Category Archives: economics

Deflation: friend or foe?

Our powers-that-be have invoked deflation as a kind of ultimate economic bogeyman.  Prices fall, so people don’t spend, but wait to buy cheaper.  Economy grinds to a halt.

Can we find any evidence to test that theory?  Actually, it’s very easy.  Look anywhere in electronics.  WebThing’s first desktop computer cost about £2000.  About 10 years later, its current replacement was in the region of £200, not to mention more powerful by a yet bigger margin.  Computers have been falling in price for 30 years.  Other electronics, such as phones or home entertainment kit, show similar patterns.

So which electronic industries have been choked by this “deflation”?  Apple?  Nokia?  Sony?  But you don’t need me to list a whole bunch of global giants.

And in recent years, we’ve had lots of other price falls due to globalisation and cheap imports: the rapid rise of Asian countries, most recently China.  Clothes, for example, are cheaper than a few years ago not only because we have Primark, but also in staid and conservative M&S.

The problem they’re scared of isn’t falling prices, it’s falling consumption.  Or in an economy reliant on growth, even static consumption.  So we must consume ever more.  Consumption grows above income, so we have to borrow.  Over time, the borrowing grows into a bubble that can never be repaid, leaving the lenders to take heavy losses.  But we can’t stop borrowing ever more against illusory future income, because then we stop spending, and that’s the bogeyman deflation.

That’s where we are now.  And there’s no way out.

Printing money won’t help: you haven’t added anything to the real economy, you’ve just debased it.  More borrowing won’t help, when the only people who want to borrow are those who’ll never repay.  More lending won’t help in a saturated market.

We have deflation, because a bubble is deflating.  At the same time we have inflation, which the government is desperately trying to raise higher.  And we have the bottom line: even when we’ve push inflation up to 1970s crisis levels (above 20%), we’ll still have the deflation.  Because it’s not, nor ever was, about consumer prices!

Someone should explain biflation to our powers-that-be.

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The pound in your bank account

… is today worth 96p (yesterday’s value).  Note: not the pound in your pocket: in the absence of a gold standard or similar, that’s just a convenient token.

The Bank of England has just officially magicked £75 billion into existence.  That’s money the banks loaned into existence over the past years, and today’s “Quantitative Easing” is an admission that 75 billion of it will never be repaid.

That’s nearly 4% of current M4 money supply: hence the devaluation of the pound.  Everyone with sterling-denominated assets has just been robbed of 4% of our fortunes.  Though in reality, this is just an admission of past inflation, and only those of us who didn’t own property through the boom have been robbed of more than we were previously gifted.  At least, for the time being.

It’s also an admission that we’re not a working capitalist society.  When money is loaned, it must be paid back (which is non-inflationary), not printed into existence (raw inflation).  That implies someone has to earn the money through productive activity: bring something to the value of the money into existence.

The interesting question now is, who will buy in to sterling-denominated assets when they’re being systematically devalued?  So long as interest rates remain ridiculously low, the only willing buyer is the government itself.  Since government itself needs to borrow huge amounts which the markets are already shying away from lending, the only possible outcome of continuing low interest rates is inflation rising to Zimbabwe-like levels!

Investing in obsolescence

20-30 years ago, Mrs Thatcher dragged us kicking and screaming out of our last chronic slump.  An important element of Thatcherism was the idea that it’s not a good idea for industry to produce things noone wants to buy.  Against huge opposition, she stopped pouring taxpayers money into a number of obsolete lame-duck industries.

But there was one suicidally inconsistent exception: she threw taxpayers money into lame-duck motor industries.  Thus she perpetuated an industry that’s gone bust and (as predicted at the time) been back for more taxpayer billions every few years for as long as I can remember.  More recently it’s been made just a little more subtle, morphing into things like sweeteners for a takeover by management, alchemy, BMW, or Tata, but it’s never changed from pouring good money after bad.

Now there’s pressure for a bailout of Jaguar-Landrover, as our lame-duck-in-chief calls itself these days.

The argument for a bailout is unchanged from the one that ruined us before Thatcher: jobs.  Those directly employed are the tip of an iceberg, with far more in the supply chain.  If rebranded-BL goes bust, so do lots of suppliers.

But many (most?) of those suppliers have put substantial investment into their capability to supply specialist widgets.  So long as the bailouts continue, we’re perpetuating a false market for suppliers.  Some of them will inevitably be pouring their own money into further investment in this zombie of a market.  It’s not just the jobs that are the tip of an iceberg: it’s also the money poured in.  This is a huge fraud perpetrated on all those suppliers!  But for Mrs T’s bailout, they’d’ve been spared nearly 30 years investing in failure!

If there was ever a clear case for correcting Thatcher’s inconsistency, this is it.  Put the lame duck out of its misery, and draw a line under the fraud perpetrated on the supply chain.  At the same time, seek to help the latter re-gear to real markets: produce things that someone actually wants to buy!

One suggestion: help that huge industrial capacity re-gear to energy-efficiency projects and production of clean energy!  Not by selecting projects, but by stimulating that market.  But that’s another rant.

Shorting Bank Shares

Who says you can’t short bank shares?

Back in August, I invested in a small shareholding in Lloyds TSB, a bank that’s suffered but remained sufficiently prudent not to be a total basketcase. Commonly described as boring. For me, holding banking shares is a hedge against any recovery in house prices: so longer as houses are crashing, I’m quids in, no matter what happens to the value of my shares. And that’s on top of a generous dividend.

Come September. Lloyds TSB to bail out the basketcase HBOS – an albatross around its neck. Share price plummets. But then the shorting ban, and for a few hours the price soared. I caught it and sold up at a small profit, with a view to re-establishing my position at a price not more than half what I sold for.

Today I’ve done exactly that. I now own twice as many LloydsTSB shares as before. And I’m still sitting on a cash profit that’s over 10% of what I paid. Guess I just successfully closed my first virtual short position, just where it was supposed to be banned 🙂 The dividend may be shattered, but it’s still a gamble on longer-term prospects, and a hedge on housing.

King Canute takes a step back

Just a fortnight ago I wrote “Losing money and glad of it“, following the Lehmans collapse.  Bizarrely, my holdings survived the next couple of days big falls intact.  That’s now corrected itself firmly downwards, despite the fact I was able to sell my banking shares at a small profit on Sept 19th (and a very substantial profit compared to their value this morning)!

In the intervening time, my optimism over the powers-that-be’s stomach for doing the right thing has taken about as much of a battering as dodgy banks around the world, including the four(?) that collapsed in a single day yesterday.  More scapegoating (short-sellers are parasites but they didn’t cause this mess), and more throwing money, King Canute style, into the system on a breathtaking scale.  Our own government and most of the chattering classes are still wedded to the principle of keep on trying the same failed policies and hope the problem goes away.

Hint: the original problem was too much money.  Throwing ever more money at it will do us as much good as the same policy in Zimbabwe does for its economic collapse.  The Northern Rock bailout bought our surviving banks a year or so before reality crept up on them again, at a terrible price (the tangible market distortion is probably more damaging than the taxpayer losses).  Bear Stearns bought the ‘merkins a few months.  Fannie and Freddie were even bigger, but bought only a few days.

But some of the ‘merkin legislators appear to be quicker on the uptake than ours.  They’re still throwing money at it, but in formulating the Paulson bailout, they’ve started talking about something other than blind, reactive panic.  And in rejecting that, they’ve taken another step forwards from “we must do something – never mind what – at any price“.  Perhaps it’s an admission from those who have an economic clue (Ron Paul keeps getting mentioned) that the bailout now would’ve been lucky to buy good news for long enough even to get through the US presidential election.

The Lehman non-bailout may have been the first step from King Canute denial to facing the storm so we can come through to the other side[1].  The Paulson plan and its rejection are further positive steps.  Eventually – one might venture to hope – it’ll pick up a firm direction, and sweep up our own spineless legislators in its wake.  The [Obama|McCain] presidency will be interesting times.

[1] Unlike the ecological destruction we’re causing, there is another side of economic recession to come through to.  Unless we really do succeed in driving the entire productive economy abroad, by taxing them ever more to prop up house prices (and now banks too).

Losing money, and glad of it

Today’s news about Lehman Brothers seems likely to hit stock markets hard enough to send my portfolio firmly into the red.  No, I don’t have stock in or near Lehman or its peers, but the expectation is that there will be substantial collateral damage throughout the world’s stockmarkets, including those stocks I do hold.

Why am I happy to make such losses?

Well for one thing, there’s no reason they should be sustained.  They won’t vanish as quickly as the surreal gains that followed news of the fannie/freddie bailouts (gains of 10-15% in UK bank shares on Monday didn’t even last the week).  But neither do they reflect on the fundamental value of unconnected businesses.

More importantly, the end of the bottomless taxpayer purse is long overdue.  The US allowing Lehman to fail is moving on from its King Canute phase to face reality (and so close to an election, they must expect it to be popular – or at least less unpopular than another bailout).  The UK is showing signs of doing likewise, with Mervyn King reportedly taking a stand against throwing ever more taxpayers money into the black hole of housing.  In the meantime both countries have suffered huge losses, but better late than never.

This weekend seems to bring us much closer to drawing a line under “housing rescue” schemes that serve only to prolong the pain.  The Vested Interests can stop talking the market up[1], and start telling vendors to drop 60% from peak prices if they’re serious about selling.  When a £200K house has fallen to £80K we’ll be back to something like the long-term average in terms of income multiples.  Then I’ll be able to afford a house, and those stockmarket losses will cease to matter.

[1] Mainstream predictions – coming from vested interests – started this year at about +1%, moved to -10% in six months, and are now moving to -25% and more amongst those who need buyers as well as sellers.  All in an effort to convince people like me to start buying at prices that are still a long way above their long-term trend, in the expectation they won’t fall very much further.

House prices: Statistics vs Reality

The chattering classes profess confusion over discrepancies in the various house price indexes. There are several indexes published regularly and closely watched, with plausible claims to statistical validity:

The Rightmove index represents asking prices, and is unsurprisingly much higher than any of the others – which represent actual sold prices. No problem there.

The Nationwide and Halifax are our long-term biggest mortgage lenders, and their indexes represent the sale price of houses purchased with a mortgage. Reassuringly, these indexes are closely correlated (graph: BBC News), so we can infer that any differences between the two lenders’ markets (who they lend to) are not important. That might not hold for smaller, specialist lenders, but we can surmise that these fairly represent the mainstream.

What seems to have the pundits baffled is why the Land Registry differs from the Nationwide and Halifax. There is a time lag, said to be around 3-4 months, built in to the Land Registry compared to the others. But that doesn’t explain the divergence we now see, as noted today by the FT.

It seems to me there is a perfectly simple explanation, and that we can extrapolate from it what will happen at a hypothetical turning point where confidence returns to the market. The issue is that the downturn is affecting different parts of the market in different ways.

Let’s consider a hypothesis with some plausible assumptions:

  • Tighter mortgage conditions have a disproportionate effect at the lower end of the market, particularly first-time-buyers. Higher up the market, rich people are less reliant on mortgages.
  • Therefore the reported 60%[1] drop in numbers of transactions is concentrated primarily at the lower end.

That’s enough. Let’s put some representative numbers to these assumptions[2]. The numbers themselves don’t matter: feel free to vary them, consistent with the assumptions. Your results will differ from mine, but they’ll still demonstrate why the observed discrepancy exists. Just to emphasize the point, we’ll take one figure way in excess of what any of the indexes tell us (of now): an actual drop of 20% across the entire market!

Applying that to some representative price points, we hypothesise:

  • First time buyer, down from £150000 to £120000
  • Mid-market, down from £250000 to £200000
  • High-end, down from £500000 to £400000

In “normal” times – before the crash – there’s little doubt that the majority of transactions were in the lower price ranges. Let’s say the above price points represent 60%, 35% and 5% respectively of the market. That gives us a pre-crash average of (0.6 * 150000 + 0.35 * 250000 + 0.05 * 500000) = £202500, which is roughly consistent with published figures (for sale prices, not asking prices).

Now we know that the crash has affected the bottom end disproportionately, and left the top end relatively intact. Let’s put some figures to that too, bearing in mind that the overall drop in activity is reported as being at least 60%[1]. Suppose activity levels are down by 70%, 50% and 10% at our three price points. That gives us an overall percentage drop of (70 * .6 + 50 * .35 + 10 * .05) = 60%.

Now, here’s the crux. Let’s calculate the average post-crash price with the above figures, bearing in mind that we have assumed each individual house is down by 20%. Our post-crash distribution of market segments have changed:

  • First time buyers: 60% reduced by 70% = 18% of the pre-crash market
  • Mid-market: 35% reduced by 50% = 17.5% of the pre-crash market
  • Top-end: 5% reduced by 10% = 4.5% of the pre-crash market.

That’s a total of just 40% of the pre-crash market (the 60% reduction). So what we see is different shape of post-crash market:

  • First-time buyers: 18% * 2.5 = 45%
  • Mid-Market: 17.5% * 2.5 = 43.75%
  • Top-End: 4.5% * 2.5 = 11.25%

So with the 20% drop in price of each individual house, we get an average of

(45 * 120000 + 43.75 * 200000 + 11.25 * 400000) / 100 = £186500

as compared to our pre-crash

(60 * 150000 + 35 * 250000 + 5 * 500000) / 100 = £202500

That’s a percentage fall of 100 * (202500 – 186500) / 202500 = 7.90%.

While individual houses have fallen by 20%, the market average – and hence the published statistics – has lost a mere 7.9% in our model. That’s actually smaller than the current falls reported by the Nationwide and Halifax!

Now my gut feeling is that the figures I’ve used may be conservative: the market skew may be much bigger than that (bearing in mind reports about first-time-buyers being near-eliminated, rather than 45% or the market as above). That would indeed be consistent with the mere 2% fall recorded in the Land Registry index.

Now it’s not hard to see how the discrepancy arises. The mortgage lenders see a different market profile to the land registry. We could perform a similar analysis with some more numbers: say 95% of first-time-buyers, 75% in the mid market, and 50% at the upper end have mortgage, we see their figures are biased towards the market sector that’s been most affected. I’ll leave it as an exercise to the reader to calculate hypothetical Nationwide/Halifax indexes based on those numbers (or choose your own).

Side-Effect: Rise of the Rental Market

A well-documented fallout from the crash is the rise of the rental market:

  • People unwilling to sell at current prices are letting their houses instead.
  • People waiting for further falls are choosing to rent for the time being, even those who could afford to buy.

So suddenly the rental market has changed. The quality has risen – with lots more houses than before that the owners thought good enough to live in themselves! And the status of tenants has risen too: it’s no longer so heavily dominated by those too poor to get a mortgage (and too honest to lie for one). And because the UK rental market is traditionally small (most people own their own home), the effect on it is disproportionately large. Even if the traditional rental market (the rich exploiting the poor) were little-changed, the overall market has risen with the coming of the new landlords and tenants.

Predicting the bottom of the market

Supposing this month, we were to hit the bottom of the market. Confidence suddenly returns. All the prospective buyers who are currently renting decide it’s time to buy.

  • The profile of the market returns to “normal”. The statistics catch up with the individual houses, so a 7.9% drop suddenly becomes a 20% drop in the published indexes.
  • Corollary: the sharpest adjustment to the Land Registry index. If it happens after more than a year of falls (so the indexes aren’t measuring from the top of the bubble) it will not merely catch up with, but overshoot, the Nationwide and Halifax indexes in terms of year-on-year percent falls.
  • Even so, the market doesn’t return to bubble-level, because the mortgage lenders have got burnt giving out pyramid-scheme money willy-nilly.
  • The top end falls off the rental market, leaving only the poor as tenants for all those buy-to-let landlords.

Clearly the key to that is the first point. Such a sudden fall in the indexes is going to kill of that returning confidence. Corollary: there will be no sudden return of confidence, now or anytime: it’ll be a gradual thing, with several years in the doldrums after the sharp falls have gone. That fits the pattern of past house price corrections, including the 1989-97 one[3].

The third is also interesting, as it could mean (far) more buy-to-let landlords in trouble with falling rents and far-more-fallen sale prices. That’ll be the point Bradford&Bingley (the specialised buy-to-let mortgage lender who just raised money on very unfavourable terms in a rights issue) will be in real trouble. With any luck, the Northern Rock fallout will be so visibly horrendous by then that the government of the day will have the guts not to pour in yet more taxpayers money to do the same for B&B.

So what will the house price statistics look like as the market bottoms? Well, the key is that activity has to return to the lower end of the market, and that’ll be gradual. But from the above analysis, we’ve got a visible sign. So long as the Land Registry index trails the Nationwide and Halifax (over and above the 3-4 month difference in reporting time), we can infer that real prices are falling ahead of any of the indexes. When the Land Registry starts catching up could be a good time to look for a bargain. Once it’s caught up, we’re back to a saner, and lower, market, and we can finally start to take the statistics at something closer to face value again.

[1] From memory, and very probably wrong. Not important – you can get a similar analysis with a different (large) percentage drop.

[2] This is the kind of analysis mathematicians do all the time: take a complex problem and get a handle on it by making simplifying assumptions. It’s useful in that it can provide a good insight into “what if” questions – how does it affect the overall picture if different inputs vary, or if our working assumptions are incorrect. My degree was in Maths, and my first professional job after graduating involved precisely this kind of operational analysis.

[3] Mathematicians will often prove a result by an approach of assume the contrary, and show that implies a logical contradiction. Mine isn’t a mathematical proof of anything, but it’s a similar kind of argument.

Enron Accounting

When Enron collapsed, we heard the trouble was with off-balance-sheet liabilities that had been hidden.  Today, Fannie Mae and Freddie Mac are revealed as the same thing: off-balance-sheet liabilities.  Only this time, it’s government doing it.

When Enron collapsed, a few Enron executive faced criminal charges, but the main casualty was their auditors, Arthur Anderson.  So who is going to face charges this time?

/me declines to mention Northern Rock or Bradford&Bingley.

What is £13400 a year?

Someone called the Joseph Rowntree Foundation is reported as saying a single person needs £13400 a year to live an acceptable lifestyle, whatever that means. Couples and families need correspondingly more.

Let’s see. In round numbers, you’d pay 31% tax on £8000 of that, leaving just under £11000, or £900 per month. In a reasonably cheap area, that would leave £300 after rent, and £150 after council tax, water/gas/electricity, telephone and ADSL. Indeed, not a lavish lifestyle, but not too bad: well over twice what I had in the lean years (before 2004).

What if you live somewhere expensive, like London? I don’t know where London prices are nowadays, but I don’t imagine you’d get anything more than a grotty bedsit in a run-down area for £600 – or even £900 – a month. Standard lifestyle for a student or young graduate, but not something I’d care to return to, at least not without the package (rich social life, zero/low cost clubs and societies).

But hang on a minute! Googling the actual report tells an altogether different story. They put rent at £52.80 a week. Erm, where the **** do you get that? Highly-subsidised “social housing” maybe, but did you ever hear of a single person qualifying for that?  Must be an average that includes those who own a home or live rent-free – e.g. with parents.

And they put spending-money at £157.84 a week (£684/month)!

Yow! I don’t think I’ve ever sustained that much (excluding housing) for as much as a year, nor ever will until and unless I’m a property-owner[1]. Not even now that I’m paying top-rate income tax on more than half my income[2].

Furthermore, I can’t imagine many non-property-owners have that much spending money after housing costs. Have they just arrived at the fundamental principle of economic life in the UK: If you own property, you’re rich, if not you’re poor. Income is irrelevant except at major-celebrity or city-banker level.

[1] OK, that’s just a half-truth: it relies on excluding the money going into a SIPP, so I’ll be able to pay off a mortgage when I retire without all my money going in tax.

[2] And reclaiming some of it, by virtue of having the SIPP.

Inflation!

‘Absolutely horrendous’? Or absolutely predictable?

The first is an economist quoted by the BBC, on the subject of today’s producer price figures – one element in our rising inflation. The second is, well, me (e.g. here, here) and anyone else with basic numeracy.

In basic commodities (though not yet in manufactured goods, thanks to China), we have regression to the mean: the return of something closer to normality after a period in which prices were artificially low. In the case of food and energy, that’s no mere economic cycle but a generational period. As of now, rising food and energy prices are getting the lions share of the blame. International factors make a good scapegoat when the more important factors are what the late Douglas Adams called Somebody Else’s Problem.

But we’re missing the monetarists’ basic lesson. Printing more money doesn’t create more value, and increasing the money supply will fuel inflation, unless there’s something real and new to spend that extra money on. Pouring billions into subsidised housing, Northern Rock, and now the banking system at large, doesn’t create extra value, so it can only fuel inflation.

And then there’s the housing crash, which has finally begun in spite of yet more government money to prop up prices. Real-world interest rates are rising in spite of the Bank of England, and have a long way to go before they re-align with debt levels (after all, it was Gordon Brown paying off the national debt in the Prudence years that enabled rates to come down from double-digits to their boom-years values).

No government dares not bail out their articulate, well-represented middle classes. So there will be more tax, more downward pressure on the pound, and much more inflation, to help shift the great bulk of the burden from the established powerful but over-borrowed to the hapless hard-working.

Here’s an easy solution, if they’d dare be honest about it. Include house prices in inflation figures. That gives a measure of inflation as it affects those of us who are not so rich as to own property. And the good news is that after years of hyperinflation, it’s finally falling!