Economic Comment

What is happening in Europe?  (update 8/12/11)

Most of the EU members who use the Euro have the same problem as ourselves and the US – they have borrowed too much and spent too much.  I say ‘most’ of them, because Germany, with World War II and the hyper-inflation of the 1920’s still in living memory, have been much more prudent than the rest of us over the last 40 years or so.

This is the nub of the ‘problem’: the US and UK have simply printed more money to pay the bills – watering down the values of their currencies in the process and risking serious inflation in the longer-term.  But Greece, Italy, Spain and so forth are ‘trapped’ in the Euro with Germany – they can’t print more money to pay for their profligacy, because Germany wont let them.

However, the problem for Germany is that, having ‘got into bed’ with these spend-thrift nations (in the form of the Euro), they find that they have to help out their bankrupt bedfellows or suffer a very bad night’s sleep when they finally fall out of bed..!

The term ‘on the horns of a dilemma’ never seemed more appropriate.

The ‘fudge’ being put together by EU leaders is to allow the European Central Bank to bail out the big-spenders, subject to more stringent rules designed to ensure they get their affairs in order.  The trouble is that these rules look very much like the rules they had in place to stop the problem in the first place – that no one took any notice of!

So we shall get the worst of all worlds – more borrowing, more spending – followed by a gradual deterioration in relationships within the EU as the Germans become ever more resentful at having to spend their hard-earned savings bailing out Greeks – who retire to the beach in their early 50s – and the Greeks continue to riot at what they see as the Germans telling them how to run their country. 

Where will it all end?  Not well, I fear: the most likely end-game for all over-borrowed, over-spent nations is a major deflationary crash in asset values as confidence finally ebbs away, followed by massive inflation as governments panic and run the printing presses night and day. 

Perhaps the biggest concern is the political outcome in Europe: democratically elected leaders in Greece and Italy have already been replaced by non-elected ‘technocrats’; it’s bad enough that we all tend to feel that our leaders are ‘out of touch’ with the electorate, but when leaders are not even elected, it will be a foregone conclusion – and the riots will just get uglier. 

If the economic and political situations deteriorate in tandem, then anything could happen - the EU was conceived of (supposedly) to avoid another war in Europe (some of us voted in the referendum for that very objective, back in the optimistic 1970s); but experience has shown that the old saying 'good fences make good neighbours' makes sense - and the more the leaders try to shoe-horn us all into one system, the worse it gets. 

The risk goes much deeper than the economy.

Over two years of 'emergency' low interest rates - can't be right, can it...?  (update 14/4/11)

When the last government lowered interest rates to 0.5%, it was the first time in the 300 year history of the Bank of England that rates had been that low.  This was not a great achievement - it was a declaration that the UK could not afford to pay the market rates to borrow money and, instead, the government printed the extra money that it needed.  (See earlier posts below for more about the impact of such measures.)

The move was stated to be an emergency measure, but here we are, two years later and the rate remains at 0.5%.  It is a statement that the economy is too weak to pay any more than this and that, if no one will lend us what we need at that interest rate, we (as a nation) will just have to print more of our own.

So here we are, after 300 years of 'progress', since before the Industrial Revolution - which has seen the horse drawn cart give way to canal barges, then railway trains, then the motor car and finally air travel - and our economy is weaker now than at any time during that 300 year period.  Not good, is it..?

The reason for this disaster?  Because we live in a democracy where people vote for politicians who promise ever better public services and the money that the governments borrow to pay for all of this 'trickles down' to the rest of us and enables us to live in a manner that we, as a nation, simply cannot afford.  As a nation, we spend more and more of our resources on keeping a whole section of the working population engaged in seeing to our every need - we have come to expect 'cradle to grave' molly-coddling from our paid servants - the public sector. 

And 'paid' is the crucial word here - once upon a time, public servants were not well paid, so they were given generous pension arrangements to compensate for this.  Unfortunately, (whilst no doubt there are going to be notable exceptions) as a group, their pay and benefits have soared - and with them, the value of their pension schemes.

If someone in the private sector wanted to retire at 60 on a pension equal to two-thirds their final salary (inflation linked up to 3%pa and a widow's pension of half this on death), they would need a pension pot approximately 20 times their final salary.  For someone on £50k this is a pot of £1m - how many people in the private sector have pension pots of 20 times their annual income...?  And if inflation does take off big-time, it will wipe out private sector pensioners (generally limited to 3% rises), whilst boosting the value of public sector pensions even further.

But when the government talks of cutting back our spending on all these highly paid servants (with the inevitable fall in the level of services they provide) people are up in arms.  The problem is that we all want to keep our own servants, the ones that provide services that we ourselves use - we don't mind getting rid of the ones who provide services to other people! The simple fact is that we are all going to have to get used to having fewer servants around - we can't all live like Kings and Queens, as much as we would like to. 

At the moment, despite talk of 'cuts', the government is still borrowing more money, every day, to pay the servants' wages - and it will have to borrow even more to pay their pensions.  The UK is like a family that has got used to living on borrowed money and simply takes out a new loan every so often, paying the minimum payments each month, so that they can keep all the trappings of wealth.  Deep down they know that it has to come to an end sooner or later and the sooner they cut the spending, the more chance they have of getting it all back under control.  For 'they' read 'we' - we are that family - Gordon Brown was a 'credit-junkie' and he encouraged the rest of us to do likewise - even those who did not borrow benefited from the borrowed money, when the borrowers spent it on everyone else's goods and services.

So what to do?  As individuals we are helpless to change the nation's financial mess, but we can try to anticipate the effects and take defensive action:

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 in 2006...)

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 2010 and Spring 2011

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