February 23, 2015

Is Sterling Overvalued?

Filed under: Economic Crisis, Economic Forecast, Uncategorized — drderrick @ 10:10 am

Over the past five years trade weighted Sterling has appreciated by 8%. Over the same period, it has fallen against the US$ by 6%, and it has fallen against the Yuan by 15% – US$ and Yuan account for 17.5% and 8.9% respectively of the currency basket. The strength of Sterling is entirely due to the weakness of the Euro, which accounts for 46.2% of the currency basket, and against which Sterling has risen by 15%.

Over the past twelve months, while Sterling has fallen against both the US$ and Yuan by 11%, overall the trade weighted index has fallen by only 1%, due again to the weakness of the Euro, against which Sterling has risen by 3%.

Given its great importance, the strength of Sterling against the Euro will have contributed to the startling growth of the UK current account deficit, which now stands at some 6% of GDP – the worst ever! It will also have contributed to the weakness of UK inflationary pressure. Alongside low oil prices, strong Sterling should be seen as one of the temporary contributors to current low inflationary environment.

When the Euro eventually strengthens, the value of Sterling could fall significantly and, together with domestic political factors – discussed here: https://drderrick.wordpress.com/2014/12/29/the-sterling-crisis-of-2015/ – may lead to an overshoot, leading to an undervalued Sterling. While exporters might welcome this, it would also increase inflationary pressures, and the likelihood of the Bank of England raising interest rates.

When this happens the anaesthetising effects of the current interest rate regime will begin to wear off, and the economy will slow.

December 29, 2014

The Sterling Crisis of 2015?

By all accounts, the UK general election to be held in May 2015 is too close to call. On May 8th the nation is expected to wake up to another coalition government, quite possibly composed of three or more Parties. While the composition of the new government cannot yet be foreseen, it seems most likely that either the Conservative Party or the Labour Party will be the senior partner in whatever coalition government emerges from post-election negotiations. While for political pundits this election may well be one of the most interesting in many years, the economic risks are daunting; two very dark economic clouds are on the horizon. The first is the issue of government debt reduction, and the second is the question of UK membership in the EU.

A left-wing coalition led by Labour would put aside for now the question of UK membership of the EU, as Labour, Liberal Democrats, Scottish National Party, and the Green parties are all pro-EU, but they are expected to commit to a much slower pace of deficit reduction than is proposed by the Conservatives. Slower spending cuts, alongside any increased borrowing and higher taxes that they may propose to finance government efforts to stimulate economic growth, may lead to a significant risk that markets may well begin to lose confidence in the government’s commitment or ability to address its growing debt problem, with potentially serious repercussions for the value of Sterling.

If the Conservatives are the senior partner in a more right wing coalition their deficit reduction plans may prove politically difficult to implement, leading to politically expedient delays. The Conservative plan to eliminate a £90 billion annual deficit over the course of the next Parliament will seriously affect the well being of a lot of people, and will not happen without a great deal of political opposition. Of similar danger to the deficit problem is the question of UK membership of the EU. Responding to popular disaffection with the EU – amply demonstrated by the rise of UKIP – the UK Prime Minister David Cameron has pledged to hold an in-out referendum on UK membership of the EU by 2017, if he is returned to Office in 2015. This will cause great uncertainty amongst investors as to what the “rules of the game” will be post 2017. Such uncertainty will depress investment in the UK economy, which will further constrain economic growth and exacerbate the political difficulties of meeting deficit reduction targets. Such a reversal of fortunes would again put pressure on the value of Sterling.

Over the past four years, through a combination of luck and contrivance, the current government has enjoyed a fragile recovery from the market crisis in 2007/08. That economic growth has been due almost entirely to an accumulation of household and government debt, supported by historically low interest rates, that has been used largely to maintain high levels of current consumption. While some moderation in the growth rate of the economy should be expected over the coming years, the election in 2015 poses the greatest domestic challenge the economy has faced over the past seven years. Whichever Party holds the senior position in the government after the elections in May 2015, there is a real risk of a Sterling crisis. Such a crisis in confidence in Sterling might be welcomed by exporters, but it would also exacerbate the extremely high current account deficit, increase consumer price inflation, and necessitate an increase in interest rates faster and further than would otherwise be implemented. If this happens, significantly weaker economic performance than is currently foreseen can be expected, including a return to recession.

November 6, 2014


Filed under: Economic Crisis, Economic Forecast, UK Economy — drderrick @ 11:12 am

Ongoing and accelerating economic growth over the past 18 months has surprised most economists, and forecasts have all been revised up. 12 months ago the consensus of the economists surveyed by the Treasury was for growth of 2.2% in 2014. That has now risen to 3.1%. A closer look at the key elements of the economy may help to explain why we have seen this unexpected rise in growth, and provide some clues as to how that may develop over the next few years.

While the economy is on track to expand by some 2.5 to 3% over the course of 2014, suggestions in some quarters that “the recovery is now firmly established” are premature. Looking closely at the published statistics, the only substantial growth in the economy has been almost entirely in the service sector, which accounts for over 78% of all economic output. Although the first half of 2014 has seen some growth in the production sectors, after a long period of static and declining output, most remain significantly below their 2011 activity levels. By contrast, most industries in the services sector have seen, and continue to enjoy, good growth. This is especially the case with the wholesale and retail trades, with transport and storage, and with professional and administration services, which have led the expansion of services output. Given the size of the services sector in the economy, recent indications that the growth of services output may be slowing suggest the economic recovery may be encountering renewed difficulties.

In terms of expenditure, the growth over the past 18 months or so can be traced to substantially faster than expected growth in household consumption and government spending. While it has been encouraging to also see a substantial improvement in business investment, there has been a correspondingly large increase in inventories, which suggests that there may be some moderation in investment spending over the coming months. Similarly, with government continuing to run a £100 billion budget deficit, it is difficult to imagine government-spending continuing at recent levels over the course of the forecast period. With global economic conditions deteriorating, especially in the Eurozone, net exports are unlikely to make any positive contribution to growth for some time. That leaves, household consumption – accounting for some 62% of domestic spending – as the only significant potential source of economic growth.

Over the past few years, household spending has been remarkably buoyant and resilient, but it is increasingly unclear how much longer it can continue to grow. There are a number of underlying reasons for the growth in consumer spending, including wealth effects from rapidly rising house prices, and improvements in employment rates. With average real wages under continued pressure, however, of particular importance have been a number of government initiatives to encourage borrowing and spending by businesses and households, and by the extremely low interest rates that ease the burden of servicing large and growing debts.

Chart 1: Household Net Lending (+) and Borrowing (-) – £ millions

Household Credit

Source: ONS

Bank of England figures show that net consumer borrowing began to increase about 2 years ago and has been accelerating since. It is currently growing at an annual rate of 5.4%. As a result, as shown in Chart 1, household finances are deteriorating and reductions in spending may need to be made – especially when interest rates rise.

Households spend just over £1 trillion each year, and Chart 2 shows a breakdown of that spending by type. It shows that households spend almost as much on “enjoyment” alone (£257 billion) as all the spending on investment in the economy (£281 billion). While much household spending is non-discretionary in the short term, spending on “enjoyment” can be trimmed relatively quickly. Any such curtailment of household spending, possibly due to the deterioration in household finances suggested by Chart 1, would quickly arrest the growth seen over the past 18 months.

Chart 2: Household Spending by Type

Spending by Type

Source: ONS

In short, there are no signs yet of a sustainable recovery of the economy, and the growth that there is remains very vulnerable to the interest rate increases expected during 2015.

In light of the challenges faced by the UK, as well as by other economies around the world, the outlook for the next few years is especially uncertain. Continued high private household debts, further constraints on government spending, and an expected start to the normalisation of monetary policy during 2015, contribute great uncertainty to growth forecasts over the coming 3 years. Currently I expect the economy to continue to grow throughout 2014 but start slowing as we move into 2015, and continue to weaken over the course of the following months. Of course, it would not be surprising to see some modest growth in some quarters over the course of the next 3 years but, in my view, there is little reason to expect overall annual economic growth to accelerate beyond the end of 2014.

The median estimate for GDP growth in 2015 of the economists surveyed by the Treasury is 2.3%, slightly higher than my forecast of 2.1% growth. Looking further forward, most published economic forecasts see continued, if modest, growth being maintained.

UK Growth Outlook

GDP 14-17

These outlooks are usually based on a few key assumptions that are increasingly doubtful:
With the economy growing at nearly 3%, and the unemployment rate at a 6 year low and falling at the fastest rate on record, the assumption that interest rates will remain unchanged seems increasingly unsustainable. The Bank of England is now widely expected to begin increasing interest rates by the middle of 2015.
It is also assumed that the deteriorating current account deficit becomes a growing surplus, but the latest official figures show that in Q2 2014 it had deteriorated to 5.2% of GDP, which is the worst in recorded history in both cash terms and as a percentage of `GDP. With the Eurozone economy – the UKs largest trading partner – suffering from a wide range of serious problems, there is no reason to suggest a turn-around in the foreseeable future.
Business investment is expected to continue to grow strongly, despite the many risks and challenges faced by the economy. Given the current economic uncertainties, it seems unreasonable to continue to assume that strong private investment will be maintained for long, or to be a strong driver of overall growth over the next few years.
Above all, the more optimistic forecasts assume household spending will be maintained and continue to grow: an assumption about which there is increasing doubt.
As David Kern, Chief Economist at the British Chambers of Commerce has argued:
“Rises in sterling, making UK exports more expensive, and uncertainties around early interest rate increases are adding to the difficulties, and our excessively large current account deficit is posing risks. UK growth cannot rely permanently on rising consumer spending, which is driven by buoyant housing market and excessive household debt. Unless investment and net exports make bigger contributions to growth, the recovery will stall.“

Given these problems, I suggest that UK average annual GDP growth will be somewhat weaker than the consensus outlook. I expect the economy to grow by 2.6% over the course of 2014, by 2.1% in 2015, 1% in 2016, and 0.7% in 2017. Moreover, the possibility of an in/out EU referendum in 2017 add great uncertainty and means that the risks are mainly that the outturn will be worse than currently foreseen.

October 14, 2011

We were warned 25 years ago

Filed under: Economic Crisis — Tags: , — drderrick @ 10:21 am

The current crisis in financial markets should have come as a surprise to no one.

In April 1986, the Bank for International Settlements published a study titled “Recent Innovations in International Banking”. With remarkable prescience, it warned that:

“in a world financial system with many imperfections. there can be no guarantee that increased efficiency in financial intermediation at the individual firm level will necessarily improve economic welfare overall.   Many innovations have been designed to exploit existing imperfections in the financial system. Some of the ‘imperfections’ around which innovations are manoeuvring their way represent official measures, such as capital adequacy requirements imposed in the interest of safety and soundness of the financial structure, or measures to deal with liquidity problems or to promote market stability.  Others constitute regulations designed to meet the needs of domestic monetary and credit policy objectives; and still others are meant to serve investor protection needs.”

The report identified a “major source of concern to be  that “many new financial instruments appear to be underpriced, “that is, that gross income from the transactions is insufficient, on average, to compensate fully for their inherent risks.”

Also in 1986, the late Professor Susan Strange of the London School of Economics published a book titled “Casino Capitalism”. It begins:  “The Western financial system is rapidly coming to resemble nothing as much as a vast casino.”  She argued that those who should be in charge rarely know what is going on, while those operating in it are often doing so in the dark. “Yet none of us could escape the disastrous consequences were the precarious edifice to collapse.”

We were warned.

October 13, 2011

The MPC – time for a rethink

Mervyn King, Governor of the Bank of England, recently acknowledged that we are facing “the most serious financial crisis we’ve seen, at least since the 1930s, if not ever.”  The Governor’s observation was made while he was discussing the latest conclusions of the Monetary Policy Committee.

To no one’s great surprise, the MPC had concluded that the most sensible policy to address this historic crisis is steady as she goes and a bit more of the same: maintain interest rates at historically low levels, and print some more money.  They are seriously misguided.

The current historical lows in the Bank base rate of 0.5 percent are crucial to an “aggressive policy” designed to deal with a “once-in-a-century” financial crisis, according to Charles Bean, Deputy Governor of the Bank of England.

In practical terms, these very low interest rates have seen a net transfer of £8 billion per year from savers to borrowers. That is comprised of a £26 billion reward for borrowers, and an £18 billion loss of interest income to savers.

“What we’re trying to do by our policy is encourage more spending, ideally we’d like to see that in the form of more business spending but part of the mechanism that might encourage that is having more household spending so in the short term we want to see households not saving more but spending more.”

In short, the MPC believe that the best way of dealing with a problem widely recognised as being caused by excessive spending and debt is to engineer a substantial transfer from the prudent to the profligate, and to encourage yet more spending and debt.

The current base rate of 0.5 percent has remained unchanged since March 2009 yet, as Mr King argued in his October letter to the Chancellor, economic conditions have continued to deteriorate dramatically.  Both consumers and businesses have failed to respond and return to the pre-crisis growth in economic activity.  This should have come as no surprise. Consumers are deeply in debt, their incomes are increasingly insecure, and their assets are being devalued.  Businesses see the fall in demand and constrain their activity and investment accordingly.

With no scope remaining for further interest rate cuts, and firm in their resolve that more spending and debt are the best solutions to the current economic difficulties, in an act of desperation the wise men of the MPC agreed to redeploy their last weapon — print more money. This is sheer folly. They printed £200 billion in 2009 and there is no credible evidence that it worked then.  Nor, indeed, did printing money work when the Japanese tried it earlier in the decade, or when the US Federal Reserve tried it more recently. There is no reason to expect that printing a further £75 billion will work this time — at least not in the way that has been suggested.

There is a very long world-wide experience with the consequences of printing money and it is not a happy one. Printing money does nothing to add value in an economy. It debases the currency and, to the extent that it supports demand, it causes an increase in domestic price inflation. With such dubious credentials, the first thing central banks did was to rebrand it:  gone is “printing money”; in is “quantitative easing”, or QE.  Whatever it’s called, why have the monetary authorities responsible for maintaining the integrity of the currency advocated using it, how is QE expected to work, and what do they hope to achieve with it?

The first thing to understand is that monetary policy is not set to address current economic conditions but the conditions expected to arise over the coming year or two.  No doubt, the Bank would argue that economic conditions now would be far worse in the absence of the policies they put in place, but the view of the MPC remains that the economic outlook is now so dire that price deflation is the real challenge.  They maintain that despite the fact that inflation has substantially exceeded the 2 percent target set by the government every month for the past two years.  That the general economic outlook is difficult is not questioned, but the long-standing expectation of the MPC that that will lead to excess productive capacity and falling prices has been consistently wrong.

Its policy of easy money through very low interest rates has done exactly what should  have been expected: it has served to support inflated asset prices — especially in the housing market — and has devalued sterling, thereby increasing inflation through higher import prices.  Is this the best that we can expect from an independent central bank?

The recent proposal of the MPC to print £75 billion is even more dubious.  With remarkably convenient timing, the Bank’s proposal to print more money was accompanied by research published two weeks earlier in the Q3 edition of the Bank of England Quarterly Bulletin. In agreeing to that proposal, the Chancellor especially noted that that research showed that QE was effective “in particular in supporting demand”.  The MPC argue that, by thus supporting demand, QE will counter a “sharp fallback in inflation next year”, and it expects that inflation will undershoot the 2 percent target in the medium term. In the light of those expectations, and “in order to keep inflation on track to meet the target over the medium term, the Committee judged that it was necessary to inject further monetary stimulus into the economy”.

It is certainly true that the Bank’s research paper concludes that QE has had “economically significant effects”, adding perhaps 1.5 to 2 percent to GDP and, as a result, 0.75 to 1.5 percent to CPI inflation.  A careful reading of that paper, however, suggests that that conclusion is not justified.

Simply put, under QE, the Bank buys financial assets with newly created money.  Of the £200 billion created last time, £198 billion was used to buy Government gilts, thus increasing the price of those assets and depressing the yield.  It is estimated that gilt yields fell by about 1 percent as a result — no doubt a welcome development for the Government as it seeks to reduce its deficit.

It is then suggested that that newly created money may be spent on other assets, raising those prices, and that it will thereby find its way into the real economy and support aggregate demand.  This is called the “portfolio balance transmission channel”, the main way by which QE is thought to work.

Thus the effects of the QE policy can be broken down into two main elements: the impact of asset purchases on gilt prices and other asset prices, and the effect of asset prices on demand and hence inflation.

That the purchases of gilts led to a decline in gilt yields should come as a surprise to no one.  £198 billion of gilts was nearly 30 percent of all gilts held by the private sector at the time, and gilt yields duly fell by about 100 basis points.  The effects on other assets is “much more uncertain”.

Of central importance though is the effect that it may have had on the wider macroeconomy.

As the paper admits, “the wider macroeconomic effects of QE are difficult to quantify. A host of other factors have been important in influencing the UK economy during the crisis period, making it almost impossible to isolate the incremental effects of QE.” Nonetheless they give it a try.

The increases in asset prices identified by the paper “suggests an overall boost to households’ net financial wealth of about 16%”. What exactly “suggests” this is not clear.  Nonetheless, it is assumed that consumers will want to spend their extra “wealth” evenly across their lifetimes – notwithstanding the fact that a key cause of the debt crisis being faced was that consumers did not use their wealth in that way.  By plugging these assumptions into a “range of simple models” , the suggestion is that any increase in asset prices induced by QE is translated into a boost to household wealth, which in turn leads to an increase aggregate demand and inflation.  What do the models actually show?

The models cannot show anything useful.  Recall that the paper argues that the increase in asset prices was due mainly to what the paper calls the “portfolio balance channel”.  Yet the paper admits that “the forecasting model used by the Bank of England, in common with most large-scale macroeconomic models, does not explain risk premia and therefore does not embody a portfolio balance channel.”

Regardless, the statistical evidence is not yet available.

One of the models used, as the paper says, “should be taken as illustrative, given the simplicity of the model and the fact that it has been estimated on a sample predating the crisis.”  The other models used rely on examining more recent statistical evidence, but no available statistics could yet possibly contain the information being sought.  As the paper says, “the timing of the output effects from a change in asset prices might be expected to be slower than from a normal interest rate cut, which has a peak effect on output after a year.”  In other words, if the output effects occurred at all, they would only now be starting to appear in the official statistics – statistics that have been subject to greater than usual revisions.

Similarly with inflation, the papers estimates are no more reliable because they rely  on a simple Phillips curve rule of thumb based on nothing more than the dubious output estimates suggested by the paper.

The paper admits that “of course, there are major uncertainties here and this sort of calculation ignores some of the transmission channels discussed earlier. It makes no allowance for any effect through confidence or any effect through the exchange rate. So it might well understate the effects.”  I would say: ‘might well mis-state the effects’.

As noted, the MPC may well — and indeed do — argue that the crisis is one of a lack of demand.  It is true that demand has weakened, but it is important to understand why.  Only if we understand properly what is happening can we hope to develop appropriate policy responses.

Over the past 40 years or so, western economies have become increasingly reliant on the benefits of the low labour costs and high savings rates in developing economies, and on access to dubious sources of cheap credit to finance ever more affluent lifestyles.  The era of easy affluence is over. Developing economies that competed only on price are increasingly competing on quality as well.  The dysfunctional global finance system that enabled the excessive buildup of government and private sector debts has left itself fatally impaired by an excess of capital of dubious value, and left western economies over-burdened with debt that cannot easily be repaid.

In this time of crisis, the main effects of MPC policy are not those suggested by their complex theorising but rather the much simpler ones of confidence and the exchange rate.  The weak exchange rate has contributed more to inflation than it has to providing a competitive advantage to exporters.  Inflation is real and persistent, and it erodes real incomes and hence demand.  At the same time, the MPC are signalling clearly and loudly that worse is yet to come.  That depresses economic confidence, while the very low interest rates at the heart of MPC policy penalise the savers who are essential for business investment.

It is not the role of monetary policy to try to offset the austerity that results from a financial system awash with devalued and worthless assets, and from government and households reducing their debts. The MPC should not try.

It is time for a rethink.

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