Friday, 30 July 2010
We Dive At Dawn
In my post Wages & House Prices I pointed to the analysis on BBC's “Money Watch” programme about the relation of house prices to wages being out of whack. The long term average is 3.5, but now even though we are in such dangerous economic times, and house prices were supposed to have fallen due to the credit crunch, the fact that now buyers are supposed to show that they can actually save a reasonable deposit, and that they have some chance of paying the mortgage, the relation is nearly 50% higher than that at 5. Just to get to the long-term average, prices would have to fall by a third, or wages would have to rise by more than 40%. In fact, just as such relations always spend some time above the long-term trend, in order to get that trend, to get that average, they also have to respond by dropping below it.
So, the likelihood is that when the relation is restored then its likely to drop to 2.5, or 2 for a while. That would imply a much bigger drop in house prices, or huge rise in wages. Under current conditions, its more likely there will be no real rise in wages, certainly not in disposable income, far more likely as the effects of the Liberal-Tory Budget kick in, the job losses, and cuts will see wages and other incomes fall significantly in real terms. Recessions are never caused by collapses in the housing market, it is always the other way round. But, a recession under way, that causes a house market crash, can give that recession a further downward twist. Just look at Spain now, where the housing market crashed after the Credit Crunch, and recession, burst the property bubble on which the Spanish economy had been built. That caused construction to stop, throwing tens of thousands of building workers on the dole, and has left the Cajas with huge amounts of debt on their books, for property they technically own – on the basis of mortgages to individuals and property developers – but, as with the sub-prime crisis in the US, no one is prepared to value on a true mark to market basis i.e. not what is the theoretical price of this property, but how much could you actually sell it for, here and now.
When I was in Spain a couple of months ago, I was shown some fairly new four bedroom villas, on large plots with pools, where the asking price was 230,000 euros, but the estate agent showing us round said, don't take any notice of that price, the sellers will take at least 60 – 70,000 euros less than that! According to Paul Mason, Barclays economists best guess is for a further 25% fall in Spanish prices from here, but the reality is it could well be much more than that in an economy with 1 million empty new homes, 20% unemployment, and an austerity package only just starting! But, also the question is 25% more off what? As the above shows, and this was true with the sub-prime crisis in the US, no one is facing reality, the actual asking prices bear no resemblance to selling prices, and for any kind of market to work, there has to be some chance for what economists call, “price discovery”. That is it must be relatively easy and cost free for buyers and sellers to determine within reason, what they should be asking for what they are selling, and for buyers to know if what they are being asked to pay is reasonable. Without that, what happens is, for example, a Credit Crunch. Or in this case a property crunch, sellers will be reluctant to sell, but may have to because of their financial position, but buyers not only will be reluctant to buy, but will have every reason to hold back from buying so long as there are forced sellers, and so long as prices, therefore, continue to drop like a stone into a bottomless pit.
As the graph above shows that could be the kind of scenario about to unfold here. Economists often speak about being interested in the “second derivative”. That is if you were talking about a car, not how fast it is going, but whether it is accelerating or decelerating, the third derivative being how quickly it is accelerating or decelerating. The graph shows that although house prices are higher than they were a year ago, they are lower than they were a month ago. It shows that as an annual figure the rate is falling, it is decelerating. What is more significant here, though, is that third derivative, the rate of change of how quickly it is falling. Look at the graph to see the previous fall, and you can see the trend.
But, there is a difference between these two drops. Firstly, there was a plateau in 2007 of price changes, and the fall, which reflected the tightening of mortgage and other availability of money due to the unfolding Credit Crunch after Northern Rock, is quite deep – dropping by nearly 20% by the start of 2009 – but drops fairly steadily. The reason for that is that although, the Credit Crunch really started in August 2007, after Northern Rock, the Bank of England, and other had already started throwing huge amounts of money at the problem. They bailed out Northern Rock, which was only a small bank, to the tune of half the NHS Annual budget, for instance. As a result, the UK economy was actually still growing quite strongly for the rest of 2007, and into 2008. It was still growing, just, even in the second quarter of 2008, just before the collapse of the financial system. In fact, in the Summer 2008, I was writing blogs, about the concern about inflation, and the fact that the Bank of England was raising interest rates!
So, if house prices were falling steadily due to the inavailability of credit, but whilst the economy was growing, whilst confidence was quite high – most economists believed after the shock of Northern Rock that Central Banks had dealt with the Credit Crunch – as unemployment fell, and wages rose, imagine what happens when credit is unavailable, but when confidence is low, when wages and other incomes are falling, when disposable income is squeezed hard due to rising unemployment, falling wages, and rising prices. Worse, you might say, well we had that after the Credit Crunch started, and it set off the recession, but house prices only continued to fall a bit more, and for only a few months, and then started to rise again. True, but the immediate result of the Financial crisis, was that the Bank of England, which had been raising rates in 2008, slashed them, as did every other central Bank. In the UK, down to just 0.5%. That resulted in Banks and Building Societies slashing their mortgage rates, which meant that tens of thousands of homebuyers with variable rate mortgages saw their monthly repayments cut to a fraction of what they had been. Many who had been on the point of default, were saved as a result. In fact, as I pointed out in my post, Aftershock, the average homebuyer had the equivalent of something like a 20% pay rise, just from the cut in their mortgage payments! In addition, the Bank introduced open money printing – Quantitative Easing – to push even more billions of pounds into the economy. Short of following Ben Bernanke's suggestion that they could defeat deflation by printing money and throwing out of helicopters, its hard to see how much more they could have done to give people money to spend on such things. In reality interest rates were already negative. Its no wonder that the decline was halted, just as the economy itself began to stop falling, and then recover.
But, therein lies the problem, a problem that Nouriel Roubini has referred to. If the economy continued to grow as a result of the stimulus already provided, then incomes would rise, debt would get paid down, and so on. But, if the stimulus is now taken away, before the recovery is firmly established, there is the possibility of a double-dip. The dangers of that, or even just a serious slow down, should be obvious. The very things that have propped up the housing market over the last year or, that limited the fall in prices, and underlay their recover over the last year, would disappear overnight. But, now the tools available for dealing with the problem would also disappear. When house prices were falling in 2008, interest rates were being slashed, and means of putting money in buyers pockets found. Today, interest rates can't go any lower, and with inflation rising sharply, at some point, banks are likely to raise not cut interest rates. At such minimum rates that exist at the moment, only a very small increase will result in a large percentage rise in repayment costs. As wages are cut, and inflation rises, affordability will decline.
The basic outlines of this, and the real problem/situation lurking beneath the waves has already been pointed out by RBS as I said in my post RBS & Monster money printing, and in this Independent article.
In other words all the conditions are present for a double-dip, or serious slowdown in economic activity, the pressure on wages, and disposable incomes will increase, the leeway that banks have offered – in this country as much, and for the same reasons as the cajas in Spain – will come to an end, with a consequent need to revalue their Balance Sheets, as mortgages are foreclosed and property is sold off in a firesale, causing prices to drop precipitously. This is coming at a time when the ECB has just conducted its “Stress tests” on European Banks that everyone believes was a sham, and public relations exercise to try to convey confidence in a European Banking system that everyone knows has very serious problems. As David Blanchflower told CNBC, the tests didn't pass his, “Kick it, Punch it, Poke It” test.
If RBS are correct, and that is combined with a sharp fall in Stock Markets and Commodity Markets, their prediction of 2% UK Bond Yields as opposed to the current near 4% would mean a huge rise in Bond prices which would also suck funds out of those other markets, then the fall in asset prices would have a significant wealth effect. Economists believe that as well as income it is people's perceived wealth that also plays a part in their consumption patterns. The rise in house prices was an obvious example of that, as people thought they were better off, borrowed against their house, and increased spending. But, if their wealth is declining, or they think its going to decline, they are likely to try to balance that by spending less, and saving more.
In short, even if a double-dip is unlikely – and they are very rare – the consequences of the Liberal-Tory policies is that there will be an imminent, and significant economic slowdown, in conditions where the tools to reverse it no longer exist, and where the consequentness of that slowdown on asset markets, particularly housing, will be severe, which in turn will feed back into the economy and likely lead to a double-dip, at least. Over recent months, there has been evidence that there has once more been a tightening in credit markets, though as yet nothing like that in the Credit Crunch. That is despite, though, all of the QE, the stimulus, and the cajoling and other measures by Governments and central Banks to get Banks to lend.
The suggestion by Vince Cable, who should know better, and the Liberal-Tories that the Banks are refusing to lend when they should be is ridiculous. How do banks make profits? Essentially, by borrowing money cheap, and lending it expensively. Over the last year or so, they have been able to borrow it essentially for nothing, whilst lending it out at 5 or 6%. That's why their profits have risen spectacularly! To accuse the banks of not lending when they should is like accusing Toyota of not selling cars to people they should. The reason both do not sell is because they have good reason to believe that the buyer will not pay up! In fact, as the Independent article showed, at the moment the Banks are probably sitting on a load of loans that will go bad. These are very troubling signs. The latter is just one indication of politicians wanting to close their eyes to economic realities in the hope they will go away, and in the hope that they can make the rest of us believe that everything is if not okay, then at least it is under their control. The European bank Stress tests were just another example of that. Usually, that means something very nasty is lurking beneath the surface.
Europe has a bifurcated economy with places like Germany doing well, but with some economists arguing that countries like Greece, Spain, and Portugal might have to leave the Eurozone, and that some like Greece are likely over the next couple of years to default if they don't leave. Already, the austerity packages are having an effect, Spain's unemployment is rising again according to latest figures here . As an integrated economy with the vast majority of trade internal between EU members, Northern Europe, including Germany and the UK, will be deeply affected by any slowdown in Southern Europe, and certainly by any new economic or financial crisis. The US is also slowing down, and there is discussion of a new economic stimulus package. But, Obama has lost his appeal for many US voters. Healthcare reform drained large amounts of support from workers who saw it as raising their taxes, and undermining the quality private healthcare many get through union negotiated company insurance schemes. At the same time, the bail-out of the banks, stood in stark contrast to the problems many Americans had in getting jobs, or raising wages. From the other direction the Right-wing have been able to use that to attack his “Socialist” big state measures, and to point to Europe as an example of the need to cut the budget deficit rather than introduce a new stimulus. Even in China, and Asia, where the economies are booming at around 10% - and hence Cameron's willingness to slag off Pakistan to get a few economic crumbs from India's business community – policymaker's are worrying about the opposite danger of overheating, and are tightening credit, and withdrawing stimulus.
Some “Chartists” - not the 19th century revolutionaries, or their 1970's namesakes – analysts who try to predict how markets are going to perform on the basis of looking at charts of previous trends, have referred to what is called a “Death Cross”, some arguing that the same chart patterns that exist now appeared just before the Great Depression. Personally, I think its baloney. Charts can illustrate patterns, but its necessary to study the underlying causes of the movements to identify whether those same causes repeat on some kind of cycle such as the Business Cycle, the Innovation Cycle, or the Long Wave Cycle. All of those things have material bases in production. But the Stock Markets, whilst obviously tied to what is happening in the real economy, have a life of their own, driven by psychology. Just because two lines crossed on a graph in a certain pattern in 1929, and a similar pattern appears today – and exactly what is similar – does not mean that the same economic events will play out today. They might, but only if the underlying economic and material conditions are the same, and if every economic and political actor responds to them in exactly the same way. Chances of that are slim – though it has to be said that the Liberal-Tory ideology today of cutting, and balanced budgets is remarkably similar to the same mistakes made by Governments and policy makers in 1931.