.95% when the benchmark was at 5% in September 2008), a £5000 unsecured loan is currently 15% (compared with 11.5% when the benchmark was at 5% in September 2008). More interesting is the interest rate being paid to savers for time deposits, with 2% as the current average (compared with 3.22% when the benchmark was at 5% in September 2008). There are several points to note from these numbers. What we are seeing in these figures is far greater caution on the part of banks, despite the low interest rates, even during the bouts of money printing (called quantitative easing - QE). We are also seeing that the current interest rate is exceptionally low, which frees income from debt repayments to allow for more spending within the economy (all the above statistics from the Bank of England here). However, this is undertaken at the cost of savers, in particular when considering the inflation rate, as seen below:

Despite the poor returns and the rate of inflation, since the economic crisis became apparent, the savings rate has increased from 2.2% in 2007 to 5.4% today, though the increase in savings has gone into reverse and has fallen back from 6.4% in 2010. It is quite likely that the poor returns on savings and the squeeze on household finances are enough to offset the motivation to save through insecurities about the future. For example, average earnings in 2010 only increased by 2.1%, with inflation therefore eroding real earnings. As the chief economist of the Bank of England observed:

Mr Dale, appointed to his position in July 2008, admitted pressures on household finances would “likely to persist for some time”, or for at least “the next year or so”.
Aside from the optimistic timescale, he is acknowledging that there is an ongoing real decline in household disposable income. It is therefore unsurprising to see that retail sales are now in decline. The trend is not unique to the UK, as the middle and bottom are falling further behind in the OECD. A recent Economist report confirms my longstanding prediction that the emerging economies would not move up to OECD standards of living, but rather that the OECD standard of living would fall even as the emerging markets moved up, only to eventually meet somewhere in the middle. Just as real earnings are being squeezed, the asset that was formerly the 'piggy bank' of choice continues to decline in value in real terms:

A recent Halifax report suggested a decline in house prices, and offered the following dose of optimism on affordability:

Martin Ellis, the housing economist at the Halifax, said current low volume of sales tended to make house prices more volatile from month to month. "The underlying trend, as measured by the latest three monthly figures, showed a modest improvement in house prices from the second consecutive month," he said. Prices in August were 1pc higher than they were in the previous three months.

He pointed out that it wasn't all bad news for home owners. "The recent decline in average mortgage rates has further boosted home affordability for those able to raise a deposit to make a new purchase." He pointed out that low interest rates were likely to continue to support the market, but increased uncertainty about the economic outlook and pressure on householders' finances would continue to constrain demand, which was likely to act as a brake on prices.

He goes on to predict 'stability' in house prices, which means ongoing real decline in value of housing. Houses are no longer piggy banks. As for affordability, this is reliant on the continuation of rock bottom interest rates, and it is quite possible that, in the current state of broader economic instability, there could be a sudden dramatic reverse in response to crisis. Also, as earnings are further squeezed, there is real risk in purchasing based upon assumptions of low interest rates.

Returning to the inflation in general, the most curious point about the inflation rate shown above is that the Bank of England (BoE) is supposedly targeting inflation, and inflation has near as damn-it exceeded the target since the onset of the economic crisis (or rather since the economic crisis became apparent in the so-called financial crisis). At this stage, it is ever more apparent that the Bank of England is going beyond its remit to target inflation, and it can no longer be denied that they are now in the business of trying to target broader economic outcomes. If they had been following their inflation targets, they would have increased interest rates long ago. Curiously, the actual inflation target of 2% has disappeared from their general introduction to monetary policy.....I seem to recall that in past versions of the introduction, it was the central point.

However, as a contrast, in the BoE August Inflation report, the failure to meet the target leads the report. The report suggests that inflation will climb further in the short term, but then argues that it will later fall back. It is a familiar tale, and it is very similar to previous reports. The BoE are sounding increasingly like a broken record. Inflation exceeds the target, but it is always about to fall back. But it never does. In part, the inflations is resultant from the decline in the £GB. Below is a chart based upon the BoE trade weighted index:

It does not look too bad at the moment, but there are several factors that are supportive of sterling. The first key factor is that most of the other OECD economies are looking distinctly ugly. As such, the competition at the moment is not which is the most attractive currency, but which is the least ugly. Rightly or wrongly, the £GB is not perceived as too ugly, but that might be about to change. This from Bloomberg:

Bank of England policy maker Adam Posen’s signal that he may need to double his call for bond purchases will intensify the debate at the U.K. central bank for more stimulus as the economy falters.

Posen said yesterday the central bank may need to buy as much as 100 billion pounds ($158 billion) in securities within three months and warned that officials’ delay in acting has made economic prospects “worse.” He has voted since October for a 50 billion-pound increase in the bond plan.

Posen’s attempt to convince his colleagues on the Monetary Policy Committee that they are damaging the economy by doing nothing comes as central banks from the Federal Reserve to the Swiss National Bank seek new ways to bolster their recoveries. He has been the sole voice on the MPC voting for more so-called quantitative easing, and minutes of this month’s meeting on Sept. 21 will show if anyone else joined him.

“It wouldn’t take much to convince a few others,” Richard Barwell, an economist at Royal Bank of Scotland Group Plc in London and a former central bank official, said by phone. “We may see one more joining.”

The central bank bought 200 billion pounds of bonds in a program that ended in early 2010. Posen’s comments may point to a further shift in the MPC just two months after Spencer Dale and Martin Weale abandoned a push for higher interest rates to control inflation that accelerated to 4.5 percent in August. While that’s more than twice the bank’s goal, it has set its key rate at a record-low 0.5 percent since March 2009.

Posen has admitted that the first bout of QE added 'at least' 0.5% to inflation, but claimed that it had also added 1.5% to GDP growth. You might note that, in admitting this, it just serves to confirm that the inflation target at the BoE has been abandoned, albeit that he is alone in being explicit in this, and other members of the MPC may at least have some vague and loose sense of obligation to the target.

In my last post, I mentioned the emergence of currency wars, and it is not difficult to see that the BoE might react to the actions of others in their attempts at devaluation, and seek to devalue as a response. If QE were to be resumed in conjunction with dismal economic statistics, then there is room for further devaluation, and then the knock on effects on inflation. However, this would be to assume that the wider policy initiatives remain static, but with an emerging currency war, where policy in one country is a reaction to policy in another country, then the situation might go in any direction. However, the one certain result of a currency war in which countries rush to the bottom is that there will be further inflation in commodity prices, and this will feed into inflation. It just becomes a question of who gets how much of the inflation.....

In respect of these policy feedbacks, it would be a brave individual who would take a firm stance on the direction of the £GB in relation to other currencies. The role of GBP is going to be crucial with respect to another element in the UK economy, which is the current account and balance of trade:

The article which the graphic is taken from is gloomy, and rightly so. The trade deficit is an ongoing worry, and illustrates some of the policy dilemmas. The rock-bottom interest rates are in place to reduce the cost of servicing debt, but this in turn frees more income for expenditure. However, more expenditure translates into more imports, and this supports ongoing imbalances. However, if interest rates were raised, then this would encourage a 'carry trade' into the UK (interest rate arbitrage), which would see an appreciation of the GBP, with a potential knock on effect on exporters and encouraging imports. At the same time, carry trade money would start slushing around the economy, with a potential for reduction in real interest rates, as more money chases the same investment opportunities. The same carry trade money might further increase inflation, even as interest rates are rising, with asset price inflation driving general inflation upwards.

There are too many variables to consider (and currently too much extreme policymaking more broadly) in this dynamic system to see how each policy might finally impact upon the UK economy. Of course, the real underlying problem reflected in the trade imbalance is not interest rates and currency, but a fundamental problem with the competitive position of the UK economy overall. Even when the currency devalued, the problem of the ongoing trade imbalances continued. It is impossible to look at this in isolation, as the world as a whole was confronted by economic problems, but the worldwide economic problems left pre-crisis imbalances largely intact. The question to ask is why the same imbalances persisted even as some deficit countries fell into the economic quagmire, and even as they devalued. This should have left these countries in a position of reduced imbalances or (dare I say it) positive trade balances - but it did not.

What we have is the offset of government borrowing and rock bottom interest rates, along with money printing. In other words, we are straight back to the policy dilemma. The UK is creating policy which of itself encourages the problems that it seeks to resolve. The problem is that they see consumer spending as a support for the economy, but consumer spending just continues the trade imbalance. At the same time, they make saving a fool's errand with extremely low interest rates in relation to high inflation, again encouraging spending. Whilst savings rates did increase, as mentioned earlier, they appear to be reversing direction.

Poor savings rates also limits the capital available to financial institutions, outside of the problematic wholesale market, which in turn leads to the relatively high differentials between the benchmark rate and the retail/business lending rate (yes, I also accept that this is function of increased risk perception, new capital adequacy regulation and attempts to repair dubious balance sheets). The poor returns on saving in the UK also encourages banks into international wholesale markets, which in turn encourages private sector debt accumulation from overseas sources.

The real problem is that the current account imbalances must be funded from somewhere. That means that there must be an ongoing source of lending from overseas, to allow the UK to have the currency to pay for the import of goods and services. In the end, that means that the UK MUST continue accumulating debt funded from overseas, or must find ways to export or invest its way into current account surplus. The problem resolves around over-consumption in the UK economy, and this is being encouraged with low interest rates. Again, the policy dilemma looms large.

So what is to be done? It is a question that I have been pondering over the days that I have been writing the post, and I have to admit, I am somewhat at a loss. In particular, in the environment of currency wars, does it make sense to have high interest rates, or not to print money? The Swiss example is a worry, with the huge appreciation of their currency hitting exporters hard. Regular readers will know that I think that printing money is a road to ruin, but how do you react to other countries doing this? My normal certainty of the right course of action is wavering in the sea of madness that is the current state of the world economy. The mounting instabilities, and the ever more extreme policies being enacted, leave the UK bobbing around in a storm of uncertainty and confusion. Internally, the UK is beset with challenges as it tries to reverse the debt mountain accumulation, with the potential to see the downwards spiral. Externally, the situation of the global economy can only point in the direction of a further negative lever on the UK economy.

A certainty is that the UK economy must commence the process of reducing debt accumulation, however hard that may be. The spreading Euro crisis is indicative of the limits of ongoing borrowing by governments, companies, and individuals. A second certainty is that the downward trajectory of living standards cannot be reversed, and this has implication for taxing and government spending. This returns me to one of the themes of the blog, which is that only through reform can the UK government address the changes in the structure of the world economy. This means that sacred cows must be slaughtered. For example, the welfare state is currently unaffordable. It is no longer possible to have generational unemployment, and legions of individuals hidden away on disability benefits. I have previously suggested reforms of some of the sacred cows (see top left of the blog), and the necessity of these reforms grows with each year.

However, when I first proposed the reforms, the UK still had the possibility of financing the reforms. For example, the proposals for the reform of the benefits systems would, in the short term, be more expensive. Would the bond markets have the patience for reforms with a medium term positive outcome, in particular with risks of politics seeing a later reversal of reform?

The fundamental problem is that the policy actions undertaken since the economic crisis broke into view have only served to magnify underlying problems. As the world plunges ever deeper into economic chaos, the room to act is diminishing, and the UK may just be too late to enact any policy that might avoid a serious depression. Even if, and it seems unlikely, the UK were to enact reform now, the problems of the wider world and the legacy of past policy now have too much momentum to be stopped. I commenced the post with the idea that Europe was now set on a course dictated by past policy. So it is with the UK, and so it is with the world economy more broadly. Policy now, it seems, can only be enacted to pave the way for a route out of the unavoidable crises that are brewing. The crises are now beyond stopping, and can only be delayed at yet greater eventual cost.

So my conclusion for this post is that the UK can still act. However, it cannot act to avoid a coming crisis. It can act to position itself to emerge from the crisis as one of the stronger economic players in an ever more competitive world. My worry is that, as the real crisis finally breaks, will politicians and the general public have the courage to enact the reforms that are necessary, to accept that past wealth does not mean future wealth, and seek to rebuild a leaner and more efficient UK economy? I have my doubts, but....

Note: I have written a long post, and have therefore only had a limited time to check through it. As such, please accept my apologies for any 'clunkiness' or any small errors.

Note 2: Updated as some of the graphics were not showing correctly.