To spend or not to spend...?  (update 20/10/09)

The interest rate on loans and so forth is the price that we pay for borrowing money. If only we could print our own, it would be free. Of course, if we were the government, we could do just that. And, that is just what the government is doing - instead of borrowing the money, they're just printing it (well, to be precise, the Bank of England prints it and lends it to the Treasury). In doing so, they are not only keeping the cost of their borrowings low, but they are reducing the competition for available funds (real money) and so they avoid pushing the price of that money up (the price being the interest rate the rest of us pay).

So, it seems, everyone's a winner -- the government gets to spend cheap money and those who rely on borrowings to get by, also enjoy cheap money. So what could go wrong?

As a nation, we are spending more than we earn, hence the need for more borrowings. Therefore, it is foreigners who are effectively lending us this money. However, if you were to lend your neighbour some cash and he paid you back using money he had not actually earned, but had printed in his garage, you would be a bit more careful before lending him any more...

Now, the pounds that the government is printing are real pounds, but in simple terms, the value of each pound is the total value of 'UK plc' divided by the number of pounds printed. Therefore, the more pounds you print, the lower the value of each pound -- simple as that.

This explains why the value of the pound is falling and why it now costs so much more to holiday abroad. It also explains why imports are becoming more expensive -- if the value of sterling falls by 10%, then we need 10% more sterling to buy that imported television etc.

Of course, the other side of this coin is that the goods that we make here and export will appear cheaper to our customers abroad, so hopefully they will buy more. This stimulates economic activity here in the UK which, hopefully, in the longer term will enable us to be more self-sufficient and not have to borrow so much.

In the meantime, we have to hope that overseas lenders do not completely lose faith in the value of sterling or our ability to ultimately repay our debts. If they do start to lose faith then they will demand a much higher interest rate when they lend to us, and the economic downturn will take a very nasty turn indeed. So the government, whoever that may turn out to be, has the challenge of stimulating the economy whilst cutting spending / borrowing -- an almost impossible juggling act...

How much money has a been printed?

Up to October 2009, the government has authorised the Bank of England to issue £175 billion. They insist that this is not the same as printing money, but the fact is, it is precisely the same. And, when you consider the "multiplier" effect, the sum is considerably greater.

Let me explain how the multiplier works. Say the Bank of England prints £1000, which it lends to me and I pay someone to redecorate my house.  The £1000 I pay him goes back into the banking system (albeit into his account). The banking laws require banks to keep roughly 10% in reserves, but they are allowed to lend the rest out again.

So the bank keeps £100 in reserves and lends £900 to my neighbour, who pays the same decorator to decorate his house. The decorator banks the £900, out of which the bank is required to keep 10% but they then lend the remaining £810 to the next neighbour down the road who pays the same decorator to redecorate his house. The decorator pays that money into his bank account, the bank keeps back 10% and lends the rest to the next guy down the road who employs the decorator, etc etc. So the process goes on until the entire street is redecorated and the decorator has enjoyed an income many times more than the original £1000 that was printed.

Of course, it doesn't have to be my neighbour that borrows the money, but this illustrates that, by the time the money has circulated around and around, each time with 10% being kept in reserves, the actual value works out at much more than the original amount.  It also demonstrates how printing just £1000 can keep one person gainfully employed for quite a long time.

The actual arithmetic works out that, if they can lend 90% each time, the total amount lent by the end of the exercise is 10 times the original amount printed.  When you apply this to the £175 billion, the figures are quite staggering.  There are roughly 30 million employed people in the UK, earning on average around £23,000 per annum each. When you build in the multiplier effect, it works out to be enough to keep the UK workforce gainfully employed for two and a half years.

So next time you are walking round the shops thinking that the economy is not doing so badly, considering that we have been experiencing an economic upheaval described as being on a par with the 1930s, reflect on the fact that all these people are being kept in employment by the printing presses at the Bank of England. Reflect also on how this must be viewed by the rest of the world and ask yourself one simple question - how long can this go on ...?

(Click here to see what we were saying three years ago...)

What will recession mean for you?  (August 08)

My 24 year old son recently asked me “What happens in a recession?”  This brought it home to me that a large section of the population just has no experience of recession. 

So, what does happen in a recession?  Well, the most visual effect is rows of empty shops – whole shopping centres closing down, as one after another goes out of business and eventually people stop coming in because it looks so run down, so that those who remain also go out of business. 

Or gangs of unemployed youths, disenchanted and lacking any stimulus in life, roam the streets, looking for trouble – maybe taking over whole areas, so that no one goes there any more, so more shops go out of business. 

Then the government, which relies on tax collected from profits and salaries, starts to run out of cash, because more people are claiming benefits and those who are working are  earnings less, so paying less tax.  Less cash for public services means spending on non-essential items is slashed, so public buildings become run down, public areas neglected, roads upswept.

Everyone feels unsure about their future, adding to the general feeling of malaise. 

One thing is sure - after a decade or more of rising incomes and a general feeling of well-being, the recession is going to feel very bad for many.

How did we get into this state?

Economics is naturally cyclical – in the up-swing, people feel good, work harder and see the fruits of their labours.  They are more optimistic, so they take risks (which are more likely to work out, due to the general buoyancy of the economy), borrow more and spend more. 

Shops need more stock, so they buy more and keep more in stock – this in turn keeps suppliers and manufacturers even busier.

Eventually, once people have ‘maxed out’ their borrowing, it all slows down.  Then, businesses that have grown up on the basis of the excessive consumption of the boom find that they are struggling.  Shops find that they have too much stock, so they stop ordering and their suppliers have to lay people off. 

This ripples through the economy as everyone feels the pinch and the downward spiral begins.  More people lose their jobs, so things get worse and down we go.

The property boom

On this occasion, the property market has played a major role.  As property values started to rise steeply in the late 1990’s, banks started competing for new mortgage business and they threw the basic principles of sound lending out the door.

Worse, though, the banks found a way of ‘packaging up and selling on’ their loans.  Following the stock market crash of 2000, investors were looking for safer investments and loans are generally considered safer than shares.  Loans secured against property are considered even safer.  So someone had the bright idea of using investors money to ‘buy’ the loans off the banks. 

Imagine XYZ bank has £100M to lend – say they hand out 1,000 mortgages of £100k, which uses up the £100M.  In the old days they would be content to manage these loans and collect the interest, but they realised that if they sold the loans to an investment company for £100M, then they could lend it all again!  Meanwhile, the investment companies took money from investors who wanted their money held somewhere safer than stocks and shares.

But the apparent over-supply of cash caused banks to become a little less cautious about who they would lend to – the people employed to make the loans were paid by results – not based on secure lending, but based on the amounts lent. 

And while property prices were increasing, the risks seemed lower, because the value of the property against which the loan was secured would quickly rise.  This even caused some (including Northern Rock) to lend up to 125% of the property value.

Buyers saw property as a sure bet and everyone was encouraged to ‘get on the ladder’ or stretch themselves to climb up the ladder.  Others decided that property would be their pension and went for ‘buy-to-let’.

For a while, it seemed that ‘everyone was a winner’.  But they had all overlooked the fact that economics is cyclical.  We tend to grow up thinking that the world in run by people who know what they are doing, but sadly this is not the case – or maybe greed just gets in the way of sound judgement.

UK politicians and banks like to blame it all on the US economy, but this is not correct – what happened in the US was always going to happen here – it just hit them first.  In fact, our housing boom has been much longer and more pronounced than the US boom – so the downside is likely to be more pronounced

The credit crunch

The term ‘Credit crunch’ has been coined to sum up the sudden decision of banks to stop lending.  The value of these packaged loans suddenly came into question, so banks were no longer able to sell them on, so could not lend any new money.  So all of a sudden, banks who had been almost dragging people off the street to lend them as much as they wanted, were short of cash. 

People couldn’t borrow so much, so they were unable to pay the high property prices.  Property values faltered and lenders started to cut their valuations or lend a lower percentage of the value.  This further reduced the cash available and prices started to slide.

The bubble was burst – people stopped buying as they waited to see if prices fell further.  Naturally this caused prices to fall further and the downward spiral continued.

The effect on business

All of a sudden, people feel less confident, less affluent and less inclined to spend what little money they have left after paying their bills.  Therefore, what is known as ‘discretionary spending’ dries up – spending on life’s luxuries, such as a new car, new kitchen etc.  People keep their cash to pay for the essentials, such as food and warmth.

So businesses selling luxury goods need to take particular care, as do businesses who supply primarily to these companies.  If Joe Public can get another few years’ service out of their car, their kitchen, their three piece suite, then they will.

But of course not everyone loses out – for example, car repairers may well see an upturn in business, as people hang on to older cars.  Others, such as those in the building trades, will have to look for repair and maintenance work, where before they might have worked on new building sites.

However, everyone will need to make sure of one thing – that they get paid for their goods or their work.  There will be too many people who just do not understand how they could be so short of cash and who convince themselves that it’s all someone else’s fault – and if you are demanding payment from them, then you are part of the problem – it’s your fault!

So beware of the ‘poor me’ syndrome – people who believe that when they made money it was through their own skill and business acumen, but when they lost money it was just bad luck, or other people (like you!) conspiring against them.  They will tell you that it’s not their fault they can't pay you…

On the other side of the coin, you too need to reduce your own spending and commitments wherever possible.  In particular try to avoid the temptation to maintain spending by yet more borrowing.  And don’t forget that long term leasing is just another form of borrowing – that new car or van that only costs £99/month in fact costs whatever a new car costs (plus interest) – you just end up paying for longer and having to pay a lump sum at the end. 

Above all, be ready for this to be a long, deep recession – that way, if it’s really bad, then you will be prepared, whilst if turns out not so bad, then you will be pleasantly surprised…

Tony Marshall
Aug 2008

For an update on the economic situation, see our recent newsletters - Xmas 2008 and Spring 2009

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