Sunday, December 30, 2007
Rocked by an event that nobody foresaw
Posted by David Smith at 10:00 AM
Category: David Smith's other articles


Never one to pass up the opportunity of employing a useful cliché, I have lost count of the times I have used “a year of two halves” to describe the preceding 12 months. But now, just when I have worn it out, the expression seems more apt than ever.

Cast your mind back to the first half of the year, and the exuberance was tangible. Every day, it seemed, there was a new private-equity deal. The economy was booming and so were house prices. The governor of the Bank of England was forced to write an open letter explaining why inflation had risen above 3%. He and the rest of the monetary policy committee (MPC), desperate to control this bucking bronco of an economy, raised interest rates from 4.5% to 5.75% and promised more. The last of those increases came, appropriately enough, in early July, just after the middle of the year.

Then the wind changed. It was not quite a Michael Fish moment for King, but his insistence on August 8 that there was no international financial crisis was followed on August 9 by the equivalent of a hurricane in the money markets.

Since then, of course, it has been a question of watching and waiting. Most of the economic data, it should be said, have continued on the strong side, including perky figures for November retail sales on both sides of the Atlantic. But the surveys have suggested weaker growth ahead and so has a sharp drop in business and consumer confidence. The housing market has been notably weak and appears to have felt the impact of the credit crunch most intensely, coupled as it was with the introduction of home information packs (Hips).

At first it seemed as though the eye of the storm had passed quickly, and money markets began to return to normal in October. But a second gust followed, to which central banks were obliged to respond.

So who got the economy right? The answer, in important respects, is nobody. There were people who worried about losses on sub-prime lending in the United States. There were those who were concerned that the Bank and other central banks were raising rates more than was necessary. I drew the line at the last of the MPC’s rate hikes.

But nobody, to my knowledge, predicted that the sub-prime crisis would spread as it did, forcing central banks into unprecedented action to support the markets, forcing some of them to reverse previous rate rises and forcing Northern Rock into the unwilling arms of the Bank of England. The story of the economy in 2007 was not in the numbers but in the drama of real-life events.

In terms of the numbers, forecasters were too downbeat about Britain’s growth prospects this year, something to bear in mind perhaps when assessing some of the direr warnings for 2008. Economists did better on inflation, predicting it would get back to 2%, having been above it.

Even so, the consensus was that the Bank would not have to raise rates as much as it did. Most Bank rate forecasts for the year-end were clustered around 5%. Unemployment was expected to rise rather than fall.

The recent bombshell announcement from the Office for National Statistics that the current-account deficit in the third quarter was £20 billion also ruined quite a few forecasts. Although the numbers will probably be revised, it is hard at present to come up with a number of less than £60 billion for the full-year deficit for 2007. That is a lot of red ink, roughly double the average forecast made at the beginning of the year.

It is an ill wind, however, that blows nobody any good. The only economist who got close to my guess for what would happen to the balance of payments deficit was Michael Saunders of Citi, who predicted £56.9 billion.

Saunders, a previous winner of my annual forecasting competition, was also more optimistic than most on growth (2.9%), close on inflation (2%), and predicted a fourth-quarter Bank rate average of 5.4%. The only one he got wrong was unemployment. But a score of 9 out of 10 was a very creditable performance, and he deservedly tops the table again.

Speaking of 2008, he said recently: “The UK has probably been the fastest growing country in the G7 this year but is likely to have the sharpest slowdown among G7 countries in 2008.”

Congratulations also to Peter Spencer at the Ernst & Young Item Club, and to JP Morgan and the others who got close. (For the full table, see the print edition of The Sunday Times).

How did I do? I was a little too low on growth, 2.6%, and thus too high on unemployment, 1m; okay on inflation, 2%, but my prediction of a £40 billion current-account deficit was not gloomy enough. I suggested Bank rate might rise and fall, but to 5.5% and 5% respectively. I would have scored seven out of 10.

I am always accused of being too optimistic about house prices, but this year, as for the past couple of years, the rise exceeded my expectations, certainly in the early part of the year. I thought house prices would rise 5% in 2007 as a whole, with most of the strength concentrated in the first half. That will not be too far out but is probably still a little on the low side.

In looking at the forecasting record for 2007, however, I also have to give a large bouquet to the Treasury. It can never get top marks in my forecasting league table because it does not make predictions of interest rates (because this would be seen as second-guessing the Bank) or unemployment (because it could be politically difficult openly to predict a rise).

But in a year when every independent forecaster was too gloomy about growth, the Treasury’s optimism came good, having the only forecast (2.75% to 3.25%) with a three in front of it. By sticking with its convention of predicting that inflation will always gravitate towards the government’s 2% target, the Treasury got that one right, too.

For 2008 the Treasury is expecting 2% to 2.5% growth and, as before, 2% inflation, on the optimistic side of the consensus. Let us see if its luck lasts. More next week on the 2008 outlook and the chances of a Bank rate cut in January.

PS: I hope that those who have not already done so are beavering away on the Christmas quiz, published here last week, and available online for those who missed it. In the meantime, let me offer you an end-of-year insight into the most popular subjects in this column, as defined by the response from readers.

I have hinted before that readers can be relied on to reply robustly on a range of subjects. Some appear a little taken aback when I respond in similar vein. One of my frustrations is not always being able to respond to the strange criticisms that sometimes appear out there in the zany world of the internet.

Anyway, here are my top 10 reader-response subjects for 2007. 1. House prices – no surprise there. After a period of hibernation, the bears have wandered out of the woods again. 2. Gordon Brown’s economic record. 3. Inflation, and whether you can believe the official figures. 4. Immigration and the economy. 5. The Bank of England and whether it is (a) ignoring the pain out there in the real economy or (b) ignoring its duty to keep inflation under control. 6. Tax and, over the past few weeks, Alistair Darling’s capital-gains-tax reforms. 7. The rise of China and India. 8. Northern Rock. 9. Britain’s gaping trade gap, what it might mean for the pound and the decline of UK manufacturing. 10. Oil prices and “peak” oil.

Keep the responses coming.

From The Sunday Times, December 30 2007


Good article.

Just one comment. The Michael Fish forecast is an urban myth. The infamous clip was filmed some time beforehand. And in it, he is referring to reports of a hurricane in Florida and is reassuring a viewer who was due to holiday there. Unfortunately, following the hurricane in the UK, the clip has been taken out of context.

Merv seems to have suffered a similar fate. As you say David, no-one could have predicted the events of August 9. But just six weeks earlier in his Mansion House speech, Merv made a few prescient remarks:

"The development of complex financial instruments and the spate of loan arrangements without traditional covenants suggest another maxim: be cautious about how much you lend, especially when you know rather little about the activities of the borrower. It may say champagne – AAA – on the label of an increasing number of structured credit instruments. But by the time investors get to what’s left in the bottle, it could taste rather flat. Assessing the effective degree of leverage in an ever-changing financial system is far from straightforward, and the liquidity of the markets in complex instruments, especially in conditions when many players would be trying to reduce the leverage of their portfolios at the same time, is unpredictable. Excessive leverage is the common theme of many financial crises of the past. Are we really so much cleverer than the financiers of the past?"

Posted by: Sell Everything at December 31, 2007 10:16 AM

That's fascinating - I could have sworn that Michael Fish was talking about reports of a hurricane hitting France, not Florida. It appears, too, that we have to take his word for it, no complete video record of his broadcast being available. Spooky - almost like a UFO mystery.

I agree with you about the general warnings about subprime, CDOs, etc. Central banks were, however, happy to merely warn, and regulators were happy to let the markets get on with it.

Posted by: David Smith at December 31, 2007 11:15 AM

Yes you are right. The viewer rang in to say they had reports that it was going to hit the UK.

Posted by: Pete Balchin, Solicitor at January 2, 2008 08:47 AM

"I agree with you about the general warnings about subprime, CDOs, etc. Central banks were, however, happy to merely warn, and regulators were happy to let the markets get on with it."

Yes, I think you're right David. But it's difficult to know exactly what pre-emptive action could've been taken. Regulators could've tightened up, yes. But you wonder whether banks would've circumnavigated these by inventing even more exotic instruments. And central banks? Well, they could've tightened rates more aggressively in an attempt to curtail credit growth, but that would've been risking the health of the wider economy.

Perhaps they could've done something slightly less orthodox. Tinker with capital adequacy ratios maybe? I'd be interested to hear your thoughts.

Posted by: Sell Everything at January 2, 2008 10:18 AM

Hindsight is easy in these matters, so in future regulators will be looking at liquidity as well as solvency and there will be a greater emphasis on international co-operation - both of which should have been in place before. What more could they have done at an earlier stage? Maybe warn a little louder. Maybe lean a little more on the rating agencies. Maybe require institutions to increase their insurance cover. Maybe some of those things Mervyn King told us he wishes he had done. Would it have made a difference? Hard to say.

Posted by: David Smith at January 2, 2008 12:19 PM

In times of easy credit and boom, nothing else matters apart from profit profit profit.

When we do eventually look back at all this mess, it will be the most obvious outcome that anyone could have expected.

Lend lots of money to people who have no money/poor credit? What on earth were they expecting to happen? Interest rates to stay low forever? Economies to not dip causing unemployment?

Profit Profit Profit, that's all that matters.

Posted by: Dan O'Connor at January 2, 2008 04:31 PM

In times of easy credit and boom, nothing else matters apart from profit profit profit.

When we do eventually look back at all this mess, it will be the most obvious outcome that anyone could have expected.

Lend lots of money to people who have no money/poor credit? What on earth were they expecting to happen? Interest rates to stay low forever? Economies to not dip causing unemployment?

Profit Profit Profit, that's all that matters.

Posted by: Dan O'Connor at January 2, 2008 04:32 PM

"But nobody, to my knowledge, predicted that the sub-prime crisis would spread as it did"

Funny how you smacked down a commentator on here back in March for describing the US housing market in freefall caused by subprime rot ("US housing - not dead yet", March 23, 2007). It would seem that some people out there were clearly predicting problems, whether or not you chose to hear them.

You catch a lot of unjustified flack on here, and I don't wish to contribute to that, but saying that nobody foresaw this happening is just a little too far fetched. Plenty of people were shorting Northern Rock prior to August.

Posted by: RichB at January 4, 2008 05:42 PM

If you read again what I said in this piece I conceded that plenty of people were worried about the US subprime crisis - more than I was. What I said is that nobody predicted it would spread to the world's credit markets and then to Northern Rock as it did. If you can find me such a prediction, I'd be glad to see it.

I'd take issue even now with the idea that US house prices nationally are in freefall. We're looking at 12-month national falls of 3%-6%, the latter on the more volatile Case-Shiller series. The OFHEO measure probably will not show a calendar year fall for 2007.

Posted by: David Smith at January 4, 2008 10:29 PM

Umm, okay, go to orNouriel Roubini's blog for a discussion in the first months of this year of how problems in the US sub-prime market would lead to weakness in the banking sector and a lowering of interest rates by the Fed and other central banks. Did they specifically single out Northern Rock? No, but many other people clearly did as their share price was falling for almost 6 months before they went to the Bank of England for a bailout.

And, as for a "freefall", it all depends on how you define it. There are cities in California where prices have declined by almost 30% in a year. The current nationwide declines in the US property market are unprecendented in modern times. 95% of Americans have not seen declines like this in their entire lifetime. For many people that meets the definition of freefall.

(Btw, OFHEO exludes the majority of houses in California from it's calculations because the median price in the state is significantly above OFHEO loan limits.)

Posted by: RichB at January 4, 2008 11:08 PM

I just don't know where you get that from. This is OFHEO's description of the coverage of its index:

"The HPI includes provides indexes for all nine Census Divisions, the 50 states and the District of Columbia, and every Metropolitan Statistical Area (MSA) in the U.S., excluding Puerto Rico. OMB recognizes 363 MSAs, 11 of which are subdivided into a total of 29 Metropolitan Divisions. As noted earlier, OFHEO produces indexes for the Divisions where they are available, in lieu of producing a single index for the MSA. In total, 381 indexes are released: 352 for the MSAs that do not have Metropolitan Divisions and 29 Division indexes. The starting dates for indexes differ and are determined by a minimum transaction threshold; index values are not provided for periods before at least 1,000 transactions have been accumulated."

Case-Shiller is, of course, a more limited index, excluding 13 states entirely from its calculations.

As a matter of interest, which California cities are showing 30% annual average price falls?

Posted by: David Smith at January 5, 2008 10:06 AM


Just to remind you that on 21 August 2007 'This is Money' and other articles stated that an unnamed bank had borrowed £314 million pounds from the BOE.

My response was:

"...I wouldn't think its Northern Rock would it?
Not Northern Rock or if it is I should be surprised.

Only about a month ago they were lending 6 times income. Not that there's a sub prime problem here anyway the Council of Mortgage Lenders tell us there isn't.

- Pete Balchin, Solicitor, Bristol, UK


However it may of course have been any of the Sub Prime lenders that I had been watching for some time. The beneficiary of course may have been Barclays even? Or any of the banks.

I think there is much more to play out here in the Sub Prime debacle, could the economist who predicted that we are at the point where the national anthem has only just finished playing be right?

Posted by: Pete Balchin, Solicitor at January 5, 2008 12:43 PM

It was, of course, Barclays, as reported fully at the time, and this was well after the credit crisis broke out into the open in full fanfare on August 9. Northern Rock's problems lay in the nature of its borrowing, not its lending.

Posted by: David Smith at January 5, 2008 02:18 PM

David, I thought that you would know this, but the OFHEO index only includes houses that have a mortgage purchased by Freddie Mac or Fannie Mae. Those entities are only able to purchase mortgages up to a certain value -- a value that is currently below the median cost of homes in California.

From the OFHEO website:

There are, however, some limits to the coverage of the HPI. The HPI is produced using data on single-family detached properties financed by conforming conventional mortgages purchased by the enterprises. Thus, mortgage transactions on attached and multi-unit properties, properties financed by government insured loans, and properties financed by mortgages exceeding the conforming loan limits determining eligibility for purchase by Freddie Mac or Fannie Mae are excluded.

The figure for 30% decline comes from the California Association of Realtors (the NAR affiliate for the state) and are available on their website. Cities seeing big year over year declines in median price as of November: Brentwood -32%, Inglewood -30%, Pacoima -35%, West Hollywood -35%, Los Banos -29%, Sacramento -21%, North Highlands -38%, Lakeside -40%, Benicia -44%. The NAR methodology has its problems, but these numbers are huge.

Posted by: RichB at January 5, 2008 10:06 PM

It is true that the OFHEO index under-represents properties in high-price areas such as San Francisco for the reasons you state and which are well known but it still has significant coverage in California and broader coverage than Case-Shiller.

I find those NAR figures almost impossible to square with its regional data. They imply that prices must be rising very strongly in other parts of the West.

Posted by: David Smith at January 6, 2008 12:06 AM

Here's a few (California Association of Realtors):

Statewide, the 13* cities and communities with the greatest median home price increases in November 2007 compared with the same period a year ago were: San Juan Capistrano, 42.3 percent; Newport Beach, 31.5 percent; Santa Monica, 29.4 percent; Mountain View, 18 percent; Cupertino, 18 percent; Truckee, 10.2 percent; Redwood City, 9.7 percent; Yorba Linda, 9.6 percent; Santa Barbara, 7.5 percent; Moorpark, 7.2 percent; San Francisco, 7.2 percent; Pasadena, 7.2 percent; and Los Angeles, 5.8 percent.

Posted by: David Smith at January 6, 2008 12:13 AM

If NR's problems lay in it's borrowing. Why could it not simply borrow some more elsewhere? Why did no lender want to lend?

I'd suggest that there were major problems with its lending.

Posted by: Piers Ponsenby-Smythe at January 6, 2008 04:19 PM
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