London property market is burning up

(click on the graphic for a larger version)

This graphic presents a different way at looking at London property prices.  Dark red represents rapidly growing prices, dark blue represents rapidly falling prices.  The shades in between represents different degrees of price change (remember red means up, blue means down).

A couple of things to note.  First, the dark strip that starts towards the end of 2009 represents the crash.  As we know the change was abrupt.  This can be seen by the sudden shift from dark red to blue. 

Second, the market recovered in 20010.  However, the graphic tentatively points to a more recent slowdown - the right hand side edge is shifting from dark red to orange and yellow.

Finally, the data points around 2005 are very revealing.  At that time, the London property market was losing steam.  Unfortunately, the Bank of England started worry, and cut interest rates.  London prices surged afterwards.  Many of the worst excesses of the housing bubble occurred between 2005 and 2007.

Just think for a moment, what would have happened if the Bank of England had held their nerve and kept interest rates at more elevated levels.  Property prices would have cooled, the impact of the financial crisis would have been muted and the UK economy would have been in better shape to handle the crisis.

That rate cute also killed the Bank of England's inflation credibility.  For 40 of the last 48 months inflation has been above the 2 percent target. 

Ultimately, the rate cut in 2005 was the worst monetary decision in two decades.  We are paying for it now.

European bank regulation - full of sound and fury

For the European Commission, every crisis is an opportunity to concentrate power and diminish the authority of the member states. Today, it initiated another power-grab. This time, the target is the European financial sector. The takeover strategy is outlined in a document published today - "A Framework for Bank Recovery and Resolution".

The document proposes the creation of a European Resolution Authority. There will also be far-reaching new powers permitting regulators to seize failing banks, fire bank board members, and inflict financial losses on bank creditors. It is all Draconian stuff, but is this what the European financial system needs?

Many things went wrong during crisis and the list of villains is long. However, at the core of the crisis, there were two failures. European banks failed because they had insufficient buffers in the form of capital to absorb losses. Banks also failed because they lacked sufficient liquidity - in other words, cold hard cash. Unfortunately, the European commission's proposals are a little light in these two areas.

It is understandable why the European Commission would avoid these issues. Serious reform is painful. Forcing banks to increase their capital and liquidity levels would be costly in terms of economic growth and financial sector profitability.

Banks have a number of options for increasing capital. None of them are terribly attractive. Banks could slash dividends payments to shareholders, but that will send bank share prices southward.

Banks could boost the interest rate spread between what they charge on loans and what they offer on deposits. Depending on how they did it, this could generate one of two distasteful outcomes. If they raise lending rates, economic growth is likely to suffer. If they cut deposit rates, they will find it difficult to attract funding.

Alternatively, Banks could reduce lending in order to shrink their balance sheet in line with their existing capital levels. This would be a renewed credit crunch, again adversely affecting growth.

Increasing liquidity levels would have comparable detrimental effects on economic growth. Banks could try to books cash levels by reducing their assets and calling in loans. Banks could also move an increasing proportion of their portfolios from illiquid high interest assets to cash. Bank profitability would inevitably take a hit.

The financial sector needs to shrink, become less profitable, and more liquid. Before the crisis, Europe enjoyed a wonderful decade of rapid growth. It was, in large part, built on low interest rates, a lack of proper lending standards, and huge asset inflation. A properly constructed financial sector reform would insure that these things never happen again.

The European Commission - and European politicians generally - are reluctant to go down that road. Instead, a furious sounding but essentially vacuous set of measures offers an easier path. New agencies, rigid regulations, and government interference in the minutiae of financial sector activities - these are the policy equivalent of smoke bombs. They make a loud bang but are quite harmless.

When empirical regularities won't do what you want them to do.

The Bank of England seem rather confused about the recent alarming surge in inflation.

Adam Posen was the latest member of the committee to articulate his confusion. Earlier this week, he gave a talk at the annual christmas breakfast of Essex Institute of Directors, which was held in the "charming" town of Billericay.

Mr.Posen explained why recent inflationary develops were no different from earlier times. He argued that four important "empirical realities" affecting inflation were still at work in the UK, despite the recent upheavals caused by the banking crisis.

Those regularities were:

• Unemployment affects inflation at 1-2 Year horizons:
• Large output gaps persist after financial crises:
• Private consumption contracts in the medium-term during fiscal consolidations
• Unit labour costs are a significant predictor of inflation

According to Posen, these four regularities are at work right now in the UK, placing downward pressure on prices. The unemployment rate today almost twice as high as it was two years ago. A large output gap remains after the banking crisis. The government is about to implement a sizable fiscal consolidation, that will prompt a contraction in private consumption. Finally, wage pressure remains subdued and unit labour costs are under control.

In fact, downward pressure on prices is everywhere except in the data. Here, the inflation rate stubburnly refuses to adhere to Mr. Posen's empirical regularities.

So, where is the flaw in Mr. Posen's argument. I believe it is on this assumptions about the output gap. The UK was uniquely dependent on financial markets as a source of economic growth. The financial crisis has eliminated a key source of UK growth. More generally, the extended contraction in output has destroyed both human and physical capital, limiting the flexibility of the economy to jump back as aggregate demand picks up.

Therefore, the output gap isn't as wide as the Bank of England thinks. Competitive pressures in product markets are not that elevated, and firms can pass on the sterling depreciaiton and VAT hikes more easily into prices.

One final irony from Mr. Posen; he barely mentioned interest rates. The key policy instrument was only mentioned four times, and never in the context of a credible counter inflationary strategy.

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.

The banking behemoth

Do we really need a banking system that has assets is over four times GDP?

I have no idea what the average interest charge is on the total assets of the UK banking system. However, lets take a guess and say that it is 5 percent. If it is, and I doubt that it is any lower than that, then each year, debtors pay banks over 20 percent of GDP as interest. That is a shockingly large number, especially when you consider that the government takes around 37 percent of GDP as taxes.

I know I am mixing up my national accounts. Obviously, you can't add the two numbers together. Nevertheless, the comparison does capture a deeper truth about the UK economy. It comprises of little more than money lenders and tax inspectors.

Most banking lending finances consumption not investment. Likewise, taxation mostly goes on benefits. Neither are terribly productive.

As such, the UK has a strong smell of unsustainability about it. The contradictions built up over ten years of financial mismanagement are coming undone. It seems so unreal and incredible, and nothing symbolizes this dreadful state of affairs like our bloated banking system.

Four hundred percent of GDP? It can not be; it should not be.

Housing construction data tells the truth about Labour and Conservative

Taking a long view of housing construction and it is hard not to be struck by the modest levels of construction since 1980.

Whether it is Labour or Conservative, neither party felt inclined to increase the quantity of housing. Since Thatcher was elected in 1979, on average just 200,000 new homes were built each year. Over a thirty year period, this restriction of supply pushed house prices up, and made middle class home owners very wealthy at the expense of younger, non-property owning workers.

There is a popular myth that suggests that the town and country planning act of 1947 made it difficult for construction firms to increase their housing completions. Data from the 1950-60s suggest that the planning act wasn't an insurmountable problem. If the government were determined enough, it could push through large scale housing construction.

Over the last week, the UK electorate drifted away in huge numbers from the traditional governing parties. It was mostly working class voters that defected. It would be a bit of a stretch to argue that the lack of housing construction was behind this defection. Nevertheless, the data does reveal something about the priorities of both parties.

Both Labour and Conservative chased the middle class home-owning vote, who were easily appeased so long as property prices were rising. This also explains why Brown and Darling hijacked the Bank of England, paving the way to zero interest rates and massive government guarantees designed to revive mortgage activity. In the UK, house prices determine economic policy priorities. Jobs, inflation, fiscal sustainability all come a poor second.

Working class voters may not be aware of long term housing construction trends. Nevertheless, they see enough to understand the true nature of both parties. It is therefore any wonder that traditional Labour voters should abandon Brown when they see him pump in around 90 percent of GDP to save the bankers, while at the same time allow the Birmingham van maker - LDV - go bust for the want of a few million quid. They also know that Cameron would do the same thing.

Last week's elections told Westminster that working class voters feel cheated and betrayed by both Labour and Conservative. They have come to understand that a vote for either of them is a wasted vote.

So you think the UK is in trouble?

Our recession here in the UK looks a rather mild affair compared to the slowdown in Japan. From its peak in 2008q1, the Japanese economy has declined by 9.1 percent. Moreover, the economy is only 10 percent larger relative to 1994. This current slowdown has wiped out six years of growth.

The reason of Japan's catastrophic collapse sits on the other side of the Pacific. US consumers stopped borrowing and buying. In the first quarter of this year, alone Japanese exports declined by 26 percent.

US bad loans keep on rising

The US recovery story took two devastating knocks this week. First, there was the housing starts data. There nothing in the numbers that even gave a hint of a recovery.

Then, there was the US banking data for March. In particular, bad loans are still increasing. It is not easy for banks to push out loans when so many of their earlier credits are turning bad.

The US has some way to go before we see any robust signs of recovery.

Paragon wants a piece of the action

Its been a while since we heard from Paragon, the BTL lending specialist. However, they cropped up today. The company wants the government to give specialist mortgage lenders, like itself, a chance to use all those generous credit guarantee schemes.

Why would the government even consider such a thing? Lenders, like Paragon have a standard, albeit self-serving answer. The economy needs credit markets to unfreeze, and allow lending to recover. Presumably, this will somehow lead to faster growth and rising living standards.

The reality, however, would be that Paragon would receive cheap financing, with all the credit risk being transferred to the public sector. It would be just another tired old game of "heads the private sector wins; tails, the taxpayer pays up".

Moreover, if Paragon did receive guarantees from the government to finance extra lending, this cash would go to BTL speculators. The price of housing would go up, and again, young workers would be robbed of their chance of financial and personal independence. What is more, they would end up paying for this scam as public sector debt increases, and which in turn, will push taxes up in the future.

It is a nice try, but there is no case for Paragon to receive public assistance to expand its balance sheet. If this company wants to lend more to BTL speculators, then it should go to the capital market, issue a bond or raise more equity. It should leave the poor beaten down taxpayer alone.

UK firms reduce inventories

Firms are emptying out their warehouses, offering discounts in order to expand sales.

This destocking will put downward pressure on prices, at least in the short term. But what happens when firms have cleared these unwanted stocks? Firms will start to push up price mark ups and prices will again begin to rise.

Why inflation will rise.

Earlier, I posted the most recent University of Michigan survey on US inflationary expectations. The number has recently ticked sharply upwards, indicating that people expect prices to rise.

Almost as soon as the post was completed, I received the following comment:

What sector of the economy has pricing power outside of the light ammo industry? Has the spare capacity or supply been used up in the housing market, commercial real estate market, auto manufacturing plants, existing autos (we have far more than we need on the road already), or the financial industry (which should be shrinking far fast than it is)?

UMI must be surveying economists or other such idiots.

It is a fair question that deserves an anwer.

Recessons have a well understood dynamic pattern. The process starts with a fall in aggregate demand. Firms begin to accumulate inventories, a sure sign that a recession has begun. Initally, firms will be reluctant to fire valuable workers with their firm specific skills. This is called labour hoarding. However, hoarding, rising inventories, and declining sales put enormous financial strain on companies, particularly badly run ones. Revenues are falling, but costs remain high. Eventually, firms start firing workers, while weaker businesses go bankrupt.

During the early stage of a recession, there is significant downward pressure on prices. Faced with those huge stockpiles of unsold goods, firms discount heavily and inflation comes down. The discounting does the trick insofar as firms empty out their warehouses. It does little to promote growth or stabilize employment.

When the recession really begins to hold, two conflicting pressures emerge. On the one hand, as firms go bust, the supply side contracts and supply chains are disrupted. firms go bust, the supply side of the economy contracts, and supply chains are disrupted. If a factory closes, the spare capacity disappears completely. A bankrupted firm has no influence on prices at all.

On the other hand, unemployment continues to rise. Initially, people without work will run down savings, which will in part, sustain demand. Eventually, savings run out and demand will begin to suffer.

These two forces will fight it out as the recession matures. Eventually, firms will have reduced their inventories to a minimum, the discounting will stop stops, and profit margins will recover. At this point in the cycle, the downward pressure on prices abates. Inflation stabilizes, at a high level of unemployment.

Eventually, the lack of inventory, along with the disappearance of weak firms, and capacity contraints will create the basis for an economic recovery. The key message is from all of this is leave the private sector alone and it will sort the recession out by itself. It may take time, but growth will return.

However, the UK and US governments don't have the patience for natural self sustaining private sector led recovery. Instead, they want unproductive and wasteful public sector expenditure to sustain demand. They believe that governments can stabilize economies better than the market. It is an arrogant and conceited belief that has been repeatedly exposed by history. Nevertheless, politicians love intervening.

The Fed and the BoE have also joined the game. They have cut interest rates to almost zero and pumped out uncountable trillions into insolvent banks. In the case of the UK, the central bank is now actively financing the unsustainable fiscal deficit.

Of course, this policy activism has done nothing to support economic growth. Both economies have crashed, with GDP growth likely to fall by about 4-5 percent this year. More surprisingly, inflation, particularly in the UK, has proved to be rather sticky downwards. Insofar as inflation has fallen, it has been due to falling commodity prices, particularly fuel.

However, the private sector is not totally stupid. When it considers the economic future; it sees three things; a collapsing supply side of the economy; a massive increase in wasteful public expenditure which will inevitably lead to higher taxes and a large dose of irresponsible monetary growth.

Will this lethal concoction cause inflation to increase next month; maybe; maybe not. Will it cause inflation to rise sharply in 2010? Absolutely; hence the April rise of inflationary expectations.

UK investment crashes

In any recession, investment is one of the first casualties. When economic prospects darken firms cut back on their expansion projects and reduce expenditures on capital equipment.

During the last two quarters of 2008, UK investment levels nosedived. The chart above illustrates this collapse by breaking down UK investment numbers into its three main compoments; government; housing and business.

Before the credit crunch, it was the business sector leading the way. In the chart, business investment is denoted by those beautiful yellow bars that sit above the zero axis. By the beginning half of 2008, business investment had stalled, and by the end of the year, investment expenditure was falling.

The decline in housing investment happened earlier. It had effectively stalled as soon as the credit cruch hit in the third quarter of 2007. However, even before NRK failed, investment levels were falling; further proof that the housing market was in trouble long before the current financial crisis began,

Currently, only the public sector is increasing investment expenditure. However, the amounts concerned are comparatively small. This raises an interesting observation about those huge fiscal deficits. The increase in government expenditure is not focused upon building up the UK pubic sector capital stock. The deficit is being driven by expenditure on new hospitals and road. Rather it is on current expenditure; wages, state benefits and MPs housing allowances.

As the investment data so cruelly points out, all those New Labour financial sector bailouts and guarantees have failed miserably. Investment has crashed, particularly in the private sector. It hasn't even helped that sector most beloved of goverment ministers and MPs - housing.

US inflationary expectations picking up

The US headline inflation rate has come down sharply following the collapse of GDP and the sharp rise in unemployment. However, no one expects inflation to stay low for long. According to the University of Michigan's monthly survey, inflationary expectations bottomed out in January, and they have been rising ever since.


Quantitative easing, the near-zero federal funds rate, and the massive Obama deficit make for the perfect inflatioanary recipe.

Mortgage repossessions - the true story

This chart points to a rarely acknowledged fact; the UK housing market was in trouble long before the credit crunch. Mortgage repossessions began to rise in 2005, while prices were increasing and loans flowed freely.

Mortgage repossessions in 2008 didn't quite reached the horrific heights of 1991. However, this year, we might see repossessions reach an all time high.

Maybe next month

The green shoots of recovery, which sprung up so tentatively in the March US retails sales data, withered in April. US consumers have kept out of the shopping malls, threatening the recovery that some believe they identified in recent data.

Maybe next month, eh?

QE - little impact on government debt yields

The impact of quantitative easing on government yields has been minimal. After printing ₤50 billion, the 30 year gilt yield is actually four basis points higher than in early February, when the Bank started its insane policy of printing money.

The most impact has been on the 10-year bond. Its yield has fallen 40 basis points. This contrasts with a 500 basis point cut in the bank rate.

The Bank of England's explanation for this abject failure of QE is ominous. In today's inflation report, it said

"Projections for government borrowing were revised upwards by more than the market expected in the Budget in April, contributing to an increase in expectations of bond issuance; this may have raised yields."

What does this mean? The Bank of England is printing cash to reduce bond yields, and trying to put downward pressure on all interest rates, including those faced by corporate borrowers. At the same time, the government is issuing more debt, pushing yields the other way.

This is policy incoherence; it is fiscal crowding out, and above all it is the road to higher inflation, macroeconomic instability and falling living standards.

Welcome to the mad world of New Labour.

Where did the quantitative easing money go?

In March, the Bank of England hoovered up ₤15.3 billion of government debt. Everyone else was happy to sell. On a net basis, the BoE was the only institution that actually accumulated any holdings of government paper. These purchases were, of course, the infamous quantitative easing, which the Bank is using to affect monetary conditions, given that the bank rate is close to zero.

Lets remind ourselves why the Bank of England began creating money. This strategy is supposed to improve liquidity conditions, reduce interest rates, and lead to higher lending. However, government yields have actually crept up in recent weeks. So, what is going wrong?

The answer lies with who is buying the debt. The biggest sellers of government paper were non-residents. This raises a troubling question; if an foreign holder of a UK government bond sells to the Bank of England, how does this help liquidity conditions in here in the UK?

The second largest seller were non bank resident investors. Again, it is not entirely obvious how these sales helps credit growth. It might help to the extent that the proceeds of these sales are placed in UK banks. However, yields on bank deposits are lower than government debt, so that would appear to be an unlikely destination of the funds.

I am going to take a wild guess and suggest that the proceeds of these sales went into equity markets. Over the last few weeks, equity markets, including the FTSE, have enjoyed a healthy recovery.

The suggestion here is not that quantitative easing is the primary cause of the equities recovery. Rather, it is that as equity prices have increased, bond holders have an incentive to sell government paper to the Bank of England and move the funds to equities. This pushes up equity prices further, pulling money from the bond market, raising yields on government debt.

So far, the QE strategy has been riven with inconsistencies. The initiative was supposed to help corporate lending. However, the bank has bought government paper instead. Very little of the new money has gone into banks. Most of it has gone out the door or into the equity markets.

One thing is for sure, within about 18-24 months, this massive, historically unprecedented expansion of high powered money will lead to rapidly increasing prices.

Inflazione

Its inflation report day, so lets kick off with a youtube clip reminding us that the Bank of England are actually trying to create some price instability.

In the dying days of the New Labour regime, the UK its starting to look rather latin.

Muchos gracias to olivier for the link. If anyone sees anything interesting that should be posted on the blog, then please send me an email here.

"Boys go to Jupiter to get more stupider..."

"...girls go to college to get more knowledge."

Forgive me lads, but that playground rhyme emphasizes the importance of education for girls. However, it is a pity there wasn't something similar for the boys. There is a huge unrecognized problem of male unemployment in the UK. It is closely associated with poor educational achievement.

Education levels are the key factor in determining labour force participation for both genders. An incredible 37 percent of men without qualifications are not in the labour force.

For women, the rate is 57 percent. Of course, much of female non-participation is associated with child rearing. There are also well understood perverse incentives within the benefit system that encourages young girls to enter motherhood rather than the labour market or further education.

For women, the higher the level of education, the greater the probability of being in the labour market. For men, there doesn't appear to be much variation. So long as a man has some kind of qualification, then he is likely to be working.

Education really matters; for both girls and boys.

(Source: ONS, Social Trends 39)

The US labour market implodes

Here is more evidence of the parlous state of the US economy - the civilian employment to total population ratio. It peaked in April 2000, when 64.7 percent of the adult population were working. As late as November 2007, the ratio stood at 63 percent.

However, in the last six months, the ratio has tumbled. Today, the ratio is 59.9 percent; more than 40 percent of the US adult population are either unemployed, serving in the armed forces, or sitting at home watching Jerry Springer.