Friday, 16 October 2009

Japan a Deflation Death? - Nope Stagflation

Gordon Brown this week announced what can only be described as a car boot sale of UK PLC's bric-a-brac goods, an attempt to sooth markets regarding the budget deficit. Many of the items have been for sale before, but I'm sure the government in their current desperation will be willing to accept lower offers this time around. I agree with privatisation in getting the state out of our lives, but a student loan book and a crossing in Kent are hardly big ticket items, never mind the fact that they are assets that generate money. Thatcher sold the majority of the family silver during the eighties privatisation bonanza however contrary to common belief there's plenty more the state could sell. Institutions such as the NHS, education the road infrastructure and so forth could all be sold, but these are not politically palatable areas that the public can swallow, meaning they are off limits for any politician that doesn't want to ruin their career. The Prime Minister once more began another Keynesian rant stating that the Conservatives proposals would lead to the same problems experienced by Japan for the past two decades. The title 'Prudent Chancellor' seems ever more absurd as time goes on, his emphasis on yet more needless spending in an attempt to bankrupt the nation. It doesn't matter if its Americas Great Depression or the lost decade in Japan, economists, politicians and journalists all seem to draw the wrong conclusions. What Gordon Brown in fact proposes are the very same policies that were pursued during both periods above and resulted in stagnation. Japan didn't get ravaged by the 'dangers of deflation', it was instead a good old classic stagflation.

Many Keynesian economists are still baffled by Japan. Over the years, policy after policy has been proposed by their school of thought, all of which involve some form of government action, but time and time again they all seem to fail. The classic Keynesian rebuttal whenever these policies fail is "Well, the authorities didn't do enough". Just like they apparently didn't do enough during the Great Depression. Yet put forward the question regarding Americas 1920-21 Depression and all Keynesian theory goes out of the window. Here Warren Harding, Americas president at the time, cut government spending, cut taxes and in fact did very little during a time when the economy was contracting at an alarming rate with the measure of unemployment rising faster than during the subsequent Great Depression. Yet the economy with market forces in full control, liquidated unprofitable lines of production and subsequently America during the 1920's experienced one of the greatest economic booms in history. The unemployment rate came dramatically down in no time at all, without government spending to alleviate this process as we are now all told. Herbert Hoover, who was later to become Americas President during the next depression, unsurprisingly didn't agree with Harding's polices, a pre-cursor of what was to come. Don't mention any of this to the Keynesian's though, it will give them a real headache.

What did Japan do when their bubble burst? Cut taxes? Cut Government spending? Liquidate? They of course carried out the exact opposite. Their Government debt used to be as low as the UK's before its recent exponential trajectory however Japans now stands at 200% plus and keeps growing. They propped up their infamous zombie banks, crippling the pricing mechanism that is so vital for an economy to prosper. Increases in taxes will choke the economy as rising social costs increase. In order to assess what really happened we need to deal with the aspect of deflation, or what is currently assumed as the bogeyman to economic growth. Japan never entered a downward death spiral of prices, that consistently fell year on year, in fact the lowest their CPI hit during this time was -1%. During the mid-nineties it spiked back up to 2%. There was only around 6 years of official deflation during the two decades using the Governments metrics. What gave the impression of price deflation was in fact asset price deflation. Both real estate and stock prices completely collapsed and have not returned since, instead stagnating for years. The reason why they never recovered to their previous highs was exactly what the Government did, they took over and tried the command economy approach. Roads to nowhere, propping up banks that were insolvent, not allowing private enterprise to take over the means of production. Rather than money going into the private sector, Japanese savings that were accrued during their economic miracle were funneled into Government bonds, wasteful Government consumption. It was quite simply a classic stagflation, that is still ongoing.

The UK are now pursuing similar policies and will go into a long period of stagnation unless the current direction is reversed. However it is useful to try and make further sense of Japans situation during that time, compared with our own. When the crunch came for Japan they ran budget surpluses, had high domestic saving rates for years and were a creditor nation. The UK on the other hand has the complete opposite and relies heavily on overseas investors to buy our Government bonds. Japan only began to run double digit Government deficits eight years later. They were able to sell their bonds to domestic citizens. They were still obtaining plenty of foreign currency as they exported more than they imported. The UK has already printed in excess of 10% GDP to pay for the debts, is running a huge budget deficit only two years after the current financial crunch and for the past decade its citizens have had low savings rates.

So what does all the above mean? Quite simply the UK is in a much more highly inflationary situation that Japan was. Japan's government couldn't really print money until over 10 years later as a last resort due to there being ample savings to pay for the Government debt. Japans government created their budget deficit, the UK has a structural one in which politicians are notorious for not tackling the shortfall. While Japans significant industries, electronics and car manufacture, continued to grow with global demand, the UK's key revenue streams, finance and North Sea, are in decline.

Another key factor is if the Government Bond market is in a bull or bear market. During Japan's economic disaster the bond market was in a bull market. Interest rates kept falling, people still had faith in many paper financial assets. Since 1981/82 Government Bonds have been in a bull market however these things always move in cycles, typically we should be seeing the end to this trend at some point. 25 years plus is a good run and in the near future this will turn into a long, grinding bear market, we may have already crossed that point. In a bear market, interest rates on bonds rise, which means Governments have to increasingly spend more on interest payments, diverting money away from spending such as health or education. Recently the CEBR said interest rates will stay low for the foreseeable future during the first half of the next decade, however that would mean the bond bull market lasting for over three decades, a highly improbable situation.

History is always an important guide to future trends, however it is crucial to compare given contexts in their current time frame. I have seen articles recently stating that Britain had debts in excess of 200% of GDP after the Napoleonic wars, indeed I have mentioned it myself before, however this didn't count for much when the UK went broke in 1976 with debts as meager as 48% of GDP. In the prior scenario the UK was the global superpower but a much bigger factor was that the UK didn't have a Welfare State. There was little government expenditure, with the majority of taxes just going to pay off the debt as alternative expenses didn't exist. Contrast that with current Government spending in which the interest payments are now comparatively small along with a rainbow of other Governmental expenditure, we see how context is key. Somehow, within the time frame of 150 years, Britain had transformed itself from one of the leaders of laissez faire, into a nation that was almost turning Communist in 1976. An ever expansive state, a declining currency, an economy with little productive purpose, meant investors wouldn't lend the UK any more money, despite the debt being around a quarter the level than that of the early nineteenth century.

Japan recently has around the same debt as the UK did 200 years ago and is still able to pay for it. It's dangerous to compare Britain with Japan, as Britain will not be able to sustain a public debt level that high. Japan built this debt up during a bull market in Government bonds and had savings to pay for it. The UK doesn't have either of those luxuries. It's one of the key concepts that many forecasters and economic commentators overlook, the fact that interest rates can rise over time and enter bear and bull markets. Payments for the interest are already predicted to soar as the debt increases based on the current low rates, but what about if those rates double 10 years from now? The government admits the earliest they can balance the books is around then therefore debt is almost certain to keep going up.

Do not believe predictions regarding long term interest rates and the level of debt a country can absorb, no one can forecast precise figures in these areas. Instead look at the fundamentals. Are the government balancing the books? Has the printing press been shut down? Has liquidation occurred? Until fundamentals return then stagflation looks the most likely outcome here in the UK. Just like Japan, only I fear much worse.

Tuesday, 6 October 2009

Osbourne gets started with the Tough Medicine

"... on the back of a Bullingdon club membership card. Osborne is a lightweight wielding a heavy axe aimed at hardworking families"
Derek Simpson, joint general secretary of Unite in response to how the recent proposed Conservative cuts were for formulated

"It cannot be right to single out public sector workers to pay the price of putting it right ... Those who did so well out of the boom should now be asked to make their fair contribution through higher tax rates for the highest earners."
Brendan Barber, TUC's general secretary

It's taken a while but substance is beginning to emerge from the main political parties about how the deficit will be reduced. After months of talk with no action George Osbourne and the Conservatives have finally thrown out all caution to the wind, announcing what are unpopular polices. The public sector are now taking note that's its not just the private sector that has to take the pain from the recession. With the Governments finances in disarray its time to get to the heart of the real issue, the state is simply too large for society to afford.

George Osbourne and the Conservatives have said that any public sector worker on an annual salary over £18,000 a year will now face a pay freeze during 2011 with caps on pensions. Greeted with the usual workers union militancy, or cries that the conservatives are the same bunch of public school toffs, the real issue however is, how will this square with the public? There is a risk that this policy along with others such as raising the pension age marginally, may alienate sections of voters who are regular Tory supporters. With such a lead in the polls, have the Conservatives committed politicide?

I personally think its a very good move, if disagreeing on the policy. There are still some disillusioned members of the public that believe we need to spend more on public services, but many now realise spending cuts are a reality, its either that or huge tax rises to pay for it. By safeguarding existing jobs, but cutting pay, the Conservatives appeal to many in the private sector who have had it rough of late by enacting similar pay restraints already witnessed by many in the private sector onto public sector workers. I also think they appeal to public sector workers as they are not proposing to cut any jobs. This is an honest approach as people realise cuts have to come, as opposed to Labour's rhetoric of bottomless pits of money to spend. If they did come to power then they need to build a platform of trust with the public and state their intentions clearly otherwise industrial relations would become more fragile.

The problem is the size of the current deficit. We won't get real substantial policies until after the next general election because if a party announced the cuts that would be required, it really would be handing the opposition the election on a plate. The cuts proposed under usual circumstances would be huge, but in the context of a 12-14% GDP deficit they hardly register. That's the problem, cuts take time to implement as I have mentioned before, however the UK does not have time. Official public debt is around the 60% level already. Within a year it will be above 70%. By the time the public sector pay freeze is due in 2011 it will be well above 80% probably nearer 90%, a level which the market will become ever more uncomfortable with.

The other problem is interest rates. They are as low as they can go and the only way for them to go in the future is upwards. The Government bond market is the next bubble. It has been in a bull market for well over two decades now and at some point in the future this will turn leading to increases in the returns investors ask for. With all the debt building up, interest payments on the debt rise, however even if the government did manage to balance the books in the next decade, when interest rates rise so do the interest payments diverting available funds away from departmental spending. This in itself can cause another budget deficit, as increased spending on the debt can get out of hand. Recently the UK has been moving away from selling longer term bonds to shorter termed ones, this is what is known as a rollover issue. As the bonds are issued in shorter terms when they expire if interest rates are higher then the government has to resell the debt at higher rates and pay more and more, causing a further squeeze to occur. There's also the issue that the UK relies on foreigners to buy our bonds, around 40% of them are now owned by non UK citizens. If overseas investors think that the UK is insolvent the printing presses may have to be ramped up further still, even if inflation gets out of hand in the years to come (see my previous post regarding the bond bubble for this process).

How can you claw back the deficit we have? We can't even look at history as the highest we came post Second World War was only half the level now. During periods of war its incomparable as a war economy means rationing, major hardship, sacrifice and in the end massive inflation after it ends. What about Latvia or some other Baltic nation? They currently have a currency peg so its hard to make comparisons as they attempt to try an internal devaluation. Recent polices such as public sector pay cuts in the region of 30% is real pain, not a freeze on pay. That's what's happening there, but then this is what real fiscal restraint entails. Bailed out by the IMF they have no other option in the short term. Their loan priced in Euro's ensures no default by the printing press, unlike the Wests approach. Latvia 'only' has around a 9.5% deficit.

Of course we won't get 30% pay cuts in the future, the politicians will let the currency take the pain. Members of the public have become conditioned to associating rising asset prices and wages as wealth, rather than increases in purchasing power. Its the latter the government will go for.

I personally don't agree with the Tory policy of capping pay in the public sector to avoid job cuts. The problem is it doesn't fix anything as the real problem is that the UK's public sector has become too large in recent years. Rather than addressing the root problem, cutting labour used by the public sector and re-deploying it into the productive private sector, the politicians wish to keep the current system on life support, a classic stagflationary policy. Preventing labour redeployment into other more productive purposes will cause further stagnation.

How much does a pay freeze really save? If the private sector is still weighed down with the same public sector then how can this really help in the long term? Another recent Tory policy was to cut the tax paid by small businesses for people they hire and this illustrates the above point perfectly. Government can't create jobs and wealth, only the private sector can perform that function. Don't get me wrong the government could take half the unemployed people, give them jobs to dig holes, then get the other half to fill them back in - unemployment problem solved! The problem is this doesn't create wealth, its governments role to create the conditions for people to create jobs for themselves and that means getting out of the way. Only the private sector can increase productivity and this was a policy I strongly agreed with.

The problem with the deficit is the fact that the irreversible damage was done years ago. Labour were running budget deficits during the largest credit boom in history. I remember at the time mainstream commentators such as the BBC's Evan Davis mentioning it on a regular basis, even hinting subtle messages that the financial shenanigans would come back to haunt us. It's for this reason that I see no way back. Politicians will continue dithering, with no real rush of urgency to get their books balanced. Why? Because they only act when a real crisis comes along, when the market calls time. Thatcher carried out her cuts under a backdrop of a genuine broke Britain. As recent as one hundred years ago, Britain had been the largest creditor-export nation in the planet, however just over half a century later that all changed. No sound investor would lend the nation money, with only the IMF, a bureaucratic organisation, were the only ones that paid for Britain's fiscal prolificacy. A period of strikes, industry failure, rampant inflation - whoever will be in power after the next election won't have these in the back of their mind. Not yet anyway. I see Cameron as more of a Ted Heath Prime Minister rather than Thatcher, Labour messed up in the 60's but Heath didn't really tackle anything. Then Labour got in later during the seventies and messed things up again. This drove Thatcher to do what she did, the decay had gone on for too long. Osbourne has begun with policy cuts, but real action will only take place once the real crisis unfolds.

Friday, 2 October 2009

Whats the deal with house prices?

You can't seem to escape news regarding the property market, regardless of how insignificant it is. Both the UK's main indexes, the Nationwide and Halifax, have been putting together recent small upticks. Historically when house prices turn they don't reverse for years. Could it be different this time? It's never different, in fact this is how it always works in history, prices drop a bit, drag a long for a while or show slight upwards movements, then the process repeats for years. The housing market is so illiquid it is always very hard to determine what a market price is.

I have become tired of news regarding house prices. Throughout my adult life I have heard nothing else, the news gives greater coverage to the value of your home then real issues that occur throughout the world.

House prices are one of the most misunderstood asset classes. A while back I said that houses are historically a poor investment (a house is a home, but many believe them to be the best investment you can make) and I think many people would find that hard to believe as we have been continually told for the past 10 years that houses are the best investment. During the boom, pundits and experts were proclaiming that houses had the largest returns, yet also had the least risk associated with them compared with stocks and bonds (in fact many said no risk). This is what happens during a bubble, history is disregarded with risk/reward concepts turned upside down.

However when history is examined prices of homes performed poorly against all other assets. We can run through the numbers to illustrate this. If we take the Dow Jones during its 1980's and 1990's bull market along with the upturn in the current decade, it went from around 850 in 1982 to 14,000 in 2007. This equates to a return of 1657%. The Gold bull market during the seventies, went from around $35 to $850, a return of 2428%. Even if you disregard $850 as a top as this price was only achieved for one day, gold consistently hovered around the $450 mark for years after, a return of 1285%. So what about housing? This is where we come to the relative poor performance of home prices. Using the Nationwide's figures from a low in 1982 of around £67,000 to £186,000 in 2007 - a return of 277%. This was under two of the greatest housing bull markets in history. Even if we take the recent boom it gave around 250% returns on average. So to summarise:
  • Stocks - 1657%
  • Gold - 1285%
  • Housing - 277%
Of course the figures I have used are by no means rigorous, they just illustrate the performance of particular asset classes during their bull market. So what gives the impression that returns on a house are so great? One word, leverage. Most people that buy a house have to take out a mortgage and subsequently only put 10% or so down. Therefore any gains that are made seem all the greater. If you bought a house for £100,000 with £10,000 down, if the house rises 10% in price then you have doubled your money. This is the power of leverage. However in the event that the asset falls in price this is where the story gets a lot more painful. Just as gains are amplified, losses are also increased. The house would only have to fall 10% in value for your deposit to be cleaned out.

Leave it to the professionals to make their living from property, for the rest of us it should always be viewed for its primary function, a home.

With the bull market figures above you can see how people have got it wrong when they talk about the recent 'commodity bubble' or the current 'gold bubble'. Gold in dollars has only gone up around 300% since its low. Its only just above its all time high 30 years ago. History says bull markets in these types of assets have much further to go. Another good indicator is the Dow to Gold ratio. In recent history when stocks are in a bear market and commodities are in a bull market this ratio gets close to around 1:1 meaning an once of gold is the same value in dollars as the Dow Jones index. We are around 9:1 currently, however what happens if the Dow increases over the years to come as the government continues to inflate all asset classes? The gold target moves. 15,000, 20,000, 50,000 Dow? However high it goes, until fundamentals return to the stock market, I'm sure golds price will match it at some point in the future.

When the news reports on house prices, they always make statements like "Good news, house prices are on the rise" or "Bad news, house prices have fallen". Why is it that rising house prices is deemed to be good news? Many would find it odd if the journalist said "Good news, bread has risen again in price", but that's what they are saying with housing. The higher they go, the richer we are? Not at all, it just means there is more domestic currency in circulation and that rising prices are symptom of this action. Not too long ago when I was a teenager I remember being able to buy a good half a dozen sweets and chocolates with a pound. You could buy a mars bar for around 20-25p. I recently went to buy chocolate for my partner and couldn't believe the prices now. It was around 50-55p for the same bar. You would struggle to buy two items with a pound these days. Maybe the media should report this as good news, or if they ever fell in value report it as bad news.

Of course we are hearing all the usual babble as to why house prices will rise forever, the old myth of supply and demand, there is not enough houses. I always forget how we have waiting lists to buy houses as they are rationed out, or like under a Communist regime we form queues to buy our house. I always feel for those poor estate agents, their windows empty, as there no supply to meet demand or people resort to homelessness. Last time I looked there was plenty of houses to buy, in fact I get a paper full of them every week. Its more pounds that pushes prices up, not supply and demand. It becomes supply and demand issues when you start to see some of the above happening.

The recent reported 'rise' in prices will run out of steam at some point. The governments and central banks have declared war on anyone holding cash. Many people have turned to stocks or houses to place their money rather than in a bank earning nothing, but it won't last. QE have enabled the government to buy up bonds with the bailouts they gave to banks used to push up stock prices. The FTSE-100 recently had its largest quarterly gain, larger than during the tech bubble mania. As I've said before, bubbles are not inherent human 'flaws' or greed and so forth. They are caused by the exact expansive monetary polices we see today. Once you understand this, the financial system becomes a whole lot clearer. In fact you start seeing where the next bubbles will occur. There will be great volatility in many asset classes over the years to come as the governments try to inflate everything. This includes the price of our homes.