In August, QE hit the economy

What are UK banks up to? Last month, their cash deposits at the Bank of England fell by 6 percent. In crude cash terms, banks withdrew almost ₤10 billion.

In the previous six months, banks had accumulated huge deposits. This was due to quantitative easing. The BoE was buying up bank holdings of Treasury paper. In return, it paid for this paper by increasing bank deposits held at the Bank of England. This was how the BoE were "printing cash"; it was generating big increases in reserve balances.

In principle, UK banks could have withdrawn that cash and used it to create new credit. However, during the first half of this year, banks preferred to park the money in the vaults of the Bank of England. That all changed in August, when for the first time since QE began, deposits shrank.

There is, of course, no explanation from the BoE about this recent development. The most likely story is that banks are beginning to lend again. The question, however, who are their new customers?

The most recent lending data, which goes up to June, shows that banks have a strong preference for mortgage lending. On a net basis, mortgage lending is still growing, although not at the levels seen during the recent bubble. Corporate lending, on the other hand, was shrinking rapidly. Meanwhile, unsecured consumer credit was rather flat.

Has QE unleashed a new housing bubble? It is early days, but the signs are really bad. The pick up in house prices since QE began has been remarkable. It is likely that house prices will record positive growth this year.

Since QE began, the BoE has pumped in breathtaking amounts of liquidity into the banks. In six short months, the BoE has created around 15 percent of GDP in new cash. That is a lot of spending power to throw into an economy with declining output. So far, that money has been held in the BoE. Now, banks are starting to pump it into the economy. It is highly doubtful that the economy can absorb such a massive increase in liquidity without sparking off a further round of asset inflation and a rising price level.

Can the BoE quickly withdraw this liquidity, should things get out of control? It is going to be really hard. There is only one mechanism; sell the government paper that they have accumulated. If they start to unwind, they are likely to cause a run on UK gilts, and interest rates will spike. This could, of course, push the UK straight back into recession.

So, the UK economy seems to be heading towards one of two extreme outcomes; another bubble or a double dip recession. Moreover, this mess was caused by one bad policy mistake being followed with another.

There are days, when I really wonder if the BoE know what they are doing. Today was one of those days.

The 3 o'clock lunch break

Here is a cracking article from the New York Times. It offers a scathing account of how Mr. Madoff fooled the SEC, who were supposed to be regulating his ponzi scheme.

I particularly liked the idea of a three o'clock lunch break.

Unseasoned investigators from the Securities and Exchange Commission were alternately intimidated and enthralled by a name-dropping, yarn-spinning Bernard L. Madoff as he dodged questions about his financial house of cards, according to a scathing new report on the agency’s repeated failure to uncover the huge investment fraud.

When one of Mr. Madoff’s employees was talking to investigators in 2005, an aide to Mr. Madoff broke up the conversation, explaining that it was time for lunch — at 3 in the afternoon.

More "good news" on housing

It always amazes me how journalists equate house price inflation with good news about the economy. Weren't they paying attention, when half our banking system almost crashed last year? Can they recall the reason why Banks like NRK, RBS and HBOS began to wobble?

From today's Telegraph....

A surge in new buyer inquiries, and rises in mortgage approvals have signalled that conditions have bottomed out.

The most startling trend though has been house prices. Nationwide has reported house price rises in five of the past six months, and is now expecting prices overall in 2009 to rise in the region of 0-5pc.

Rival Halifax has reported fewer rises – two out of the last four months – but is expected by economists to say this week that house prices rose again in August.

So undeniably the picture is looking rosier for the housing market, and house prices are likely to continue to stabilise for the rest of this year and into 2010.

But the prices we have seen over the past six months do not necessarily signal the beginning of a smooth or strong recovery, and risks remain which could threaten to derail recovery in the market where the recession began.

The Wilson's sell up

The King and Queen of Buy to Let are selling up. Fergus and Judith Wilson have put up their 700 properties for sale, hoping to pull out about £70 million, once they have paid off the loans used to accumulate their little property empire.

The former comprehensive school teachers had built up their massive portfolio during the bubble years, when credit was easy and house prices were inflating. However, since property prices have crashed, the couple have seen their net worth fall by more than half; such is the magic of leverage.

However, I wonder what the Wilsons will do with their cash once they have offloaded their tenants. Will they put it in a bank and watch it slowing whittle away once quantitative easing feeds through into higher inflation? Goverment bonds might be another money losing alternative. Equities? Off shore, on shore?

Whatever the decision, the Wilsons don't seem to be all that confident that house prices will continue to go up. If they did, they wouldn't be selling up.

The one thing you should know about inflation

In the UK, prices always increase.

This chart the price level for goods and services between 1910-2007. During that period prices increase by over 8,000 percent. Through peace and war, recessions, depressions and booms, prices go up. There may have been the odd year of low inflation, but the long run trend is undeniable.

Prices keep going up; but you knew this already. You didn't need of one of Alice's charts to tell you that.

See how the Bank of England has clobbered savers

There is one place where the Bank of England have successfully engineered an interest rate cut - saving deposits.

Since the crisis, rates have fallen from around 5.5 percent to just a little over 2 percent. Banks have been able to reduce their funding costs from deposits by around 350 basis points. Since they haven't cut their lending rates, that rate reduction has gone into boosting bank profits.

There is a stark message for savers from this chart You are being made to pay for the bubble. Banks are covering up their losses from those huge defaulting mortgages by making savers pay through low interest rates on their deposits.

This is a crude redistribution income away from prudent savers to reckless speculators. Moreover, it was the unelected and undemocratic members of "independent" monetary policy committee of the Bank of England who arranged for this scandalous bailout.

Corporate credit crunch

It is a simple story. During the second quarter, banks lent out ₤27 billion, and received loan repayments of ₤37 billion. In other words, banks squeezed out ₤10 billion of cash from UK firms.

The house price guarantee

It is painful admission, but UK house prices are beginning to recover. In fact, the monthly increases look very much like those recorded during the bubble years. If present trends continue, then within about 15 months, the UK housing market will have recaptured all the losses recorded since October 2007.

The bubble might be back, but its return is due to the implicit guarantee that the Bank of England and the Treasury have put in place as a response to the financial crisis. The government has given home owners now have an implicit insurance policy that the taxpayer will make up any losses on property speculation. It was a guarantee that was easily granted, and will prove virtually impossible to remove.

With each passing price increase, confidence in this guarantee will grow, and as it does, more and more speculators will try to take advantage of it. With the Bank of England pursuing their extraordinary policies of near zero rates and cash creation, everything is primed for a renewed round of speculation.

It is tempting to think that within a few years time, that another financial crisis, similar to the recent one will take place, with its dramatic bank failures and dropping asset prices. However, I see another scenario. The UK will drift into an extended period of increased government intervention, stagnant growth, and asset inflation. The state and the financial system are welded together, the interests of finance dominating the policy stance of the government.

In reality, neither the Bank of England nor the Treasury have any clue how to disentange the financial system from the taxpayer. They have no idea how to remove the tangled web of guarantees, liquidity support and capital injections.

Since they don't have an effective exit strategy, the support will continue indefinitely. Just watch what happens next to house prices.

Socially useless, privately useful.

Earlier this week, Lord Turner described much of our banking sector's activities as "socially useless". Well, if much of banking provides no value to society, why do bankers bother? The reason is simple, industry insiders are using these "socially useless" activities to rip off shareholders and savers.

Whatever bankers might say, running a bank is a straightforward business. A bank makes loans, and receives interest. It also provides non-lending services, such as money transfers, exchange rate sales, for which it receives fees. So long as a bank lends to firms and individuals who can pay back the loans, then the cash just rolls in.

Once the cash floods into the bank, it needs to be distributed. Some of it needs to go on running costs. Of course, the government needs their cut; a modest amount of tax needs to be paid. The rest goes to either the staff, the shareholders, or to depositors.

For the jokers who run banks, the question is simple; how do we get to keep as much of the residual profits without passing it on as interest payments to depositors or alienating the shareholders?

The answer is to generate a huge quantity of useless financial transactions which can be passed off as risk management techniques. These transactions, which are typically described as derivatives, generates huge bonuses for the staff and neatly redistributes income away from shareholders and depositors.

So, Lord Turner is right when he says that much of banking is socially useless. However, for bank staff, it is privately very useful. It keeps the profits of banking in the pockets of bankers at the expense of the rest of us.