Sunday, June 17, 2007
Boom times and doom mongers
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

The markets are very jumpy, worried that the era of low global interest rates is at an end. Rising bond yields, of which more in a moment, are flashing an amber warning signal.

And if you want to get really gloomy, you could do worse than browse Amazon’s website. There you will find titles like The Great Reckoning: Protecting Yourself in the Coming Depression, by James Dale Davidson and William Rees-Mogg; The Return of Depression Economics, by Paul Krugman; and Boom Bust: House Prices, Banking and the Depression of 2010, by Fred Harrison.

If that’s not enough, how about The Second Great Depression: Starting 2007 Ending 2020, by Warren Brussee; or Crash-proof: How to Profit from the Coming Economic Collapse by Peter Schiff and John Downes?

I should mention, perhaps, that not all these are hot off the press. Davidson and Rees-Mogg’s book was published in 1994, Krugman and Harrison’s in 1999 and Brussee’s in 2005. Schiff and Downes’s book is new.

You might say that some of them have already been proved badly wrong, though this does not seem to dim the appetite for this kind of tome. The blogosphere (the trendy name for folk who sit in front of PCs in their dressing gowns) is full of predictions of economic and financial Armageddon. One day they’ll be right. Are we there yet?

The context for this question is the world’s extraordinarily strong economic performance. Last year global growth was 5.4%, the fourth consecutive year in which it has grown near or above 5%.

“The current economic situation is in many ways better than we have experienced in years,” said Jean-Philippe Cotis at the Paris-based Organisation for Economic Cooperation and Development.

Simon Johnson at the International Monetary Fund, reflecting on last year’s strong growth, said: “We have not seen a four-year span like this since the early 1970s.”

The IMF is brave enough to publish illustrative forecasts right through to 2012 and they suggest the good times will continue, with growth in the 4.5%-5% range. It won’t stop the publication of new, doom-laden books, though by then plenty of the old ones will have long been recycled.

One disturbing aspect of the present situation is that comparisons are being drawn with the early 1970s. Then, as now, commodity prices were booming (which helped persuade the Organisation of Petroleum Exporting Countries to exert some of their pricing power). Then, as now, the global and UK money supply was growing strongly.

In the early 1970s economists such as Alan Walters and David Laidler warned of the inflationary consequences of the soaring money supply. Now economists such as Tim Congdon and my namesake David B Smith do so.

Then, of course, it all ended in tears. The world economy endured nearly two decades of turbulence, including the stagflationary (a double dose of stagnation plus inflation) 1970s. No two periods are alike. In the early 1970s, not only was global money supply growth stronger but so was inflation, even before it headed into the stratosphere (nearly 30% in the case of Britain). Inflation in the industrialised countries averaged between 5% and 6% even over the period 1970-72.

But the echoes are there. Standard Chartered, in a new report on the global economy, sees little risk of a downturn in growth. If anything, it could be even stronger next year as the US economy picks up, the bank said. But its economists are worried about the inflationary consequences of the boom. Food-price inflation has replaced energy inflation as the big concern and global money-supply growth has strengthened significantly over the past year. There is a lot of liquidity sloshing about.

It is possible that the current period of global expansion could end as a result of a “black swan” event of the kind identified by Nassim Nicholas Taleb in his bestselling book. These are the kind of random or highly improbable events we convince ourselves afterwards we saw coming but which constitute a genuine shock to the financial system.

Or it could be that the seeds of the next downturn are already sown, and are reflected in the recent rise in bond yields in major economies to their highest level for several years. Bond yields are important because they reflect two related things – market expectations of inflation and market expectations of interest rates, over the longer term. So the recent rise tells us the markets have become gloomier about inflation, or about interest rates, or both.

It is possible to argue that the global economy’s four-year boom has been the result of the easy monetary policy adopted by central banks in the wake of the last global mini-recession in 2001, brought on by the bursting of the dotcom bubble and the 9/11 attacks.

Central bankers would blanch at the idea that they are a cartel but their message has been remarkably uniform recently. Whether it is Mervyn King at the Bank of England, Ben Bernanke at the Federal Reserve or Jean-Claude Trichet at the European Central Bank (or their counterparts elsewhere) the tone has been tough. Interest rates will stay high and could go higher.

One reason for the low bond yields of recent years, the so-called global glut of savings, may be peaking. Goldman Sachs reckons that, barring a renewed surge in crude-oil prices, the petrodollar surpluses of the Middle East oil producers may now start to decline.

The big factor unsettling bond markets, however, has been inflation. Economists and analysts at UBS, in a paper, Crisis, what crisis?, have taken a detailed look at whether market worries about inflation are justified. They did this from the bottom up, by looking at the pricing evidence from individual sectors, on a worldwide basis. They also looked at it from the top down, by studying survey evidence on pricing power, of the kind that has worried central banks.

UBS’s conclusion is that we have seen some evidence of increased pricing power in “old economy” sectors like manufacturing but that in other “newer” sectors, including technology, falling prices are still the norm. The survey evidence, it suggests, points to somewhat higher inflation than the exceptional low rates of a few years ago but it says that inflation is stable at these higher levels and not accelerating.

That is a reassuring message for financial markets and the global economy, but it is unlikely to settle the argument about whether current exuberance will spill over into higher inflation. Growth is good. But you can have too much of a good thing.

PS Gordon Brown’s decision to open up appointments to the Bank of England’s monetary policy committee is to be welcomed; the posts will be advertised. Eventually, perhaps, we’ll see an Apprentice-style televised appointments process, with Mervyn King in the Sir Alan Sugar role.

In the meantime, the MPC has some puzzles to deal with. Inflation dropped last month, as expected, with the consumer-prices index showing a drop from 2.8% to 2.5%. More remarkable was the benign behaviour of earnings, up by 4% in the latest 12 months, including bonuses, and 3.6% excluding bonuses.

Economists have focused on the fact that inflation expectations remain low, sharply increased migration and evidence of labour-market slack as reasons why pay has remained so low, even in the light of the earlier rise in inflation.

There could be another reason, advanced in a paper to be published in the Royal Economic Society’s Economic Journal this week. Job Insecurity and Wages looks at the role that fear of unemployment plays in moderating the growth of wages.

Among men, fear of unemployment is indeed a significant factor in keeping pay down, the research finds, though not so much among women. Some men are quite good at gauging the risk of losing their job but plenty of others worry unnecessarily; they overestimate the danger of redundancy. Whatever the cause, pay behaviour has certainly changed.

From The Sunday Times, June 17 2007

Comments

You've changed your tune!

From what you've written over the last 3 years I was led to believe that low inflation and low interest rates were permanent.

If the rate of growth of the money supply exceeds the rate of growth of output the result is, eventually, inflation.

I'm looking forward to your revised analysis on home prices. They only ever go up don't they?

Posted by: Nigel Watson at June 17, 2007 10:23 AM

Don't know where you get that from. I describe the markets' concerns and conclude with the reassuring message on inflation from UBS. But, as I say, this is an exceptional period of growth for the world economy, so people will be looking for the pace of growth to ease back before the inflation danger is seen to have passed.

On the money supply, don't suppose you've heard of velocity of circulation, but never mind. As for house prices, the usual obsession, I don't know whether you're giving me your view that they always go up, or suggesting that's what I've written, which it never has been. All I've done, from time to time, is correct sad crash fantasies.

Posted by: David Smith at June 17, 2007 01:47 PM

You've been proven wrong on inflation and interest rates. You'll also be proven wrong on house prices too. Now what's really sad is sheeple like you that believe that house prices can only ever go up.

I remember Lawson's claim that he's abolished the trade cycle just before the last slump. Like this time, a credit boom created inflation, which pushed up interest rates leading to a fairly predictable downturn.

Oh, by the way. The velocity of circulation tends to be fairly stable over the long term.

Posted by: Nigel Watson at June 17, 2007 10:20 PM

Nobody likes an economy that produces extravagant house prices. Its easy to talk about doomsdayers who wish that prices will crash than economists who report otherwise.

Its a simply a question of SUPPLY. Will Brown be able to deliver? First and foremost he should uphold the said view that prices should come down and for his own benefit and that of his party, he should work in that direction until the next elections are due.

Ofcourse I am talking about house prices!

Posted by: H.Damani at June 18, 2007 12:53 AM

Nigel

I think you will find David has already been proven right on House prices, they haven't crashed over the last three years as many suspected, and preached.

And I am sure that David doesn't think house prices only go up, after all that would be blimin stupid, because they crashed 15 years ago, which I am sure is within his living memory.

Basically, David has called the market correctly (if not to bearishly IMVHO), over the last few years, and the bears have called to totally incorrectly. Blimin heck Bootlle was waffling on about 20% crashes starting in 2003!

Posted by: kingofnowhere at June 18, 2007 08:55 AM

Ah, I see where Nigel is coming from. In previous posts, he's suggested rents aren't rising - wrong. Rental yields have fallen, but that's not the same. He's suggested that demographic factors have no impact on house prices - wrong. Now he suggests that velocity of circulation is stable in the long-term - wrong, M4 velocity has declined sharply since the early 1990s. He suggests that Nigel Lawson claimed to have abolished the business cycle - wrong. And he seems to think I have said house prices can only ever go up - wrong again. This site welcomes a range of views but it helps to have some basic acquaintance with the facts. Otherwise, there are plenty of sites for crash obsessives.

Posted by: David Smith at June 18, 2007 09:01 AM

Hi David

Have you got a link to the historical velocity of M4? Does the BOE have it as one of their codes?

Cheers

Posted by: kingofnowhere at June 18, 2007 09:53 AM

Not on a regular basis, though they have the numbers and occasionally produce charts in the inflation report on declining velocity. Here's something from the April 2006 minutes:

"M4 had continued to grow strongly; by over 12% in the year to February 2006. Excluding the volatile ‘Other Financial Corporations’ component, growth had been around 9%. With nominal domestic demand growth having slipped below 4%, the velocity of broad money had continued to trend downwards, as it had for most of the previous 25 years."

Posted by: David Smith at June 18, 2007 11:04 AM

Dear David,
The National Statistics online at:
http://www.statistics.gov.uk/statbase/tsdlistfiles.asp

provides an M4 velocity ratio series (code: AUYU). This has a value of 0.90 (for the last quarter of 2006). Thinking about "equilibrium"as a value of one), this should imply 10% below.
Thanks

Posted by: Costas Milas at June 18, 2007 03:29 PM

Yes, thanks for that. It suggests M4 velocity has halved over 20 years.

Posted by: David Smith at June 18, 2007 06:37 PM

Hi costa

Thank you for that, I've been looking for a source of M4 velocity. I was dammned if I could find one! Typical hidden in the ONS.

Thanks again.

Posted by: kingofnowhere at June 18, 2007 08:43 PM

M4 velocity declining -
Surely this is the same as saying it takes more money - (M4 money supply) to produce a unit of GDP output.

(v = Nominal Product/Money Supply) from Mv = PY

This would rather make sense, as during the 1990s there was strong technological productivity growth, while now we have increased government spending, and lower productivity growth.


Posted by: J Law at June 19, 2007 05:42 PM

I wonder if this decline in velocity would make a good article?

Posted by: J Law at June 19, 2007 05:48 PM

It certainly means that more money - a bigger increase in M4 - is consistent with a given rise in money GDP. The Bank has suggested that 9% M4 growth is consistent with trend GDP growth and target inflation, suggesting that the current rate of M4 growth is excessive. Though, of course, there are other well-known distortions associated with M4 at present.

Posted by: David Smith at June 19, 2007 05:54 PM

Dear David,
The implication is that if the MPC wanted to target M4 (and there are good reasons for NOT doing so), the target would be 9%.
Many thanks.

Posted by: Costas Milas at June 19, 2007 06:25 PM

From the equation v = PY/M where PY is GDP and M is broad money, (v therefore gives GDP/M)_, so

GDP/M = MoneyUnitsGDP/Amount_Of_Money

.: Amount_Of_Money to produce 1 unit of GDP = M/GDP = 1/v.

It would seem clear from this math - if I am not mistaken - that 1/v is the amount of money needed to produce 1 money unit of GDP output.

I calculate, on the recent year 2006, using the above, it took 1.16p of money to produce £1 of GDP output at market prices, by my figures (which may differ from the ONS slightly).

And, interestingly this is very unusual - going all the way back to 1981, on this same data, it has always taken somewhat less than £1 of money supply to produce £1 of GDP output.

Apart from the period 2003-2006, which unusually, increasing amounts of money supply - over £1 - seem to be needed to produce £1 of GDP output with P constant.

I read that hyperinflations usually have v well over 1 - usually 3-4 as people try to spend of all thier money before it devalues, meaning that just £0.50 of money produces £2 of nominal GDP output, PY, however, P, prices, rise by the velocity multiple, not Y - output.

Assuming P roughly constant, and Y, output, varies with increasing M, declining velocity must mean real output, Y, must be declining in relation to the increasing size of the credit/money supply over 2003-2006.
Is this a fair assessment?

2006
Broad money: 1497056 (BOE: M4)
GDP (at market prices: 1289989)
Mv = PY (GDP) .: v = PY/M = 129/150 = 0.86 and 1/v = 1.16p


Posted by: J Law at June 19, 2007 10:01 PM

You've done your homework, very impressively, and I'm sure Costas will have something to say about this. Two observations from me:

1. Monetarists believe in a lag between the money supply and money GDP, so this year's M will not necessarily be related precisely to this year's PY (though that may be the way the ONS calculates velocity).

2. I would tend to look at changes in the money stock - in other words the money supply - and relate that to changes in money GDP, rather than just look at the stock position for each.

Posted by: David Smith at June 19, 2007 10:15 PM

Dear David,

I would add the following:
Thinking about inverse velocity (and ignoring interest rates for simplicity) as a long-run relationship among prices (p), money (m) and output (y) , then (in logs):

m-p-y=-v.

Therefore, when money rises above its long-run relationship with prices and output (in which case inverse velocity, -v, increases), the extra money generates inflation (i.e. the change in prices is positive).
Personally, I think this extra money (as it happens now since inverse velocity is rising) has a very small positive impact on UK inflation.

Thanks.

Posted by: Costas Milas at June 20, 2007 12:08 AM

Have now looked back to 1970 (on stocks) of both UK GDP and M4, and this ratio of money supply to GDP - taking over a £1 of money:to produce £1 of nominal GDP is exceptionally unusual, as money velocity has always been over 1, money supply always less than GDP, even during the 1970s as the money transactions/velocity was very high. (nearly 2 during the inflationary 70s)

2003 v = 1.03 (Money supply stock still smaller then GDP)
2004 v = 1 (Money supply growing faster than GDP)
2005 v = 0.92
2006 v = 0.85


This situation with velocity less than 1 from 2004 indicating growing money supply:nominal ouput, is enough lag time (I would have thought) for this greater supply of money to output show up in nominal GDP, as a combination inflation or rising real output?

From googling about - People are either increasing their savings and holdings of money itself, or the money is not showing up in GDP due to transmission lags - such money raises asset values, which do not directly show up as GDP transactions directly.

Looking at the money supply and asset price gains of the 1970s, nominal incomes also rose, and money velocity rose to 2 by 1979, resulting in massive nominal GDP growth + inflation, far in excess of the increase in the money growth itself, and far in excess of real output.

(GDI = GDP, so all nominal income depends on nominal GDP increasing or vica versa)

If velocity increases - if incomes rise, while output stays the same - we are at near full output/employment for example, then the result on prices can be calculated -

%P = %M + %V - %Y (http://www.hussmanfunds.com/wmc/wmc040524.htm)

This indicates, with %M at 13, even if the change in %V is 0%, the effects of price inflation due to %M being 13% will be fully felt in %P.

So if v is rising - nominal GDP rises upwards in relation to the money supply, this would have a massive effect on inflation, %P
If %M stays around the same level and Y% doesn't increase.

If %Y rises by 5% this year, %M is at 13%, and %V rises by 1%, %P, inflation, would be (13%+1% - 5%) = 9%!

How far can broad money supply outpace nominal GDP (thus v continues to decline?)

I think the real question may be asking how far can asset prices continue to rise, where the money may be going, while incomes do not?

Posted by: J Law at June 20, 2007 08:38 PM

Or course,
Its still perfectly possible for Money supply to rise further by 13% in 2008, Houseprices/assets prices to continue to rise by 10%, and GDP to grow by 3% more or less.

So velocity - which is just a ratio of money supply to nominal incomes (nominal GDP), to decline further!


Posted by: J Law at June 20, 2007 09:25 PM

Yes, if M4 has predictive power it suggests asset-price inflation will continue.

Posted by: David Smith at June 20, 2007 09:41 PM

The only was asset price inflation will continue is

1) Debt increases further above inflation
2) Wage inflation assists in asset price inflation (not going to happen if 10% is the prediction)
3) Economy (high street) suffers as more money is directed from this into assets.

any others?

Posted by: Kev M at June 24, 2007 04:44 PM

I don't think many people would approach it in that way. Assets will rise in price if there is more demand than supply and (a) people can afford to buy them and (b) they think they are a good long-term investment.

Posted by: David Smith at June 24, 2007 05:19 PM

David, I don't disagree with you, unfortunately banks do not look on people as "not being able to afford" housing any more. Therefore if houses keep going up, then debt increases further pushing that 1.3 trillion ever closer to 1.5 trillion (people spending even more of their future earnings today)

Posted by: Kev M at June 24, 2007 06:42 PM

you might find this interesting as well as nigel watson (1st comment)

For the moment, mortgage rates are still reasonably low for borrowers with good credit. And though regulators have started clamping down on the riskiest lenders, so far they don’t seem to be overreacting by tightening up too hard on new loans for people with good credit.

The problem is that the people who borrowed more than they could afford – and the companies that sold them the loans — are now in pretty deep hot water. By some estimates, as many as a third of the people who got a mortgage last year — many of whom had bad credit histories to begin with – would have a hard time getting a new loan now that the lenders who catered to them are in trouble.

This borrowing hangover hurts the housing market two ways. First, it knocks a lot of would-be home buyers out of the market because they can't get a loan. Second, all the homes bought by borrowers who got in trouble — and are now defaulting on their loans — are being put back on the market. That means there are even more unsold homes, some of which are now owned by banks willing to cut prices to get rid of them quickly.

No one can say for sure how — or when — this downward trend will turn around. But, as the CEO of one of the biggest U.S. homebuilders said famously last week, the 2007 housing market looks like it’s “going to suck.”

WORST CASE SCENARIOS
... Since the economy has started to slow down, home prices are coming down too. However, the U.S. has a large deficit which keeps getting even larger. If foreigners lose their patience and start selling dollars, the dollar will devaluate. What will then happen to the home prices inside the U.S. Will they go up or down?
— Anonymous, Greenbrae, Calif.

A lot of other variables are probably more important to home prices than the value of the dollar. But it you continued your scenario, a falling dollar (depending on how quickly it falls) would typically force interest rates higher, which would throw more cold water on the housing market, which could further hurt prices.

But at each stage of your scenario, other forces are at work that could knock it off course.

Markets tend to correct themselves — even if painfully in the short term. We had a much worse real estate scenario brewing in the late 1980s. It cost taxpayers hundreds of billions to clean up failed savings and loans that made bad loans. Some homeowners lost money, and some developers got wiped out. But the lasting impact was relatively mild: a short recession in 1991.

But not everyone got hurt in that housing slump. One reason is that for owner-occupied residential housing, the best defense against a market downturn is usually to stay put if you can. That tends to dampen the kind of pressure that typically force other investment markets (like stocks) into steeper — and more rapid — declines when the selling starts.

At the moment, the surge in defaults among borrowers who are in trouble seems to be contained. If these credit problems spread, you could see an overreaction by lenders, a contraction of consumer spending (which accounts for 70 percent of U.S. GDP) and a resulting recession.

But we’re not there yet.

Posted by: Dana at July 16, 2008 04:53 AM

you might find this interesting as well as nigel watson (1st comment)

For the moment, mortgage rates are still reasonably low for borrowers with good credit. And though regulators have started clamping down on the riskiest lenders, so far they don’t seem to be overreacting by tightening up too hard on new loans for people with good credit.

The problem is that the people who borrowed more than they could afford – and the companies that sold them the loans — are now in pretty deep hot water. By some estimates, as many as a third of the people who got a mortgage last year — many of whom had bad credit histories to begin with – would have a hard time getting a new loan now that the lenders who catered to them are in trouble.

This borrowing hangover hurts the housing market two ways. First, it knocks a lot of would-be home buyers out of the market because they can't get a loan. Second, all the homes bought by borrowers who got in trouble — and are now defaulting on their loans — are being put back on the market. That means there are even more unsold homes, some of which are now owned by banks willing to cut prices to get rid of them quickly.

No one can say for sure how — or when — this downward trend will turn around. But, as the CEO of one of the biggest U.S. homebuilders said famously last week, the 2007 housing market looks like it’s “going to suck.”

WORST CASE SCENARIOS
... Since the economy has started to slow down, home prices are coming down too. However, the U.S. has a large deficit which keeps getting even larger. If foreigners lose their patience and start selling dollars, the dollar will devaluate. What will then happen to the home prices inside the U.S. Will they go up or down?
— Anonymous, Greenbrae, Calif.

A lot of other variables are probably more important to home prices than the value of the dollar. But it you continued your scenario, a falling dollar (depending on how quickly it falls) would typically force interest rates higher, which would throw more cold water on the housing market, which could further hurt prices.

But at each stage of your scenario, other forces are at work that could knock it off course.

Markets tend to correct themselves — even if painfully in the short term. We had a much worse real estate scenario brewing in the late 1980s. It cost taxpayers hundreds of billions to clean up failed savings and loans that made bad loans. Some homeowners lost money, and some developers got wiped out. But the lasting impact was relatively mild: a short recession in 1991.

But not everyone got hurt in that housing slump. One reason is that for owner-occupied residential housing, the best defense against a market downturn is usually to stay put if you can. That tends to dampen the kind of pressure that typically force other investment markets (like stocks) into steeper — and more rapid — declines when the selling starts.

At the moment, the surge in defaults among borrowers who are in trouble seems to be contained. If these credit problems spread, you could see an overreaction by lenders, a contraction of consumer spending (which accounts for 70 percent of U.S. GDP) and a resulting recession.

But we’re not there yet.

Posted by: Dana at July 16, 2008 05:09 AM

Because the US$ is "more equal" than other currencies in our global system, the US current account deficit plays a specific, and very important, role in our global monetary systems. In essence, the US current account deficit provides the world with its working capital. After all, at any given point, the world needs US$. For example, Nokia needs US$ to pay for the chips it may buy in Taiwan. China needs US$ to pay for the iron ore it buys from Australia and Sweden needs US$ to pay for the oil it buys from neighboring Norway...

This is why, whenever we see an improvement in the US current account deficit, somebody somewhere goes bust. Indeed, when the US exports a lot of dollars, then the rest of the worlds gets used to a "plentiful" liquidity situation... and when the US exports less money, then somebody gets cut off.

So in essence, the current account deficit has always been the mechanism through which the United States could reflate, or deflate, the global economy. When the US current account deficit improved, the US deflated other countries and vice versa.

Posted by: Alice at July 28, 2008 11:41 PM