Cutting question - Consumer Boom?

By Andrew Bounds and Chris Giles

Published: June 16 2009 03:00 Financial Times p 7

As Britain's recession bit over the winter, the country became obsessed with finding someone or something to blame. Greedy bankers, addicted to taking risks and paying themselves lavish sums, took much of the flak, as did hapless financial regulators who failed to react to the danger signs.

But fingers were also pointed at ordinary households: Britons had become hooked on material consumption, fuelled by debt and rising house prices. People flocked to the "Together" range of mortgages from Northern Rock, which offered loans of up to 125 per cent of a property's value until the lender ignominiously failed. London's house prices and luxury shopping boomed on the back of big City bonuses. It was unsustainable and, as economists like to say, things that are unsustainable do not last.

But as Britain starts to enjoy its new sport of spotting the green shoots of economic growth sprout up (and seeing whether they will wither), was it all the standard story of consumer boom followed by inevitable comeuppance? Once you get past the anecdotes, the evidence is against that.

One good place to start is a comparison with the 1980s, when no one doubts Britain's consumers went shopping crazy. As a share of gross domestic product, household consumption rose by almost 2 percentage points, with the big boom between 1985 and 1988, when it reached 60.5 per cent of GDP. In comparison, for all the talk of shop-till-you-drop consumers bashing their credit cards, consumption this decade has fallen as a share of GDP by 1.3 points, with declines even during the supposed consumer boom years of 2006-07.

In this decade, the price of imports, particularly from China, has gone down - so people can feel happier about falling consumption. But this underscores the data findings that households did not go on some dreadful borrowing and spending binge. Based on this and other evidence, economists such as Ben Broadbent of Goldman Sachs become agitated, saying: "I just don't understand why people persist in saying there was a consumption boom - there just wasn't."

But the popular belief, also stoked by many economists and officials, remains that consumption has boomed and that is the prime cause of unsustainability in the economy. The rise in household debt to 160 per cent of disposable income, from 100 per cent in 2000, has to unwind, says Andrew Bridgden of Fathom Financial Consulting, and if that happened gradually, "then growth in consumption would be subdued, perhaps close to zero, for the next 10 years".

The International Monetary Fund last month sang from the same hymn sheet in its annual survey of the British economy. "The high level of household indebtedness constrains the pace of economic recovery," it concluded, at the same time fretting about weaknesses in banks.

Mervyn King, the Bank of England governor, came close to the same interpretation of the feebleness of household finances and the resulting sluggish outlook when presenting the central bank's latest inflation report. "In the light of the state of balance sheets, especially in the financial sector, the [Monetary Policy] Committee judges that the risks are weighted towards a relatively slow and protracted recovery," he said.

The dispute about the fragility of household finances stems from a legitimate fear, underscored by a plunging household savings rate in 2006-07, that households were living well beyond their means. The savings rate even briefly turned negative at the start of 2008, fuelling concerns about overconsumption among households and the inevitable retrenchment to come.

But a closer look shows the main reason for the savings drop appears to be that as inflation rose over that period, so did households' bills and spending. Consumers did not cut other items much, sensing the rise in prices was temporary - which turned out to be the case. Subsequently, incomes rose faster than expenditure, bringing the savings ratio back to 4.8 per cent, a level no different from a decade earlier. Though households could decide to retrench, the evidence that they will is so far rather thin.

But as so often with aggregate data, the real behavioural response of households is difficult to infer from the figures because so many things are going on. This is where microeconomic evidence can help - and this year, evidence has accumulated to suggest that there was indeed no housing-fuelled consumption boom.

John Gathergood and Richard Disney of Nottingham University compared the spending and saving behaviour of the same households over time and found, first, that those renting properties were just as likely to reduce their saving when house prices were booming as home owners were. This result has been seen repeatedly in large-scale economic studies of the UK and is a real challenge to the consumption boom protagonists. Why would renters spend more and save less when house prices rise, since their chances of getting on to the housing ladder had just grown worse?

The two researchers went further and added household expectations of their future incomes to their equations. This they found to be the most important determinant of active decisions to save. Renters, it transpired, saved less alongside homeowners because both groups were optimistic about their future incomes.

Looking at similar data across the Atlantic, the two could also spot a difference between British households, whose upbeat income expectations made them shun saving, and US households, who did respond aggressively to higher house prices.

If there is almost no evidence that consumption boomed this decade in Britain as a result of house price appreciation, why did household debt rise so explosively?

There is no disagreement that high house prices are related to this increase in debt, but a fierce disagreement persists between those who think loose lending criteria forced house prices higher and those who believe, as Mr King does, that high house prices led to higher debt because those buying a home needed a bigger mortgage than the people selling - as the vendors enjoyed capital gains from previous house price rises. While both arguments have merit, the important point is that debt and house prices went together, not debt and consumption.

Then, if consumption is not the obviously unsustainable element, where should the spotlight fall? Government spending on goods and services is the short answer. Health, education, defence and law and order spending (including capital expenditure) grew extremely rapidly from 2000, when all this accounted for 20 per cent of GDP, to the 24.4 per cent it reached in 2008. Although financed by borrowing, this rise appeared under control until the recession hit, because tax revenues were strong, particularly corporation tax paid by the risk-taking financial sector. Again, this was the reverse of the 1980s.

The public spending bonanza, financed by erratic financial sector profits, was clearly unsustainable. With tax revenues slashed by the recession and borrowing set to rise to £175bn ($286bn, €207bn) or 12.5 per cent of GDP, this level of government consumption will not be able to continue. The big story of the next decade will be government retrenchment and deficit reduction.

So what does that mean for the UK economy? As ever in economics, there is good news and bad news. The good news is that the absence of a boom over the past decade implies that a consumer retrenchment is far from a certainty, even with falling house prices. As in the past, incomes - and expectations of income growth - are more likely to determine household consumption than household finances and debt are.

Sterling's 20 per cent fall since November 2007 raises the competitiveness of the UK and should allow net exports and business investment to contribute significantly to growth, replacing government spending. Monetary policy is likely to remain very loose, to encourage demand as the government consolidates the budget. This is a reasonable expectation, says Malcolm Barr of JPMorgan, though it is impossible to know in advance "where is growth coming from".

But the bad news is that the recession has destroyed some of Britain's productive capacity forever - 5 per cent is the Treasury's estimate. Charlie Bean, the Bank of England's deputy governor, adds that the fragility of banks will hit working capital, corporate investment and research and development, so limiting potential growth, while unemployment reduces the skills of many employees.

Moreover, continued household consumption at today's level cannot be taken for granted. Households may find their income growth in the years ahead disappointing, especially as taxes and unemployment rise.

There is also the big unknown global element, which is whether the Asian countries that run big surpluses will put more effort into consuming at home rather than saving abroad. Such a shift would raise global real interest rates and make consumer debt feel more onerous.

Although what is not known outweighs the certainties, the outlook is not as bleak, at least for households, as the simple story of excess followed by penitence. Britain is often a miniversion of the US - but its unsustainable expansion of the past decade was very different.

Do not adjust your data set

One of the problems in determining the degree of any surge in household consumption is that the answer depends on which bit of the national accounts you use.

Gross domestic product - the value of goods and services produced in the economy each year - can be broken down into contributions from household consumption, investment, government spending, and the balance between exports and imports. This decomposition can also be adjusted for the inflation of each component part.

If no inflation adjustment is used, there was no consumer boom this decade. Household consumption fell from 63.5 per cent of GDP at the start of 2000 to 61.4 per cent in the second quarter of 2008, just as the recession began.

But after standardising everything at 2003 prices, the official figures show consumption rising from 61.1 per cent to 62.5 per cent of GDP over the same period.

Over long periods the nominal, or unadjusted, figures are preferable because they are easier to measure and they quantify what households actually spent, not the rather more nebulous concept of what their spending would have been had they bought the same goods and services but at 2003 prices.

Leeds

From mills to tills: an industrial centre turned shopping mecca

Few institutions epitomised the boom and bust of Britain's economic "miracle" more than Leeds United.

The Yorkshire soccer club, whose rugged style won league titles in 1969, 1974 and 1992, transformed itself into a leisure brand listed on the stock market and boasting a team full of young talent. By 2001 it had reached the semi-finals of the European Champions League. Then its debt caught up with it.

Owing £79m, it began a fire sale of players. Peter Ridsdale, chairman, left in 2003 but the shake-up could not stave off bankruptcy - or relegation. "We lived the dream," he said. The nightmare of a third season in the third tier of English soccer continues.

Could the city, which has undergone a similarly stellar transformation, suffer the same fate?

Regenerated after the collapse of the clothing industry in the 1970s, its centre is almost unrecognisable from the days when Montague Burton ran the largest clothing factory in Europe there. With engineering and textiles in decline, Leeds fell back on its other strength: finance. Yorkshire was the home of the building society movement and had a big legal sector. The city rediscovered a taste for shopping evident in the graceful but neglected Victorian arcades. Nothing did more to change its image than the opening of the first branch outside London of Harvey Nichols, the upmarket department store,in 1996.

In a decade from 1991 the number of bars and cafés doubled, with nightclubs and restaurants not far behind, as the leisure economy came to life. Up to £4bn has been ploughed into shops, apartments and offices in a centre once dominated by warehouses and mills.

That may reflect an unsustainable consumer binge, or it may just mark Britain's conversion to continental- style café culture. Since 1999 Leeds, with a population of 750,000, has added 31,600 net new jobs, a rise of almost 10 per cent. Yet a large amount have been in public services, and almost all the rest in finance and business services, which each account for one-quarter of the working population. The council believes it will be 2015 before employment returns to 2007 levels and is reducing its own staff by 450.

Civic leaders believe the financial goose will lay golden eggs again. There is still plenty of untapped wealth around: SG Hambros, the private bank, opened an office in the city only in March.

Howard Kew, chief executive of the Leeds Financial Services Initiative, points to the diversity of the sector, which includes asset management, call centres and retail banking. He also notes a tradition of innovation. First Direct, the first telephone bank, set up there in 1989. The recession could even help, as costs in Leeds are one-third lower than London, he adds.

Martin Allison, dean of Leeds Metropolitan University Business School, accepts the city has "suffered a systemic shock". But, he says, "it has had them before. Thirty years ago we were wondering what would come after textiles".

Andrew Bounds

Credit crunch causes analysts to rethink rational market theory

By Gillian Tett, Capital Markets Editor
Published: June 16 2009 03:00 Financial Times

A new realisation has dawned among the most fervent advocates of financial analysis and collective investor wisdom: markets are not always rational.

For the past five decades, the Chartered Financial Analyst Institute has been teaching the tenets of analysis based on efficient markets to tens of thousands of adherents from banks, fund managers and investment houses that make up the global financial system.

Now, however, the credit crisis has forced high priests of rational market theory to question their own creed.

The British CFA recently asked members for the first time whether they trusted in "market efficiency" - and discovered more than two-thirds of respon-dents no longer believed market prices reflect all available information. More startling, 77 per cent of the group "strongly" or "very strongly" disagreed that investors behaved "rationally" - in apparent defiance of the "wisdom of crowds" idea that has driven investment theory.

The shift is significant as the assumption of efficient markets is a cornerstone of calculating the value of everything from stocks to pension fund liabilities to executive compensation.

William Goodhart, chief executive of the CFA Society of the UK, yesterday admitted the results showed a new mood of "questioning" following the financial crisis.

However, the trend appears to reflect a wider intellectual swing. In the past three decades, the global asset management industry has been dominated by the so-called "efficient markets" hypothesis, which has given birth to ideas such as the capital asset pricing model, that portrays investing as a trade-off between risk and return.

Extremities of recent market swings have sparked interest among politicians and investors in the field of behavioural finance, which asserts that markets do not behave rationally but can be driven by human emotions such as fear.

However, the CFA survey suggests the finance industry is not yet ready to rip up its creed.

It is in Beijing’s interests to lend Geithner a hand

By Martin Wolf
Published: June 9 2009 19:06 Financial Times

Creditor countries are worrying about the safety of their money. That is what links two of the big economic stories of last week: Chancellor Angela Merkel’s attack on the monetary policies pursued by central banks, including her own, the European Central Bank; and the pressure on Tim Geithner, US Treasury secretary, to persuade his hosts in Beijing that their claims on his government are safe. But are they? The answer is: only if the creditor countries facilitate adjustment in the global balance of payments. Debtor countries will either export their way out of this crisis or be driven towards some sort of default. Creditors have to choose which.

Germany and China have much in common: they have the world’s two biggest current account surpluses, at $235bn and $440bn, respectively, in 2008; and both are also powerhouses of manufactured exports. They have, as a result, suffered from the collapse in demand of overindebted purchasers of their exports. So both feel badly done by. Why, they ask themselves, should their virtuous people suffer because their customers have let themselves go so broke?

Germany and China are also very different: Germany is a highly competitive global producer of manufactures. But it is also a regional power that has shared its money with its neighbours since 1999. Its problem is that its surpluses were offset by its neighbours’ largely private excess spending. Now that the borrowers are bankrupt, their countries’ domestic demand is collapsing. This is leading to a huge expansion in fiscal deficits and pressure for easier monetary policies from the ECB. So Ms Merkel is driven towards undermining the independence of Germany’s central bank, in order to protect the still more vital goal of monetary stability.

Germany may be Europe’s pivotal economy. But China is a nascent superpower. Without intending to do so, it has already shaken the world economy. Incorporating this dynamic colossus into the world economy involves huge adjustments. This is already evident in any discussion of a sustained exit from the crisis.

A recent paper from Goldman Sachs – unfortunately, not publicly available – sheds fascinating light on the impact of China’s rise on the world economy.* In particular, it broadens the analysis of the role of the “global imbalances”, on which I (and many others) have written.

The paper points to four salient features of the world economy during this decade: a huge increase in global current account imbalances (with, in particular, the emergence of huge surpluses in emerging economies); a global decline in nominal and real yields on all forms of debt; an increase in global returns on physical capital; and an increase in the “equity risk premium” – the gap between the earnings yield on equities and the real yield on bonds. I would add to this list the strong downward pressure on the dollar prices of many manufactured goods.

The paper argues that the standard “global savings glut” hypothesis helps explain the first two facts. Indeed, it notes that a popular alternative – a too loose monetary policy – fails to explain persistently low long-term real rates. But, it adds, this fails to explain the third and fourth (or my fifth) features.

The paper argues that a massive increase in the effective global labour supply and the extreme risk aversion of the emerging world’s new creditors explains the third and fourth feature. As the paper notes, “the accumulation of net overseas assets has been entirely accounted for by public sector acquisitions ... and has been principally channelled into reserves”. Asian emerging economies – China, above all – have dominated such flows.

The huge capital outflows were the consequence of policy decisions, of which the exchange-rate regime was the most important. The decision to keep the exchange rate down also put a lid on the dollar prices of many manufactures. I would add that the bursting of the stock market bubble in 2000 also increased the perceived riskiness of equities and so increased the attractions of the supposedly safe credit instruments whose burgeoning we saw in the 2000s. The pressure on wages may also have encouraged reliance on borrowing and so helped fuel the credit bubbles of the 2000s.

The authors conclude that the low bond yields caused by newly emerging savings gluts drove the crazy lending whose results we now see. With better regulation, the mess would have been smaller, as the International Monetary Fund rightly argues in its recent World Economic Outlook. But someone had to borrow this money. If it had not been households, who would have done so – governments, so running larger fiscal deficits, or corporations already flush with profits? This is as much a macroeconomic story as one of folly, greed and mis-regulation.

The story is not just history. It bears just as heavily on the world’s escape from the crisis. The dominant feature of today’s economy is that erstwhile private borrowers are, to put it bluntly, bust. To sustain spending, central banks are being driven towards the monetary emissions of which Ms Merkel is suspicious and governments are driven towards massive dis-saving, to offset higher desired private saving.

Today, Germany wants to preserve the value of its money, while China is desperate to preserve the value of its external assets. These are understandable aims. Yet, if this is to happen, debtor countries have to stabilise their economies without another round of profligate private borrowing or an indefinite rise in government debt. Both paths will ultimately lead to defaults, inflation, or both and so to losses for creditors. The only alternative is for debtors to earn their way out. At the level of an entire country that means a big rise in net exports. But if indebted countries are to achieve this aim, in a vigorous world economy, the surplus countries must expand demand strongly, relative to supply.

China’s decision to accumulate roughly $2,000bn in foreign currency reserves was, in my view, a blunder. Now it has a choice. If it wants its claims on the US to be safe, it must facilitate an adjustment in the global balance of payments. If it and other surplus countries wish to run huge surpluses and accumulate vast financial claims, they should expect defaults. They cannot have both safe foreign assets and huge surpluses. They must choose between them. It may seem unfair. But whoever said life is fair?

Economists clash on shifting sands

By Robert Skidelsky
Published: June 9 2009 18:52 Financial Times
History is replete with famous intellectual battles. In the natural sciences, these have usually led to decisive victories, with good science ousting bad. There are few Ptolemaic astronomers left, or believers in the phlogiston theory of combustion. In the social sciences, the situation is different. There have been famous battles galore, but no decisive victories. Indeed, it is characteristic of the social sciences that their battles are interminable, temporary defeats being followed by the regrouping of the defeated forces for a renewed assault.

That economics is not a natural science is clear from the inconclusive engagements that have punctuated its own history. A hundred years ago the classical theory reigned supreme. This “proved” that free markets were automatically self-adjusting to full employment. They were either continually at full employment or, if disturbed by an outside shock, rapidly returned to it. The only thing capable of wrecking the workings of the market’s invisible hand was the visible hand of government interference.

Then along came the Great Depression of 1929-32 and John Maynard Keynes. Keynes “proved” that markets had no automatic tendency to full employment. This failing of the invisible hand justified government policies to maintain full employment.

For 30 years or so Keynesianism ruled the roost of economics – and economic policy. Harvard was queen, Chicago was nowhere. But Chicago was merely licking its wounds. In the 1960s it counter-attacked. The new assault was led by Milton Friedman and followed up by a galaxy of clever young disciples. What they did was to reinstate classical theory. Their “proofs” that markets are instantaneously, or nearly instantaneously, self-adjusting to full employment were all the more impressive because now expressed in mathematics. Adaptive Expectations, Rational Expectations, Real Business Cycle Theory, Efficient Financial Market Theory – they all poured off the Chicago assembly line, their inventors awarded Nobel Prizes.

No policymaker understood the maths, but they got the message: markets were good, governments bad. The Keynesians were in retreat. Following Ronald Reagan and Margaret Thatcher, Keynesian full employment policies were abandoned and markets deregulated. Then along came the almost Great Depression of today and the battle is once more joined.

Haunters of the blogosphere will know that the main ground of the current engagement is about the effect of the “stimulus”. FT readers will have caught a faint whiff of the intensity of this battle in Niall Ferguson’s column of May 30, headed “A history lesson for economists in thrall to Keynes”. Prof Ferguson and Paul Krugman, the economist and New York Times columnist, had previously locked horns at a public symposium in New York on April 30. The historian had asserted that large fiscal deficits would push up long-term interest rates. This implied they would have a zero stimulatory effect: public spending would simply “crowd out” private spending. An enraged Mr Krugman responded on his blog that Keynes had proved that such crowding-out could occur only at full employment: if there were unemployed resources, fiscal deficits would not drive up interest rates without also expanding the economy. Prof Ferguson’s ignorant remarks only confirmed that “we’re living in a Dark Age of macroeconomics, in which hard-won know-ledge has simply been forgotten”.

However, this is not a debate between economists and historians. It is a battle within the economic profession – between the New Class-ical Economists and the New Keynesians. What is fascinating is that it is an almost exact rerun of the debate between Keynes and the British Treasury in 1929-30. The Treasury view was that bond-financed public spending was bound to diminish private spending by an equal amount. Keynes replied that if this were true it would apply to any new act of private spending. “In short, the fatalistic belief that there can never be more employment than there is is altogether baseless”.

Later the Treasury retreated to a more defensible position. The danger of extra government spending, it came to argue, lay not in the “physical” crowding out of resources but “psychological” crowding out. If doubts arose about the government’s solvency – a concern Prof Krugman has acknowledged – it might lead to capital flight, which would push up the cost of government borrowing.

Are we doomed to rehearse the same arguments time and again? In this particular debate, I am on Prof Krugman’s side, but I do not agree that Prof Ferguson’s position represents a retreat to a phlogiston state of economics. This is to take economics to be like a natural science, which Keynes never believed it was, because he thought its subject matter was much too variable over time.

Keynes’s view was that we need different economic models at different times. The beauty of his General Theory of Employment, Interest and Money was that it was general enough to accommodate a variety of models applicable to different conditions. Markets could behave in ways described by the classical and New Classical theories, but they need not. So it was important to take precautions against bad behaviour. Ultimately, the Keynesian revolution was a triumph not of good science over bad science, but of good judgment over bad judgment.

Lord Skidelsky’s ‘John Maynard Keynes: The Return of the Master’ will be published by Allen Lane in September

Investors’ rollercoaster ride

Short View:
By John Authers, Investment editor
Published: April 29 2009 19:45 Financial Tiems

Florida’s Disney World this week hosted the annual gathering of the CFA Institute, which controls the education of investment managers and analysts globally.

Investors ended days of grim talk by going to a theme park, where they could choose between a rollercoaster ride or being dropped from a building. The symbolism was obvious.

A year ago, the meeting was dominated by talk of “black swans” – extreme events that were unpredictable from existing data. The credit crisis was such, chartered financial analysts said.

This year, it is accepted that it was all too predictable. Investors should have heeded precedents for crises following a credit binge.

Furthermore, the industry did a bad job last year, even taking into account losses on the markets. Pension funds did not understand their own liabilities, and so the gap between their assets and liabilities widened sharply. Asset allocators using hedge funds to spread risk away from equity markets made minimal investments in managed futures and dedicated short-selling funds (which did well), and allocated money to funds that did badly.

There is also growing acceptance that basic assumptions must be jettisoned. CFAs no longer believe that markets are efficient – meaning that prices incorporate all known information – or that investment returns follow a normal “bell curve” distribution. The search is on to apply biology and psychology to better understand markets.

Duke University’s Douglas Breeden spoke for many when he said the industry had been guilty of hubris. He also pointed out that Paul Samuelson, the great economist who laid the foundations of efficient markets theory, always warned that his theory was “subject to refutation by observable facts”. That refutation seems now to have happened.