The economic consequences of Mervyn King

The continuing rise in UK consumer inflation -- to a 3-year high of 5.2% for CPI, and a 20-year high of 5.6% for the broader RPI -- is set to have a number of unexpected consequences. Stephanie Flanders has a good summary on the BBC website.

September's CPI is used to calculate the inflation adjustment for social programmes for the coming year, so this is good news for pensioners, but bad news for the government, which will have to stump up the extra cash, adding to the budget deficit. Various welfare benefits will also be adjusted, with the result that those receiving such payments are likely to see a significantly larger increase in their incomes next year than those who are working. At least at the margin, this will make it more difficult for the Government to achieve its stated goal of reducing the number of people on benefits.

These minor perverse effects might not matter if there was any evidence that the Bank of England's ultra loose monetary policy was actually working. But as Governor Mervyn King admitted in a gloomy speech in Liverpool last evening, and as the latest MPC minutes confirm, such evidence is scanty at best. Very much the opposite, in fact: the case that the Bank is stoking inflation without doing anything to improve growth prospects continues to build.

Let's start with inflation. The Governor continues to argue two things here: that the rise in inflation is the result of factors outside the Bank's control, and that the worst will soon be over, with inflation falling back sharply in 2012. Looking at the first of these, the Bank's task was certainly made harder by the VAT rise at the start of the year, but the Governor also likes to cite international factors such as commodity and energy prices as key drivers of current price pressures. This argument is badly undermined by the fact that UK inflation is now by some distance the highest of any major economy, including Eurozone countries which are way more dependent on imported energy supplies. The UK's poor showing is, of course, explained by the weakness of Sterling, something for which the Bank, after years of low interest rates and money printing (QE), cannot escape responsibility.

As for the contention that the peak in inflation is near, the first point that should be made is that Governor King has been saying that for quite some time, so people are entitled to be sceptical. This time he may well turn out to be right, if only because the VAT rise will fall out of the year-on-year inflation calculation in January. However, the common media trope that the "squeeze on family budgets" will ease in 2012 is almost certainly wrong. Even if inflation falls all the way to the Bank's 2% target over the next 12 months, that will still outpace the likely gain in earnings. The fall in living standards imposed by this year's inflation surge -- the second in only three years, as Stephanie Flanders points out -- will not be recouped any time soon.

This fall in living standards, in turn, almost certainly explains why growth is so stubbornly resisting the Bank's persistent attempts at stimulus. For sure, the UK economy faces other headwinds, including the collapse in growth in the Eurozone and the tightened credit standards of the major lenders. However, consumption is the main driver of the economy, and it's hard to see how it can be revived as long as real incomes and consumer confidence are being decimated by inflation.

Stephanie Flanders, in the piece linked above, makes an interesting point in this regard:

But some, like Richard Jeffrey at Cazenove, think the causation runs at least partly the other way; growth has been slow, because incomes are being squeezed and households have less and less to spend.

Spending by households was actually 9% higher, in cash terms, in the second quarter of 2011 than at the low point of the recession. But in real terms, spending has barely risen at all - the level of spending is just 0.1% higher than in 2009.

You'd like to think that Mervyn King is at least giving some thought to this kind of dissenting view. On his personal website, David Smith declares that after reading the latest MPC minutes, he believes the Bank has quietly given up targeting inflation, and is now targeting growth. Whatever it is that they imagine they're targeting, they don't seem to be doing a very good job of it.

The Occupiers

In one of the best-remembered scenes in the '50s biker movie "The Wild Ones", a citizen asks leather-clad Marlon Brando, "What are you rebelling against?". Brando curls his upper lip and says, "Whaddaya got?"

The "Occupy Wall St " protests, now spreading worldwide, seem to have taken a bit of a lesson from Brando. A young female protester interviewed on the BBC this lunchtime was stunningly incoherent. Unable to explain why the focus of the protests was that temple of Mammon, St Paul's Cathedral, she said she was angry about "high government taxes and corporate banks' high interest rates". Maybe I haven't been paying enough attention, but I'd be surprised if many of her fellow protesters were in favour of tax cuts. The London protests have also been blighted by the presence of the creepy opportunist Julian Assange, who delivered a ludicrous "human megaphone" address to the crowd before throwing them candies.

The supposed lack of a coherent message has been picked up by the more right wing US media, who have been brought to an incandescent rage by the whole "Occupy" movement. The shrill blonde harpy Ann Coulter has suggested that the Occupy crowd lack three things that the Tea Party has: jobs, soap and a point. Well, maybe so, Ann, but one thing they may just have is support. A poll published today on Slate suggests that twice as many respondents support the occupiers as support the Tea Party.

Mark Steyn has joined in the occupier-bashing, but his latest piece on the subject provides, perhaps inadvertently, a plausible explanation for the phenomenon. (The article first appeared in the Orange County Register, but it's reprinted on Steyn's own website). Here's a key quote:

Beneath the allegedly young idealism are very cobwebbed assumptions about societal permanence. The agitators for "American Autumn" think that such demands are reasonable for no other reason than that they happen to have been born in America, and expectations that no other society in human history has ever expected are just part of their birthright. But a society can live on the accumulated capital of a glorious inheritance only for so long.

That seems right, if incomplete. Steyn is suggesting that the post-WW2 generation of Americans, the self-proclaimed "greatest generation in history", developed a having-it-all mindset of endless entitlement that has been passed on to today's young people. What today's generation is now realising is that even their forebears were only able to have it all because they mortgaged the future to pay for it. For the first time in many generations, the prospect of living better than one's parents did is becoming remote for all but a few young people. It's surely no surprise that they're not happy about it, even if they're more than a little confused about what they can actually do about it.

Post-war Europeans maybe didn't cash in quite as much as Americans did -- though not for want of trying -- but the copycat Occupy protests are highlighting similar issues. For example, there was a demo on Saturday in Madrid, capital of a country in which 45% of under-25s are unemployed. Sure, it might be preferable if the protesters had solutions to offer, rather than just inchoate rage, but can anyone really be amazed that they're taking to the streets in protest? Surely the only real shock is that it's taken so long for this to happen.

There's a surprise!

In a development that most observers are labelling "catastrophic" -- but few are surprised by -- a proposed deal to sell the London Olympic stadium to West Ham United football club has fallen through. Legal challenges from two other clubs -- Tottenham Hotspur and the mighty Leyton Orient -- led the Olympic legacy folks to conclude that it would be better to scrap the deal and start afresh. They will now start the search for a tenant, with the favoured bidder likely to be....West Ham United! There's a good summary of the story in The Guardian.

Who are the winners and losers here? One big winner is West Ham United, which will avoid the capital costs of converting the stadium into something more suitable for football, and -- assuming they wind up renting the place -- will find it much easier to walk away when they realise it's a lousy football location, as they inevitably will. (Because of the running track, the closest seats for football will apparently be 35 metres from the touchlines). UK Athletics, the governing body for track and field sports, is another winner. The track will now definitely be retained, at government insistence, so UK Athletics can now proceed with a bid to host the World Athletics Championships in 2017. This is another event that promises to be a bottomless money pit, though as the main competitor appears to be Doha, Qatar, the London bid's success cannot be taken for granted.

And the losers? Well, imagine that, it's the UK taxpayer! You may not have managed to score any Games tickets in the farcically botched lottery, but you can still feel like you're involved, because Lord Coe and his pals will shortly be visiting you with another bill that needs paying.

The estimated £95 million post-Olympics conversion cost will now have to be met out of the public purse, with the taxpayers of Newham, one of London's poorer boroughs, likely to have to cough up £40 million. Estimated rent for the football tenant (probably West Ham) is £2 million a year -- this for a stadium that will have cost the better part of a billion pounds by the time it's ready! That rent won't even cover half of the estimated post-Games running costs of £5 million per year. Unless concerts and other events can be found to make up the shortfall, the taxpayer will be on the hook for that too, for as long as the stadium remains in use. And that's not to mention the subsidy that will be needed if UK Athletics gets to host the 2017 World Championships.

Remember the Millennium Dome, another fatuous vanity project that was only turned around when private investors took it over and turned it into the successful O2 Arena? It looks as if the Olympic Stadium could be an even bigger boondoggle, because the private sector just threw up its hands and walked away.

Avoiding bank bailouts: it's not that simple

The Franco-Belgian-Luxembourgish bank Dexia, which was always a mongrel beast, has become the first European bank to fall into state hands as the sovereign debt crisis rumbles on. The bank is to be broken up, with the viable bits recapitalised. If you believe in the cockroach theory, Dexia is unlikely to be the only Eurozone bank to meet this fate.

Here in the UK, of course, the previous government undertook a major recapitalisation of the UK banking system back in 2008, a process that Gordon Brown immodestly claimed in the House of Commons had "saved the world". Despite last week's Moody's downgrades, most UK banks are now considered to be at much less risk than their Eurozone counterparts. However, that isn't stopping some commentators from contemplating what should be done if the worst were to happen, and the banks came back to Downing Street cap in hand, looking for a second bailout.

One man who has come up with a detailed plan is the right-wing doomster Andrew Lilico, whose profile has risen sharply in the past few weeks despite his resemblance, both in appearance and in manner of speech, to Mitchell and Webb's character "Sir Digby Chicken-Caesar". Lilico has laid out his ideas in a column in today's Daily Telegraph.

In brief, Lilico wants no further taxpayer injections into the banking system. He wants unlimited liquidity support for fully solvent banks; forced conversion of senior debt into equity for banks that are heading for insolvency but have a viable business model; and break-up or winding down of clearly insolvent banks.

Can anyone seriously doubt that Messrs Brown and Darling would have chosen such a course back in 2008 if it had been at all practicable? It's not as if they wanted to hurl huge wads of taxpayers' money into the RBS/Lloyds abyss, but the tight timeframe they were faced with and the uncertainty over the true viability of the banks left them very little choice in the matter.

There may seem to be more time to plan for a Lilico-style tough love approach now, but if another crisis really does come along, it's unlikely that the government will have the luxury of sorting the banks into the three categories Lilico describes and dealing with them accordingly. Banks are by their very nature extremely complex black boxes that are all but impossible for outsiders to understand, let alone understand quickly.

Even Northern Rock might well have looked solvent to an outside observer just before it failed. Its asset portfolio, mainly consisting of its mortgage book, was of good quality, and this alone might have been taken as evidence that the bank was solvent. Its main area of vulnerability was its funding model, which relied far too heavily on wholesale deposits, and caused the bank to collapse when interbank lending abruptly dried up.

All of the UK's banks have been busy drawing up "living wills" to be filed with the regulatory authorities. These are meant to be plans for orderly wind-down of each institution in the event that it runs into serious trouble. In principle, the existence of these "wills" would make Andrew Lilico's approach more feasible -- though of course, there's zero chance of any bank's "will" admitting that the institution is close to insolvency. If (heaven forbid) a UK bank finds itself teetering on the brink of insolvency some time in the coming months, with depositors lined up outside its branches, it would be a brave government that would opt to let it fail just to prove a point of principle.

Keeping a straight face

As far as anyone could tell, Bank of England Governor Mervyn King neither smirked nor blushed when he announced a further £75 billion of quantitative easing (QE) yesterday, though of course he may have had his fingers crossed under the desk. The move is needed, says King, to make sure inflation does not fall below the Bank's 2% target. Here's part of The Independent's report:

The Bank, which left interest rates at a historic low of 0.5 per cent yesterday, dismissed the argument that asset purchases will stoke inflation, which at the moment runs at more than double the Bank's official target.

On the contrary, the Bank's Monetary Policy Committee said, price pressures throughout the economy are receding as the economy weakens and QE is needed to help Britain avoid a deflationary slump. "The deterioration in outlook has made it more likely that inflation will undershoot the 2 per cent target in the medium term," it said. "In the light of that shift in the balance of risks... the Committee judged that it was necessary to inject further monetary stimulus into the economy."

Well, if the goal of QE is to boost inflation, it's certainly been a roaring success -- and the latest producer price figures, released today, strongly suggest there's more of the same to come, despite King's assertion that the peak is nigh. However, if the goal is to boost growth, the evidence is rather more mixed. Although it's impossible to test the counterfactual (what if there had never been any QE?), even the Bank's own claims for QE -- that it has added 1.5-2.0% to growth -- are modest enough to be not much more than a rounding error.

It's hard to be surprised by this. If Mervyn King were to listen to the vox pop, he'd find that most people say they are cutting back on spending because they are being hit hard by inflation. Sure, unemployment is severe problem for some, but joblessness has risen much less than anyone feared, and well over 90% of the workforce are still employed. In contrast, inflation and the fear of worse to come affects just about everyone. QE2 can hardly fail to ratchet up inflation fears even further, and hence must be rated as most unlikely to do anything significant to boost real growth.

The Bank of England now seems to have completely lost touch with one of the key tenets of inflation targeting: you have to take divergences from the target equally seriously whether they are to the high side or the low side. The Bank has been warning of the risks of below-target inflation for month after month, and did so again in announcing QE2, even while watching with insouciance as the actual inflation rate has risen relentlessly to more than twice its 2% target. The credibility of the entire targeting approach may well have been blown to smithereens -- maybe it's no wonder Mervyn wasn't smiling yesterday.

The Bank of Gideon

Apparently we will have to wait until the pre-budget report in late November for full details of UK Chancellor George ("Gideon") Osborne's new "credit easing" plan, which is aimed at kick-starting lending to small and medium-sized enterprises (SMEs). Still, the whole concept is sufficiently surprising -- dare one say, out of left field? -- that there's plenty to be said about it even now.

"Credit easing" will apparently involve the Treasury becoming directly involved in the financing of SMEs by acquiring their debts or bonds. The fact that the government is even thinking along these lines seems like an admission that two key initiatives -- quantitative easing (QE) and the "Project Merlin" agreement with the banks -- have failed to produce an acceptable rise in bank lending to SMEs. This should not really be a surprise to anyone. As has been regularly pointed out, both in this blog and in more reputable circles, the government wants the banks to do two essentially contradictory things: boost their capital ratios, and make more loans.

QE has always been a pushing-on-a-string endeavour. Banks are happy to see all that cheap cash washing around in the economy, but it does nothing to increase their willingness to lend. As for Project Merlin, most of the available data suggest that the banks have in fact come quite close to meeting the lending targets agreed with the government. The banks' contention that any slowness in lending growth reflects a lack of demand for credit seems quite plausible, though there is some evidence that SMEs have been less well served than larger corporations.

As long as the pressure to rebuild capital remains in place, there's little reason to think that credit easing (CE) will do much to change the behaviour of the banks. If CE involves the Treasury buying packages of loans from the banks, which is one of the possible approaches, it's more than likely that the banks will simply use the proceeds to add to their capital reserves, rather than going out and sourcing new loans. In that case, the result would simply be to shift some of the risk of lending to SMEs from the banks to the Treasury, or rather, to the taxpayer.

That risk will be further heightened if the banks are "selective" about what they pass on to the Treasury. Banks can only make money if they lend money, so they have no incentive to divest themselves of good. well-secured, performing loans. It's been suggested that the Treasury will protect itself from getting stuffed with the banks' less desirable loans by using credit rating agencies to assess the quality of what's on offer, which for some indefinable reason seems like a less than reassuring prospect.

OK, then what if CE involves direct lending by the Treasury (or a newly-established SME lending body), rather than just a giant secondary market or factoring scheme for the banks' existing loans? This would raise a whole different set of issues. What expertise does the Treasury have in this area, that would allow it to reassure taxpayers that it can assess credit risk better than the banks? There are plenty of currently or soon to be unemployed bankers out there that could be hired, but it would be truly astounding if that was what a Conservative government had in mind. And in any case, setting up such a body, funded at the lower rates available to the Treasury, might induce the banks to wash their hands of SME lending altogether, which would be in nobody's long-term interest.

No doubt the lobbying will be intense in the coming weeks, and it's clear that to this point, the SMEs are out-shouting the banks. It will be interesting to see what winds up in the pre-budget statement, due on 29 November. In the meantime, do I detect the ghost of Harold Wilson chortling somewhere in the background?

Tackling the "Great Stagnation"

Economists at Goldman Sachs are warning that the world may be tipping from recession into a "great stagnation", with real growth set to remain below 1% per annum for many years to come. (Daily Telegraph report here). Their research into downturns over the past 150 years apparently reveals that the probability of stagnation is always higher after financial crises, as opposed to more "conventional" recessions.

With the global economy, or at least that of the Western world, struggling for momentum three years after the financial crisis, Goldman's report seems less like a forecast than a factual description. And in any case, is anyone really surprised at their conclusion? Financial crises differ in their details but not in their essentials: people get carried away by good times and mortgage the future to the hilt. When things go pear-shaped and the bills start coming in, it takes forever to struggle out from under the accumulated debt.

This is not to belittle the Goldman team's work; it's always good when someone provides solid factual support for something that you strongly suspect to be true. However, the real question now is, what can be done about it?

One man who thinks he knows is the head of the House of Commons Treasury Committee, Tory MP Andrew Tyrie. On the eve of the party's annual shindig (sorry, conference), he's published a report that calls for....no, go on, have a guess. Right! He wants lower spending (he's especially upset about rising spending on overseas aid and environmental initiatives), together with lower taxes on business. (BBC story here). Other right-wing Tories, including John Redwood, have already come out in support of Tyrie's position.

Well, as the almost forgotten Tory-shagger of the 1960s, Mandy Rice-Davies, might put it, they would say that, wouldn't they? Yet it's highly doubtful that cutting taxes on businesses and the well-off would do much to give the economy a lift in current circumstances. There's no evidence that the corporate sector is being held back by a lack of cash, or even a lack of lending -- the banks' repeated assertion that slow credit growth is due to a lack of demand rather than over-cautious lending policies is almost certainly true. Rather, companies are refusing to invest because they are profoundly uncertain about the future, which is hardly surprising as policy-makers struggle to come up with coherent policies to deal with an unprecedented set of problems. It strains credulity to think that a lopping a couple of points off the corporate tax rate would be enough to unleash entrepreneurs' "animal spirits".

Still, as the Goldman report puts it, "a pick-up in the recovery is likely to depend on policy being able to restore confidence and putting in place reforms that can decisively jolt growth". As I've noted here before, even centuries ago monarchs knew that slow economic times were the best times to get the castle rebuilt or the fleet refurbished on the cheap. Something of that logic seems to lie behind President Obama's jobs initiative, which of course the Republicans are hell-bent on destroying. And here in the UK, there's widespread media support, across most of the political spectrum, for infrastructure spending as a way of giving the economy the needed "jolt". For example, today's Times (paywa££) offers up six megaprojects, including a Thames sewage tunnel, Oxford-Cambridge motorway and new London airport as possible means to that end, though unfortunately, the paper wants to finance these in the worst possible way, through private finance initiatives.

Messrs Tyrie and Redwood's statements today suggest that the Government would have a hard time getting any kind of infrastructure spending past its more right-wing supporters, even with the incentive of PFI profits. Stagnation, anyone?