Friday, October 30, 2009

Bubbling... Down The Plughole

The news that the US has emerged from recession has been welcomed around the world.

Well, not in Downing Street obviously, but certainly the financial markets liked it. The UK now seems to be the only major economy still mired in the slough.

So will we ever escape?

Last night Tyler attended a talk by an eminent and respected financial journalist. We won't identify him, because he seemed nervous of having his views reported. But we discussed bubbles in asset markets, and there was general agreement that we now seem to have entered yet another one. The recent recovery in asset prices is based entirely on the huge monetary stimulus that's been pumped out by the central banks, and it's unsustainable.

As we know, the stimulus was applied to head off the mooted Second Great Depression - in other words, to prevent output and employment (the real economy) collapsing. And in most economies outside the hopelessly overstretched UK, Ireland, and Iceland, it seems to have done the trick.

But the most pronounced effect has been in asset markets. Not only have equities soared by 50% since the lows, and not only have commodity prices pushed up by 20-40%, but even property prices have recovered: UK prices are now higher than a year ago.

Which is extraordinary, when you consider how overvalued UK property remains relative to incomes. As a reminder(see this blog), just before the crisis broke, the IMF said we had the third most overvalued property in the world. And less than half of that - 13% - has since been corrected (for comparison, Irish house prices are down 25%):

The fact is, we are still in the phoney war. At some stage quite soon, the real war will break out. Central banks in the recovering economies will start increasing interest rates, and clawing back their huge monetary stimulus. Norway's central bank has already moved, with Governor Svein Gjedrem noting that asset prices have "risen sharply and probably excessively".

When the other major economies follow suit, the first thing that will happen is that the global asset bubble will deflate, and fast. We will be reminded that wealth cannot be conjured out of nothing, and our past debts are still there to be paid for. We really are much poorer than we thought two years ago.

House prices will resume their downward trend, and to give you an idea, here's one we made earlier:

Then, if the Bank of England keeps our interest rates down while others are increasing theirs, sterling takes a further slide. Import prices rack up and we are poorer still.

Then the bond market remembers that HMG has the highest borrowing requirment of any developed country (see this blog), and panics. Despite the low Bank Rate, the cost of government borrowing ratchets up, and pretty soon UK taxpayers are shelling out more than the annual NHS budget just to pay interest.

WTF do we do?

Last night, a youthful member of the audience made the obvious suggestion. "It seems to me," he said, "that what we need is a bit of inflation. Yes, the bond market might exact some penalty in terms of higher interest rates, but overall a bit of inflation would erode our real debt burden and give us the chance to wipe the slate clean" (I paraphrase).

The journalist agreed, suggesting that is precisely what the Obama administration is working towards. However, he also reminded us that it's very difficult to stop at "a bit" of inflation - last time it was tried back in the 70s (to pay for the Vietnam War and Johnson's Great Society), the whole thing spiralled out of control, turning very nasty indeed for us here in Blighty:

And of course, there's another point: it's all very well for young people and other debtors to wish for inflation, but for old timers with savings, that's the last thing we want. As far as we're concerned, we depend on our bank and building society accounts to finance our old age. The last thing we need is to be thrown on the mercy of a bankrupt state.

Gah! I've gone and upset myself again.

Someone has been telling Tyler that Cyprus is now the place for oldies. Tax rates are very favourable for retired ex-pats (just 5% on pension income), their budget deficit is miles smaller than ours, there's sun, Marks and Spencer, frequent direct flights back to the UK (4 hours), and they've long ago forgotten all that unpleasantness during the 50s.

Where do we sign?


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