Sunday, September 09, 2007
Will the turmoil stamp down on the economy?
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


Along with politicians, estate agents and journalists, bankers are least likely to elicit sympathy. So the fact that bankers have been hurting badly as a result of the turbulence in financial markets – one senior figure described it as the equivalent of a heart attack for the system – will not cause too much angst in the wider world.

But bankers can pass on their hurt to the rest of us and here lies the big question. What will the credit crisis, which shows few signs of abating, do to the economy?

You could be forgiven for thinking we have two parallel economic universes. The one in which ordinary consumers live is doing well. The other is in crisis, with banks unwilling to lend to each other, markets for certain assets having ground to a halt because of traders’ inability to price them and money-market interest rates surging.

If you want to know why this happened, let me quote from the just-released quarterly review from the Bank for International Settlements in Basle, the central bankers’ bank.

“Concerns about exposures to US mortgages cast a dark shadow over global financial markets during the period from end-May . . . with deepening losses on mortgage-related products spilling over to markets for other risky assets,” it wrote. “As uncertainty about the extent and distribution of these losses spread, investors fled to safe havens and liquidity demand surged. This caused a pronounced squeeze across major financial markets, prompting central banks around the globe to inject large amounts of liquidity.

“Triggered by declining confidence in the valuation of mortgage-related and structured credit products, spreads rose sharply . . . increasingly affecting higher-rated products and assets other than credit. The price of credit risk, a measure of investor appetite for credit-market exposure, jumped upwards, suggesting that a large part of the repricing was due to changes in investor sentiment towards risk.”

Three-month Libor (the British Bankers’ Association London interbank offered rate) was once a reliable guide to the level of base rates. Now it has become a symbol of money-market distress, climbing to a nine-year high of nearly 6.9%, more than a percentage point above the 5.75% rate set (and maintained at that level on Thursday) by the Bank of England’s monetary policy committee (MPC).

The Bank, which has been criticised during this crisis for its apparent aloofness, last week set out its rules of engagement. It increased the supply of liquidity to the markets and said it was ready to give more – an extra £4.4 billion for each of the next three weeks. But the aim was to keep overnight rates close to Bank rate, not cut the cost of three-month money, which did not “lie in a lack of central-bank liquidity”. The Bank is, in other words, no fairy godmother. There are some things central banks cannot do, such as make banks start lending to each other again, or restart trading in dormant markets.

The Bank’s actions did not stop the carping in the Square Mile and Canary Wharf. For anybody operating in the economy’s other parallel universe, however, the air of gloom and crisis is puzzling.

There is a neat symmetry in Britain’s manufacturers making whoopee, pun intended, even as bankers have been suffering. In recent years it has been the other way round, and if anybody had cause to complain about the Bank it was manufacturers.

Last week the EEF (formerly the Engineering Employers Federation) said industry was experiencing its best conditions since early 1995. “Manufacturers are enjoying a sustained period of growth and reaping the rewards of investment in skills and innovation,” said Steve Radley, its chief economist. “Gone are the days when a strong currency and increases in interest rates would have stopped companies in their tracks.”

The upbeat EEF survey was backed up by the latest purchasing managers’ index. Britain’s manufacturing sector is leaner, fitter and benefiting from the strength of the global economy, which is enjoying its best run for 35 years.

While it is pleasing to see manufacturing enjoying a mini-boom, though official figures convey a weaker picture than the surveys, this is not at the expense of services. The purchasing managers’ index for Britain’s service sector also rose last month. Taking manufacturing, construction and services together, the economy is growing at close to its best levels this year.

The housing market is also firm. The Halifax said prices rose 0.4% last month for an increase of 11.4% on a year ago. House-price inflation has been in double figures since March.

So while the banking system is seizing up, the real economy is doing nicely. That was why the MPC did not seriously contemplate a rate cut last week. But when do these parallel universes come together? When does the shoe drop on the real economy?

The OECD says it will drop on America quite soon. Jean-Philippe Cotis, its chief economist, says downside risks to the global economy have become “more ominous”, and he sees a sharp second-half slowdown in the American economy. France, Germany and Italy will grow more slowly than expected three months ago. But Britain is doing better. The OECD originally expected 2.7% growth this year; now it thinks it will be 3.1%.

This is the Bank’s dilemma. All financial crises are different, and I cannot recall one quite like this. In the nearest parallel, the autumn 1998 crisis brought about by the collapse of the Long Term Capital Management hedge fund, the MPC moved quickly to cut interest rates.

But back then the risks to UK growth were more tangible. Business confidence collapsed, normally a harbinger of recession. Oil prices were $11 a barrel rather than in the mid$70s. The rate cuts were from a high level of 7.5%.

The Bank will not want to go down that road again until it is sure the shoe is going to drop on the economy. “It is too soon to tell how far the disruption in financial markets will impair the availability of credit to companies and households,” it said last week.

There will undoubtedly be some effect on Britain from slower global growth, and the tougher credit conditions (and higher savings rates) that amount to a further tightening of monetary policy. But the MPC will need to be convinced that this goes significantly beyond the UK economic slowdown it was looking for anyway. By then, of course, it could be too late.

PS: George Osborne is a bright young man with a sharp wit, which he has used effectively against Gordon Brown. But is he promising things he cannot deliver?

Last week, to head off the charge that Tories would cut public services, he pledged to match Labour’s spending plans through to 2011, with increases of 2% a year in real terms. This is similar to Labour’s pledge 10 years ago.

Then, Brown and Tony Blair promised to stick to Ken Clarke’s tough Tory spending plans, and did. Labour’s plans for the next few years are not quite as tough as back then but represent a significant slowdown after the splurge.

But do they, as Osborne suggests, “create the headroom for sustainably lower taxes”? Brown is imposing lower limits on spending not because of a Damascene conversion to small government but to stop taxes rising further. As it is, government receipts will rise from 39.6% of gross domestic product to 40.4% in 2008-9, before levelling off.

Even then, according to the Institute for Fiscal Studies, it will be a close-run thing when it comes to whether the Treasury will meet its fiscal rules. One, the sustainable investment rule of keeping government debt below 40% of GDP, looks particularly vulnerable.

So talk of lower taxes looks premature. Unless, of course, Alistair Darling decides to help out his opponent in this autumn’s prebudget report by rewriting the fiscal rules.

From the The Sunday Times, September 9 2007



I quote from one of your other pieces in the Sunday Times:

"... He also believes it is not the Bank’s job to protect “unwise lenders from the consequences of their past decisions”. ...."

The robust state of the manufacturing and other "real economy" is great news. And I hope it can successfully take the baton from asset price inflation and mortgage equity withdrawal as the driver of our economy. It is just a shame that we have had to go through the MEW phase in the first place, but I guess it did avoid deflation, so was the lesser of two evils.


Posted by: Nick Thorne at September 9, 2007 10:25 AM

Yes, it is good, but it is also a mistake to think that the economy has been driven by mortgage equity withdrawal and asset price inflation. Most MEW is saved, and 90% of consumer spending in the past decade has been financed out of real income growth, not debt.

Posted by: David Smith at September 9, 2007 11:38 AM

Nice piece, but you missed out on the big story which is the £70bn of commercial paper due in the next 10 days, which the Telegraph has got some good coverage of. That's your "smoking gun" explanation of why banks won't lend to each other - they know they're going to need the cash to cover their losses on ABCP.

Also, lots of talk about the MPC, but the MPC is becoming less and less relavant to the economy by the day at the moment isn't it.

Posted by: Minh at September 9, 2007 01:04 PM

Sorry David, just seen your other piece in on the Times website, looks like you had it covered all along. :)

Posted by: Minh at September 9, 2007 01:42 PM

Wouldn't taxation on savings interest make you worse off than if you kept the mortgage low ? Or is this a different sort of savings ? Say an emergency fund to be dipped into if needed, rather than as an investment decision.
Also, if MEW accounts for 10% of consumer spending, that means we are 10% higher than we would otherwise be, which is 3 years at 3.3% growth. But I could be wrong !

Posted by: Nick Thorne at September 10, 2007 07:44 AM

I am also confused by David's info. The idea that most MEW is saved seems strange: As Nick points out, you would need to get a post tax RoR higher than the IR, which is impossible without accepting high levels of risk.

So, David must be refering to MEW which is then used to purchase BTL property here or in the costas (or Bulgaria, or wherever). This is what he, and the statisticians must mean by 'saving'.

But, to classify this as 'saving' is a misnomer. This is wild speculation. It is a gamble. In the UK the PE on BTL property is 30+. It's not saving, it's not a yield play, it's speculation. The costas are crashing. Bulgaria is a ponzi scheme. If this is categorised as 'saving', then David is abslutely correct, and most MEW is 'saved'.

Funny kind of saving though. Would it also be classed as savings if you bought sub-prime CDOs with it at marked to model price I wonder?

Posted by: T Gumbrell at September 10, 2007 09:26 AM

In response to Nick's first point, I'm not sure I understand it. Are you saying that savings interest should not be taxed to encourage more saving? If so, I have some sympathy with that.

On mortgage equity withdrawal, there's no need for convoluted theories about Bulgarian property or buy-to-let, though I appreciate that some people love this kind of thing, as they love the idea of UFOs or Diana conspiracies. Most mortgage equity withdrawal occurs where older people are trading down in the housing market or leaving it altogether, for example to moved into residential care. They don't then blow the proceeds on a new Ferrari. The Bank has done quite a lot of work on this. Here's link to a paper last year:

And the argument was summarised in an earlier 2003 paper:

"This article examines data from the 2003 Survey of English Housing (SEH) in order to shed light on the link between gross equity withdrawal and spending. Our analysis suggests that the bulk of gross withdrawals is not consumed in the near term. Those who sell a property without purchasing another one and those who trade down are more likely to pay off debt or save withdrawn equity than spend the proceeds. Remortgagors and those who obtain further secured advances are likely to spend the equity, but we estimate that their equity constitutes only about a quarter of total gross withdrawals. Of those who spend equity, financing home improvements rather than purchasing consumer goods appears to be the most important use of funds. That is consistent with the relatively weak relationship between consumption and mortgage equity withdrawal recently observed in aggregate data."

Posted by: David Smith at September 10, 2007 09:42 AM

Aha, I see, my view of MEW was too narrow. I was only considering the 25% who use MEW to finance spending/DIY.

As you say, downsizing and retirement funding MEW is probably trickled into the economy at a fairly slow rate.

So that leaves say 2.2% (25% of the 10% total MEW plus a bit for slow release MEW, minus a bit because MEW won't dry up completely) of the economy financed by MEW, which is still significant when overall growth is about that number.
But does illustrate that a slowdown in MEW will not in itself cause economic "Armageddon".

I'll have to check through your linked report later.

Posted by: Nick Thorne at September 10, 2007 11:22 AM

My understanding of MEW was also the narrower one, hence the difference in thinking.

I will need to read the report, but the conclusion about how MEW is used I find very hard to swallow.

If the deposit monies for BTL purchases are not coming out of MEW, then where are they coming from? Cash in bank accounts that has been diligently saved from income? I find it hard to believe that the the BTL boom was spawned through the use of traditional savings given the very low savings rate in the UK. Is this what you think?

Posted by: T Gumbrell at September 10, 2007 12:07 PM

In terms of consumtion and GDP, I would echow Nick Thorne's repsonse, 25% of MEW delivered over to consumption is a big deal att the margin, especially when we are dealing with GDP growth rates of around 2%.

Furthermore, David, you stated above that 90% of consumption has been paid for through income growth, impying that 10% is through debt. 10% is not a small figure, especially at the margin.

Posted by: T Gumbrell at September 10, 2007 12:14 PM

The economic usage of 'saving' can be a little unintuitive. Debt repayments also count as saving so the 'Shark Finance' version involves running up large unsecured debts such as credit cards, personal loans, then remortgaging to provide cash to pay off the debts at very high interest rates and penalties. The debt repayment provided by the remortgage counts as saving in this context.

Posted by: paulbiv at September 10, 2007 12:56 PM

Paul, good point. In response to earlier comments, many people throw around the idea of a "debt-financed consumer boom". The correct description is that it has been overwhelmingly an income-financed consumer boom.

As for buy-to-let investors, you can't try and devise a macroeconomic explanation for microeconomic behaviour. Buy-to-let landlords have got their deposits from a variety of sources - selling other businesses, switching from other investments, City bonuses, etc. Some people back into buy to let, as when a couple - each of whom owned a flat or house - get together but don't sell the "spare" property.

Posted by: David Smith at September 10, 2007 07:44 PM

David - with respect, I think you may have misunderstood paulbiv's point; alternatively I must have done!

What paulbiv said (as I read it) was that MEW is classifed as 'saving' when it is used to pay of credit card and loan debt. Given that credit card and loan debt are mainly used to fund consumption, it follows that paulbiv infact made the point that MEW used for consumption is frequently classified as having been 'saved'. If this is correct then the stats relating to MEW having been 'saved' are extremely dubious.

Implicit in your point about the source of BTL deposit capital is the belief that such money usually does not come from MEW from exisitng property. I think that you are wrong on this point. MEW is frequently used to facilitate the purchase of another (and another, and another) property. It is precisely the method through which large numbers of people have become extremely wealthy over the past seven years without having had a large amount of capital to begin with. I have to admit to being quite surprised at your apparent under-weighting of this process of asset-inflation, and credit-creation in your thinking about Britain's recent economic history. Maybe I have just misunderstood your point.

In relation to the income vs. debt fuelled boom discussion, could you do a back of the fag packet calculation and tell us by how much less the UK economy might have grown over the past 10 years if personal debt had remained constant as a proportion of GDP in that period? I suspect that things would have turned out very differently. In any event, in the absence of the asset price inflation and massive growth in credit, surely incomes would not have grown so much in the first place. I'm not sure that these things can be separated in reality (or in a model for that matter).

Posted by: T Gumbrell at September 10, 2007 11:23 PM

Hi T

By Definintion MEW (or as it is now correctly called HEW, Housing equity withdrawal), can't be used to fund BTL deposit

HEW is money withdrawn from the housing market by way of a mortgage (Please note it doesn't matter who takes out the mortgage). Therefore taking money out of your house and then putting it into another is a 0 sum, and isn't HEW.

Posted by: kingofnowhere at September 11, 2007 09:47 AM

Paul can speak for himself but while it is true that the saving ratio is a net figure; true saving as a proportion of income being much higher than the numbers we get for the saving ratio, but being offset by borrowing. Debt repayment is saving. I find it hard to see circumstances in which what is counted as saving is really consumption. Kingofnowhere makes the killer point about MEW/HEW and the housing market. As to what the economy would have been like in the absence of the rise in house prices - it would have been different but it is impossible to say that it would definitely have been weaker.

Posted by: David Smith at September 11, 2007 10:16 AM

It's all a question of timing. I don't think many people remortgage directly to fund consumption. I strongly feel the common pattern is for the consumption to come first, financed by credit cards and unsecured loans, followed by remortgage to repay debts.

Of course, if people believe that this pattern can be repeated on the back of continuing rises in house prices and competition for low-start mortgages, then consumption can be at a higher level than indicated by income alone.

The question is how one measures the extent to which MEW takes place for this purpose as opposed to others.

Posted by: paulbiv at September 11, 2007 12:45 PM

1 - MEW, savings and consumption -

OK, so when I MEW release to pay off a loan, that counts as having 'saved' money on the MEW stats. I understand that this must be the case in order to keep the over-all debt figures in balance, BUT hey, doesn't this make those statistics a little misleading?

25% of MEW is used for consumption, the rest is 'saved', where saving is defined as paying off a credit card or loan debt that was probably used to fund consumption!

Illustration -
So, take your typical naughties Brit, who runs up £10K pa debt on her cards every year knowing that her house always, forever, and conveniently increases in value such that she can MEW £10K at the end of each year to clear the debt. The national accounting stats show the national debt burden increasing by £10K per year, it doesn't matter if it is MEW or credit cards BUT what do the MEW stats show?

The MEW stats show that this young lady MEWs to save £10K every year! That's right, she doesn't MEW to consume, she MEWs to save!

Every year she repeats the process, she uses cards to fund consumption above income, and pays them off at the end of the year when she MEWs again. This makes perfect sense, since she would not want to MEW £10K, put it in the bank, and spend it gradually over the year since she would be losing money on the interest differential, and she's not sure just how many pairs of shoes she's going to buy this year. (One MEWs to pay off consumer credit on an ad hoc basis, one does not normally MEW to spend immediately (with exceptions like cars)).

If this example does not need to be corrected, then I think it illustrates that the link between MEW and consumption is far stronger than David would have us believe, and the stats used are misleading.

I'm looking forward to being knocked down wit hwords or affirmed with silence.

Posted by: T Gumbrell at September 11, 2007 01:12 PM


David said the below....

"It [BOE] increased the supply of liquidity to the markets and said it was ready to give more – an extra £4.4 billion for each of the next three weeks"

Does this mean, it printed more money or lent on favourable terms or something else?

Posted by: ScribbleSheet at September 11, 2007 01:43 PM

AFAIK (as an economics lay person), the BoE is being "lender of last resort" which means extending loans at a punitive rate (1% above base) to insitutions that can provide good quality collateral.
If used, the £4.4bn will be used for loans that must be paid back, so will not cause inflation.
The aim is to stop banks going insolvent due to periods of withdrawal of credit from the normal sources due to exceptional circumstances. Thereby preventing overspill into the wider economy occuring during the period of limited credit.

Posted by: Nick Thorne at September 11, 2007 04:53 PM

T Gumbrell, you're showing an uncanny knack for getting hold of the wrong end of the stick. As I said about 12 entries ago, 75% of MEW is saved or used to pay off (mortgage) debt as people trade down. This has nothing to do with remortgaging, and does not involve remortgaging.
This leaves 25% that is used for consumption, but much of this is for capital spending on houses, notably home improvements. That 25% includes the phenomenon that Paul refers to. End of story. Please don't respond because it is very tiresome.

Posted by: David Smith at September 11, 2007 05:22 PM

people MEW to pay off mortgages?

lol, dont buy it myself, but nice try.

Posted by: Dave at September 11, 2007 07:43 PM


OK example of MEW which pays off a mortgage

If someone retires, and moves from a house valued at £500,000 with £250,000 mortgage, to a house worth £250,000 with no mortgage,

The person buying it takes out £500,000 mortgage

Therefore this transaction overall creates MEW of £250,000
And the people retiring have paid off their mortgage

Other examples of MEW

1) Your parents die, and the house is sold for £500,000 and they had no mortgage

The peson buying it raises £400,000 mortgage.

Therefore this transaction has created a MEW of £400,000

2) You sell your house for £250,000 and move into rented. You repay your mortgage of £100,000. The person buying it funds it with a £250,000. Therefore you have a MEW of £150,000

3) The repayment element of mortgages (Not the interest) is negative MEW (Ie money put into the housing market). However when you withdraw this (maybe because you over paid), then this is MEW

4) Someone selling a share of their house for an income ie Equity release for the old, is becoming more popular

What is not MEW

1) Using money raised from one house as a deposit to purchase another. Ie BTL or to children

BTW technically home improvements aren't MEW. If you take money out, and put it back in it is 0. However the BOE do make that point about the original survey....

So there you have it, what is and what is not MEW or HEW

Posted by: Kingofnowhere at September 11, 2007 08:11 PM

It seems simple enough to me. Mortgage equity withdrawal should properly be called housing equity withdrawal, as has been said, because we're talking about housing equity. Older couple has house worth £400k and a £50k mortgage. Downsize to a £250k bungalow on which they choose not to have a mortgage, £150k of housing equity has gone into (a) paying off the mortgage (b) a nest egg for retirement.

Posted by: David Smith at September 11, 2007 08:13 PM

Hi David

This is also worth a read (I'm sure you have already), about why MEW isn't driving a consumer boom.

Posted by: kingofnowhere at September 12, 2007 08:52 AM

in all your examples, the mortgage has been paid off by selling the assets that cover it not by MEW/HEW.

first example from KofN the couple have 250 mortgage/housing equity and still have after.

DS's example, couple have 350 mortgage/housing equity and after have 250 after and 100 savings.

Posted by: dave at September 12, 2007 03:52 PM

No. The couple could have kept a £50k mortgage, thereby leaving themselves with £200k of housing equity in the new property and withdrawing the full £150k. They've chosen to use part of the £150k to pay off their mortgage debt.

Posted by: David Smith at September 12, 2007 04:50 PM