Monday, 21 April 2008

Good times, bad times

Perhaps we now live in a much simpler age.

Pick up any newspaper, switch on the TV, or talk amongst friends or colleagues and there is only one serious economic problem facing the UK today – the housing market. To be more specific, how do we avoid a calamitous house price crash?

Can it really be this simple? Go back ten years and the UK faced a host of economic difficulties - competitiveness, exchange rate policy, inflation, unemployment, and labour market reform - just to name a few. Were those problems resolved; leaving us with just one question – how do we sustain long-term price appreciation of one key asset.

No, the problems did not go away. We hid some with some dishonest statistics, we simply ignored others, and even created a few new ones. Therefore, here is my list of the UK’s seven obscured and neglected economic difficulties.

What ever happens to house prices, these little difficulties will still be there making life more miserable than it should be.

1. The current account deficit

As economic problems go, they do not come any bigger than a massive and unsustainable UK external deficit. Last year, the UK imported about 4.2 percent of GDP more than exported. Last year’s deficit was the second highest since 1948.

How did this problem come about? Too much shopping and not enough saving. We can find the counterpart of this deficit in the huge increase in personal sector debt, particularly unsecured debt.

What do we need to do to reduce this huge deficit. we would make a start if we avoided the local shopping centre for a couple of weekends.

2. The net investment position

Unfortunately, our external problems do not end with a large current-account deficit. The UK is also deeply in the red in terms of assets and liabilities. The net investment position is the difference between UK assets owned abroad, and foreign owned UK assets. Last year, this difference amounted to ₤350 billion.

The problem is not about the ownership. Rather, the problem is about the net outflow of payments that such a negative net investment position generates. Each year, foreigners expect a rate of return on their UK assets, while we expect a return on our foreign ones. The difference between these two income flows turns up in the current account.

Previously, the UK had a positive net investment position. This generated a lot of income that helped us finance a large trade deficit. Since we now have fewer assets and more liabilities, that positive income flow has now gone, and our current account position is now a lot weaker.

3. The crashing pound

This problem is a lot more noticeable when on holiday in Europe. Since last August, sterling has depreciated by about 16 percent against the euro. The collapse of sterling threatens to push UK inflation higher, as imports become more expensive.

The rapidly devaluing pound also weakens the attractiveness of the UK as a financial centre. Why would any foreigner buy a UK asset, only to find its value disappearing down a hole? However, we will return to the UK's particular vulnerability to the ebb and flow of money markets later.

4. Inflation

Okay, I will admit that this problem gets a mention about once a month. However, the true extent of UK inflation is hidden by some crafty statistical manipulation.

For many years, the UK had a perfectly reliable measure of inflation - the retail price index (RPI). Over the last 10 years, the Bank of England sidelined this index and replaced it with the consumer price index (CPI).

Guess what. The RPI has consistently shown much higher inflation than the CPI. Over the last couple of years, the RPI regularly recorded an inflation rate of around four to five percent. Meanwhile, the consumer price index increased at a much more modest and politically convenient two to three percent a year.

Therefore, despite what the newspapers might tell us, the UK has a deep-seated and persistent problem with inflation.

5. Low savings rate and the demographic time bomb

No one in the UK saves anymore. To some extent, this is probably a rational, if shortsighted, reaction to high inflation. Why save today when inflation will reduce the purchasing power of savings later.

The low savings rate would not matter too much if the demographic structure of the UK were more stable. There are too many middle-aged single people, and not enough children. Sadly, the UK is, on average, getting older, crinklier and uglier. Within about 15 years, one person in five will be a pensioner. This raises a deeply troubling question; how will pensioners avoid a retirement mired in poverty in the absence of personal savings.

Let us cross off one potential answer straight away. Pensioners in 2025 cannot expect much from the state pension. It simply will not be enough workers around to generate the income to pay for a generous pension.

6. U.K. vulnerability to financial sector shocks

The UK economy is dangerously dependent on just one activity – the money lending business. If financial services were bananas, then the UK would look a lot like a dodgy Central American republic.

Today, about one person in five works in some kind of financial institution. With a credit crunch now in full swing, financial sector activity is slowing quickly. This, alone, might be sufficient to push the UK into recession.

The rapid growth of financial services allowed us to ignore difficulties in other sectors of the economy. The most egregious example is manufacturing, which for the last ten years has been in state of almost constant recession.

7. Unemployment

Are you surprised to see this one on the list? Didn't Gordon Brooon sort this one out with prudence and no more boom and bust.

Like inflation, UK statisticians are adept at hiding protracted and difficult economic problems. The UK has a cleverly disguised unemployment crisis, which disproportionately affects unskilled and poorly educated men. The key statistic is that between 1971 and 2007, the number of economically in active working age men increased by 2.4 million. Today, about 3.2 million working age men have dropped out of the labour market. How do they survive?

Statistically, the government describes these workers as disabled and allows them to survive on incapacity benefits. However, if a little more honesty were applied to this problem, these discouraged and vulnerable people would be properly described as unemployed and added to the regular unemployment statistics.

The irony is that everyone’s obsession with housing prohibits a deeper and more intelligent discussion about the real problems facing United Kingdom. Rather than enjoying ten years of unparalleled economic success, the UK is an undiversified, high inflation, high unemployment economy with a rapidly devaluing exchange rate, a huge current account deficit and a negative net investment position. It is a country without savings, and where large numbers of its citizens are heading towards a retirement mired in poverty.

However, none of that seems to matter so long as house prices keep rising.



According to Don Boudreaux at Cafe Hayek, trade deficits are good.

ghostwriter said...

Bradford and Blingley say that BTL demand is still very strong (FT Alphaville). What on earth is going to stop the insanity?

Vodka drinker said...

Ghostwriter, answer: when there is a run on Bradford and Bingley.

I hear Virgin is sniffing B&B.

Ged said...

Are things that bad in England?

Alice Cook said...
This comment has been removed by the author.
Anonymous said...

What a desperate state of affairs.

Anonymous said...

Good post but make inflation number 1 (over the past twenty five years but about to reverse) and demographics number 2.

I still urge you to read some Ludwig Von Mises to get that inflation=rpi/cpi idea out of your head. So long as people can write sentences like this:

"For many years, the UK had a perfectly reliable measure of inflation - the retail price index"

then inflation will always be the best disguised theft in all of government and banking history.


Mista B said...

I see many similarities between the UK, the US, and Australia. Financial markets have obviously been roiled by the housing problems in the US. But have they discounted a similar problem in the UK and in Australia? Both experienced price appreciation in excess of what occurred in the US. Though I haven't seen figures, neither country of course overbuilt as much as in the US. Nevertheless, since prices went up then so did loans (evidenced by your excellent charts). If we were to enter a recession in at least the developed countries, I'm left wondering what would be the effects on housing, and then banking, were the housing situations in the UK and Australia even to approach what's happening in the States.

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