Sunday, May 14, 2006
Could political turmoil bowl over the pound?
Posted by David Smith at 11:00 AM
Category: David Smith's other articles

A constant for the British economy in modern times has been that a stable pound and political uncertainty don’t mix. When currency dealers see a government or a prime minister in trouble, they tend to dump the pound.

This was not what the term political economy was invented for, but it fairly described how Britain’s economy usually behaved.

Labour was always associated with sterling crises. Philip Snowden, the first Labour chancellor, had to take Britain off the gold standard in 1931 (albeit in a coalition government); the Attlee government devalued sterling in 1949, as did the Wilson government in 1967. In 1976 James Callaghan endured the IMF (International Monetary Fund) crisis, when Britain came as close to bankruptcy as is possible for a sovereign nation.

Sterling volatility rocked the Tories at regular intervals in the 1980s. When Margaret Thatcher resigned, in November 1990, the pound fell sharply. It fell again, 18 months later, when opinion polls pointed to Neil Kinnock leading Labour to victory in the April 1992 election.

That did not happen, but a really big Tory sterling crisis did, the pound being driven out of the European exchange-rate mechanism in September 1992, despite the kitchen sink being thrown in support of it.

That is why the past few weeks have been unusual. So, for that matter, have the past few years. The pound has not only refused to fall in response to Tony Blair’s difficulties; it has risen against a sickly dollar.

That has continued the pattern under this government. Having risen a few months before this government was elected, sterling has been more stable, and less troublesome, than under any other administration — Tory or Labour — in modern times. If we used to have a political economy, it now appears we have an apolitical economy.

Why has there been no currency-market response to the prime minister’s travails? There are a number of reasons. The markets, perhaps like the rest of us, have got tired of the Blair-Brown saga, which has now had more episodes than the real Neighbours. There’ll be a response, in other words, when there’s a real crisis, not just another phoney one.

There’s something in this. Labour’s poll ratings were this low, briefly, in 2000 and 2003. Blair may rank as the most unpopular Labour prime minister ever, but that partly reflects the fact that we are no longer as deferential towards politicians.

Alternatively, an unkind interpretation of the pound’s recent rise would be a variation on the old “chairman quits, share price rises” headline. The markets, in other words, think Britain will do better under new management. That, however, would be unfair to Blair. The rise is due to changing UK interest-rate expectations here and the much bigger currency market story of a falling dollar.

In the end, though, the sterling story is explained by two things. The first is that the markets see political continuity and, tied to this, they see continuity in economic policy, with the pound safe in the guiding hands of the Bank of England.

Let us explore that a little. Would a Brown government be indistinguishable from one run by Blair? I’m not so sure. If it was just a case of changing the leader, why is there such pressure from within the Labour party, and the trade-union movement, for an early handover?

It is not only that Brown is seen as more concerned about social justice, and more hostile to the kind of reform of the public services that involves greater use of the private sector. It is also that they believe a Brown-led government would be more like Labour used to be; no more sucking up to rich businessmen, and no embarrassment about spending large sums of money on health and education. Would Brown, unfettered by Blair, be more willing to hit the better-off and business with even higher taxes? He has done it by stealth, most recently with the Treasury’s assault on trusts.

Brown is keen to emphasise his enterprise-friendly credentials, as he has done since the days when Labour was in opposition and he and the late John Smith embarked on their famous “prawn-cocktail offensive” in the City. But business sees him differently. They see a chancellor who has turned the tax system into a minefield of complexity, and who has loaded a cumulative £50 billion of red tape on them with abandon.

These things do not translate immediately into pressure on the currency, or even damage competitiveness straight away — the latest report from Geneva’s Institute for Management Development ranks Britain above France, Germany and Italy — but it does great harm in the long run.

More important for the markets, there should be concern that after Blair could come a political deluge, or at least there could be some serious political instability, and not just the kind of post-Thatcher infighting suffered by the Tories. The next election may not give us Brown or David Cameron in a clean victory but something much messier.

Maurice Fitzpatrick of Grant Thornton, the accountant, has looked into the erosion of support suffered by long-serving governments, notably the Tories from 1951-64 and 1979-97. His conclusion is that past experience points to Labour securing around 300 seats next time: still the largest party but short of an overall majority. We would, in other words, be into hung parliament, coalition territory. Nobody would want that, but that is also what the polls are telling us.

What about the role of the Bank as a guarantor of stability? Last week’s inflation report, in which the monetary policy committee (MPC) nudged us towards expecting higher interest rates, although not for a while, was another demonstration of the Old Lady’s unfussy style.

The politicians may be having an attack of the vapours but the Bank, behind its solid walls, is keeping its feet firmly on the ground. The inflation report, according to Mervyn King, the Bank’s governor, “describes a benign central view of steady growth with inflation remaining close to the target”.

It doesn’t get much more calming than that. It is indeed the case that if interest rates were still under political control, the markets — and in particular sterling — would be much more turbulent.

Central banks can, however, only do so much. Long-established independent central banks, such as the US Federal Reserve and Germany’s Bundesbank, helped in the past to limit volatility, but they could not prevent it altogether. The pound has been spookily stable. As the political winds blow harder, that may not last.

PS Talking of King, the governor chose last week to warn again that houses are overvalued, notably when compared with average earnings. It may be that these measures no longer tell us very much, but I know why he said it. King is rather keen that the current touch of irrational exuberance in house prices — up 8% this year, according to Halifax — abates quickly. A similar warning two years ago stopped prices in their tracks and had estate agents crying foul. Let’s hope it works again.

The governor was also keen to reverse the recent rise in inflation expectations, and to provide a health warning about debt. Mind you, critics say the Bank’s policy in recent years of encouraging the consumer to maintain economic momentum when the global economy was weak was directly responsible for the debt build-up.

The Bank also touched on global warming. A few cold snaps don’t make a trend, but the inflation report had some interesting figures last week to explain the rise in energy demand. In two out of the past 15 months (January and October last year), temperatures were more than 1 degree Celsius above the 10-year average. In five — February, August and November 2005, and February and March this year — temperatures were more than 1 degree below that average. I’ll return to this another time.

From The Sunday Times, May 14 2006

Comments

David,

Some well made and interesting points. I'm not sure that to what extent Prime Minister Brown might revert to 'Labour type' but Chancellor Brown's record to date suggests that he won't neessarily simply throw money at problems. After all during Labour's first two years in power he was so determined to nail the notion that Labour Chancellors were synonymous with mismanagement that he stuck to Tory spending plans. As Prime Minister he'll be faced with having to persuade the Britsih people that a Brown administration won't be a profligate tax and spend affair. If he is planning on calling an election within two years of taking over might he not simply hold back public spending and get his own mandate before embarking on more ambitious plans?

However - and I know you're not keen on those of us who fear the wheel's coming off the wagon - events may yet tie his hands. Sharp falls on the NYSE and LSE Thursday and Friday have led to talk of a sharp correction - and that the froth might yet come of an rather overexcitable market.

You are doubtless a better judge of this than I but a very large percentage of economics would appear to be psychology. Efficient market is a fine theory, unfortunately markets are made by irrational, emotional and inefficient human beings. Just as the herd has rushed into property and in the last couple of years into retail shares again, might not the herd just rush out?

To be honest I'm more interested in what you make of the possibility that we may have reached a tipping point with the situation brought about by what some describe as a global asset bubble, combined with high levels of consumer borrowing in the West and an increasing reluctance on the part of Asian central banks to underwrite that. Add oil prices and the prospect of cheap money (courtesy Japan) becoming less cheap into the mix and it's possible that we could have a situation where Gordon Brown's desire to spend more on education and the NHS becomes a mere sidebar.

What think you Mr Smith? Are we teetering on the brink perhaps or should the doom-mongers fix themselves a stiff drink and reach for their collection of X File DVDs?

Posted by: Jonathan at May 14, 2006 10:44 AM

Yet another quality post Mr Smith. What is your view over the threat of mulitnationals in the UK moving production and thier offices to the eastern european economies such as Poland. It is a cause for concern in the short run and the long. what do you think would be solution to this, apart from reducing the coorperation tax?

Posted by: Stefan at May 14, 2006 05:01 PM

Thank you. In response to Jonathan, there is indeed an air of nervousness about. The Dow moved close to its all-time high and then suffered an attack of vertigo. Steve Roach, chief economist at Morgan Stanley, recently declared himself to be less bearish about the global economy because of signs that the great imbalances were at last being taken seriously, and tackled. Time will tell whether he switched from being a bear at exactly the wrong moment. My view is that most of the recent market turbulence has been caused by an inexperienced Fed chairman, Ben Bernanke, sending conflicting signals to the markets, rather than anything (yet) more fundamental.

In response to Stefan, a shift to Eastern Europe is happening, even if the journey is not necessarily a direct one. Peugeot, for example, is closing down production in Coventry while expanding in Slovakia.

Posted by: David Smith at May 14, 2006 05:27 PM

"My view is that most of the recent market turbulence has been caused by an inexperienced Fed chairman"

It's a rather parochial view though isn't it? Soaring debt is already damaging consumer confidence in the US, where housing prices have plummeted by nearly 20% this year alone. $20bn was wiped off the FTSE on Friday (and that incident is being called "the tremor before he big one". Oil prices are breaking new levels (not dropping back as you predicted), and you blame the "turbulence" on Bernanke and Westminster's usual political spats?

Posted by: Paul Owen at May 14, 2006 06:17 PM

No, it's not parochial at all. First US house prices haven't fallen by 20% this year - they haven't fallen at all nationally. Second, I'm not blaming the Blair-Brown spat for anything - the whole basis of the piece was that so far the markets haven't batted an eyelid about the government's problems. Third, Bernanke has upset the markets by first appearing to suggest US rates were close to a peak, or at least an extended pause, and then appearing to rein back from that view. That's what had the markets hypersensitive to inflation worries last week, and spooked them. Fourth, oil prices have indeed been high but I did warn that the progress towards lower prices would be a bumpy one, and that we could see fresh peaks first.

Posted by: David Smith at May 14, 2006 08:27 PM

US house prices haven't gone down? I must have been seeing things.

http://www.weeklystandard.com/Content/Public/Articles/000/000/012/053ajgwr.asp
http://money.cnn.com/2006/05/03/news/economy/realestateguide_fortune
http://www.msnbc.msn.com/id/12644758/

Most analysts are pretty sure that oil prices are not coming down any more, unless you know where to find some more. Easily would be good, cheaply would be better.

Posted by: Paul Owen at May 14, 2006 09:53 PM

You are confusing falling home sales, which these reports refer to, with prices, which are not falling on a national basis.

My oil argument is a subtle one. It acknowledges that we have moved to a more expensive oil era. But it challenges whether enough has changed to produce a more-than-trebling of prices in three years. An increase from the low-$20s to a sustainable $40 is a big shift. Take away speculation and some of the current scares and prices will settle, though it may take time. Global oil production, by the way, has increased substantially over the past three years.

Posted by: David Smith at May 15, 2006 09:05 AM

The first article says:

"WITH NEW HOME SALES DOWN 10.5 percent in February, and with home prices declining for the fourth month in a row, it's high time for a sober look at the consequences of a major housing correction."

*sniff* Arabica, Columbian, or Kenco Instant?

I understand your oil argument, but "Take away speculation and some of the current scares and prices will settle".

Take away speculation from any market and prices will settle. With dwindling supply or a perceived dwindling supply, removing speculation is much easier said than done. Current housing prices are not proving sustainable in the US. I fear that oil prices however are.

Posted by: Paul Owen at May 15, 2006 12:22 PM

It does say that, but it provides no back-up evidence, and the entire article is about whether there will be a housing correction, not that it is happening. The latest figures we have are that new home sales were up by 13% in March, but that new home prices were down by 2% on a year earlier. That's a long way from 20% and does not cover the full market. The best measures of national prices - new and existing homes - suggest stability after a big rise. This, of course, is what happened in Britain.

As I said before, oil supply is increasing. There is evidence, too, that demand growth is weakening, as the International Energy Agency reported last week, though these things take time.

Posted by: David Smith at May 15, 2006 01:30 PM

More evidence that the US residential market is in a tailspin? oh okay:

"The price of new houses in the US has been tumbling for five months at an annualised rate of 18.4pc, while mortgage applications are down 20pc."

http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2006/05/11/cnus11.xml

"There are signs a housing slowdown that has gripped certain high-growth markets during the past few quarters is now spreading nationwide."

http://www.myrtlebeachonline.com/mld/myrtlebeachonline/business/14576739.htm

You understand that Sydney has already seen up to 20% falls in residential property prices?

I'm quite sure it'll never ever ever happen here though so there's no need to worry. The more bullishness there is, the better the roses are fertilized, and the sweeter they smell!

I have a nagging feeling that saying "demand growth is weakening" is a compromise when you can't say "demand is weakening". Speculation in oil prices is here to stay - but only time will make that clear.

Posted by: Paul Owen at May 15, 2006 07:56 PM

There's a lot of confusion over US house price data, and a tendency among commentators to focus on new homes, which make up onloy a tiny proportion of the market. These figures, from the National Association of Realtors, are widely accepted as the best measure of sales and prices for existing homes. They'll report again soon but their latest figures show house prices up by roughly 7.5% on a year ago. This is their last release:

"WASHINGTON (April 25, 2006) – Sales of existing homes edged up in March following a strong rebound in February, according to the National Association of Realtors.

Total existing-home sales – including single-family, townhomes, condominiums and co-ops – rose 0.3 percent to a seasonally adjusted annual rate1 of 6.92 million units in March from a pace of 6.90 million in February, but were 0.7 percent below a 6.97 million-unit level in March 2005.

David Lereah, NAR’s chief economist, said sales are leveling out. “It’s a good sign to see home sales holding close to the level of a strong rebound in the month before,” he said. “This is additional evidence that we’re experiencing a soft landing. We may see some minor slowing in home sales as interest rates rise, but the market clearly is stabilizing.” Lereah expects 2006 to be the third strongest year on record for home sales.

“We now see appreciation cooling to single-digit rates of price growth – another sign that the market is normalizing,” Lereah said. The national median existing-home price for all housing types was $218,000 in March, up 7.4 percent from March 2005 when the median was $203,000. The median is a typical market price where half of the homes sold for more and half sold for less.

Posted by: David Smith at May 19, 2006 04:26 PM

So, we have the opinion and data of Lombard Street Research saying the market is plummeting and backing it up with data, vs. the opinion of the National Association of Realtors and a statement "This is additional evidence that we’re experiencing a soft landing"

I'm speechless that you think the NAR would offer a balanced view, David, without figures to even back it up!

Maybe it's worth asking your barber if people will need might haircuts next year?

Posted by: Paul Owen at May 20, 2006 01:55 AM

Now you're just being silly. Either that or it doesn't take much to make you speechless. Or, as I suspect, you fire off these responses, and scour the internet for dubious supporting evidence without reading or understanding it. The National Association of Realtors produces a detailed and widely used series for existing home sales and prices. Lombard Street was talking about the annualised rate at which new home prices are falling. Annualised rates, as you may or may not know, are very different from annual rates. If prices fall by 2% in a month, that's an annualised fall of 25%, but sensible people would wait a while before pronouncing on it. Nobody, repeat nobody, thinks US house prices have fallen 20%. They could, but they haven't.

Your other "fact" about Sydney house prices is also highly dubious. The most reliable series, produced by Australian Property Monitors and used by the Reserve Bank among others, suggests Sydney prices have fallen by 3.8% in the past 12 months and are down by 9.6% from their 2003 peak. The Sydney market, with a huge proportion of properties bought by investors, was highly speculative. In other Australian cities prices are still rising, typically by 0% to 4% but in Perth by 24.8% and Darwin by 16.3%.

I don't know whether the American and Australian property markets will crash but you're not going to make it happen by pretending it's already occurred. I'm happy to have an intelligent debate with anybody but it's not intelligent at all to make up numbers.

Posted by: David Smith at May 20, 2006 11:00 AM

David, you took a while to respond to the data from Lombard Research and the other sources which I presented - were you busy searching high and low yourself perhaps?

You found something, but the figures you've given actually back up Lombard Street's findings. As I mentioned, Sydney has already seen falls of over 20%, and the specualtive nature of that market has arguably been replicated all over the world! Sydney is not special in that respect.

I'm interested in fact-based discussion too. I would still caution presenting opinion of vested interests as overriding data from other sources. Just as I'm not going to make a property crash happen by talking about it, you're not going to ease the crash by not talking about it ...

Posted by: Paul Owen at May 20, 2006 01:32 PM