Mobs can be terrifying. Recall the story of the crowd who terrorised a paediatrician because someone had confused the word with paedophile? If democracy is the best hope for creating peace, explain why the most democratic state the civilized world has ever known (at least, democratic if you ignore the fact that neither women nor slaves had the vote) – Ancient Athens – behaved more like Hitler towards neighbouring states than Hitler did.

And earlier this year, the US media and politicians turned the full force of their venom on Toyota.

This is what we said at the time: “Those in the car industry say Toyota’s reliability is second to none. In Germany there are no official figures looking at recalls of German cars. Not so long ago there was a serious gearbox default in BMWs and Land Rovers – which as you know are owned by the German company. But where were the headlines?

“One could say that Toyota is the victim of a concerted PR campaign orchestrated by its rivals. But this column is not a fan of conspiracy theories. A more likely explanation is that the cultural characteristics of the French, the Germans and the Americans are such that any whiff of failure in a seemingly unbeatable Japanese firm is greeted with such schadenfreude that a media backlash is inevitable. The media, after all, do little more than pander to the whims of populism.” See The PR behind is a Toyota

This is what researchers for the US Government’s National Highway Traffic Safety Administration have found.

Of 58 crashes involving Toyotas this year, and in which the problem with the so-called faulty accelerator was blamed, in 35 cases brakes were never used; in 14 cases brakes were only partially applied; in another the brake and the accelerator were pressed simultaneously. So far the investigation has found no evidence of an electronic failure.

Toyota had insisted that the problems were caused by pedals getting stuck under floor mats.

The investigation is not over, and may yet find Toyota was to blame in some way. But it is clear that most of the criticism thrown at the company was based on a false premise. And even if Toyota is found to be somehow culpable for some accidents, it seems unlikely its offence is any worse than those committed by other car makers – such as US car makers who were not forced to squirm under the same media spotlight.

Is it the same with BP?

So far the jury is out on whether it was cost cutting at BP that caused the oil spill. The jury is out on whether it was actually BP’s US partners who were more to blame.

BP’s safety record, even before the Gulf of Mexico oil spill, was not good. But then again, BP specialises in exploiting oil in the harder-to-reach places. Its expertise in deep-sea oil drilling is second to none. But when you dig miles beneath the bottom of the ocean, into territory that not even Jules Verne wrote about, accidents are inevitable.

One might conclude, therefore, that deep-sea oil drilling is itself too dangerous. But then, the pioneering risks that BP has been taking are very much in keeping with the American ideal. The US was built on risk taking. The Pilgrim Fathers, or the settlers of Roanoke Island who disappeared without trace in the late 16th century, took crazy risks, and that is why America is what it is. It is called the American Dream.

Maybe the BP debacle is an example of the rapidity with which we approach peak oil, the day when oil output begins to fall. Maybe we are running out of oil so fast that we have no choice but to take more and more risk in our endeavours to exploit this resource. If this is so, then the US shoulders much of the blame.

Maybe BP followed guidelines set down by the US authorities, but the guidelines themselves were too soft.

What we can say is that one investigation revealed that other oil companies could just as easily have suffered the same fate. The only real difference is that they have fewer deep-sea oil wells to worry about.

One can also say that the technology and expertise applied by BP in fixing the oil leak was quite simply breathtaking. What the company did was the stuff of science fiction.

And yet some in the US called for their government to do more. One so-called expert suggested the solution lay in using some kind of nuclear weapon to create a sufficient explosion to cover the leak with debris. The only snag of course is that it could have gone very badly wrong.

Thankfully Barack Obama had the good sense to allow BP to apply its expertise in fixing the leak, and in that sense, at least, the mob was ignored.

BP’s fight back began with replacing the CEO, with his English way of understatement but who patently was not to blame for the incident, with the American accented man who was actually boss of the US arm of BP that was presumably responsible for the oil leak in the first place.

The US is determined to punish BP all the more, banning it in as many ways as it can think of.

Lynch mobs should not determine policy. But for crisis stricken US, it is the soft option to blame Johnny foreigner, whether in the shape of superb Japanese car makers, hard-working Chinese who have the gall to want to earn wages that pull them above the poverty line, or brilliant British managed engineers who work at depths previously the preserve of science fiction. In the 1930s the US was obvious about its protectionism, with the Smoot-Hawley Act of Congress which raised tariffs on 20,000 goods. This time around its protectionism is by act of mob rule.

The were a few “no-nos” in the press conference this morning. One such “no-no” was talk of a double dip recession. “We don’t consider this,” he told the journalist from the Sun (you can just imagine the Sun headline – King says I am not bothered about recession). But actually, his point was a serious one. The Bank of England makes projections based on expected performance over four quarters. It does not predict what the economy will be like in, say, Q4 this year; rather, its forecasts look at a broader time frame.

But for all that, its message was a little downbeat: “The considerable stimulus from monetary policy, together with a further expansion in world demand and the past depreciation of sterling, should sustain the recovery,” went the report, “but the strength of growth is likely to be tempered by the continuing fiscal consolidation and the persistence of tight credit conditions.” Mervyn King said: “Looking ahead, the UK economy is facing a major rebalancing away from private and public consumption and towards net exports. Achieving that rebalancing, while confronting those headwinds, is likely to mean a choppy recovery.”

But it boils down to this: the bank has downgraded its forecast for growth in the short run. As for the medium term, it was talking about a slow but steady recovery. It said history tells us recoveries from financial crisis are usually very gradual, but this morning in the press conference Dr King said that thanks to the recent budget, some of the downside risks have been removed.

As you know, the bank does not do precise forecasts. Rather, it publishes fan charts showing the range of possible growth rates, and here is the one it revealed today:

On the subject of banks and their lending, he kind of criticised and stuck up for them, all at once. Businesses have been complaining about their treatment by banks, but banks have been insisting that they have been providing ample funding to business. Dr King suggested there is no doubt that bank lending to business is not what it used to be; that money terms are much tougher; and the spread between the rates that banks charge and official bank rates is high. But, he said, there are good reasons for this, namely that banks are still recovering from the crisis and are trying to repair their balance sheets, and in any case the spreads between rates on lending to banks over Bank of England rates are themselves unusually high. He said for larger companies, some of which have better credit ratings than the banks, it makes more sense to borrow directly from the markets.

He was also asked whether the bank should extend quantitative easing to lend directly to SMEs. Here he was unequivocal. It is not down to the bank to decide where the money it creates should go. It buys government bonds. If the government decides to use some of the money from these proceeds to lend to business, then that’s its decision. He said this was purely a political judgement.

But the real attention is on inflation.

The inflation report stated : “Inflation is likely to remain above the 2 per cent target for longer than judged likely in May, in large part reflecting the increase in the rate of VAT to 20 per cent in 2011.”

But then it expects to see inflation fall below target.

And in this morning’s press conference, Dr King continuously emphasised how recent price hikes are down to one-off factors. He said: “Over the past three years inflation has been volatile and above the target for much of the time. That does not mean that the MPC has taken its eye off the inflation ball, nor has gone soft on inflation. We have not. Rather, it is the consequence of a series of large price-level shocks. With a rebalancing of the economy to come, price-level shocks are likely to continue to affect measured inflation. Monetary policy can do little about short-run movements in inflation and must reflect a judgement about the balance of risks to inflation in the medium term. Short-run volatility is making that balancing act more difficult. But in whichever direction monetary policy moves over the next few months, it will reflect the MPC’s judgement about the actions necessary to meet the inflation target in the medium term.”

He talked about the effect of hikes in the price of oil, and the one-off effect resulting from the big falls in sterling during 2009. And he talked about the effect of the reversal of the VAT cut from 17.5 per cent to 15 per cent in 2009, and the effect of the impending hike in VAT to 20 per cent in 2011. To illustrate his point he waved two charts at the press:

This one demonstrating the assessed probability that inflation will be over target over the next three years.

And this one showing how energy costs have contributed to inflation.

Dr King was right when he said changes in interest rates would have no effect on the inflation that is being caused by these external shocks. Savers might bemoan the fact they are enjoying negative real interest rates, but as far as using interest rates to influence inflation is concerned, this is an irrelevance.

The key as far as Dr King is concerned appears to be spare capacity. For as long as there’s lots of slack in the economy, the internal inflation threat, which is influenced by interest rates, will be weak.

Recent data from the ONS revealed that average earnings rose by just 1.3 per cent in June 2010.  Hardly the stuff inflation is made of.

And despite record low interest rates, the savings ratio has shot up from minus 0.9 on the eve of the recession to 8.5 in Q3 of last year. With consumer confidence falling, according to the Nationwide, and with retailer spending rising at a mere 0.5 per cent in the year to July according to the BRC, internal inflationary pressures are practically non-existent.

Mind you, the critics are already lining up. The following statement arrived in our inbox seconds after the Bank of England press conference had finished.

Report from Chris Williamson, Chief Economist at Markit:

“The Bank of England has downgraded its forecast for economic growth compared to its central expectation in May, but still seems remarkably relaxed about economic growth prospects relative to the US Federal Reserve and Bank of Japan, who appear to be getting increasingly worried about the outlook. This is all the more surprising given the particular combination of headwinds now facing the UK. On the domestic front, surveys such as the PMI and Household Finance Index show that business and consumer confidence collapsed following the announcement of the austerity measures in the emergency Budget of 22 June. The timing of this drop in domestic confidence is unfortunate as it has occurred alongside a slowing in global economic growth, emanating most notably from the US and China, which will hit export sales. With the PMIs for July suggesting that GDP growth has already slowed sharply from the 1.1 per cent surge seen in Q2, perhaps down to around 0.5 per cent, the Bank’s forecasts for growth look optimistic.”

Every month RICS asks surveyors whether prices are up or down in their region. It takes the percentage number who say up, and subtracts from that the percentage number who say down, with the resulting sum forming its headline index. Over time this has proven to be a good barometer for the UK housing market. One of the nicer aspects of the RICS headline index is that the graph showing the history of the index is quite smooth, and does not suffer from the volatility seen with the Nationwide and Halifax indices which make it quite hard to extrapolate trends.

In July the headline index fell from plus 8 in the previous month, to minus 8. It was the first negative showing since July last year.

The index tracking price expectations fell to minus 28, from minus 6 in June.

But the really interesting indices relate to the movements beneath the surface. The index tracking new instructions, which affects supply, rose from plus 27 to plus 33, the highest reading since May 2007. The index tracking new enquiries, which relates to demand, fell from minus 6 to minus 10.

The index tracking instructions has been greater than the index tracking enquiries every month this year. But in recent months the gap between the two indices has been growing. RICS is not owning up to this, but surely the fact that the headline index has only just turned negative is a reflection of what these underlying indices were saying several months ago, and the recent developments are unlikely to show up in the headline index for a little while yet.

RICS said: “The average number of properties on surveyors’ books rose by 4.1 per cent on the month to 69.1. At the same time, the average number of sales per surveyor remained essentially flat at 16.6 (down 0.1 per cent on the month). As a result, the sales to stock ratio – an indicator of market slack – fell to 24 per cent, the lowest level since June 2009.”

A partial explanation for the rise in new instructions is the removal of HIPs. HIPs was a major disincentive for speculative sellers. It was also bad news for those who needed to sell, but had limited funds. In fact, HIPs may provide one of the explanations for why supply fell so sharply during the recession, leading to increases in the price of houses even while the economy was in the midst of its worst slowdown in decades.

The prognosis for the next few months is clearly down, but what about the prognosis beyond that?
Average property prices are clearly still too high. Talk is that first-time buyers really need to find a mortgage of around 25 per cent of a property’s value. This means they need to find around £40,000 just to buy an average home. Those who harbour the dream of buying a bigger property are well and truly … well, the word to describe their predicament is not appropriate for this column.

Property bulls talk about low interest rates helping affordability, but in the cold light of the post credit crunch era, people have woken up to the reality that it is not just interest that matters but also the cost of repaying the initial sum borrowed. And if you sign up to the school of thought that says deflation is a bigger danger than inflation, then mortgage holders no longer have the luxury of knowing inflation will erode the true value of their debt.

We asked the question, Is the stock market overvalued, and said we would take another look at this question shortly, but from a different perspective. Well, we are delivering on that threat.

Perception

Perception matters. If we believe prices will rise, we act in a way that is consistent with this belief, ie we spend our money more quickly and demand higher wages for our work. This in turn can lead to the happening of the very thing we are expecting. In short, our prophecies can become self-fulfilling. By the way, the same principle applies in reverse to deflation.

Clearly the same applies to stock markets. If we expect prices to go up, then we buy, and prices go up as a result. Such reinforcing behaviours can come unstuck eventually, as prices rise to ridiculous levels, then we get crashes, bubbles bursting, and expectations go into reverse.

But supposing our perception is based on false data? We can get a boom, but based on non-existent fundamentals. The end result can be nasty. Pick up any general psychology book and you will come across a chapter on illusion. You will see images of an old lady, who suddenly becomes a beautiful young girl if you change the angle of your view.

And, as most of us must know by now, crowds can get it wrong. That herd instinct can charge bubbles.

Was noughties housing boom built on an illusion?

It has been argued here that such a false view may have developed with UK house prices. At the end of the Second World War, average house price to GDP/capita was low. Wages then shot up over the next few decades. They shot up in part because of inflation, but even in real times they rose dramatically, because the 25-year period that followed the last World War was a golden era for economic growth. Also, during this period home ownership levels more than doubled.

And then we had double digit inflation, a period in which real interest rates – that’s rate of interest minus inflation – were minus for years. In 1975, real rates were minus 12 per cent. Inflation is good news if you are in debt, because the true value of your debt falls every year.

The combination of these factors may have moulded the British public’s view of house prices, creating the expectation of rises in house prices even when the perfect storm of circumstances that promoted the initial boom had blown out. Today we have trivial levels of inflation; wage inflation that lags behind High Street inflation; and home ownership levels that have actually fallen. At current prices, home ownership ratios are likely to fall further still, and while interest rates set by the Bank of England are negative in real terms, for most mortgage holders the interest they pay is much greater than the rate of inflation on their disposable income.

And yet still the Brits have faith in house prices. This is surely the underlying reason why prices went up last year during the midst of the worst recession in 60 odd years.
And that brings us to the stock market.

Was the stock market boom from 1960 to today built on an illusion?

In the noughties they used to say house prices always go up in the long run.
In the nineties they said the same thing about stock markets. (As an aside, why should stock markets go up? The market capitalisation of a company is supposed to be based on that company’s expected future dividends, discounted to give a net current value. If stocks consistently go up, it means markets are consistently getting this forward measure wrong.)

But ignore that rather inconvenient point, and look instead at fundamentals.
Just before the credit crunch, yours truly attended a lecture in which some professor was asking why have stock prices gone up faster than GDP over such an extended time frame. His conclusion is one that is widely accepted by the academic community, and is because the risk premium has gone up.

But why? Why should stocks today be more expensive relative to earnings than stocks sixty years ago? And if stock market growth exceeds economic growth, how can this be sustainable in the long run?

Those who retired on the eve of the dotcom crash, didn’t know how lucky they were. The value of their savings over their working life had been compounded by the rise in risk premium.

According to figures from Moneyfacts, if you had saved £100 per month for 20 years and the money was invested into a balanced management fund, and if you retired at the turn of the millennium, your pension pot should have been worth £103,914, and that should have given you an annual income of £8,998. Now, imagine that your twenty years of saving began ten years later and you are coming up for retirement now. Your savings would be worth £40,749, and the annual income you could expect from that would be £2,542.

But can future generations look forward to better returns?

Last year Robert Buckland, Global Strategist at Citigroup, put out a note saying that before 1960, US equities yielded twice as much as US bonds. He said: “The S&P would need to fall by another 40 per cent to deliver that yield on the current dividend base.”

Mr Buckland reckons it is possible the unusually good period for investment over the last few decades changed investors’ attitude to risk. But this could now reverse. He says: “Since the end of 1999, global equities have returned minus 29 per cent compared to plus 80 per cent return from global government bonds. Not only have equity returns been dire, but the volatility has been brutal. Having two 50 per cent bear markets in one decade is enough to test the patience of the most determined equity cultist. Just as excellent equity returns helped to promote the cult of the equity in the 1950s, so terrible returns seem to be tearing it down now.”
But once again, why? Why did the risk premium rise?

Maybe the answer lies with that magical period of economic growth that lasted from the early 1950s to the mid 1970s, the best era for growth ever recorded. Maybe the boom moulded investors’ perception.

High p/e ratios for stocks became the norm, and when the golden era ended, these new attitudes to risk were so entrenched that investors did not adjust.

So maybe it all boils down to the future of growth.

Globally the economy is now growing at a pace that rivals that golden era.
Will it continue?

As you know, this column is a fan of technology, and believes new technology can provide the foundation for another golden era, even in the West; providing that is, we let it.

But the real point of this story is that in the long run, stock market performance is a reflection of the economy. Risk premium may have a time lag factor built into it. Pensioners who retired in 2000 may have benefited from a delayed psychological effect of the golden era of growth, even though it ended 25 years before their retirement.

And whether the pensioners who retire in, say, 2020 have a better time than the class of 2010, really does depend on economic performance, which itself depends on how we embrace technology. But it also depends on psychology, and the time lags inherent in human nature.

The FTSE 100 rose 12 per cent last month. It’s 5 per cent down from the year high set in March, and down a tiny 0.3 per cent from the last day of 2009. It seems all the market shenanigans seen earlier in the summer and spring meant nothing. The old adage, “Sell in May and go away”, was proven correct. Why do we actually bother to look at daily changes on the stock market? It is rare indeed that a major sell off, or a big rise, is not reversed a few weeks later.

Of course, one might argue the markets have become overly complacent, even behaving naively. Their reaction to the Greek crisis, which has not gone away but is merely quietened for a few months while the EU bailout package papers over some very nasty gaps; and the banking stress tests that were little more than shambolic; does leave one shaking one’s head.

But let’s ignore the economics; what do the numbers say?

Well, what could be better than to start with a big fat letter Q.

In this case, Q relates to a measure defined by James Tobin, the American economist who came up with the idea of a tax on foreign exchange transactions. In one of those remarkable coincidences the tax is also known as a Tobin, or Tobin tax. You may recall, earlier this year and in 2009 there was much talk of introducing a kind of global Tobin tax. Anyway, Tobin also came up with a cunning way of testing whether stock markets, or indeed individual companies, were overvalued, and the measure is known as the Q test.

It works like this: add up the cost of replacing a company’s tangible and intangible assets, and divide this number into the market capitalisation of the company. If the result of the sum is greater than 1, then the stock is overvalued.

Thanks to the recent publication of the Blue Book by the Office for National Statistics, we now have a figure for the combined net worth of the UK’s non-financial corporate sector: it comes out at £1,510bn, using the same formula as used by the Fed for calculating the net worth of US corporates, or so says Capital Economics.

At the end of 2009, the stock market valuation of the same companies was £1,873bn.

In other words, equity Q quotient for non-financial UK companies is 1.24. Suggesting they are overvalued, and need to fall by just under 20 per cent.

But Q hardly ever is at the level James Tobin said it should be. The average since 1988 has been 1.15. So, it appears that by historical standards stocks are overvalued, but not by much.

We would like to suggest that you now help yourself to a pinch of salt. Just because equities have had a Tobin value greater than 1 for the last 25 years, it does not mean they always will. It is possible that markets have been consistently too exuberant for decades. See: Is the cult of equities dead?

But there is another way of looking at things. Instead, compare company profits with stock market valuation; or in other words look at p/e ratios, and in particular the cyclically adjusted p/e ratio which is calculated by taking average earnings over the prior decade and adjusting them for inflation, and comparing with stock market valuations. This, apparently, is the calculation preferred by Robert Shiller – he of the Case-Shiller US house price index and one of those gurus other economists defer to.

This particular measure of the p/e ratio was around 14.5 at the end of Q2, calculates Capital Economics. The average since 1988 was 18.4. Since 1975, the ratio was 15.8.

Put it all together and what do you get? A historical comparison of the Q ratio suggests stocks are slightly overvalued, but the historical p/e ratio suggests they should rise slightly from current levels.

Our own view is that markets are being overly optimistic, and are not taking into account the very real danger that a eurozone debt crisis as serious as the US subprime crisis proved to be, could yet erupt. In the long run, James Tobin’s view that the Q ratio should be 1, may well prove to be right.

We will take another look at the question of this Q ratio later this week, but from a slightly different, and a tad more optimistic perspective.

Then Portugal found itself on the receiving end of Moody’s poisoned analysis. You could say the credit rating agencies have been hopeless, waiting for the moment that countries try to implement measures to pay back debt, before slamming them for their indebtedness. But then you could say it’s a long journey to the moon. Both statements are pretty much stating the bl***ing obvious.

It is just that it has taken China to spell the problem out, with a credit rating agency of its very own. And the agency ain’t much impressed with its Western counterparts.

Talking of not being impressed, there was just a hint earlier in the year that Bill Gross, he who heads the giant asset manager PIMCO, had his doubts about the UK. Mr Gross was very subtle in voicing his opinion of course. This is what he said: “The UK is sitting on a bed of nitro-glycerine.” Investment and Business News can exclusively reveal that our analysis of Mr Gross’s comments earlier in the year clearly demonstrates that the investment guru had some qualms about the UK. You see, wonderful things are journalists. When someone says something really ambiguous, we can clear things up. Anyway, Mr Gross has been at it again. But this time his thumbs have done an about turn, and are pointing upwards.

Meanwhile, Andrew Sentance is getting worried. He is the man who voted to up interest rates at the last Bank of England rate setting meeting. Inflation fell again in June, but by less than expected. The inflation hawks are revealing themselves now in growing numbers. Squawking and swooping, the hawks with all those warnings earlier in the year about inflation were right all along. Interest rates are on their way up, quantitative easing has been proven to be the work of the devil after all. Except, they aren’t really and it wasn’t. We are going through a dangerous phase, and now those people who totally failed to call the economic crisis want to impose policies that would make things a hundred times worse.

But finally, hope arrives at the party, all dressed up to the nines – or is that nine billion tiny little ‘nine-ers’. Intel has just posted its best results in a very long time. You would have to wind the clock back all the way to … well, actually, you would have to keep winding, for Intel’s results were its best ever.

You see, it’s the three Is: innovation, innovation and innovation; that’s how we can get out of trouble, and it is something that credit rating agencies, bond investors and the inflation hawks, just don’t get.

Credit rating agencies eat cake, but why can’t they have it, too?

The UK has kept its triple-A credit rating, as measured by Standard and Poor’s. Phew. But the agency is worried. There is a 33 per cent chance the rating may be downgraded, or so it says. “The negative outlook reflects the potential of a downgrade if the government does not implement its challenging fiscal consolidation programme on the scale planned,” said Trevor Cullinan from the agency. Or at least that’s how the Guardian quoted him. He added: “A slackening of that, in our view, could put the UK’s net general government burden on a trajectory that would be incompatible with a triple-A rating.”

‘Hello, is there anybody out there?’ Haven’t you heard of the austerity budget? George Osborne has just announced a budget that was much, much tougher than anyone had predicted in the build up to the election of just eight weeks ago, and now Standard and Poor’s, which kept quiet for so long when things were going all wrong, starts making warnings. It seems that during the boom they were comfortably numb, and now they have built a wall blocking themselves off from reality.

Mind you, the OBR doesn’t help. Alan Budd, its boss, is the economic world’s answer to Fabio Capello. His reputation was without equal. But then when it comes to the crunch, things don’t look so good. No one seems to believe the OBR’s predictions for growth. You can’t blame Budd. Economic forecasting is guessing, disguised to seem like science. A good technique they may want to try is called the ‘blindfold and pin’ technique. It can be a whole lot more accurate than the predictions of the professionals.

Still, at least Bill Gross seems to be more cheery about the UK. Apparently, thanks to George Osborne, PIMCO is more optimistic about investing in Britain. See this Guardian piece for more: PIMCO turns bullish about UK gilts in light of budget cuts and euro debt woes

Meanwhile, Portugal has seen its Moody’s rating downgraded from AA2 to A1. It’s quite confusing, all these As. Most of us were delighted to get an A-anything for an essay when we were at school. Even a B-minus was quite good. Presumably the awarding of B-plus would have been greeted with pleasure, too. And a BB-plus, one assumes, would have been even better. This is strange, because BB-plus is what Standard and Poor’s gives Greece. And yet a growing body of opinion says Greece will default. The grades are a part of the problem. Why not have an honest system and give Greece a D-minus? We all know what that means.

Maybe it is not so much cake that the credit rating agencies have been eating, but rather they have been taking something else entirely. The Guardian quoted one anonymous hedge fund manager as saying: “Credit rating agencies are always two steps behind the market… The time when a credit rating could determine whether people would buy your bonds is over: now politicians know they must do their homework to sell their bonds. Money is now expensive, and you need to pick where it works best.”

There is a good summary of the latest credit rating agency scores on this website: Credit Writedowns

It is no wonder that China’s top credit rating agency Dagong Global Credit Rating Co. has come up with a quite different conclusion. It reckons that when giving a country a credit rating, it should take into account things like the size of its debts. And would you believe it, according to its way of doing things, neither the US nor the UK have top notch ratings. China, Germany, and Canada all boast higher ratings.

Then again, the Chinese agency may have got it wrong, too. The fact is, Germany and China are reliant on these indebted countries to charge their growth. If the US and UK do go bust, which China seems to think is not an impossibility, the crash in global demand which will follow will create an even bigger problem for Germany and China, which are, after all, totally reliant on the rest of the world buying its products.

See this Telegraph piece for more: Chinese rating agency strips Western nations of AAA status

Break up the banks, says leading politician

Andrew Tyrie is no lightweight. He is none other than the new chairman of the Treasury Select Committee. And he is giving a good impersonation of John McFall, the previous chairman, but with a lot more teeth. (Not that we are casting aspersions on Mr McFall’s dentures.)

Anyway, this is what our new toothy chairman said yesterday about banks that are currently owned by the government: “I want to put the consumer first… and the only way that can happen is with the break-up of those banks.”

Is he right? Ahh … let’s think about that … ahh … yes.

You don’t need us to spell it out. We are getting an awful service from banks. If you have a question, you get put through to a call centre. Your local branch has virtually no decision making authority at all. During the boom, getting a loan to fund a jolly abroad, creating an exodus of money overseas, was easy; getting a loan to fund a business creating wealth was much, much harder.

Economic evolution works via failure. Bad businesses go bust, leaving a vacuum that may be filled by businesses that have better products. Banks that are too big to fail are a problem, because then economic evolution stops working.

It hurts to say this. It is, after all, so much more fun to point out when politicians are messing up, but Mr Tyrie has hit the nail right on the head.

Inflation dips, but not enough

Inflation fell from 3.7 per cent to 3.4 per cent in June. The retail price index dropped from 5.1 per cent to 5 per cent.

Stop right there. Re-read. Inflation, as measured by the retail price index, was 5 per cent in June. Deflation? – do me a favour.

No wonder Andrew Sentance is worried. He is the Bank of England Monetary Policy Committee (MPC) – the people who set interest rates – man who voted for a hike in rates last month. Upon the unveiling of yesterday’s inflation rate, he said: “If the recovery continues and headline inflation remains relatively high, there may be a further upward drift in pay growth in the private sector, offsetting some of the downward pressure from limited wage growth in the public sector… I favour a gradual rise in Bank Rate… to avoid destabilising confidence through a sudden lurch in policy.”

Mr S is worried about spare capacity. Excuse the pun, but he reckons the paragraph in the book on the UK economy that says ‘there lot’s of spare capacity’ may be over.

Or to put it another way, Mr Sentance has put a question mark on the Bank of England’s rosy view on inflation. Wage inflation is higher than one might expect, given where we stand in the cycle. Average wages rose 4.2 per cent in the year to April. Okay, that was lower than the retail price measure of inflation, meaning workers are becoming worse off in real terms. Even so, the wage increases are higher than common sense would have predicted.

Here is why we disagree with this viewpoint.

CPIX, that’s inflation with indirect taxes (VAT) stripped out, was 1.7 per cent. According to the British Retail Consortium, shop price inflation in the year to June dropped from 1.8 per cent in the previous month to 1.5 per cent. Even food inflation was lower, at 1.7 per cent. Producer prices fell in June. Input prices fell 0.2 per cent, output prices by 0.3 per cent. The Nationwide’s Consumer Confidence Index crashed to 63 in June, the lowest level since June last year. This suggests consumer demand will fall in the months ahead, again pushing down on prices.

But the big one is the money supply. M4 lending decreased by £15.1 billion (0.6%) in May. The twelve-month growth rate fell to 2.5% from 4.1% in April.

The untold story of 2010 is the change in global money supply, that is to say, the broad money supply. It is contracting fast. Such a development has deflation written all over it.

Corporate America provides hope

Where Investment and Business News differs from other publications is that we do have a belief in technology. New technology, be it faster chips or synthetic life, leads to new wealth; providing, and this is a big proviso, that demand rises with productive potential.

Globally, and over the last few years, demand has not been keeping pace with this potential. Or at least, it has only been keeping pace via increased borrowings from some, to make up for the higher savings from others.

But at least Intel has had a humdinger. In fact, Q2 saw the best quarter ever for the chip maker for both sales and profits. A year ago the company made a loss in this quarter, with $400 million flying out the door. This time around, net income has been $2.9 big ones, or billion, as big ones are also called. The company’s boss Paul Otellini said: “Strong demand from corporate customers for our most advanced microprocessors helped Intel achieve the best quarter in the company’s 42-year history. The PC and server segments are healthy and the demand for leading-edge technology will continue to increase for the foreseeable future.”

And that is where hope comes in. The US is like the economic equivalent of David Bowie and Madonna combined. It has this extraordinary ability to reinvent itself. Or at least corporate America does.

Its high indebtedness is the other side of a coin which says optimistic, and optimism fuels risk taking, which leads to wealth creation.

But even so, one snag still remains. Martin Wolf covered this well in the FT today. “As Corporate America has boomed, income distribution has got worse,” he said. Mr Wolf was himself quoting a new book by Professor Rajan called “Has Financial Development Made the World Riskier?” The FT piece quotes Prof Rajan as saying: “The political response to rising inequality . . . was to expand lending to households, especially low-income ones.” The financial sector’s “failings in the recent crisis include distorted incentives, hubris, envy, misplaced faith and herd behaviour. But the government helped make those risks look more attractive than they should have been and kept the market from exercising discipline.”

It is good news, really good news, that Intel is leading the way to record results. That’s one box ticked in the column that says road to recovery. But, somehow, another box has to be ticked, too; the one that says ensuring the fruits of globalisation and new technology are distributed in a way that promotes more growth. Martin Wolf and some others, and maybe this column falls into this bracket, have said what the problem is. But no one seems to have come up with an answer yet.

2009 was a puzzle. The UK economy was in the midst of the deepest recession since the dinosaurs became extinct (or at least since before the author was born, which is much the same thing), and yet the great, long predicted crash in house prices came to a shuddering halt, and then moved into reverse.

Property bears, that is to say those creatures who believe a crash in house prices is as inevitable as four-yearly disasters for the English football team, had their faith tested to its very core. Property bulls, that is to say those creatures who believe rising house prices are as inevitable as four-yearly saturation of the TV schedule with football matches, said: “TOLD YOU SO.”

The truth is, the reasons behind the recovery in the housing market are quite complicated. See: Why did house prices rise in the depths of recession?

But whatever the reasons for the 2009 recovery, evidence out this morning suggests things are changing.

The latest survey from the Royal Institution of Chartered Surveyors (RICS) pointed to the most significant change in the dynamics of demand and supply since the days leading up to the housing crash.

Also in the news today are two separate reports; one predicting anaemia for the UK housing market for the next decade, another providing evidence on why it is that overreaction can often be the biggest factor that lies behind crashes and booms.

Then there’s the ‘big three’ and the Bank of England. The last ten days or so have seen the latest housing surveys from the Halifax, Nationwide, and Hometrack. The picture that emerges from these reports is getting clearer, with growing evidence that house prices are turning down again. And this evidence seems to be supported by the latest data from the Bank of England on mortgage approvals.

RICS points down

Every month RICS asks its surveyors if prices were up or down in their region. It takes the percentage number who said up, deducts from that the percentage number who say down, and out the other end comes its headline index. In June the index stood at plus 9, so it is still positive. But this was the lowest reading since July 2009. In the previous month the index stood at 26, and in the last few months of 2009 was in the low 30s. If the index continues to fall and goes negative, then it will be undeniable that house prices across the land are falling again.

And it does indeed seem likely this headline index will turn negative soon. First off, the RICS index tracking price expectations has turned negative.

But more significantly, the index tracking new instructions (which determines new supply) rose to its highest level since May 2007, with a score of plus 27. The index tracking enquiries (which determines new demand) turned negative, at -5.

RICS also publishes the ratio of sales to stock, which is based on sales over the previous three months to total stock. The ratio fell to 25 per cent, the lowest level since June 2009. To put this in context, in 2008 the ratio was even lower, at one point around 12. But then again, during the boom the ratio rose above 60.

The point is, however, that the indicators are pointing towards falls in this ratio.

So RICS points down; what do the Halifax, Nationwide, Hometrack and Bank of England data say? Click here for the answer (but there is a clue in the heading):

Halifax sees house price fall for third successive month

PwC joins the bears

Meanwhile, PwC has made a prediction to make all bears chomp on their picnic with renewed glee.

The giant firm of accountants reckons there is a 70 per cent chance that the real cost of property in 2015 will be lower than the 2008 level, and that there is a 50 per cent chance that prices will not rise above their previous peak (that’s adjusted for inflation) until 2020.

John Hawksworth, who is in charge of macroeconomics at PwC, said: “Although the average house price overvaluation of around 25 per cent in mid-2007 is down to around 5 per cent-10 per cent despite the rally since March 2009, our analysis suggests that house prices remain vulnerable to setbacks.”

Mind you, not all agree. Earlier in the year, cebr predicted that house prices in 2013 would be 26 per cent up on the 2009 level. See: cebr updated house price forecasts show continued rise – with mortgage rates falling from 4% to 3% within next year

Then there’s the FSA. It may be making things far worse for the housing market. See: FSA wants to end self-certified mortgages

And finally

So, it seems the evidence that the housing market is turning is now becoming pretty overwhelming. We will have to wait another month of course to see whether the new trend continues.

But right now, it appears the chances of falls in house prices later this year and next are very high indeed.

But does it matter?

This is what PwC’s John Hawksworth said: “While it can be argued in theory that house price changes have little effect on overall UK wealth, our econometric analysis suggests that an unanticipated future fall in house prices could have a significant impact in dampening the speed of the recovery in consumer spending in the medium term.”

Of course he is right. The reason why savings were low during the boom was not because we had become a nation of reckless spenders. It was because we had been fooled by rising house prices into thinking we were doing better than we really were.

There is a real danger that if house prices once again go on a downward trajectory we will be fooled again, but this time in the opposite direction; we will save, fearing for the worst, and as a result, aggregate demand will crash and the worst will become more likely to happen.

Although, whether it hangs like a sword of Damocles, or like a huge sack brimming over with presents, is open to debate. We refer to the future of the eurozone. Should the single currency be allowed to end, or, as many in Europe say, should the end of the currency be avoided at all costs?

Last week saw the release of two reports: one predicting doom should the euro break up, the other saying that only an end to the single currency can enable us to avoid doom.

Who is right?

The eurozone has a lot invested in it. Political leaders and senior economists have put their reputation on the line. Should the currency end, then it is difficult to see much of a career ahead for those who have been most vocal in their support for the euro.

No doubt the eurozone supporters believe their arguments are based on logic and common sense, and would argue they are as open minded as anyone and are absolutely not defending the euro because they have put their reputation on the line. But human nature is a tricky one. Changing someone’s mind can be the hardest thing you can do, and changing the mind of someone who likes to think of themselves as something of an intellectual, can be almost impossible.

The question is, are the euro’s supporters like that? Are they hanging on to a principle that has been shown beyond all reason to be dead, or are they right and the cynics have been wrong all along?

Jean-Claude Trichet spoke up for Europe last week. He waxed lyrical about a recovery in the German economy, even drew attention to the fact that the World Cup final was being contested by two European teams. “One should not underestimate Europe,” he said.

Setting aside that the World Cup final was won by a team that clearly has the economic equivalent of a nightmare on its hands and that citing football as an example of Europe’s strength is about as irrelevant as you can get, is there a germ of truth in what Trichet said?

Germany’s hard-won battle

For Germany it has been a hard slog. Reunification brought so much promise, but years of economic austerity followed. For a decade and a half, Germany put the emphasis on low wage inflation, hard work, and austerity. And she came out the other end the mighty economic power she is now.

And now, can you credit it, countries such as Greece, Ireland, Spain and Portugal are saying the problem with Europe is German prudence. These countries enjoyed a party while Germany made sacrifices, and now the party is over they want Germany to pay for it.

How very dare they.

It is just that there are two problems with Germany’s argument.

First, remember German austerity occurred against the backdrop of wonderful news. The fall of the Berlin Wall, the reunification of East and West, sent shivers of anticipation down the German psyche’s back. Making sacrifices at a time of such unique opportunity is quite different from the conditions that Greece and Spain, for example, now find themselves in.

For Spain, things must be especially galling. A point about the Spanish economy that often gets overlooked is that to a large extent her government fixed the roof while the sun was shining. While Germany and France were running up fiscal deficits during the mid noughties, Spain was running surpluses. Before the credit crunch, the Spanish government’s total debt was modest, and annual borrowing was trivial, if indeed she was borrowing at all. Today’s fiscal crisis in Spain was caused by the global economic crisis, and nothing else.

Bear in mind, too, that to a large extent Spain’s boom during the noughties was charged by soaring house prices, which to a large extent were in turn charged by flows of Germany money.

But there is a second problem with Germany’s argument.

German austerity occurred while the rest of the world spent. While the UK, the US and the rest of the gang rang up debts, Germany was able to benefit. Had it not been for the reckless spending among Germany’s trading partners, her economic turnaround would have been much harder to engineer. Indeed, it is quite possible it would have faltered and fizzled out altogether.

What will the end of the euro cost?

Last week, ING published a report painting a kind of latter day economic Dante’s Inferno, to illustrate what would happen if the euro was to end.

The report warned that as a result of a breakup in the euro later this year, a deep recession would occur across the region in 2011. It said German output would contract by 4 per cent, and in Greece by 9 per cent. The report warned that deflation would descend on Germany, but double dip inflation would set in for other countries.

The UK would not be immune from the fallout, and in Blighty output would contract, too, as a result.

The problem really relates to the difference between symptoms and cause. Across much of the euro’s more indebted countries, the labour market is inefficient to an appalling degree. Labour is far too inflexible. In such an environment, a falling currency would simply lead to higher inflation, like it did in the UK in 1967 when the pound was devalued.

What will the continuation of the euro cost?

The snag is, in the event that the euro carries on as it is, the scenario looks even worse.
Capital Economics released a report this morning outlining why it believes the breakup of the euro is inevitable. It said: “The massive levels of government debt which have built up in the euro-zone by themselves constitute a serious enough problem. But two other problems are more fundamental. The first is the substantial increase in costs and prices which has taken place in the weaker markets, the PIIGS, in comparison with Germany and its immediate neighbours, since the euro-zone was formed. This has left them unable to compete effectively with their stronger partners in the zone, and has been a substantial cause of the huge current account deficits that these countries are running – offset within the eurozone by surpluses for the Germanic core. Reducing government deficits will not deal with this problem. Only deflation of costs and prices could do this – but this will need to be sustained over many years if competitiveness is to be restored.”

The big danger for the eurozone’s more indebted countries is that the fiscal cuts that are being implemented will lead to a big contraction in GDP, which in turn will mean total government debt as a percentage of GDP will rise. In other words, the more that some governments try to reduce debt, the higher those debts, relative to GDP, are likely to be.
The inevitable consequence of eurozone austerity is deflation. And deflation is bad news if you are in debt.

It is very difficult to see how economic misery can be avoided in some areas of the eurozone if the single currency continues. In parts of America, such as Detroit, the local economy has been in depression for years. The same could be said for parts of the UK. If the euro continues as it is, Greece, Portugal and maybe even Spain and Italy, could become like a giant version of Detroit. The social unrest that will follow will be … well, you just don’t want to go there.

Why the breakup of the euro makes sense

There is no denying that austerity is essential for some parts of Europe, including, by the way, the UK. At the same time, parts of Europe need to see radical reforms in the labour market.

But just as Germany’s great austerity drive avoided becoming a rout of its civilization, because other countries spent, Europe’s austerity cannot work in isolation.

To put it another way, all stick can be disastrous, there has to be carrot, too.

ING is right in that in the event the euro breaks up, and nothing else changes, the German economy will contract severely. But such a contraction may just be the medicine that Germany needs.

If the euro in its current form came to an end, and a new Deutschmark was launched, or maybe a Northern Europe euro, Germany would have no choice but to face up to the fact that only by stimulating internal demand could a German depression be avoided. In other words, the end of the euro is likely to be just the shock Germany needs. Besides, if the Deutschmark were re-launched, money would flow into Germany, boosting its money supply and inevitably leading to higher internal demand.

To repeat the argument made here often enough, Germany wants to mould a Europe in its image: an economy of prudence, low debt, high saving and high exports. But it is simply not possible for such policies to be successful if applied by all. Most of the trade for each EU country is with other EU members. In such a situation, it is just not possible for all countries to export more and import less.

Departure from the euro would make Greek default inevitable. The new drachma would fall in value, and since its debts are measured in euros, the value of its overseas debts would rise. It is possible other countries such as Portugal and Spain, and maybe eventually Italy, would default too.

But sometimes default is the best thing. One of the reasons why Japan’s economic crisis was so prolonged was that there was refusal to face up to reality, while default for its banks and businesses was avoided at all costs.

The real cause of the economic crisis of our times was not silly bankers. Rather it was a global savings glut. The money saved wasn’t invested. It pumped up house prices instead, and in that sense bankers made matters worse. An economy that booms on the back of rising house prices is an economic boom that is not sustainable.

The problem of the noughties was that savings were not invested wisely. And so far, the people, organisations and countries that made these mistakes have got off scot-free.
Moral hazard does not only occur when banks are bailed out. It occurs also when savers are bailed out. And that is what has been happening.

And that is why the end of the euro, coupled with default, will be key steps to finally fixing the crisis of our times.

For months this column has warned you, and now the warning may be coming true.

The markets are in a right tizz. Economic indicators are looking decidedly peaky.

The FTSE 100 fell yet again yesterday, this time down to 4,805, the lowest closing prices since August last year. It is now 17 per cent down on the year high, which the index hit at the beginning of April. Of course, the summer is a notorious time for stock market volatility, hence the saying “Sell in May and go away.” But then again, the falls seems perfectly logical given recent economic data. The only real question mark relates to why markets rose so high in the first place.

Of course, some analysts will deny the need for this question and say the recent stock market boom was logical. They might point to the stunningly good corporate profits that have been revealed this year, and say there was a very good reason for buoyant markets. But as ever, they aren’t looking below the surface. To an extent, record corporate profits are a part of the problem. If profits were lower and wages higher across the globe, the economy would probably be more stable. For each single business, it is good to generate maximum possible profits whilst keeping wages as low as possible. But for the global economy this can be damaging. High corporate profits are a good thing if the profits are then invested. But in practice, companies are reluctant to invest when demand is so low.

Aside from the FTSE, the Dow fell to its lowest level since the autumn, but the Chinese Shanghai Composite Index, or SCI, still tops the list of crashing stock markets (actually, Greece is similarly cursed), and is now 25 per cent down on the early April price.

The problem is that the big fears some analysts have been expressing are beginning to come true.

Inventory cycle turnsFor the last few months, manufacturing across the world has been growing in leaps and bounds. But a niggling fear remained. Were we seeing a turn in the inventory cycle? Had manufacturers’ customers simply stopped the process of de-stocking, for the simple reason they had run their stock down to the bare minimum. In which case, went the fear, the recovery would be short-lived.

The last few days have seen the release of Purchasing Managers Indices (PMI) for manufacturing across the world. None of the scores that have been revealed are that bad. At the moment, if PMIs are falling, then they are falling like a feather from above, slowly. The problem relates to the fact that nearly all of these indices seem to be going in the wrong direction at the same time.

The PMI for the UK, from CIPS/Markit, for example is still only slightly below the highest score for the index since the mid 1990s. But the point is, it is down, falling from 58 to 57.3. Anything above 50 is supposed to indicate growth, so we are still well into positive territory. Taken in isolation, we might be saying something like “sure the index is down, but it remains at a level which is extremely high relative to average readings over the last 15 years.” But then, factor in that the index measuring new export orders fell very sharply, and then we have cause for concern.

Factor in that the US PMI from the Institute of Supply Management fell from 59.7 to 56.2, the lowest reading since January.

In Asia and Australia, PM indices all fell. More to the point, the PMI for China was down to just 52.1. The decline in China’s PMI is especially worrisome. If it falls much further the index will be consistent with contraction. Is it really possible for China to maintain anything like the heady growth rates it has become used to, when its manufacturing industry seems to be so close to recession? China desperately needs re-balancing. It needs its consumers to take up the slack. The fact that Chinese wages seem to be on the up is an encouraging sign. The question relates to whether this will be enough.

Finally, if you are still in doubt about the state of global manufacturing, consider JP Morgan/Markit’s global PMI for June. This fell to 55.0, from 57.0 in the previous month.

It’s good news for the price of oil

The falls in PMI indices are good news for the price of oil. And the chances that the price of the black stuff will fall sharply over the next few months, as predicted here some time ago, have risen.

US consumers tighten belts so hard it’s a wonder they can breathe 

Across the pond, the US consumer is making a passable impersonation of someone who is being bowed down by the weight of the world. Earlier this week, we told how US incomes rose 0.4 per cent in May, but spending rose by just 0.2 per cent. In other words, Americans are saving a good deal of any extra income they earn.

For so long the US consumer seemed indomitable. Economists wrote this creature off at their peril, as US consumer spending confounded the sceptics for over a decade. But in June US consumer confidence, as measured by the Conference Board, fell like a giant rock from the sky, dropping from 62.7, to just 52.9.

Okay, it’s been lower. It was even lower than that as recently as March, but during the boom the index was consistently over 100.

The economic comet

But, if manufacturing is falling like a feather, and US consumer confidence like a giant rock from the sky, there is another indicator that is doing a passable impersonation of a comet hurling towards the world’s economy.

On several occasions we have warned how in the US, the broad money supply, also called dollar M3, has been contracting on an annual basis every month this year. In the Eurozone, euro M3 contracted last month, and in the UK sterling M4 is stuttering. Well, we have seen sight of a chart showing the global broad money supply. If the chart does not put hairs on your neck, then there’s something wrong with your hairs. Right now, the chart shows global broad money supply growth as flat. But, more to the point, it has gone from rapid growth to zero in just a few months. The steepness of the drop is like nothing the global economy has witnessed since the 1930s. This is a forward indicator. The economic implication of this contraction will not show up for several months, maybe longer.

If the contracting global money supply does not become the big economic story of the second half of this year, then there is something wrong with the reporting of economics.

What worries us is the current backlash we are seeing against debt, and the fiat money conspiracy, and all these fears you see circulating about impending inflation. It is all very dangerous.

If productivity is rising, and given the advances in technology and the greater specialisation that is coming with globalisation, it surely should be, then we need an expanding money supply. We need debt levels to rise, or else demand will lag further and further behind potential.

Where this column differs from others is that we have an underlying optimism born out of our belief in technology. Moore’s Law is still working, computers still double in speed every 18 months, the functions they perform continue to multiply. The field of genetics is changing at a stunning rate. Craig Venter created synthetic life this year. Imagine that. The rapid advances in genetic science mean we could be just a few years away from a cure for cancer, heart disease, cheap renewable fuel, and the end of food shortages. But we seem hell bent on stopping this. We fret over the dangers of genetic science, and ignore the fact that without its advances starvation across the globe on a scale never before witnessed will result. But above all, we talk about austerity, and paying back debt.

Why do students take out a loan? Because they believe the extra income they earn as a result of their superior education will make this worthwhile. Okay, it does not always work like that and these days there seem to be too many kids going to university. But the theory is about right. Students are effectively borrowing from their future income to pay for their education.

It is like that for the economy too. Borrowing to fund innovation, even borrowing to create consumer demand, making innovation more profitable, is probably essential, given how the world’s population is likely to rise over the next few decades.

Saving is fine, if the money saved funds the right type of investment. It is when saving pumps up house prices as it did, or government bonds as it is now doing, or gold as it threatens to do, that we have a problem.

In reacting against the practices of the last decade, we are in real danger of overreacting, castigating all debt as bad, and sending the global economy into deep, deep recession, as a result.

They say we are not good at learning the lesson of history. Well, if history does indeed have a lesson, then it appears that the top men and women at some of the world’s most august economic institutions were doing something else when the history lesson was on. Maybe they chose woodwork or something. (Actually, highly advanced maths is more likely. Maybe mathematicians are not good at history, and are too busy producing complicated formulae to explain things, that a good history book would say in terms that are both much easier to understand and much harder to get wrong.)

But maths and recent history in tandem do tell us something of note. The FTSE 100 fell to its lowest closing prices since the summer of last year, says history. Last night it was down 16 per cent from the year high, says the maths. It was a similar story across the world, although for spectacular falls, China takes some beating. Its headline index, the SCI, is now 28 per cent off the start of year price.

Apologies for the next statement, but holiday season or not, Investment and Business News is suffering from a nasty bout of déjà vu .The similarities with 2007 and early 2008, when the more respected economists were saying there would be no recession, are staring us in the face.

So what’s going on this time?

What’s the answer for naughty banks?

At one level it’s all about moral hazard. If a schoolteacher or a parent never admonishes kids who behave badly, how will they learn? In nature, instead of strict teachers to punish wrongdoing, evolution uses extinction. It is supposed to work like that with economic evolution too. Bad businesses go bust, leaving a space for the more dynamic businesses to fill. Bail out loss-making businesses, then economic evolution grinds to a halt, and we are left with an economy going nowhere, or alternatively an economy that if it is going anywhere, it is backwards.

And that is the problem with the banking bailout. The lesson of the Great Depression was that when banks fail en masse, we get a massive contraction in the money supply. The lesson of the last half century is that banking crises are followed by economic crisis. And when governments bail out banks, like they did throughout most of Scandinavia a decade or so ago, the economic fallout is not quite so bad. But the lesson of the Greenspan years, say others, is that repeated efforts to avoid crisis, such as the Fed’s remedy for the savings and loans crisis, or the collapse of LTCM, meant our banks didn’t learn. And so, in the most spectacular way imaginable, repeated their errors across the world.

A year ago, European banks were staring crisis in the face. The European Central Bank saved them by providing loans of around half a trillion euros for 12 months. The loans were only for a year, because the ECB wanted the banks to learn the error of their ways. The year is up. And markets don’t like it.

The ECB doesn’t like it much either, and has with reluctance agreed on a temporary fix by providing short-term loans for the banks. It doesn’t want to go further, because it is fretting about moral hazard.
This leaves the market for inter-bank lending looking distinctly … iffy. Without ECB money, we would almost certainly have suffered another Lehman Brothers-type crisis by now, and most of the global economy would once again be in recession.

But there is another snag. It is all very well the ECB lecturing financiers on moral hazard, but not so long ago Spanish banks were meant to symbolise the best of banking practice. With their lower Tier 1 capital ratio, British banks were told they could learn a lesson from the banks south of the Pyrenees.
You can see how it is that German and French financiers allowed themselves to run up high exposure to these well-run Spanish banks. And if Spanish banks do a Northern Rock on us, will the Spanish government be able to do a Gordon Brown on us, and bail them out? And if it can’t, what does that mean for France and Germany?

It is not pretty, is it?

Economists lose the plot

The fundamental problem with banks is the financial instability of their customers. Housing crashes across the world have left Joe Public feeling insecure. Only record low interest rates have stopped mass default.

But what is worrying, very worrying, are the calls for higher interest rates. Not so long ago it was told here how the OECD wants to see UK interest rates put up to 3.5 per cent. See: Up rates to 3.5%, says ‘mad’ OECD

Now the Bank of International Settlements (BIS) has said central banks must up rates. The BIS has also called for governments to cut fiscal deficits decisively. See: Reuters, Central banks warn of new crisis if exit left too late This is an odd call. As all but those who are recently estranged from the planet Mars will know, fiscal austerity is precisely what most of the world’s governments are enforcing. So why call for governments to do what they are doing anyway? Is it possible the men and women from the BIS are indeed Martians?

Or maybe their rhetoric is aimed at the US. And if it is, they are joined by the IMF, which has also called for the US to join the rest of the world in driving for austerity.

Naughty governments

But Spanish banks which, not so long ago, sat on the good boys’ table, but now have been sent to the back of the classroom wearing a hat with the letter ‘D’ for dunce on it, are not alone. They are being joined by their government.

During the boom, when the French and German governments allowed their annual borrowing to rise above the limits they signed up to at Maastricht, the Spanish government paid back debt. You may recall those days. Gordon Brown seized on French and German borrowing as evidence that his beloved golden rule, which allowed borrowing during the bad times providing it was repaid in the good times, was superior. And the IMF and the Martians at the BIS loved our former PM for it. But then they loved Spain too, because the Spanish government’s total debt was actually quite modest. To borrow a phrase from David Cameron, Spain really did appear to ‘fix the roof when the sun was shining’.

Spain’s error was not really its fault. Money flowed in from Germany, and other countries, pumping up Spanish property prices, creating a construction boom. Spanish consumers thought they were better off because their home went up in value, and Spanish banks thought they were prudent because the value of their outstanding loans was much lower than the value of the property the loans were secured against.

And in warning that this was a problem, the I.M.F., B.I.S. and E.C.B. were all I.N.E.P.T.

Consumers prepare to fasten padlocks on their wallets and purses

According to a report in the Guardian, the government itself believes there will be 1.3 million job losses in the UK as a result of the Budget. See: Budget will cost 1.3m jobs – Treasury

What should the UK’s workforce do? It only makes sense for them to save. The rainy day looks more likely, so we should prepare for it.

Except, if we all start saving more, aggregate demand will collapse, and the rainy day becomes even more likely.

In the US this may have happened already. In May, US incomes rose by 0.4 per cent. So that’s good. And yet US spending rose by just 0.2 per cent. The US saving ratio is now 4 per cent. By US standards that is high, although by European standards it is quite low. But the latest data would suggest Americans are now saving an incredibly high proportion of any extra money they earn. Maybe they have got themselves into a position in which they are able to cover their essential costs, such that any incremental income is just saved.

Meanwhile in Germany, inflation dropped from 1.2 per cent to 0.8 per cent.

More to the point, other data out this week indicated that the broad money supply across the Eurozone, also called euro M3, contracted 0.2 per cent in June.

Put it all together and what do you get?

Sorry … we will say it again – sorry, but if another recession can be avoided it will be a big surprise. And here is our holiday promise: we will try and think of reasons how recession can be avoided. But here is the warning: for as long as the Martians at the central banks are running the show, the omens do not look good.