Tuesday, 21 January 2014

Carney Hamstrung In H2

Its been said that Mark Carney has been very lucky in taking over at the BoE when he did. At the time of his appointment, the UK economy was not just in a double but a triple dip recession. The fact that, subsequent data from the ONS indicates that in reality it just technically escaped that description is neither here nor there; the fact is that the economy was very weak, and had been so since the Liberal-Tories undermined it in 2010. It was so weak that he seemed safe in offering to keep interest rates pinned to the floor for the foreseeable future, or at least until the unemployment rate fell below 7%, which at the time seemed to be the same thing. Yet, within months of taking over, the UK economy appears to be in a completely different position. It is apparently growing more strongly than many other European economies, and even than the US. The unemployment rate is coming closer by the day to the 7% limit, which poses Carney with the problem of having to raise interest rates, or else change his stated forward guidance, to avoid doing so. In fact, this is the least of Carney's problems. The fact is that in the second half of 2014, he will face economic conditions that will present him with a serious dilemma.

Long before Carney had been presented with the problem of UK unemployment falling to his 7% threshold two years before he expected, economists had puzzled over the fact that whilst UK output had been falling or growing only slowly, the unemployment rate had not increased significantly. The answer to this conundrum was, in fact, quite simple – low and falling productivity. From the 1980's onwards Thatcher and her heirs had attempted to build a low wage economy. It was consistent with the small business mentality that to make bigger profits you need lower wages. But, as Adam Smith had pointed out 200 years earlier, wherever wages are low, the price of labour is dear, because low wages discourage innovation, which raises productivity, it encourages capital to move into those types of production that can most take advantage of the low wages, and they are the low value, low productivity types of activity. The consequence is to build an economy where the value of production is low, productivity is low, and so a large number of workers are employed on low wages.

This would seem to contradict the idea that falling or stagnant output did not lead to bigger rises in unemployment. But, in fact, the two things go together. As output stagnated, employers rather than laying off workers were able to simply cut wages further, so the consequence was that unemployment did not rise on official figures, but underemployment did, and with it productivity dropped even further. The fact that so many workers now are employed on a casual basis, part-time, temporary, or on zero hours contracts facilitates this. To an extent, this should operate in the opposite direction so that when demand and output rises, the first response should be a reduction in this underemployment, but it is always the case that, where productivity is low, in certain industries it will require a large number of additional people to be taken on, even if they are taken on under those same unstable conditions rather than as permanent, stable employees.

But, there is another reason that the unemployment rate did not rise further when output was stagnating. It is that the data shows a large number of people becoming self-employed. In fact, this is something of an illusion. The reality was that these people became self-employed in most part, not because there was a large rise in entrepreneurialism, but because they had given up hope of getting a decent job, and with the conditions for JSA, not to mention the amounts to be had so abysmally low, even the prospect of making money occasionally from being self-employed as a window-cleaner, gardener etc. seemed a better prospect. The incomes of many of these self-employed people is little more than subsistence, and once again the level of productivity is very low.

The reality of the UK economic pick-up is that it takes place in the context of a continuing global economic boom, but one from which the UK is failing to greatly benefit because of the economic model put in place by Thatcher in the 1980's. It ensures that whilst the global boom lifts all boats, the UK economy sinks relative to many of its competitors. The current pick-up has been driven by that boom, which has seen a rise in growth again across the globe, as part of the three year cycle. It has also been driven by a temporary rise in UK consumption. For the last 30 years, there has been an increasing trend towards consumerism. People have been led to see shopping not as something you have to do to meet certain needs for food, clothing and shelter, but as a leisure activity in its own right – retail therapy. Its no wonder that its estimated that in the UK, households throw away 30% of the food they buy.

Such attitudes having been cultivated over so long a period are not easily changed again, and the government and retailers have no desire to change such attitudes. When David Cameron a couple of years ago called on households to reign in their consumer debt, he was quickly told to withdraw his comment, because had they taken his advice the drop in consumption would have further cratered the weak economy. A Government that came into office proclaiming its commitment to cut debt has presided over its expansion, both at the level of the state and of the individual. They have encouraged a further growth of student debt, and now with the Help To Buy scam, they seek to encourage yet more hapless individuals to go into penury to buy grossly over priced property.

And, its on this basis of a further fall in savings and increase in borrowing that the recent rise in consumer spending that led to the rise in GDP was based. A further example of that at a macro level was the sharp rise in the UK trade deficit as it sucked in more purchases from abroad without the corresponding amount of income generation from exports. These are the shaky grounds on which the bounce in the economy and Osborne's crowing are based on.

But, in the second half of this year many of these things will reverse presenting Osborne and Carney with serious problems. Firstly, the borrowing has only been possible because of very low interest rates brought about by high rates and volumes of profits over the last 30 years. But, the rate of profit is falling, and with it the supply of money-capital. A look at the figures for global company profits, shows that they continue to miss estimates that have themselves been massaged downwards. At the same time, several years of avoiding capital expenditure are now hitting the limits. Both firms and states need to engage in large scale investments and capital expenditure. Increased demand for money-capital at a time when the supply of money-capital is declining means higher interest rates. That will be the case whatever Carney and other central banks do as far as printing money. In fact, global interest rates are already rising. The US and UK 10 year Bond Yields have almost doubled in the last year.

Rising interest rates will both hit those states that remain heavily in debt, as well as consumers with huge levels of consumer debt, particular mortgage debt. It will necessarily hit banks to whom a lot of that debt is owed. In Europe, the latest exercise in futility that is the Bank Stress Tests and Asset Quality Review, has already significantly lowered the bar the banks have to jump to show that they are not bankrupt. The requirements of Basle III setting out the amount of Capital the banks are required to hold has also been lowered, because everyone really knows that the banks balance sheets are a complete fiction, based on asset prices that are themselves in the realm of Alice in Wongaland. Even with these much reduced requirements, its estimated that European banks will need to raise tens of billions of additional Euros in addition capital to shore up their books.

Of course, as global interest rates rise, and asset prices begin to fall, central banks may continue to believe that they are Gods, and that they can reduce rates by simply printing more money. They will be wrong. The other day, CNBC's Steve Liesman said that the Monetarists had been proved wrong, and essentially the Keynesians proved right that it is the level of economic activity and not the amount of money printed that determines inflation. In fact, both the Monetarists and the Keynesians are wrong. If the value money or in reality money tokens falls because more is printed, whether this results in inflation depends upon what happens to the velocity of circulation, which in turn as the Keynesians suggest may depend on the level of economic activity. But, the fact of stagflation in the 1970's and early 80's shows that there can be very high levels of inflation alongside low levels of economic activity. If the huge volume of money printing undertaken begins to circulate with a higher velocity, then inflation will increase rapidly, and as it does so, the same kind of inflationary spiral seen in the 1970's will ensue. At the first whiff of such inflation, interest rates will rise sharply, and central banks will be left way behind the curve.

And the reality is that a look at the underlying condition of the UK economy shows that inflation is there. Looking at the trend since 2000, UK inflation is moving higher towards 4% . For much of the last few years it has been way above the BoE target of 2%. The current fall in inflation like the low levels in the Eurozone is due to an actual tightening of money policy, brought about by the rise in the pound and Euro against the dollar, which has significantly reduced import prices for things like energy, whilst acting as downward pressure on internal producers in order to compete with imports. As the dollar is likely to strengthen over the next year, as its economy rebounds these effects will reverse, pushing inflation higher, and possibly rapidly.

Some of the rise in UK GDP may have arisen from the effects of the Help to Buy scam, which the government brought forward by 3 months to September last year, because it was obvious that its previous money drugs were no longer working on the UK's frothy property market. But, the current drugs seem not to be working either. There seems to have been no massive rise in property transactions in the last few months. Of the 6,000 applications under HtB, only 750 were translated into actual transactions, probably because the potential borrowers did not meet the new requirements on being able to meet monthly repayments at slightly higher interest rates. In fact, according to Rightmove, even asking prices for houses fell in December by around 1.9% month on month, and RICS have recently reported that an increased proportion of their members have become negative on property prices.

On top of all this, the three year cycle will turn down in the second half of this year. The global economy will continue to grow strongly, but any slow down in that growth will affect the underlying weakness of the UK economy, particularly in the context of rising global interest rates. By the second half of this near, the UK economy will be flat lining again. Carney will be under pressure from the government to print more money, but with inflation rising, and global interest rates rising the pressure from the real economy will be for him to raise interest rates, or face runaway inflation and the vengeance of the Bond Vigilantes.

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