Sunday, April 20, 2008
Boldly going into uncharted territory
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


Are we, like the Starship Enterprise, boldly going where we have never been before? Could we be approaching the equivalent of the point where Scotty, the engineer, warns that the "ship cannae take it anymore"?

I always hesitate to use the word unprecedented, but there is certainly something very unusual about present circumstances. Stephen Lewis of Insinger de Beaufort is one of the City's veteran economists and likens it to the 1973-4 secondary-banking crisis, but on a global scale.

Back then the Bank of England organised a 1 billion "lifeboat" for the beleaguered banks. Now it is on the brink of announcing a 50 billion rescue, intended to get the markets moving again by taking in some of the banks' mortgage-backed securities in return for more highly-rated gilt-edged stock. Whether there is a Plan B if it doesn't work remains to be seen.

One pattern is fairly constant. The banks overlend during the good times and rein back aggressively during the bad. That was the cause of the secondary- banking crisis and it extended the pain of the recession of the early 1990s, when the high-street banks were brutal in their treatment of small firms and when lenders were too quick to press the repossession button when homeowners fell behind with their payments.

This time the banks can claim that this is not a problem of their making. Unlike many previous crises, it did not arise within Britain. But they were happy to buy collaterised debt obligations and other dodgy assets originating in the American sub-prime market, which their boards did not take the trouble to try to understand.

More than that, there is a lack of remorse on the part of the banks that smacks of arrogance and insensitivity, though we may get a little contrition when RBS announces its rights issue this week. I have not agreed with everything that King has done during the crisis, but I would not blame him if he feels like dangling the bankers upside down from the window of his office until the change falls out of their pockets.

Whatever happens, the quid pro quo for the rescue must be that the banks play their part in stabilising the mortgage market and the wider economy. That means strengthening their capital bases, as RBS is doing. It also means lending feast should not be followed by permanent famine.

Are we in uncharted territory when it comes to the disconnect between the real economy and the financial economy? Last week brought news that the job market remains extraordinarily strong, with a rise of 152,000 in employ- ment in the December-February period. In the past year, employment has climbed by 456,000 to a record 29.51m.

This is another of those figures that, if you averted your eyes from the money markets and the gloomy headlines, you would be thinking described a very powerful boom. There are nearly 700,000 job vacancies, the highest since the current series began in 2001. The unemployment claimant count is at its lowest since June 1975. Confidence among consumers is very low but this, so far at least, reflects fear rather than reality.

Not for the first time, the figures did not get the coverage they deserved, drowned out by modest City job losses, gloom from Britain's chartered surveyors and the "news" that the government's official house-price measure fell in February; it always does. Some even tried to find bad news in the employment figures.

A better point, on the face of it, is that the job market is a lagging indicator and only signals problems when it is too late. In the lead-up to the last recession, however, employment matched the economy stride for stride, slowing in the run-up to the downturn but only falling from mid-1990 onwards, when the recession began.

The Ernst & Young Item Club's new forecast, to be published this week, predicts 1.8% growth this year, in line with the Treasury's estimate, and 1.5% next, below the Treasury. This will lead to a levelling-off in employment growth but only a modest rise in unemployment, it suggests.

The longer the credit crunch persists, of course, the greater the risk to jobs. Some of those directly affected in the financial-services industry and housing-related jobs will feel the pinch first, as Citigroup, UBS and Merrill Lynch are finding. But for the moment the overall job market reassures by its robustness.

Finally, there is always a bit of sport in seeing a prime minister on the rack, particularly one who gave his political opponents such a tough time when he was chan- cellor. There are, however, some strange charges flying around.

One is that under Brown the government bent over backwards to boost the housing market and we are now paying for it. Sorry? Under Brown at the Treasury mortgage-tax relief was abolished and stamp duty raised to punitive levels, particularly on more expensive properties.

If people mean that Labour should have reintroduced credit controls something that would have been condemned as a return to the 1970s and impossible without the reintroduction of exchange controls they should say so. If they mean that the Bank should have kept interest rates at levels that would have given us slower growth, higher unemployment and a big inflation undershoot, that is a pretty strange set of priorities too.

I note that Germany, which did not have a housing or consumer boom, is suffering falling house prices. The Hypoport index for existing home prices is down by 7% on a year ago.

The other bit of nonsense concerns the switch of the inflation target to the consumer-prices index (CPI) five years ago. This, apparently, took the Bank's eye off the ball because CPI, unlike the retail-prices index, does not include a house-price component.

Yes, it was a daft thing to do, because nobody much believes in the CPI. But I cannot pinpoint a single interest-rate decision since then that would have been different had the old target (RPI excluding mortgage-interest payments) remained in place. The Bank is a bit brighter than it is given credit for.

PS: The rise in food and oil prices in recent days to new records partly reflects supply and demand, though I would take issue with the chap writing in the Financial Times who suggested last week that we had hit a peak for world oil production. International Energy Agency figures show that output is up by 2m barrels a day on two years ago and by 4m on four years ago.

Demand pressures, certainly for oil, should ease with the slowing of the global economy. So how come prices are still rising? The answer lies with the new breed of commodity investor, from the hedge funds and investment banks, who has elbowed aside those who traditionally invested in metals, food and energy commodities.

Tens of billions of dollars of new money have been pouring into the markets, driving prices ever higher. The same people who bought you sub-prime crisis and the credit crunch are partly responsible for 1.20-a-litre diesel and food riots in Haiti and Egypt.

It may be that the commodity bulls have got it right and that, aided by the shift into biofuels (which the World Bank is likely to call for a stop to this summer), we are heading into a modern-day, Malthusian nightmare in which the only way is up for prices. But it looks like a spike to me, unless the history of the past 200 years of temporary shortages followed by a supply response is over.

In the meantime, the financial tail wagged by the hedge funds and investment banks in their greedy search for returns will continue to produce nasty economic and social consequences. Making money out of people's desperate shortages of food is obscene, a bit like wartime profiteering. It's enough to turn the prime minister back into a socialist.

From The Sunday Times, April 20 2008