Bank profits, correlations and tax

"Any link between Barclays Group profits and the amount of tax paid to the UK government is inappropriate - there is no direct correlation between the two."

Barclays Bank Press release

I defy anyone to find a more arrogant statement than the one produced by Barclays bank and reported in yesterday's Guardian. Whatever Barclays might claim, the vast majority of its operations are based here in the UK. Nevertheless, it somehow they contrived to pay only one percent of its annual profits to the UK Exchequer.

Some simple arithmetic highlights the absurdity of the Barclay's statement. The current rate of corporate income tax is 28 percent. Therefore, in order to pay just one percent of global profits as taxes to the UK, it follows that only 3.6 percent of those profits are attributable to UK banking sector operations. Does that seem likely? Call me a failed accountant, but I think not.

In terms of financing its operations, Barclays is proudly British. It has profited handsomely from the low rates engineered by the Bank of England. While savers are being punished by zero returns on their deposits, Barclays bank generously awarded their staff with a huge pay increase last year. However, the patriotism disappears when it comes to paying tax.

The bank also has the reassurance of knowing that should they fall into any difficulties, the taxpayer is there ready to bail it out. Yet despite this extraordinary generous financial back-stopping by the state, Barclays claims that there is no correlation between its profitability and the amount of tax it pays to the government.

Imagine if we all thought that way. Suppose that millions of PAYE taxpayers suddenly claimed that their salaries have no correlation whatsoever with the amount of tax owed to the government. It is of course an absurd claim.

Bankers are out of control. This sense of entitlement knows no bounds. They think it's perfectly acceptable to demand massive bailouts when their reckless decisions threaten bankruptcy. They also feel no obligation to pay a reasonable contribution to the public purse. Instead, they claim their corporate affairs are too complex to require paying any tax.

Earlier this week, David Cameron promised welfare reform. He pointed to a sense of entitlement that is endemic among the poorer sections of society. I'm still waiting for a similar statement about corporate welfare. When will we see a banking sector corporate welfare reform bill before parliament?

The wild and wonderful FTSE

UK equities have done spectacularly well since the beginning of 2009. Although, the Footsie hasn't quite regained all the losses incurred at the time of the financial crisis, it is almost there. If current trends continue for a few more months, the Footsie should surpass its precrisis highs.

At this point, I suppose I should warn you that the previous paragraph t is not a recommendation to buy anything. As the familiar investment mantra warnds, share prices can go down as easily as they rise.

Even though the Footsie has enjoyed a reasonably steady recovery prices have still swung around quite violently. The extraordinary volatility emphasises the great strength of equity markets. It is quite possible to lose large amounts of money on equities. As the chart amply illustrates, when prices crashed in 2008, investors suffered appalling paper losses.

Moreover, when investors make losses there is no recourse to a taxpayer bailout. If an investor places their money on a share that turned out to be a dog, they have to suck up the losses. Therefore, no one can complain or feel aggrieved if those same investors are now making healthy gains.

So if you've made any money recently on the Footsie, I congratulate you. If you start making losses tomorrow, it is your business and I don't want to hear about it.

The monetary miracle is over

One should never underestimate the importance of luck. For almost a decade, the Bank of England proved to be very fortunate. It managed to simultaneously keep interest rates low, dramatically increase the money supply, and at the same time meet its inflation target.

How did it pull off this monetary miracle? The chart above provides a comprehensive explanation. It breaks the CPI inflation rate down into two components; the rate for services, which are mostly produced domestically; and rate for goods, which are almost entirely imported into the UK.

As the chart illustrates, prices for domestically produced services have grown fairly consistently at between three and four percent a year. This is far in excess of the Bank of England's inflation target. Prices of goods, on the other hand, were falling between 2000 and 2006, exerting powerful downward pressure on the aggregate inflation rate.

The reason for this negative inflation rate for goods is well understood. China industrialised, and exported huge quantities of clothes, footwear, and electronics. Prices for these items fell massively. In contrast, domestically produced prices increased rapidly in response the the extraordinary surge of Bank of England inspired monetary growth.

For many of us, this inflationary dichotomy between its goods and services will ring true. Anyone who regularly hired an accountant or chose to educate their children privately will be familiar with the four percent a year price hike.

So, it is fairly easy to see how the Bank of England got away with loose monetary policy and low inflation. Nevertheless, there is a more intriguing question embedded in this chart. To what extent did the surge in goods prices trigger a financial crisis?

To see how the turn-around in import prices might have precipitated the crisis, it is worth remembering how monetary policy worked in the past. In previous decades, rapid credit growth would have quickly fed through into prices. Eventually, interest rates would have increased, credit growth would have subsided, the economy would have slowed, and eventually inflation would have moderated.

This didn't happen in a decade before the crisis. Credit exploded while the overall inflation rate remains subdued on account of cheap imports. The Bank of England didn't feel obliged to raise rates, and the credit bubble just kept on growing.

Unfortunately, the old trade-off, like an unwelcome relative, returned in 2006. Inflationary pressures were building in the East,and import prices began to increase.

There were tentative signs of trouble in 2005. The Bank of England made a half-hearted attempt to raise interest rates to stem inflationary pressures. But the monetary policy committee took fright when it saw the property market weaken. Rather than tackle the growing inflationary menace, the committee buckled, reduced the bank rate and gave the housing bubble a new lease of life.

This weakness before the inflationary enemy resulted in renewed price pressures. In the early months of 2007, the Bank of England and its sister institutions in the US and Europe, were belatedly hiking interest rates.

This changing policy stance was sufficient to expose all the poor lending practices and financial sector abuses that had built up through the previous decade. Many banks, particularly small ones like Northern Rock, had cut interest margins to the bone and jacked up their leverage ratios. The slightest perturbation of interest rates and the financial system was in deep trouble.

The rest of the story you know.

So here we are - four years on from the crisis - and inflation has hit 4 percent, and it is likely to go higher. The Bank of England now believes itself to be trapped. It fears to raise interest rates on account of what it thinks a rate hike might do to the frail recovery. As for dealing with inflation, it has no strategy. There is no plan, just a vague hope that somehow things will turn out alright in the long run.

In fact, there never was a plan. The only thing that kept inflation down for ten years before 2006 was luck and a flotilla of Chinese cargo ships packed full of goods.

Houses stay on the market longer

Earlier this week, Hometrack published their January survey of the housing market. Over the next day or so, I will post some of their latest numbers. The first chart looks at the average time a house stays on the market. Currently, the average is 10.2 weeks; up from 10.0 in December 2010

UK property prices in 2011 - up or down?

So what is it going to be? A return to the bubble years, or a renewed property price crash?

Recent price developments haven't provided much guidance. As the chart illustrates, UK nominal property prices have been treading water for the last nine or so months. They have shown little inclination to go either up or down. Insofar as a trend can be identified, the market appears to be weakening very slightly. Since August, prices are down 0.5 percent. However, that is hardly the sort of decline that will give the nation's rapacious real estate agents sleepless nights.

UK property prices ended last year on a downswing. In December, the Acadametrics national index fell 0.2 percent, compared to the previous month. For the year as a whole, house price inflation was just under 3 percent, and therefore slightly lower than the overall inflation rate. In real terms, house prices fell by the smallest of margins.

Most predictions point to a further round of price declines in 2011. As always, much will depend on the future path of interest rates. If the Bank of England starts to hike the bank rate, the conventional wisdom is that the housing market will weaken.

However, we live in bizarre times where the normal rules no longer apply. In the short run, a rate hike from low current levels won't make much difference to mortgage affordability. Any homeowner with half a brain cell will have already locked in their super low rates when they remortgaged.

Ironically, a rate hike will signal improved economic conditions and an exit from the financial crisis. This will strengthen consumer confidence, which might spillover into the housing market. A rate hike will also improve the functioning of credit markets, which could also increase mortgage approvals.

However, if the Bank delays a rate rise, bad things will happen. It will prolong the pervasive sense of turmoil and weaken consumer confidence. It will also give further credence to the growing expectation of more inflation. If the delay extends into the second half of the year, higher inflation expectations could push long run interest rates upwards, and open up the possibility of a slowdown in GDP.

So how does this inverted story - where a rate hike buttresses consumer expectations and the housing market - fit into the long run assessment that property prices are overvalued? The 2008 house price crash was unusual. Prices fell in nominal terms, which is a rare event in property markets. In previous corrections, the downward adjustment was slow, with rising inflation and incomes doing all the heavy lifting. Homeowners are invariably reluctant to accept nominal price reductions, but seem prepared to absorb an inflation induced adjustment. The future correction is likely to return to a more normal pattern of seller denial, and a slow deterioration of home values as consumer price inflation outstrips house price inflation.

An early rate rate might affect the adjustment path, but it will not affect where prices will be over the long run. Within five or so years, the UK property market will have given up all those gains recorded during the bubble. A delayed rate hike, ironically, might actually speed up the adjustment path, since it will both weaken consumer confidence, and strengthen the growing inflation momentum that is now building up within the UK economy.

For what it is worth, and it is not much, I think the Bank of England will delay the rate hike. Accordingly, house prices will weaken during the first six months of the year. Inflation will pick up, and by mid-year some alarming consumer price index numbers will begin to be printed. At first, there will be denial within the MPC, but eventually there will be a panic rate hike, probably towards the end of the summer.

Once the MPC have come to their senses and begin normalizing the economy, a sense of calm will prevail. Overall, it will be a good thing, but as always, UK home owners will over-react. Towards the end of the year, house prices will temporarily stabilize, and perhaps rise.

So where will house prices be this time next year? It is only a personal view, but I think they will down slightly on where they are today. although I would not rule out the possibility that they are flat, should the MPC raise rates earlier than anticipated.

(Finally, just be clear, this my humble opinion, and it is for entertainment purposes only. If you are in the business of buying property this year, make your own mind up. I make no recommendation to buy, hold or sell.)

More wikileaks means more fun for the rest of us

Such moral complexities; an alleged rapist accepts a disk from a thief who stole it from his employer. However, the disk may contain a ton load of information about tax evasion by up to 2,000 wealthy individuals and corporations, including 40 politicians and some celebrities.

The thief - Mr. Elmer - will now return home to face a Swiss court. The other bad boy - Mr Assange - will fight it out here in Britain to avoid facing a court in Sweden. As for 2,000 individuals and corporations named on the disk, will they evade a court as effectively as they did their taxes?

All these revelations, they are fun aren't they?

Eurozone debt restructuring: What is to be done?

The Eurozone periphery - Greece, Ireland, Portugal, Spain, Italy and Belgium - are tottering on the brink. Their governments have accumulated too much debt, and their capacity to repay these debts is in doubt.

What is to be done? There are two options; fiscal austerity and debt restructuring. The first requires deep cuts in expenditures, and higher taxes. The hope is that this strategy will cut the fiscal deficit, and gradually lead to a reduction in public sector debt levels.  Lower public debt might also reduce long term interest rates and help sustain economic growth.

The second is a debt default. Governments would no longer repay the full value of the contracted debt. The burden of adjustment will fall on creditors and not on the general public. Painful austerity would be avoided. Governments would not have to explain to their electorates why taxes have gone up and social services have deteriorated. However, public sector creditworthiness would suffer, which would lead to higher long term interest rates and possibly lower growth.

Here are four perspectives on the debate. First up, John Makin, who suggests that the Eurozone economies are in an untenable position, where further austerity efforts only serve to increase debt levels.

"There are several insolvent countries along Europe's periphery. Their debt levels are unsustainable in a specific sense. Attempts to reduce their debt-to-GDP ratios by cutting deficits actually have increased the ratio of debt to GDP by slowing growth for countries with an already high—over 100 percent—debt to gdp ratio."

Laurence Kotlikoff thinks default is the lesser of two evils:

"I think each of the PIIGS should do a careful fiscal gap analysis to understand if the present value of their projected spending can be covered by the present value of their projected taxes assuming normal borrowing rates. If the answer is no and the required fiscal adjustments are far beyond what can be achieved, then restructuring the debt is inevitable. And doing so sooner rather than later makes sense. Paying creditors, say, 50 cents on the euro may suffice, but it will come at a real cost in terms of higher borrowing rates for decades to come."

Harold James casts the issue in moral terms:

"The principle of not reneging on public debt is deeply intertwined with the development of legal security, representative government, and modern democracy. The experience of wartime inflations and de facto defaults in the 20th century made the theme of responsible finance a crucial part of a new European consensus. A foundation of the European integration process was a recognition of the importance of a stable currency to political legitimacy."

Paul Seabright argues that the Eurozone periphery are too deep in debt for moral considerations to play any part in the debate:

"It has long been evident that, barring a miracle economic recovery, some countries in the euro zone were going to default on some part of their sovereign debt. It has also long been evident that an orderly debt restructuring would be vastly preferable to a disorderly default triggered by a market panic. Unfortunately politicians have perceived their interests as lying in the perpetuation of the belief that restructuring could be postponed, and indeed had to be postponed at all costs because it would threaten the very existence of the euro."

Neither option looks terribly appealing.

Financial sector profitability: how things have changed

"From 1973 to 1985, the financial sector never earned more than 16 percent of domestic corporate profits. In 1986, that figure reached 19 percent.

In the 1990s, it oscillated between 21 percent and 30 percent, higher than it had ever been in the postwar period. This decade, it reached 41 percent. Pay rose just as dramatically.

From 1948 to 1982, average compensation in the financial sector ranged between 99 percent and 108 percent of the average for all domestic private industries. From 1983, it shot upward, reaching 181 percent in 2007."


Simon Johnson, "The Quiet Coup", The Atlantic (May 2009).

Finance versus industry - the war is over

Today, the Office of National Statistics reported November trade data. The mainstream media were not tripping over each other to report the latest export and import numbers. The latest numbers were, truth be told, quite unremarkable.

The numbers told the same sad story they tell every month. Britain imports far more goods than it sells abroad. In terms of export markets, the US was number one in November. In fact, the United States is the only major economy where the UK records a surplus on its trade balance. With eight out of the other top 10 trading partners, the UK has a trade deficit. In the Wimbledon of World Trade, the UK is an unseeded player.

This huge trade deficit is covered by the financial services that the UK sells abroad. It is, it seems, the UK banks that sustain our unbounded capacity to import cheap manufactured goods from China, and slightly more upmarket items from continental Europe. Has this dependence on financial services been a good thing for Britain?

The economic history of Britain during the 20th century was a battle between industry and finance. The best example of this struggle was the ill-fated return to the gold standard in the 1920s.

British industry had lost competitiveness during the First World War and needed a depreciated exchange rate to recapture its export markets. The financial sector wanted a return to the pre-war monetary system based on gold and more appreciated exchange rate. Financial interests won that battle. British industry endured a deep recession and a decade of appalling unemployment.

After the second world war, the struggle continued. Britain went through a series of volatile economic cycles, driven by a need to maintain high interest rates to prevent foreign money from leaving British banks.

The consequences for manufacturing were dire. With high interest rates, manufacturing investment levels were low, and the sector suffered decades of decline. Our once great industrial cities were slowly wasted by the demands of those rotten banks in London.

There is an enduring myth in Britain that Mrs Thatcher broke this post-war cycle of economic underachievement. With her privatisation and unsympathetic attitude to struggling manufacturing companies, she reinvented Britain.

But the myth isn't true. What she did was hike interest rates and allow the exchange rate in 1980 to appreciate to the point where no British manufacturing exporter remained competitive. The banks made a killing, London prospered, but the economy of West Midlands died.

These import and export charts may not change much from month to month. However, they recount a profound truth about our economic history. One where the dynamism that characterised our manufacturing sector was destroyed by the needs of a few greedy bankers in London.

The plain fact is that UK banks may finance our seemingly limitless demand for foreign goods, but we have paid a heavy price for that largesse. The UK has become little more than a rentier state. We are a nation of estate agents, loan officers, and buy to let landlords. We owe it all to the banks.

The old oil price excuse

Rising oil prices is every central banker's favourite "the dog ate my homework" excuse. Oil prices appear to be a strong upward trajectory. Prices have doubled since early 2009. The monetary policy committee will make heavy use of that fact this week when it meets to decide the bank rate.

The monetary policy committee is in a tight spot. The CPI inflation rate is likely to exceed four percent by February. Inflationary pressures are not just concentrated in the energy sector. November inflation data pointed to strong upward pressure for a whole range of items, including food, furniture and clothing.

But don't expect an early rate rise. The Bank of England is still fretting about a weak UK financial sector. UK banks have large amounts of debt maturing this year which they need to roll over. Low interest rates will reduce their funding costs. It would also help curtail mortgage arrears, and prevent a further weakening of bank balance sheets.

The monetary policy committee have a stark choice - should they tackle inflation or will they keep commercial bank funding costs low.

I think we all know how that decision will go. Rising oil prices will provide the necessary cover for keeping the bank rate fixed. The MPC will argue that they are powerless in the face of an unexpected energy price shock. Therefore, it is best to do nothing.

The UK deficit reduction - this is what it looks like

A quick primer in UK fiscal issues......

Issue one: We have a very big fiscal deficit

Everyone knows it, but it never hurts to remind ourselves just how big it is. It is massive, huge, gigantic, beyond large, humungus, excessive, and gargantuan.

It is running at around 10 percent of GDP.



Issue two: The deficit is big mostly because of government expenditure

Tax collections have fallen. The bulk of revenue falls occurred in 2008, when VAT was foolishly cut. That has now been reversed. However, public expenditure has continued to grow in terms of GDP.



Issue Three: The Coalition government want to cut the deficit by reducing expenditure

The coalition wants to cut the deficit by around 10 percentage points of GDP by 2016. Three quarters of the adjustment will fall on expenditures.



What does Alice think?

She thinks the adjustment lacks ambition and would like to see a more rapid decline in the fiscal deficit.

Her maxim is "if in doubt, cut it out".

Property Price Bonanza in Hull

How can a small town like Hull see home values go from £40k to almost £110k in the space of just over five years?

Same question; different town.....

Ernst and Young targeted in the first Lehman court case

Lehman is a name we would all like to forget. When it failed in September 2008, it nearly destroyed the global financial system. Looking back, doesn't it seem strange how quickly one of the giants of Wall Street came crashing down?

New York prosecutors have been asking that same question. They seem to have arrived at a tentative answer - Lehman's reported balance sheet was a sham. Since balance sheets should be audited correctly, prosecutors have pointed the finger at Lehman's auditors - Ernst & Young.

New York attorney general Andrew Cuomo has filed a lawsuit against the accounting firm. The civil fraud case claims that Ernst & Young did nothing except book handsome fees while Lehman used accounting gimmickry to mask its rotten balance sheet.

The lawsuit says Lehman was "a massive accounting fraud". This is strong language which begs the question why haven't any former top executives at the investment bank also been indicted.

The core of the case is centered on the infamous Repo 105 transaction. Lehman used this concocted "sale and repurchase" agreement to move $50 billion off its balance sheet. This allowed Lehman to temporarily to show investors it wasn’t carrying too much debt.

The lawsuit is looking to pull more than $150 million in fees from Ernst & Young, which were received from 2001 to 2008 as Lehman's outside auditor.

Where have all the young ones gone?

Twenty years ago, one mortgage borrower in five was under 25. Today, that number has fallen to little over one in sixteen.

The vast majority of young people simply can not afford to buy property. Instead, the housing market has become the domain of the middle aged and retired.

I suspect that this exclusion will have dire consequences for the current beneficiaries of the UK housing scam. Those property-liberated youngsters will soon be the backbone of the UK tax base. I wonder whether today's under-25s will be willing to hand over a large part of their earnings to finance the pensions of undeserving property owners.

Methinks not.

Happy Madoff day

It has been two years since the moneyed maestro of Manhatten was arrested.

Such a charming man.

Captured

Over the last three years, I have read countless articles diagnosing the causes of the financial crisis. While each had a particular angle, virtually all cited the appalling regulation of the financial sector as the main driver behind the crisis. Banks experimented with poorly understood new financial products; they became over-leveraged; and generally failed to properly manage risk. Rather than take the full consequences for their poor decisions, banks foisted their losses onto the public sector.

These articles also emphasise the near universal consensus that financial systems need to be more closely regulated. Yet nothing has happened. Today, banks are operating under virtually the same regulatory regimes that existed during the bubble years.

Why have politicians across the world failed to act? I don't have an answer. I don't want to drift into the murky world of conspiracy theories, but bankers appear to have a strange hold over policy makers.

Socially useless, privately useful.

Earlier this week, Lord Turner described much of our banking sector's activities as "socially useless". Well, if much of banking provides no value to society, why do bankers bother? The reason is simple, industry insiders are using these "socially useless" activities to rip off shareholders and savers.

Whatever bankers might say, running a bank is a straightforward business. A bank makes loans, and receives interest. It also provides non-lending services, such as money transfers, exchange rate sales, for which it receives fees. So long as a bank lends to firms and individuals who can pay back the loans, then the cash just rolls in.

Once the cash floods into the bank, it needs to be distributed. Some of it needs to go on running costs. Of course, the government needs their cut; a modest amount of tax needs to be paid. The rest goes to either the staff, the shareholders, or to depositors.

For the jokers who run banks, the question is simple; how do we get to keep as much of the residual profits without passing it on as interest payments to depositors or alienating the shareholders?

The answer is to generate a huge quantity of useless financial transactions which can be passed off as risk management techniques. These transactions, which are typically described as derivatives, generates huge bonuses for the staff and neatly redistributes income away from shareholders and depositors.

So, Lord Turner is right when he says that much of banking is socially useless. However, for bank staff, it is privately very useful. It keeps the profits of banking in the pockets of bankers at the expense of the rest of us.

This time it is different

Between 1964 and 2007, the UK fiscal deficit averaged 2.7 percent of GDP. Some years it was higher, others it was lower.

However, no government ever attempted to push the deficit into double digits.

Until now......

So, there is nothing to worry abou then....

Central bankers continue to be complacent about the risks of inflation...

From the FT...

The world’s central bankers were in no hurry to start raising interest rates as they headed home on Sunday from the US Federal Reserve’s annual retreat in Jackson Hole, Wyoming.

In private and in public, most officials indicated they believed that rates could be maintained at ultra-low levels for a considerable time without generating excess inflation, in spite of better economic data and a return of “animal spirits” in financial markets.

Some used the platform of the conference to push back against calls for early implementation of “exit strategies” that would reverse the current extraordinary degree of monetary stimulus.

“There is no reason to re-assess our monetary policy stance,” Erkki Liikanen, Finland’s central bank governor, told Bloomberg news agency. Ewald Nowotny, Austria’s central bank chief, said he did not favour adding a surcharge to the European Central Bank’s next offer of one-year loans to banks – a view shared by some other European officials in Jackson Hole.

At last some sanity...

The government needs to reverse this foolish VAT cut as soon as possible

From the Guardian....

The Treasury dashed hopes of an extension to the government's VAT holiday tonight after the latest figures for public borrowing revealed a collapse in tax revenues and prompted City forecasts of a £200bn deficit for the whole financial year.

With the City taken aback by the rapid deterioration in the state's finances, aides to the chancellor, Alistair Darling, stressed that the Treasury could not afford the £12bn cost of the VAT cut for a second year and the tax would return to 17.5% from January 1.