Sunday, December 23, 2007
Cheer up, things aren't that bad
Posted by David Smith at 09:00 AM


How much more gloom can you take? How much worse can it get? Bad news sells, so perhaps I should be laying it on with a trowel, frightening you into submission well before you get to the end of this piece.

Not only do we have the credit crisis but a record balance-of- payments deficit, the budget deficit is overshooting and the pound has fallen. Even the normally staid monetary policy committee (MPC) has warned that a "substantial loosening" big interest-rate cuts might be needed.

David Owen, an economist with Dresdner Kleinwort, thinks that with the latest data there is now a 50:50 chance of a "technical recession" next year two consecutive quarters of declining gross-domestic product. That has not happened for 16 years.

Perhaps, however, it is time to take a more optimistic view, this being the season to be cheerful. Gordon Brown and Alistair Darling are as confident in private as they are in public that Britain's economy is strong enough to pull through this. And, while it is easy to see the prime minister and chancellor's optimism as self-serving they will suffer most if things turn out badly they have some support on their side.

Every month the Treasury puts together a compilation of independent forecasts. The latest, published a few days ago, shows economists expect a slowdown but not a recession.

Four months after the credit crisis broke, the average growth forecast for 2008 is 1.9%. That is slow but not painfully so, and slightly better than 2005, when Britain managed only 1.8% growth.

True, there is one forecast of outright recession, with Peter Warburton of Economic Perspectives expecting the economy to contract by 0.1%. He, however, is balanced by the optimists at, who predict 3% growth. Most forecasts are clustered around 2%.

There are, of course, any number of jokes about economic forecasters, sometimes involving unfavourable comparisons with meteorologists, but they will have collectively made a huge error if the economy were to be badly derailed next year.

Britain's long run of growth, stretching back to April-June of 1992, represents a lot of momentum. Annual growth in the third quarter of this year was a buoyant 3.3%, and more if you believe the Bank of England, which thinks the official figures understate it. The brakes may now be on, particularly because of the credit crisis, but this is an economy that will take a bit of stopping.

Related to this, the labour market remains very healthy. Darling and Brown were guilty of opportunism in citing the unemployment claimant count, now at a 32-year low of 813,000, or 2.5% of the workforce. The government's preferred measure (or at least it used to be) has unemployment at 1.64m, or 5.3%.

Even so, unemployment has been falling and employment is a record 29.3m, up by 226,000 over the past year, with little or no help from the public sector. Jobs growth will soften soon but will do so from a very strong position.

The labour market is also relevant to the current benign inflation position, pay growth having remained subdued in the face of provocation. Last week's figures, showing consumer-price inflation steady at 2.1% in November, and slight rises in both RPI (retail prices index) measures, were better than expected.

They show the main inflation impetus is coming from rising energy and food prices, not generalised inflationary pressures. Inflation is still inflation, and the prospect is of some rise in the short term. But the broad picture we have is that upward pressures from the commodity markets are being offset by price cuts elsewhere. Retailers are discounting deeply.

Another big positive, for me, was last week's minutes from the MPC and the news of a 9-0 vote to cut Bank rate earlier this month. The lesson of the past 10 years has been that when the committee has been both flexible and united, it has usually done the right thing. That was the case in the autumn of 1998, when a different kind of financial crisis hit global financial markets. It was also true after the September 11 attacks on America.

There is an issue of whether the Bank can wrest control of interest rates back from the markets, the credit crisis and the scramble for liquidity having temporarily shifted the relationship between what the MPC does and the various Libor (London interbank-offered rate) maturities. But the evidence on this too has been encouraging in recent days, following concerted liquidity injections by central banks, including the Bank of England.

I am not pretending everything is rosy. The "twin deficits" budget and current account need fixing. Though I shall hazard a guess in two weeks' time, nobody can tell exactly how the credit crisis will pan out, how long it will last, and how permanent will be the change in lending behaviour.

But too many people use the excuse of the credit crisis to throw the baby out with the bathwater. If you believe there is nothing else to the economic success of the past 15 years than rising debt and a big increase in house prices, fine, but it is hard to substantiate that with serious analysis.

If you believe that a big, 10%-15% fall in house prices (which I don't expect) would take us back to the negative equity of the early 1990s, and leave banks with dodgy mortgage books, fine, but it is not true. As Goldman Sachs points out, housing turnover in the final phase of the boom was 40% lower than in the late 1980s. Loan-to-value ratios have been kept under control, so mortgage books are insulated from quite a big fall in prices.

It is possible, indeed, that the impact of the credit crisis will be beneficial, removing some of the froth and encouraging more responsible behaviour in future.

A complete collapse in business and consumer confidence and a self-feeding downturn is the gloomy alternative. Britain's consumers and businesses are, however, usually made of sterner stuff than that. Unless this is the start of a never-ending credit crunch, we should temper some of the gloom with a bit of optimism.

PS: The economy may rise and fall but some traditions have to be maintained. I am talking, of course, about the annual Economic Outlook Christmas quiz. I can't quite match last year's triumph the opening lines of pop songs with economics or money as their theme (though I have a couple of those).

There are 10 questions, and a choice of tie-breakers. The results will be announced in a fortnight and there will be prizes books also with an economics or money theme for the best two entries. Here goes:

Q1. Milton Keynes was named after the 20th century's most distinguished economists, Milton Friedman and John Maynard Keynes. True or false? Q2. The Bank of England was founded by a Scot. True or false? Q3. The Bank's monetary policy committee has nine members. What is the smallest number to have voted on an interest-rate decision five, six, seven or eight? Q4. Alan Greenspan showed youthful prowess on which musical instrument? Q5. Ben Bernanke, his successor at the Federal Reserve, is an expert on which period of American economic history?

Now those song lyrics. Think money and economics to name the songs: Q6. ".*.*. there is a barber showing photographs." Q7. "Our lips shouldn't touch". And finally, on films: Q8. Two Clint Eastwood spaghetti westerns. Q9. A film featuring a bank run starring James Stewart. Q10. A film with Eddie Murphy about commodity traders.

There is, as I say, a choice of tie-breakers. One is to come up with a better name for the credit crisis, which I am a bit tired of. The other is a new name for Northern Rock. Good luck.

From The Sunday Times, December 23 2007


The supply of housing is price inelastic in the UK for fairly obvious reasons. Therefore, even a small decrease in demand can have a pronounced effect on market price. The bulk of houses bought in the UK are financed using a mortgage, therefore, the availability of credit is probably the most important factor that affects the level of effective demand for property in the UK.

There is considerable pent up demand for housing in the UK from potential first time buyers. There are also still those that aspire to a BTL portfolio. And then there's immigration. However, these factors affect potential demand (demand that is not backed up by an ability to pay), not effective demand (demand that is backed up by money). When making predictions about market price only effective demand is relevant. David, as you know market price is a function of the balance between effective demand and market supply, not potential demand versus market supply. Only demand that is backed up by money can affect market price.

Here's my point. UK house prices currently reflect the ability to buy at 5* salaries (at least), 125% LTV, 30 year terms. Lending standards have become more relaxed over the last 10 years. When combined with the price inelastic supply these increases in effective demand have resulted in the spectacular boom in UK house prices. If there is a credit crunch and lending rules revert back to 3* salary maximum, 90% LTV etc, effective demand will crash and with it house prices. It all depends on how desperate the central banks are to keep the credit bubble inflated. If they carry on injecting massive amounts of liquidity there may not be a fully fledged credit crunch and house prices might not crash. However, if commercial banks are forced to tighten up their lending to refinance their balance sheets then the result could well be a 30% nominal fall in prices. Average household income cannot be more than 40k, multiply that by 3 (assuming that this is the new post-credit crunch multiple) and you'll get the new price of a flat/house bought by a first time buyer

Posted by: Nigel Watson at December 22, 2007 09:40 PM

Tis indeed the season to be jolly. One last party before the long hangover, anybody?

Posted by: Minh at December 22, 2007 10:47 PM

I don't think the BOE and government are on the right course by loosening credit further, just as as real gdp - investment is likely to contract. Thats a recipe for higher inflation as falling production hits more credit.

Every overly expansionist set of policies runs into a bop crisis the last time in the 90s. The pound was devalued so was on a float after a period of inappriopriately low interest rates in the 90s but we still felt pain lasting many years.

Every time we undergo a BOP crisis, credit restriction and domestic demand is curbed.

This governments one plan is that we now have mass immigration creating a pool of unemployment to offset wages rising, but this still does not mean credit will not need to be restricted again. It just means prices will continue to rise without wages rising as anyone can observe.

Does the economy not need to 'rebalance' towards exports - how can this be achieved? It would be interesting to see what you think of the possibilities now we have a far smaller manufacturing sector than in 93 and nearly all growth has been in finance. Perhaps the prospect of competing with europe is not so tough, and the pain of rebalancement quickly over?

Posted by: Tony H at December 24, 2007 01:05 PM

I don't share your optimism. Most people have their eyes fixed on the late 1980s as an example of how things might go wrong but this time round there is an awful sense of the the 1970s about what we are facing today. Then a secondary bank, London and County Securities ran out of cash. The Bank of England also stepped in to ensure the security of the banking system as a whole but the crucial difference was that they allowed London and County to go to the wall, which is what they should have done in the case of Northern Rock and what the governer wanted to happen at the time.

A tightening of credit was the cause of the problem then as now, only this time it is global rather than simply UK events that caused the problem. Inflation too played its part with oil prices surging whereas today we face not only that but a huge spike in the cost of basic foodstuffs, exacerbated by the current bio-fuels fad. How any economist can today accurately forecast how this will play out in 2008 is beyond my comprehension.

The most worrying aspect of all this however is the recent cut in rates by the Bank of England. This and any others that follow will largely be used by the banks to bolster their beleagured balance sheets, with little real benefit being passed on to the public. May I suggest that you look at an alternative view on the implications of such cuts for the economy in 2008 on titled - Bank of England Rate Cut: Sterling Falls: Inflation Rises.

I may not be an economist but in 35 years of business I have learnt some painful lessons that others seem to have forgotten.

Posted by: figurewizard at December 24, 2007 03:47 PM

A few points to make before I close down for Christmas. Nigel, I think you mean that the supply of new housing is price inelastic. One of the arguments of the bears, of course, is that there will be plenty of supply of existing houses coming on to the market from forced sellers. We're not seeing that yet. I would be worried if average income multiples were five times salary and average loans were 125% of salary. They aren't, of course, in fact they're very close to what you describe as the post credit-crunch level.

Did we have a balance of payments crisis in the 1990s? No, but we had an inflation crisis in the late 1980s. Sterling's post-1992 fall was not inflationary (spare capacity) and did succeed in rebalancing the economy by boosting exports and investment. Sterling then rose, of course, and has been pretty stable since. The aim of rate cuts now is to get investment and exports growing more strongly, and to stop consumer spending slowing too much. Otherwise there would be a risk of an inflation undershoot.

Whether this is the 1970s all over again is interesting but the differences far outweigh any similarities. London and County was a small specialist lender, Northern Rock a large consumer bank. This governor was as keen to save it as anybody else, knowing what the contagion effects would have been. In this he was following the same textbook as his predecessor in the 1970s, who launched the famous lifeboat to prevent further failures and keep struggling institutions afloat.

Posted by: David Smith at December 24, 2007 04:11 PM

Its been an interesting year. But it could have been worse.

Posted by: JohnofScribbleSheet at December 27, 2007 11:07 AM

Things are not that bad ?!!!!
Dear David(with all respect)
For whom are they not so bad? people that have nothing? own nothing? want nothing? need nothing? that leaves just about everybody else well up the creek....NOT?

I do not know from which enchanted world you have descended, but welcome to earth UK. The place where the party is now and the bill put on plastic or whatever. We do this because our government made it so that if we do not continue spending we wont have jobs they wont have tax revenue to squander on their frankly shambolic policies which never pay off.

I am frankly shocked at the ease at which the media(including you)
have rolled over and regurgitated the quite easily revealed claptrap fed to you. The facts are quite clear and concise, try for once to be a real reporter and stick to them. This may make things worse than they are what!

Rome wasn't build in a cerainly almost was destroyed in a day though!. Be truthful and please pull your head out of the sand will you.

Best wishes

Ariks Schickendantz

Posted by: arik schickendantz at December 27, 2007 09:38 PM

Bonkers or not - welcome back!

Posted by: David Smith at December 28, 2007 10:26 AM
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