Sunday, May 03, 2009
Lights are flickering at the end of the tunnel
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


After a huge rush of events, from banking convulsions through to the G20 and the budget, things have gone a bit quiet. It could be that nothing is happening, which would be worrying. Or it could just be that nothing bad is happening, which would be more encouraging.

Economists have had to fill in their time guessing at the costs of a swine-flu pandemic. Without wishing anybody ill, the economic effects of the flu should be containable, even if the virus itself is not.

Often these outbreaks prove the old adage that what we most have to fear is fear itself. Andrew Haldane, the Bank of England's executive director for financial stability, drew the interesting comparison in a speech last week between contagious diseases and contagious financial panics.

There were some fascinating facts in Haldane's speech, a couple of which I will share. One concerned the Sars (severe acute respiratory syndrome) outbreak of 2002-3. The death toll from Sars, almost 1,000, was small. But the economic impact, $100 billion in 2003 prices, a slowdown in Asian growth and a collapse in hotel-occupancy rates, was significant, if minor in comparison with recent financial events.

The other was a glimpse into the complexity of some of the financial instruments that have caused havoc over the past couple of years. Straightforward financial derivatives had the virtue of being easily understood. Investors in a standard residential mortgage-backed security a bundle of mortgages needed to read 200 pages of documentation to understand what they were letting themselves in for.

Once the complexity was piled on, however, investors were deprived of any chance of such understanding. Collateralised debt obligations (CDOs) were the most notorious of these more sophisticated instruments. So-called CDO-squared instruments multiplied their original complexity many times over.

The result, said Haldane, was that an investor would have needed to have read over a billion pages of documentation to carry out due diligence on a CDO-squared instrument. None could. None did.

Scientists are better at understanding and controlling the spread of flu viruses than bankers and regulators have been in dealing with financial contagion, though for the moment things seem to be under better control than for some time.

Let us hope so, for it would be a pity if swine flu snuffed out what appear to be hopeful signs that there is a flickering light at the end of the recessionary tunnel.

Economists are sometimes sceptical about consumer-confidence measures. What can consumers know that economists do not? In the past couple of years, however, consumer confidence has tracked the road to recession well.

Confidence began to wobble in the summer of 2007 and dived in the September when there was the run on Northern Rock. It carried on falling until last summer, when the consensus view among economists was that recession was avoidable, diving again during the near meltdown of the global banking system following Lehman Brothers' collapse in September last year.

So we should listen to consumers, and their message, according to the latest GfK NOP consumer-confidence index, prepared on behalf of the European Commission, is that things are starting to look up.

Overall, the index is up 12 points from its low point but still heavily in negative territory. However, components of the index measuring people's expectations for the coming 12 months improved significantly.

People are more optimistic about the outlook for the economy over the coming year than at any time since August 2007, pre-Northern Rock. Their optimism about their personal-financial situation over the next 12 months is at its best since the spring of last year, before the September-October banking convulsions.

This was not the only encouraging indicator. The CBI said that more retailers reported a rise in sales in April than experienced a fall. The positive balance, 3%, was the first for 13 months and chimed in with other evidence that the high street has avoided Armageddon.

The Nationwide building society, as expected, revealed that the surprise March increase in house prices was not sustained last month. But the reversal was smaller than expected, 0.4%, and did not completely cancel out the previous month's 0.9% rise. We have not seen the end of house- price falls but they are getting smaller. Bank of England data for mortgage approvals showed a 4% rise in March.

Abbey, part of the Santander Group, announced a 25% increase in profits in the first quarter and said the economy and the housing market were performing better than expected. Bank shares have been the driver of the stock market's recovery from the lows of early March.

These are all straws in the wind. Even manufacturing is through the worst of its decline, according to the latest purchasing managers' survey. But how easily could these straws be blown away? Some analysts think you can never have a recovery as long as unemployment is rising, though by that logic no recession would ever end.

The GfK NOP survey, of more than 2,000 people, was carried out before the budget, which did nothing for anybody's confidence. We might yet get panicked by swine flu, though I do not see any sign of it yet. Banking woes could re-emerge on a large scale, though recovery is at least as important to restoring banking to health as banking is to enabling recovery.

Much of the evidence now is consistent with last autumn's shock gradually abating in its impact. Businesses are starting to make decisions.

It does not mean the recession is over but it does mean we can begin to contemplate life beyond it. There is a light at the end of the tunnel.

PS: A few days ago I sat in on a meeting of the shadow monetary policy committee (MPC) at the Institute of Economic Affairs, the results of which are published this week.

These are strange days for monetary policy. Interest rates are pretty much as low as they can go and the Bank of England has embarked on quantitative easing artificially boosting the money supply by buying financial assets, mainly gilts, from the private sector.

So the shadow MPC says Bank rate should stay at 0.5% this week, it being too early to contemplate a rise. Having backed quantitative easing, which has now been running for a couple of months, it thinks it should continue. The first 75 billion will be completed soon, and the question is whether the Bank decides to carry on with the other 75 billion it has permission to do.

But the shadow MPC also believes the Bank should have an exit strategy ready. Otherwise it will risk allowing inflation back when the economy revives. The Bank's conundrum is that it might want to sell back assets to reverse the policy at the time the markets are suffering indigestion as a result of the government's huge programme of debt issuance.

How will the Bank avoid this? The answer is that it will move first on interest rates perhaps hiking several times before it tries to unwind quantitative easing. Monetary policy has become a two-club operation and interest rates are quicker and easier to swing; 5% is normal for Bank rate, not 0.5%.

Some of the assets it is acquiring, like commercial paper, will quickly mature and present no problem. But the Bank will not want to hold medium-term gilts of five years or more to maturity. So it will dribble them out into the market and almost certainly lose money, selling the gilts for less than it bought them. Let us hope by then the benefits of quantitative easing have been clearly demonstrated.

From The Sunday Times, May 3 2009