Monday, 14 February 2011

How cheap dresses and fancy shoes led to the financial crisis

Fashion has never been cheaper.

Since 2000, the ratio of clothes and footwear prices to hourly earnings fell by almost 60 percent. Around half of that decline was due to the direct effects of lower prices; the other half came from higher nominal wages.

This chart illustrates this spectacular fall in the real price of clothing. It also demonstrates the extraordinary structural change that has occurred in the world economy over the last 10 years. There was a time, and it wasn't so long ago, that Britain had a textile industry. That industry has all but disappeared. Instead, all our clothes are produced overseas, mostly in East Asia, particularly in China.

This chart doesn't just highlight the disappearance of a single British industry and the rise of China as an economic superpower. It also explains how the Bank of England made some profound errors in the conduct of monetary policy. The bank wasn't looking too closely at the sudden profusion of style around Threadneedle street or the meteoric rise of Jimmy Choo. If they had noticed, they might have avoided the greatest economic and financial disaster for generations.

As clothing and footwear prices fell, it should have provided powerful downward pressure on the overall price level. Yet throughout the last decade, consumer prices continued to increase.

Until 2006, that increase was around 2 percent a year. Although this inflation rate doesn't sound too serious, it obscured huge shifts in relative prices. If clothes prices were falling sharply, other items had to be going up in order for the overall inflation rate to be two percent. In reality, cheap Chinese imports were hiding a lot of inflation.

Low headline inflation lulled the Bank of England into a false sense of security. It chose to ignore the fact that cheaper imports were distorting true underlying inflationary dynamics. Since the headline inflation rate was within its mandated target of two percent, all was well with the world. Therefore, the only sensible thing to do was to reduce interest rates to historically low levels.

This provoked a borrowing frenzy. The primary destination for cheap credit was the housing market. The Bank of England couldn't fail to notice the double digit increase in house prices. However, it argued that it wasn't the job of a central bank to target asset prices. The CPI was the thing that mattered, and that was under control.

Despite this neat excuse, the borrowing frenzy wasn't just confined to the bubblicious real estate sector. Lower interest rates also encouraged households to fund consumption expenditure with a huge increase in personal debt. Flat screen TVs, new cars, home extensions, and extravagant holidays to Asia were all funded by cheap loans from high street banks. Behind all this debt accumulation was the Bank of England, with its low interest rates, and a belief that inflation was under control.

Then, it all fell apart. There is no need to recycle the sequence of events that led to the financial crisis. It is suffice to say that from 2007 onwards, banks failed and households either could not or would not continue borrowing to finance consumption. Aggregage demand crashed, and GDP fell through the floor, taking a sizable chunk of tax revenues with it.

As the crisis unfolded, the Bank of England impotently tried to revive the economy with lower interest rates. Despite the dramatic cuts in the bank rate, the UK economy dived into the deepest recession since the war. The Bank of England was also suckered into resuscitating the banks, who quickly sucked in huge amounts of taxpayer’s money. Before you could say "Clements Ribeiro makes nicer dresses than Georges Chakra" every major economic indicator was pointing in the wrong direction.

What was it that drove Britain into this sorry mess? Superficially, it looks like interest rates. Search a little deeper and we see that for 10 years the Bank of England ignored the fact that clothing and footwear prices were falling in absolute terms. Instead, they focused on the aggregate price index and an inflation target that was almost certainly too high. This negligence gave them the justification for excessively low interest rates.

This chart has a twist. Since the beginning of 2009, clothing and footwear prices are no longer falling. In fact, over the last year, clothes and footwear prices have increased by two percent. While this is lower than the overall level of inflation, it points out that the Bank of England can no longer rely on low wages in China to keep UK inflation down.

Those days are over.


Roy said...

Were these cheap prices reflected on your own wardrobe Alice.

droog said...

You've mentioned before that England's strong policy

droog said...

(please delete previous comment)

I think you've mentioned before that England's strong currency policy has chronically favoured banks at the expense of manufacturing. Do you think that weakening the currency would be needed here and that it could be introduced sensibly? I lean towards thinking it would help except I can't grasp the repercussions of such a dramatic change across an economy that relies on imports so much.

GeneGenie said...

Nice analysis Alice, this and a previous post Looking through inflation. I've never been happy with CPI as a measure personally, not just because it stripped out house prices (which seemed strange) but because it tries to simplify a range of price movements into one headline figure. Which means, as you point out, that strong downward pressures can disguise strong upward pressures (and vice versa). As a model it is hopeless, but I think "they" felt that it was easy to explain to the public, whereas a more sophisticated model would not. The question is, what would be a more suitable inflation model, and how would you choose a target for it?

james c said...

It would help if you gave some idea of the impact of falling Chinese prices on UK inflation. My guess would be 0.5%.