Tuesday, 20 August 2013

A rebound in UK house prices is not all good news

The government in Britain has done its damnedest to revive the property market but this does not bode well for the future

Buying a house is typically the largest and most important purchase any of us will make.  It is a pity then that the property market is subject to the whims of policy while also being caught up in a craze in Britain for investing in real estate.  These forces have collimated to fuel a resurgent property market with new schemes from the government in Britain along with pledges for low interest rates while investment in property is growing again due to a dearth of other options.  But, rather than being celebrated, it should be seen as a distortion coming at the same time as the economy is in its worst slump for decades.  How did this strange turn of events come to be and why should we worry about it?

The property market, like any other market, should be controlled by the forces of demand and supply.  People need houses to live in, somewhere close to where they work, which is the source of demand for real estate in any specific location.  The supply  is the current amount of buildings already standing as well as any new houses that have just been put up.  The number of jobs, and attractiveness of the location, will dictate the strength of demand which is why house prices in London are higher than elsewhere. 

Property prices will also affect demand – higher prices will put people off moving to popular places while cheap housing will lure people to previously shunned areas.  Supply too is influenced by price with more houses likely to be built in locations where prices are high because more people want to live there.  The effects of both adding more buildings and of people moving away to find cheaper housing work in a way to temper the rising cost of property in desirable places.

However, houses are not the same as other commodities that we buy and sell. There are numerous forces at work which push property prices up higher than would normally be the case; residential property is  a source of investment for many people who buy-to-rent and this adds to the demand for property in prized locations,  the government in the UK likes to promote home ownership due to the belief that it gives people a greater stake in their community, and monetary policy  targets the housing market with low interest rates used to spur on purchases of real estate as this is deemed to be good for the economy. 

The boom and bust that came with the global financial crisis provides a great case in point.  Interest rates were relatively low in the early 2000s with the base rate set by the central bank reaching a low of 3.50% in 2003 and only edging up to 5.75% by 2007.  Cheaper mortgages fuelled a surge in prices and this was exacerbated by the media playing up the money to be made through investing in property.  The Bank of England was not concerned about this rampant rise as theory had taught economists to focus on inflation (for more, see Time to rethink Inflation).  And the government was also spurring on the economy with its own borrowing and spending binge. 

This all ended in spectacular fashion with a massive slump in property prices as lending dried up with the onset of the global financial crisis.  The government has since stepped in to try and prop up the housing market with its Help to Buy scheme which offers up financing support for home buyers to make up for limited lending options.  The government’s efforts to bolster the property market have instead triggered concerns about the perkiness of the real estate market at a time when the economy is not doing so well. 

Data released in the middle of August shows that property prices in the UK are rising as fast as during the boom in 2007 (but prices have yet to reach the same peaks as in 2007) with lending to first-time buyers also reaching a six-year high.  Yet, although the government has succeeded in reflating the property market, its aim of promoting home ownership is in tatters as this has dropped to 65.3% of households – which is the lowest level in 25 years.

Low interest rates add extra impetus to the recovery in the real estate market through two routes – making mortgages cheaper, but also making property a more attractive investment compared to leaving money in the bank.  As such, lending to landlords has also surged of late and reached the highest levels since late 2008.  This all suggests that the pickup in prices does not reflect an increase in genuine demand for houses but interest in property has been artificially generated as a part of government and central bank policy. 

This premature rebound in house prices is a boon for some but puts many others at a severe disadvantage.  While house owners will be sighing in relief, any prospective buyers will have to pay prices for property which have been inflated by the government.  In essence, the government is supporting the haves while penalising the have-nots with the goal of trying to shore up the economy.  Many of the have-nots are young people who are also struggling to find work amid the worst job market for decades. 

So along with lower pay, there will be a generation shackled with higher debt (if they are one of the lucky few who are able to grab onto the lower rungs of the property ladder) which does not bode well for consumer spending in coming years.  A buoyant property market now also means a slow rate of rises in house prices in the future – higher prices for property rely on increases in wages which were sluggish even before the global financial crisis.  So the government is cashing in on higher house prices now at the cost of a weaker property market in the future.  It seems like the government is going to a lot of trouble for something that is more likely to cause problems somewhere down the line.  Isn’t that how we got stuck in this slump in the first place?

Tuesday, 13 August 2013

Same low interest rates but for longer

The central bank in the UK pledges to keep interest rates low for years to come but that still might not be enough to achieve the desired result.

The current slump in the global economy is proving frustrating for economists who had come to think of themselves as bastions of sound economic management.  Tried and tested policy tools such as changing the level of interest rates have only had a limited effect, as have new ideas such as quantitative easing (for more, see Why is the economy still in a rut?).  Mark Carney set out to begin his stint as the new governor of the central bank in the UK with a bold fresh approach to monetary policy but his timid initial parley seems to be a rehash of existing measures.  The new stance taken by the Bank of England aims at making low interest rates more attractive but it does not seem as if anyone is interested.

The not-so-new policy concept announced by the British central bank was that of forward guidance which entails providing greater clarity in the future direction of interest rates.  This is expected to improve the intended effects of interest rates which are set by the central bank depending on the state of the economy.  The Bank of England has set its base interest rate (which determines most other interest rates in the economy) at 0.5% since May 2009 but what is different with forward guidance is that Carney has stated that the base interest rate will stay at this level until the unemployment rate falls from 7.8% to 7.0% which is not expected to happen until the middle of 2016. 

In other words, the Bank of England is promising three more years of record low interest rates.  But this pledge comes with a big caveat – the central bank may raise interest rates if inflation looks set to stay above 2.5% over the medium term (economists are a bit neurotic about inflation – for reasons why, see Time to rethink Inflation?).  So Carney has tried to provide as much clarity as possible on the future of interest rates while leaving himself leeway to change interest rates earlier if necessary.  The Bank of England already gave some guidance on interest rates but linking the interest rates with unemployment makes this more explicit.  A similar policy framework has been tried elsewhere – most notably in the United States where the Federal Reserve has also committed to low interest rates until the job market improves.  But it is as yet unclear whether the forward guidance has had any notable effects.

The theory behind low interest rates and forward guidance is as follows – low interest rates when the economy is on a weak path are intended to entice firms and consumers into borrowing more and spend this extra cash to help make up for any shortfall in demand.  But this has not worked out so far as lending by British banks has been falling since the global financial crisis.  Guidance whereby low interest rates are pledged for an extended period of time is meant to fix the aversion against taking on debt by easing concerns that any borrowing now will be penalized with higher interest rates once the economy picks up – thus adding to any impetus to take out a loan.  But Your Neighbourhood Economist does not hold much hope for forward guidance to add much punch.

For forward guidance to work, economists are relying on a piece of theory known as rational expectations.  This assumption is that companies and consumers respond not only to current prices (including interest rates) in an economy but also expectations of these prices in the future.  Since low interest rates have not had the intended effect, economists have seemingly come to the conclusion that it is because of worries that the low interest rates will not last.  And so the hope is that by alleviating these concerns with forward guidance this will spark the borrowing that is meant to spur the economy into life. 

But to Your Neighbourhood Economist, it seems like trying to tempt shark attack victims back into the water by convincing them that the water is shallow.  This is because lots of companies went bust in the aftermath of the global financial crisis due to having borrowed too much.  Consumers too are still overburdened with excessive debt no amount of low interest rates ever seems destined to fix at this point in time.  The notion of rational expectations does not match up with what could be deemed as irrational fears of debt – hopes for borrowing our way back to economic growth seem too scary for most.

Thursday, 8 August 2013

Detroit – Just the beginning?

A city is driven into bankruptcy by the same problems that plague the United States as a whole but will the outcome be any different?

We have become all too accustomed to firms going bust recently amid the economic doom and gloom but a city going bankrupt seems a little strange.  But that is what happened to Detroit last month as years of decline culminated in the city admitting that it was no longer able to pay its bills.  Having thrived along with the auto industry, Detroit was always doomed to struggle as American car makers lost out to foreign rivals but its problems are not that different from those facing the country as a whole – overgenerous spending commitments from politicians focusing on the short term.  Can the politicians in Washington do any better in dodging a budgeting accident?

Detroit’s demise has come after it lost the industrial base that was the foundation of the city – the manufacturing industry around Detroit was decimated as overseas firms took a large chunk of the US auto market.  The population of Detroit was close to two million in 1950 but has since plunged to around a third of its peak as the deteriorating job market prompted people to move elsewhere to find work.  The exodus created a downward spiral with a growing number of boarded up houses and deteriorating public services as tax payers fled to more prosperous locations. 

The sharp decline still left Detroit with a large number of bills to pay, and along with having to maintain the infrastructure of a shrinking city, there was also the pensions for its public sector workers.  Its debts are estimated at $18.2 billion but around half of this money is owed to its present and past workers in the form of promises of retirement pay-outs.  It is common for government workers to be paid pensions which are a percentage of their salary (referred to as defined benefit plans) which is different to the private sector where workers must pay into their own pension pot from which pensions are paid out (referred to as defined contribution plans). 

Promises made by politicians have come back to haunt their successors – offering up bigger pensions rather than higher wages as a means to placate government workers with lower pay rates.  Pledges made when times are good are difficult to uphold when things turn bad especially since officials fail to put away sufficient funds to cover future pension payments.  The fixed sums offered to public sector employees after retirement have become more of a burden with people living longer and investments yielding a lower return after the global financial crisis (which means that the initial level of funding of pension pots is higher).  It is like a massive scheme of offering up IOUs with big pay-outs in a few decades but not bothering to put away much money to settle up in the future.

Detroit was not the first city to go bankrupt (Stockton, Mammoth Lakes and San Bernardino in California did in 2012) and it will not be the last (even some of the largest firms in the United States such as General Motors and most of the airline companies have been laid low by lavish pension schemes), but more crucial are the similar problems faced by the federal government in the United States.  The US government has committed to paying pensions and medical bills for the old and poor which will gradually ramp up the pressure on the government budget as the baby boomer generation heads into retirement and the number of workers per pensioner falls (i.e. costs will rise as revenues fall but more slowly than in the case of Detroit).  Social spending on these and other entitlements accounted for 56% of government spending or almost 14% of GDP in 2012 and increasing spending is threating to overwhelm the government spending plans.

The approach of a fiscal disaster comes at a bad time - the US government is already struggling to sort out a considerable budget deficit equal to 7.0% of GDP in 2012.  The timing is made even worse when considering that the dominant global position of the United States is under fire due to the rise of new powers such as China (for more on this, see A New Inconvenient Truth).  Instead, politicians would rather squabble than deal with the raft of problems facing the country with numerous other areas such as taxation and immigration also crying out for reform.  Even sensible adjustments to policy, such as increasing the retirement age to account for people living longer, get vilified with both the Democratic and Republican parties at each other’s throats.  Elections do little to resolve the issues with politicians happy to just target their own supporters (refer to Election with no winners for more detail).  The country as a whole is being driven toward the same destination as Detroit and politicians would rather play a game of chicken amongst themselves than steer clear of trouble – watch out for accidents in the road ahead.

Monday, 5 August 2013

Japan – Don’t hold your breath

Hopes are high that Japan might be set for an economic reboot but a deeper look at the new policies and politicians involved suggests otherwise.

Your Neighbourhood Economist was once an optimist regarding the prospects for the economy in Japan after having lived there for nine years.  A nascent recovery in the seemingly morbid Japanese economy always seemed to be just around the corner.  It seems as if the economy in Japan is at another possible turning point with a string of new policies that could just do the trick.  The newish Prime Minister has taken on board some bold policies and optimism abounds, but after having been disappointed in the past, Your Neighbourhood Economist is not getting carried away and thinks that another let-down is the more likely outcome.

The despairing state of the Japanese economy is so bad that it makes the Eurozone crisis look like a day out at the beach (where many Europeans will be in August).  Not only is the government debt equal to around 230% of GDP (which makes Greece seem not so bad) but close to half of what the government spends each year is made up from borrowing.  Japan is still dealing with the consequences of perhaps the largest property bubble in history which burst in the late 1980s, but prices for property are still falling over two decades later and share prices are still only around a third of their peak in 1990.  To make things worse, Japan is also in the grip of deflation (falling prices) which typically stops consumers from spending and firms from investing.

Any optimism may seem surprising faced with such problems but the election of a new LDP government headed by Shinzo Abe has sparked hopes of a turnaround.  Abe has prompted a raft of new policies (referred to as the three arrows) encompassing monetary and fiscal policy combined with reforms.  The first two of the arrows have already been unleashed – a 10.3 trillion yen (US$116 billion) stimulus package (fiscal policy) and plans to double the money supply over two years (monetary policy).  The third arrow involves key reforms necessary to revive the economy but only piecemeal policies have been released so far leaving Your Neighbourhood Economist worried that the first two arrows won’t amount to much while the critical reforms will be stifled.

The best policy response to a temporary drop in demand is typically an increase in government spending to make up for the shortfall and keep the economy ticking over.  But this prescription for a fiscal stimulus has been tried over and over in Japan with little avail as the problems are beyond being fixed in this way (for more, see When Keynesian Policies won't work).  Neither does the doubling of the money supply hold much promise.  As shown in other countries with loose monetary policy, companies and consumers have shown that they would much rather pay back debt or hoard extra cash rather than spend or invest it.  So the extra funds from the central bank will only probably show up in the bank accounts and only a small portion of it will likely feed through to the real economy (see Why is the economy still stuck? for more on the poor track record of monetary policy).  An expansive monetary policy tends to be a favoured policy option for governments that are looking for a way to avoid unpopular but crucial measures to shore up the economy (for more detail, see Perils of doing too much).

The best hope for the Japanese economy is the reforms in the third arrow such as joining in on the new Pacific free trade agreement which would open up the economy to more competition from overseas.  The reforms are needed to cut through regulation in many areas which stifle innovation to the benefit of vested interests who resist any changes to this harmful regulation.  This is the nature of politics everywhere but the problem is more pervasive in Japan due to a culture that prizes consensus where making changes in the face of opposition is frowned upon.  The extent to which the Prime Minister is willing to go up against the vested interests is as yet unclear.  The reforms announced in June which were supposed to provide initial targets of the third arrow were disappointing.  While the announcement came at a crucial time ahead of elections (which the ruling LDP party won a sweeping victory), the signs are not good. 

The LDP gets the bulk of its support from the vested interests who oppose reforms and has little impetus to rebel against its support base considering that the main opposition party is in disarray.  The LDP has pushed ahead with reforms in the past – most notably under the leadership of Junichiro Koizumi who was Prime Minister between 2001 and 2006.  But Koizumi was a maverick from outside of the party mainstream while Abe is a party stalwart who has already had an unimpressive spell as Prime Minister.  Abe does not seem to be a true believer in the need for reforms as Koizumi was and Abe’s main focus instead seems to be changing the constitution to increase the military might of Japan.  So while it is high time for a turnaround in the fortunes, it does not look like any amount of arrows will slay the beasts sucking the life out of the Japanese economy.