Clouded Outlook

UK house prices down 16 percent from their peak

2011-12-07T19:56:00.001-08:00

For the last two years, UK house prices have bounced around. One month, they are up; the next they are down. November was a down month, but who knows, January could record an increase.

Overall, house prices are down 16 percent from their summer 2007 peak. Call me Cassandra if you want, but I don't think house prices will recover this side of 2020.

Why the ECB refuses to be a Lender of Last Resort

2011-11-30T18:22:00.000-08:00

Paul De Grauwe

The euro has a matter of weeks to save itself, with several institutions now preparing for its collapse. Given this, why does the ECB still refuse to bail out Europe’s heavily indebted countries? This column provides an explanation. It says that the ECB may well be behaving rationally but adds that such behaviour is also foolish – and dangerous.

A number of analysts are calling for the ECB to act as the lender of last resort in the Eurozone government bond market (see for example Wyplosz 2011). Up to now it has resisted. But why should the ECB refuse to take up the role of last-resort buyer?

A rational, non-dogmatic explanation

Here is a possible explanation that has the merit of being based on rational behaviour. Other explanations that have been popular are based on a belief that the persons deciding about this issue are driven by dogmatic thinking preventing them to see the need to act. This may be the case, but it remains interesting to try to explain the ECB’s behaviour assuming that its decision-makers behave rationally.

When a central bank is called upon to be the lender of last resort it has to evaluate costs and benefits of its actions. Let us rephrase the problem in terms of the costs and benefits of inaction, ie of not providing the last-resort buying service.

Why central banks act as last-resort buyers for banks

Picture central bank facing a banking crisis. (Later we will do the same analysis for the case of the government bond market.)

The cost of inaction arises from the risk that inaction will lead to a collapse of the banking system.
If the latter collapses the central bank will most likely be made responsible.
The benefit of inaction is the avoidance of future moral hazard risk which is beneficial to maintaining a stable banking system in the long run.
When evaluating cost and benefit, the time horizon over which these costs and benefits materialise matters a great deal.

When the central bank faces a banking crisis the cost of inaction is likely to be realised very quickly.
When banks are close to collapsing, the cost of not providing the lender-of-last-resort service is almost instantaneous. This has to do with the fact that the banks’ liabilities typically have very short maturities (demand deposits, interbank deposits).

The benefits of inaction, however, will be realised in the future, possibly far in the future.
It is even likely that only the successors will reap the benefits, and they may not even be aware of this.

Asymmetric timing of costs and benefits

This asymmetry in the timing of the realisation of costs and benefits goes a long way towards explaining why even the most conservative central bank is likely to wish to avoid the immediate cost (collapse of the banking system) even at the cost of foregone future benefits, even if these benefits are very large. This asymmetry explains why the ECB did not hesitate for a moment to provide last-resort buyer support to Eurozone banks in 2008, despite the fact that in doing so it created moral hazard risk in the future.

What about government bond markets?

We can now apply this cost/benefit analysis to the government bond market. Here we have a striking difference with the banking sector. The sovereign debt crisis occurs at a snail’s pace compared to banking crises. When investors sell government bonds and push the interest rate upwards, they affect the cost of borrowing of governments with some delay because the maturity of the bonds is typically of the order of five to seven years. As a result, there is not the imminent threat of a rapid collapse as there is with a banking crisis.

The result is that when the central bank faces a sovereign debt crisis the lack of immediate danger has the effect that a conservative central bank, such as the ECB, will attach more weight on the long-term benefits of reducing moral hazard. The central bank will therefore wait far longer to take action.

Note that this does not mean that moral hazard risk is more important in sovereign bond markets than in the banking sector. Bankers are just as likely to take additional risk when they know that in times of crisis the central bank will provide liquidity, as governments are. In addition, there is no reason to believe that the risks bankers take on is less dangerous than the risk taken on by governments. The only difference is that the imminence of a collapse is higher during a banking crisis than during a sovereign debt crisis. As a result, a central bank is likely to reduce the weight on moral hazard risk.

A forecast of action

The previous analysis leads me to the following forecast.

The ECB will only act when the cost of inaction is immediate and clear.

As a result, the ECB is likely to wait until the sovereign debt crisis has degenerated into a full-scale banking crisis.

There can be little doubt that the sovereign debt crisis will lead to a banking crisis.

The reason is that the continuing decline in the price of sovereign bonds will hammer the banks’ balance sheets to such an extent that the losses become unbearable.

In addition, sovereign debt crises lead to funding problems for banks and a risk of being shut out from the interbank market. Thus there is a moment when the sovereign debt crisis inevitably triggers a banking crisis. This will be the moment when the timing asymmetry between costs and benefits is such that the ECB will see the merits of being a lender of last resort. Only then will the ECB come to action.

Concluding remarks

All this is quite depressing for two reasons.

First, the amount of liquidity the ECB will have to inject in the banking system is likely to be higher than the amount that is necessary to stabilise the government bond markets.

This assertion is based on a simple fact. Total liabilities of the Eurozone banks are more than three times the liabilities of Eurozone governments (De Grauwe 2011).

Second, the banking crisis will also trigger a deep and long-lasting recession (see Reinhart and Rogoff 2009).

All this may in the end endanger the Eurozone itself.

References
De Grauwe, P (2011), “The ECB as a Lender of Last Resort”, VoxEU.org, 18 August.
Reinhart, C and K Rogoff (2009), This Time is Different, Princeton University Press.
Wyplosz, Charles (2011), “An Open Letter to Dr Jens Weidmann”, VoxEU.org, 18 November.

Republished from VoxEU.org

OECD forecast for next year

2011-11-28T19:11:00.001-08:00

The UK is number one.....

2011-11-27T16:11:00.001-08:00

The UK has the highest inflation rate of any major advanced economy.

Should the Bank of England mail everyone a fifty quid bank note?

2011-11-17T20:06:00.001-08:00

The UK economy is barely growing. To stimulate demand, should the Bank of England mail out a voucher worth fifty quid to every citizen of this fair land and tell them to go out and spend it on beer, fags and cheap Chinese electronics? It sounds like a mad idea, but is it any stranger than the Bank of England printing money to buy up goverment debt?

In a recent speech to the Council of Mortgage lenders - Charlie Bean, Deputy Governor for Monetary Policy, Bank of England - seriously discussed the voucher distribution idea:

"Several commentators have suggested that the effectiveness of quantitative easing could be enhanced by spending the newly created money on something other than government debt.

For instance, one idea that has been floated involves sending households a voucher, which could then be spent in the shops and redeemed for cash by the retailer. This may sound like a good idea, as it seems to get the money quickly into action in stimulating demand. Now, such a policy in effect combines an increase in borrowing to finance a temporary increase in income tax allowances with some conventional quantitative easing in which gilts are exchanged for claims on the Bank of England

But economic theory, as well as considerable evidence, suggests that such a temporary increase in disposable income would be likely to be very largely saved. Only households that wish to borrow, but presently cannot, would be likely to increase their spending materially. And making the voucher time-limited would do little to help, as households could always use the voucher instead of the cash they would have spent.

In sum, this hardly seems the most effective way to add additional stimulus."

Charlie thinks that if we received some free money, we wouldn't spend it; we would save it. On this point, he is right. However, Charlie is actually making a deep and fundamental point about fiscal policy and its ability to influence output. If it is true that we would save that spare note gifted from the BoE, it is also true that any temporary tax reduction would also be saved. In fact, any attempt to to use fiscal policy to stimulate the economy by temporarily boosting disposable income is a wasted effort.

Charlie's observation about fiscal policy has further implications. For the last four years, the UK government has issued huge amounts of debt. Since government debt has to be paid off in the future, we all know that taxes will also have to increase in the future. This means that our future disposable income will fall, and since we know we will be poorer, we are spend less now. So, running up large fiscal deficits actually depresses consumption. The conclusion is the same - fiscal stimulus doesn't work.

Mr. Bean doesn't believe in fiscal stimulus but what about quantitative easing? Printing new money doesn't create more output, it only increases the claims on a fixed amount of output. The inevitable consequence of more money will be more inflation, which is exactly what happened after the previous round of quantitative easing. Inflation went up, the economy barely grew, and unemployment remained constant.

Being a central banker Mr. Bean understands the inflationary implications of quantitative easing. Nevertheless, he still thinks borrowers will respond to quantitative easing and spend more. This is because inflation erodes the real value of debt. Inflation makes borrowers permanently better off. However, for those on fixed incomes, and savers with bank deposits, inflation makes them permanently poorer. So, quantitative easing is about robbing savers to placate debtors. This is hardly a strategy for sustained economic growth.

There is only one way that the UK can recover from this crisis. Tighten monetary policy to restore positive real interest rates. Balance the budget and pay off government debt. Reduce the size of the government and generate space for permanent reductions in taxes for working families. Reform the benefits system to create incentives for work rather than unemployment. Break up monopolies, and downsize and privatize state owned banks.

This is the only way forward for the UK economy. The question is how long will it take policy makers like Mr. Bean to realize it?

Lets make some money

2011-11-07T04:40:00.001-08:00

Jim Lacey - professor of strategic studies at the US Marine Corps War College - was recently walking through the Occupy Wall Street camp in New York. He noticed an interesting development in monetary theory.

As luck would have it, though, many of them will not have to worry about money for much longer, as several OWS occupiers had the answer to everyone’s financial problems. This innovative group, all sporting $4-bill badges, claimed to have reimagined money. Intrigued, I asked how such a reimagination worked. In short, it seems that people are to create money as they need it for their own happiness and the happiness of others.

This I liked, as I have a wonderful imagination and a deep need to use my money so as to increase my own happiness. I promptly imagined a page of my notebook into $10,000 and gave it to one of the $4 lapel-badge ladies.

She looked at the sheet of paper and smiled at me. So far, so good. I then asked for her laptop and told her she could keep the $8,000 change I was due so as to further increase her own happiness. She quickly turned away, taking her laptop with her and leaving me short $10,000 of reimagined money.

I assume the system has some kinks that the revolution will figure out as it goes.

Before we all snicker at the naivety of the $4 demonstrators, isn't this the same idea that the Bank of England is pursuing? Aren't they printing money to try to make us happy?

The UK Inflation-Unemployment trade-off

2011-10-20T12:03:00.001-07:00

UK Inflation-unemployment trade off

2011-10-20T11:57:00.000-07:00

Ten bizarre things that happened yesterday

2011-10-13T19:30:00.001-07:00

Is it just me? News stories have a strange surreal quality.Here are just a few of the weird and wonderful things that happened yesterday:

Standard and Poors downgraded Spain.
Fitch downgraded UBS.
The Portuguese government won’t pay the 13th and 14th month salary payment for civil services who earn €1,000 a month. Two Christmas bonuses a year; it can only happen in Europe.
Slovakia voted in favour of the European bailout fund – the EFSF. The Slovakian parliament voted against it earlier this week. Barroso thanked Slovakia.
German banks told the EU that they didn’t want to increase their capital buffers. If things go pear-shaped, these same German banks won’t be slow to ask for a bailout.
Hedge Fund managers aren't supposed to do jail time. However, Raj Rajaratnam, has broken that glass ceiling. He is off to Club Fed for insider trading. He received 11 years for retribution and correction. Ironically, he will be sent to the same prison as Bernie Madoff. Mercifully, there are no insider traders in the City of London.
The US economy records another huge external deficit.
At last, some good news; in the last three months, JP Morgan fired 1,000 investment bankers while their bonus pool is down by $700 million.
There is a 48 hour train strike in Greece, which should boost growth and help pay down that mountain of debt.
Berlusconi is still Prime Minister of Italy, but that could change tomorrow after the confidence vote. Italy even managed to sell some five year bonds. The real question is who is mad enough to buy them. The ECB?

UK production data - clear signs of a slowing economy

2011-10-11T19:34:00.000-07:00

cloudedoutlook.blogspot.com

The headline index of production, so are other key sectors, such as capital goods. Other sectors, such as intermediate goods, energy and oil and gas are actually shrinking.

More evidence of an oncoming recession.

New Gingrich, Herman Cain and Eric Cantor on Occupy Wall Street

2011-10-11T19:12:00.001-07:00

What is driving UK inflation?

2011-10-08T18:27:00.001-07:00

cloudedoutlook.blogspot.com

This was a tricky little number to put together. Interactive charts are complicated. At the same time, they are far more effective at illustrating key trends compared to static charts.

This chart, covering inflationary developments over the last decade, tells quite a story. It is a story in seven chapters.

First, the Bank of England has failed to meet its two percent inflation target since 2006. There have been the odd occasions when it went below, but in general, inflation has been well north of the target.

Second, before 2006 the BoE were lucky. Prices for goods, such as electronics, were actually falling. This is the "Asia" effect, as China and other emerging economies industrialised and flooded the UK and other western economies with cheap goods.

Third, prices for non-traded services have consistently exceeded the BoE's target. The UK was secretly inflating for a decade at around 4 percent a year.

Fourth, wage settlements broadly kept pace with services inflation before 2006.

Fifth, things started to go wrong in 2006. Cheap Chinese goods no longer kept the inflation rate down. The BoE were forced to raise interest rates, and popped the asset bubble that kept the UK economy growing at 3 percent a year. The financial crisis wasn't far behind. By the summer of 2007, UK banks started wobbling.

Sixth, once the financial crisis hit town in 2008, wage settlements declined sharply and fell below the headline inflation rate. Living standards began to fall.

Seventh, quantitative easing led to a devaluation of sterling, and the prices of those cheap Asian goods began to rise rather rapidly. Recently, the CPI inflation rate for goods is increasing at roughly the same pace as domestically produced services. Overall, inflation is now rising at around five percent a year.

Anyway, if you like the data application, please circulate it to friends and family. It was meant to be seen by as many people as possible.

When time permits, I will put together more......

UK house price to earnings ratio (again)

2011-10-07T20:22:00.001-07:00

A little data application....

I hope it works

The Bank of England are at it again......

2011-10-06T20:16:00.000-07:00

Quantitative easing is back. The Bank of England is on its third attempt to reflate the economy by printing cash.

We are now four years into the crisis and policy makers have made little if any progress towards stabilising the economy. Growth is non-existent, inflation is running at 5 percent, unemployment is high, and the housing market continues to slide. Inevitably, the FTSE is in the toilet.

Fiscal policy is the only area where there has been any progress. Even here, the results have been somewhat paltry, although the hope is that things will look better next year.

Printing money doesn't generate income and wealth. Only production can do that. This requires entrepreneurs finding suitable labour and acquiring capital in order to make things.

The bank will justify their renewed cash creation in terms of kick-starting bank lending. True, firms need credit. However, previous quantitative easing efforts failed to restore credit lines to small and medium enterprises.

Why? Because firms need something much more important than loans in order to survive, and ultimately prosper. Firms need macroecoomic stability. They need to believe in the future.

Quantitative easing means future chaos; it means inflation, negative real interest rates, and the possibility of more crisis. Entrepreneurs understand that QE is a panic reaction; a cheap attempt at creating the illusion of prosperity. It can not be a basis for returning the UK to stable growth.

The previous two attemps at quantitative easing only served to prolong the crisis. The third attempt will also fail. There is that tired old line that the definition of insanity is to keep trying the same failed policies, expecting things to change this time. Yet despite its overuse, it accurately explains the behaviour of the Bank of England.

Seven reasons why the European banking system is again teetering on the edge of the abyss

2011-10-04T19:52:00.001-07:00

The European financial system is again in trouble.

Dexia, the Franco-Belgian bank, has just received a government guarantee. European Union finance ministers are again cobbling together late night rescue plans in an effort to prevent the financial crisis from worsening.

So what is going wrong with Europe's banks? In no particular order, there are seven reasons why European banks continue to struggle:

1. Banks are under capitalized

Bank capital acts as a buffer that can absorb losses. However, bank capital comes with one major drawback; it is expensive. For decades, European banks reduced their costly capital buffers in order to maximize profits.

When the crash happened, many banks ran dangerously low on capital. Since then, European banks have tried to strengthen their capital base. Unfortunately, new risks to bank portfolios have emerged, especially from sovereign debt markets. Despite efforts to increase buffers, European banks remain under capitalized.

2. Weaker banks are holding back the pack

Some European banks are especially short of capital. Banks are intimately connected through the interbank market. A failing in one bank threatens all banks. Therefore the weak banks are causing problems for the strong ones.

3. Investor fear

In an atmosphere of endless stress-enhancing uncertainty, investors are unwilling to invest in banks. At best, this makes capital raising efforts expensive. At worst, for some banks it has become almost impossible to raise new funds. Furthermore, investor demand for bank debt is weak. This has made it difficult for some banks to roll over maturing debt.

4. Asset quality

Far too many European banks provided massive amounts of credit to high risk markets such as real estate. Many European property markets have fallen in a deep slump. Borrowers - that is to say property speculators - are finding it difficult to service debt. Therefore, the asset quality of many banks is, to say the least, dubious.

5. Funding pressures

European banks remain highly dependent on wholesale funding rather than deposits. Moreover, many banks are faced with growing maturity problems. They've been unable to extend maturities and the liabilities side of their balance sheets are becoming increasingly short-term. This growing dependence on short term financing is proving to be quite destabilising.

6. Government debt

European banks are holding unhealthy amounts of southern European debt. Within the Euro area, the probability of sovereign debt default has grown. With each sovereign debt downgrade, European banks have become more vulnerable. The big fear remains an actual default, which would severely test European bank balance sheets.

7. The bankers

With one or two exceptions, European banks are run by the same jokers that drove the European financial system into crisis. The vast majority of these senior bankers made their careers through excessive risk-taking and over leveraging. Unsurprisingly, they are unable to comprehend the fundamental changes wrought by the crisis. They lack the skills needed to downsize balance sheets.

So, four years after the crisis started, and Europe has made little if any progress towards stabilising balance sheets and digging its way back to profitability.

Time for another bank bailout. However, are European taxpayers ready to see obscene amounts of money being pumped into banks, with the usual post-bailout bonus pay outs to failed bankers?

Why a single European financial supervisor would be a bad idea.

2011-10-03T20:35:00.001-07:00

There are few problems facing Europe where a solution cannot be found in Brussels. Exchange rate management, tax policy, the environment, trade, foreign relations, and defence - the European Commission has the answer to every challenge. Furthermore, the answer is always the same; member states should delegate more decision-making authority to the Commission.

Right now, the Commission feels confident that it can wrest control of financial supervision from the member states. Earlier this year, it established three European Systemic Risk Boards, covering banks, markets and insurances and pensions respectively. This followed from proposals made in September 2009, which advocated the creation of three European Supervisory Authorities – a European Banking Authority, a European Securities and Markets Authority, and a European Insurance and Occupational Pensions Authority. When it sees an opportunity, the European Commission moves fast.

Superficially, the case for centralization is strong. Europe has gone through a dramatic financial crisis. Supervision has failed on a massive scale, with dreadful economic consequences. Moreover, European financial institutions are breaking out of their national constraints and diversifying into new markets across the Union. A solitary Europe wide financial supervisory framework seems obvious.

How would such an institution, or collection of institutions, work? First, consider the most practical question; where would the new European financial supervisory agency be located? This would be an easy question at the national level. The supervisor would live among the banks. It would be located in the financial centre.

Europe doesn't work that way. Everybody takes turns. Right now, France has the joint capital of Europe-Strasbourg. Belgium has the Commission and Parliament. Germany has the ECB. Spain and Portugal already have a large number of minor European institutions. London would appear to be the obvious choice, but the UK has unwisely chosen to maintain national sovereignty of exchange rate policy. There will be the inevitable food fight among member states, rather like for the honour of hosting the olympics. Most likely, it will be sited somewhere in Eastern Europe, probably Warsaw or Budapest. After all, it is now their turn. There might also be a compromise solution breaking up the institution so that it could be sited in two or three worthy locations.

Once this institution, or loose confederation of institutions, becomes operational, it would be confronted by 27 national banking systems, each working under its own legal system. Harmonization is a word that trips off easily from the tongue; it is much harder to implement it as a practical policy. European civil servants can quickly write up a directive of new banking standards. That is the easy part.

A "one size fits all" European financial sector supervisory framwork would create insurmountable problems. How would one reconcile the supervisory needs of internationalist investment banks located in city of London with the sleepy banking system in Italy? Where can one find common ground between the state directed banks of France with the highly communal credit unions of Cyprus?

European-level supervision would also create a massive distance - both literal and metaphorical - between the regulator and the regulated. Information and market knowledege are the core of effective supervision. It is not an "arms-length" business. When identifying the risk of a banking blow-out, one onsite inspection of a bank by a knowledgeable supervisor, looking at loan quality, can worth a million off-site inspection reports received by a desk based supervisor living in another country.

The answer, of course, would be to create a network of regional supervisory bodies, one for each country. This would be reinventing what Europe already has, only this time it will be controlled by Europe rather than national parliaments.

This still leaves the intractable question of how to supervise banks that traverse multiple jurisdictions. It is a difficult question, but it is not one that a centralized regulator in Europe can answer any better than a national regulator. For example, HSBC, as its name suggests-the Hong Kong and Shanghai Banking Corporation-has operations around the world. It is hard to see how an EU-wide regulator based in Eastern Europe can confront the complexities of HSBC any better than the FSA does right now in London.

Handing financial sector supervision over to Brussels is a bad idea. It is bad politics because it will strengthen an institution-the European commission- that most Europeans would prefer to see weakened. More than that, it would offer no tangible improvements on the current European supervisory structure. Rather than reduce the likelihood of a new crisis, it would make one more likely.

However, that kind of objection has not stopped the Commission in the past. The proto-supervisory institutions are already named, their extravagent budgets are prepared, now it is time for the member-states to hand over the files and let Brussels take over.

Deep impact

2011-10-01T20:20:00.001-07:00

There is an apocryphal story that in the summer of 2006, the US Federal Reserve became worried about the property bubble that was raging in many US cities.

So the Fed dusted off its macroeconomic models and conducted a simulation to see how the US economy would respond to a 20 percent fall in house prices. The model predicted that the US economy could easily absorb that kind of correction and that there would be no major impact on output or employment.

June 2006 was about the time that the housing market peaked in America. Throughout the summer it started to weaken slightly with prices beginning to fall 2007. The immediate impact on employment was, as the model projected, minimal. Employment continued to grow throughout 2007 reaching a peak in January 2008.

Thereafter, it was as if the US labour market had been hit by a meteor. Within two years, almost 8 million jobs disappeared. The post-housing bubble recession eliminated 1 private sector job in 14.

So what is the moral of the story?

Well, there are perhaps too many to enumerate. The obvious ones are the poor predictive power of economic models, the complacency of economists, and their inability to understand the interactions between financial markets and the real sector. Poor bank supervision, perverse incentives in financial institutions, and self-destructive financial engineering would be another three to add to the list. Bonuses, speculation, greed, corporate stupidity, declining moral values, the masculine inadequacies of Bill Clinton, the arrogance of Alan Greenspan and the war-like tendencies of the Bush family - I could go on......

However, the really big lesson is that asset bubbles hide the underlying weaknesses of economies. For at least a decade, the US was losing a battle over competitiveness with Asia. Manufacturing jobs were moving eastwards, and America was de-industrializing. The story is equally true for the UK and much of Europe.

Rapidly growing housing prices, cheap credit, and growing household indebtedness obscured this dangerous tendency. Once the crash happened, US economy and its labour market underwent a brutal awakening to the new global economic realities.

The rich are more fearful than the poor

2011-09-30T22:01:00.000-07:00

According to an ONS survey, over 90 percent of households earning more than £100,000 a year think the global economy is in bad shape. The poor - those earning less than £20,000 year - don't seem quite so concerned. Just over 75 percent think the world economy has gone to the dogs.

Which is better; to be rich and fearful or poor and complacent?

Greece; a country on the edge of a nervous breakdown

2011-09-29T20:38:00.000-07:00

Greece is only days away from national humiliation. The Greek government will admit what we all already know-that it can no longer service its debt. It will ask its creditors to restructure and write down government liabilities to more manageable levels.

Understandably, the Greek people have become deeply pessimistic about the future. This is reflected in the latest consumer sentiment surveys. Sentiment has fallen off a cliff, and Greeks are on the edge of a collective nervous breakdown.

Nevertheless, it is wrong to think that Greece is an outlier. It is not a special case. It is not unique. The Greek government made the same mistakes that other European countries made.

The Greeks allowed the state to grow to the point where it completely dominated economy. In parallel, Greeks created a welfare system that reduced incentives to work and take risks.

Even sectors that were notionally private, such as construction, were beholden to public officials through a complicated and obscure system of state procurement. The state was the omnipresent funnel for corruption, both on a great scale and on the most pettiest of levels.

The Greek people, for the most part, wanted a bloated welfare state, where no one paid for anything. They liked generous pensions, early retirement, and free healthcare. Greeks learned to adapt to the daily indignities that the state inflicted upon them. They bribed and scammed their way around the incomprehensible morass of rules and regulations.

Perhaps understandably, the Greeks did not want to pay for their deeply dysfunctional public sector. Tax evasion became the national hobby. When the government could not balance tax revenues with expenditures, it borrowed from the bond market. There were plenty of willing banks ready to accommodate Greek fiscal imbalances.

In order to hide its deep structural economic weakness, Greece joined the Euro at an overvalued exchange rate. The lack of competitiveness destroyed the remnants of Greek manufacturing. The Euro didn't just wreak Greek manufacturing. Traditional service sector industries, such as tourism, became overpriced.

The Greeks had an answer for the economic dislocation caused by the adoption of the Euro. Rapid credit growth to the private sector created an asset bubble, which spawned a huge service sector centred on the financial market. What it could not produce at home, it purchased from abroad. Greece ran up a huge current account deficit, which is financed with cheap loans from northern Europe.

This bizarre economic model continued so long as Eurozone interest rates remain low, and and no one paid too much attention to the health of the financial system.

Four years ago it all came crashing down. The flows of cheap capital stopped, the government could not finance its deficits, asset bubbles suddenly collapsed, and all the weaknesses of the Greek economy became horribly exposed.

Does any of this sound familiar?

UK income tax; who pays? How much?

2011-09-27T20:32:00.001-07:00

Click on the image for a larger version

A genuine exit strategy from the crisis

2011-09-23T20:32:00.000-07:00

In 2010, the global economy enjoyed steady if unremarkable growth. By the third quarter of 2011, it teetered on the edge of recession. The post-crisis recovery lasted barely 2 years. Moreover, in many advanced economies, growth proved insufficient to ensure that GDP reached its pre-crisis level.

How did things get so bad so quickly? The answer lies in the public sector balance sheets of advanced economies.

When banking sector difficulties turned into an economic downturn, tax revenues took a hit, while expenditures on unemployment benefits rose. In some countries, the revenue decline was exacerbated by a long-standing dependence on asset prices and financial bubbles as sources of taxes.

Politicians believed that they could buy their way out of recession. With revenues already weakening due to the economic downturn, governments tried to stimulate activity by cutting taxes and increasing expenditures, pushing fiscal deficits up to levels not seen since the Second World War. With rising deficits came rising debt levels, which were already extremely high in many socialist leaning European countries.

Few were willing to acknowledge that, at best, the post-crisis fiscal stimulus was a dangerous gamble. Supporters of stimulus claimed that higher deficits would re-energize growth, tax revenues would increase, and economies could out run the rise in debt. Skeptics, on the other hand, warned that if growth did not resume, debt to GDP ratios would start to rise alarmingly and bond markets could turn nasty.

Two years on, the skeptic's scenario is playing out. Many European economies are growing far too slowly, and debt levels are unsustainably high. Markets doubt the ability of many European countries to tackle their fiscal problems. Equity markets have crashed around the world, wiping out mountains of household wealth. Financial flows have ebbed away. Banks are now far more risk averse, and have begun to tighten liquidity and accumulate cash.

In the past, central banks would have used monetary policy to counteract these adverse circumstances. Central banks lost that option when interest rates were slashed to zero during the last downturn. Monetary policy has no room for maneuver.

In the UK and the US, quantitative easing temporarily stabilized asset prices, but the gushing pipeline of cash could not ignite economic growth on a sustainable basis. Printing cash did nothing to calm the nerves of investors, workers, or entrepreneurs. It looked like a short sighted and dubious measure, driven by panic and fear. Ultimately, QE served to destabilize economies.

A renewed recession now seems unavoidable. There are no quick fixes available to policymakers. So what should governments do?

First, and most importantly, they must begin to take the long view; no more panicked measures; no more ill-conceived headline grabbing policies.

Second, fiscal sustainability is the defining long-term issue facing advanced economies. More bluntly, the problem is debt. Governments must begin to move towards lower deficits and lower debt levels.

Third, governments must recognize that reducing debts and deficits will incur significant short-term output costs. This reality must be soberly and honestly communicated to voters. There is no time for absurd anti-cuts campaigns. It is just as pointless to protest against austerity as it is to rage against the freezing weather in winter.

Finally, no more stimulus. Attempts to kick start the economy using deficits is doomed to failure. Fiscal stimulus spawns rapidly rising debt levels and creates a serious risk of a disorderly fiscal adjustment. If you want to see the future of the country trying to stimulate its way out of recession, just take a look at Greece.

The hope has to be that we have learnt something over the last four years. There are no shortcuts to prosperity. Governments must always balance their books. Central banks should not misbehave and recklessly cut interest rates to zero and inject the economy with obscene amounts of cash. What we need is monetary and fiscal responsibility and an end to cheap policy tricks.

The UK house price to earnings ratio continues to slide

2011-09-22T20:03:00.000-07:00

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Lets squeeze the rich

2011-09-22T20:01:00.001-07:00

Before we address the heated question of tax policy and the super rich, let is start with a question......

In fiscal year 2010-11 how many people in Britain earned more than £1 million a year? Before you answer, here are three background facts. First, there are 31.5 million income tax payers in the UK. Second, their total tax liability was £159 billion. Third, the average nnual payment for all tax payers was £5,220.

So what is your answer? Well, according to the Office of National Statistics, the number is just 13,000. Their tax liability, on the other hand, was a little more impressive. Again, in 2011, it amounted to little over £12 billion. A tidy little sum, but still only a fraction of the total economy-wide income tax liability.

What does this tell us about tax policy? Should the Chancellor squeeze these big earners with a higher income tax rate? Or should we leave them alone?

It is this group that the leftists have in mind when they proffer a “soak the rich” alternative to austerity. The argument is by taxing this miniscule minority of super rich, we can pay for a first-class health service, a generous benefit system and ample subsidies for climate friendly start ups. The Right, on the other hand, counter that these are the wealth creators. If the rich are overtaxed, incentives are blunted, and ultimately economic growth is diminished. If the tax rate is really punitive, the super rich will pack up and go, leaving Chelsea and Kensington to be reclaimed by Chavs.

Neither of these arguments are terribly convincing. Even if the rich were taxed at the rate of 100 percent, the UK would still have an unpleasantly large fiscal deficit. While the rich earn telephone number salaries, there aren't enough of them to cover the difference between government expenditure and tax revenues.

As for the incentives argument, the vast majority of these super earners are working in the financial sector. The staggering growth of the banks and other financial institutions certainly contributed generously to UK GDP prior to 2007. Once the crash was underway, the costs of the bail out and the repression have meant that the UK economy gave back everything it gained from finance during the heady days before Northern Rock and Lehman. Moreover, the household and corporate sectors are now deleveraging massively. As the financial sector shrinks, consumption and investment will be constrained. The financial sector will impose a terrible burden that could weigh upon GDP growth prospects for at least a decade.

So, taxing the rich will not solve our problems, but neither will it make them any worse. The UK's fiscal difficulties are much more intractable. Rather than start with unhelpful rhetoric about the rich, it is more useful to think about the size of government. Currently, government expenditure is almost half of GDP. Taxation also claims a fearful amount of national output, but it's more in the region of 40 percent of GDP. In other words, public expenditure is massive, the tax burden is oppressive, and we still can't balance the books.

Prior to the crisis, the headline numbers didn't look quite so bad. However, dig into the details and we quickly find some deeply disturbing trends.

On the expenditure side, health and education spending were growing alarmingly. On the tax side, revenues became heavily dependent on financial services, asset price growth, and housing transactions. This vulnerability became painfully evident as soon as the financial crisis began. From the autumn of 2007 onwards, tax revenues fell down a dark hole. That tax revenue model isn't coming back any time soon.

Does the UK public want a government that spends half of national output? Overall, it appears that they do, especially when one considers that it was health care, pensions, and education that drove the public expenditure to GDP ratio upwards to 50 percent. Is the public prepared to allocate 50 percent of national income to taxation? Unfortunately, the answer seems to be no. We want the services but we don't want to pay for them.

This is why discussions about tax policy have homed in on the 50 percent tax rate for the rich. If the rate goes up or down or stays where it is, it won't seriously affect fiscal outcomes. It is a phony war; a largely irrelevant discussion that neatly avoids addressing the deeper and more painful issues. What should be the optimal size of government? And are we really serious about paying for public services in a sustainable way?

The UK's shrinking workforce

2011-09-18T18:01:00.001-07:00

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