Britain can no longer depend on being cool

Axel Leijonhufvud, the Swedish-born economist, once made an insightful observation about inflation targeting. It worked better in practice than it did in theory, he said. I feel the same about the UK economy. Given what we have long known – about the country’s relatively low productivity growth rate and the erosion of its scientific and engineering excellence – the British economy should clearly not have performed quite as well as it did for the past 15 years. Economic theory would suggest that this was not possible.

In the next few years, I expect the UK economic miracle to be exposed for what it was: an overlong joyride on the back of an overlong asset price bubble. The UK economy is about to undergo a downturn at least as large as that of the US – maybe even worse, because of an even more inflated housing market and because the financial sector constitutes a larger share of gross domestic product.

According to my calculations, UK residential property prices are about 30 per cent above their trend in real terms. If the trend has not changed in the past few years, that would suggest that inflation-adjusted prices could fall by up to 40 per cent from peak to trough.

Of course, it is possible that the trend has changed, that cool Britannia has attracted so many foreign buyers that the trend line may have shifted higher forever. But foreign buyers can leave just as quickly as they arrive and their presence is related to the health of the financial sector. My guess is that the half-century-old trend line is still approximately right.

Moreover, the trend is consistent with several other indicators, such as the ratio of house prices to rents achieved, which in the UK has recently been about two-thirds above its long-term average. Whatever explanations one might come up with in defence of higher house prices, they cannot conceivably explain why house prices should be out of line with rents forever.

A house price crash would take time to unfold. Assuming a constant inflation rate of 2 per cent a year, nominal house prices would have to go down by about an unprecedented 25 per cent if the decline stretched over six years. Remember: the first stages of a housing downturn consist of denial followed by anger. A fall in actual prices is a relatively late-stage phenomenon of a housing crash.

The UK financial sector is in no less trouble. The credit crisis has a lot further to run, as it moves from one subsector to another. As I have argued previously, credit default swaps pose very serious risks to financial stability and the City of London has been the centre of the European CDS market. One consequence of the credit crisis could be that banks become subject to highly intrusive regulation on the types of product they can offer, perhaps even on the profits they distribute or the salary packages they can award. The greater the extent of public bail-outs or bank nationalisations, the greater will be the public’s regulatory revenge.

Perhaps the worst thing will be that working in finance will no longer be regarded as cool, as it has been over the past 15 years. Finance will be once again what economic theory always told us what finance should be: a necessary activity, requiring some technical skills, but rather dull in the absence of bubbles.

The macroeconomic implications of the downturn in the financial sector are serious. In the UK, the financial sector is the largest contributor to the balance of payments. Its decline comes at a particularly inopportune time, as the country is running a current account deficit of 5.7 per cent of GDP. To get that deficit down to a more sustainable level will require a big fall in consumption and a big rise in savings – all the more so if the country’s largest export industry is in recession.

Could the Bank of England end this nightmare by cutting interest rates? I suspect the answer is no. This is a different kind of downturn from previous ones. It was caused by an exploding bubble, not by high interest rates. The outlook for inflation reduces the Bank of England’s small room for manoeuvre, which may already consist of rate cuts of only another quarter percentage point or two. But this is not going to persuade a rational investor to return to the housing market, let alone a bright young university graduate to seek a career in investment banking.

The adjustment ahead will put the previous 10-year performance of the UK economy into some perspective. My own guess is that Britain’s heavy reliance on financial services and housing, until recently seen as a great strength, will in future be seen as a structural weakness, similar to the French labour market or the Italian public sector.

Funny that, given what we have been told about economies in the 21st century succeeding through services and the like. But then, economic fashions are subject to violent swings. As for the gap between practice and theory, theory may on occasion provide more lasting insights.

He’s wrong.

The long term house price trend had some big changes.

1 The interest rates have falling dramatically as inflation fell, reducing the cost of ownership.
2 Nett Immigration has been substantial over the last ten years upping demand.
3 World instability puts a premium on property in a stable country.
4 Rentals have fallen as a result of property owners using their equity to buy properties to let, as the amount of properties to let has increased the rentals achieved have fallen.

What we have is a wealthy property owning class, and an expanding number of renters.

If propery prices were to fall, the averge owner has so much equity they will just sit and wait it out, till demand forces prices up.

In the long run, entirely right.

In the short run, I'll tell you a little statistic I calculated last fall, around October, before the recent bear market leg down.

The PE (price to earnings ratio) of the SP500 was 17. That is a bit high, but fair if interest rates are low enough for earnings growth expected to be decent. 14 or 15 is a long term average. Levels above 20 are getting pricey (1929, 1968, 1987, 2000 e.g.).

But a P E ratio consists of the market cap of all the companies in the index, divided by how much they earned in the previous year. I was interested in how much of both was the financials.

At the time, financials accounted for nearly a fifth of the market by share value.

But the average PE ratio of the financials was 17 like the rest of the market. It was 8. Less than half. Ok, if you take them out of the numerator and the denominator, how expensive where all the non-financial stocks?

Works out to around 25. Way up into seriously pricey territory. In other words, the market level only looked remotely reasonable based on the earnings of the financials. For a 17 PE to hold, those earnings also have to hold.

If the earnings of the financials fall two thirds, then the market PE at last October levels was 25.

Now another tracking statistic. I looked at the ratio between the value of the SP500 and nominal GDP. I plotted this with a divisor picked so the past bull market peaks poked above the GDP line, and the rest of history remained below it. Sure enough, last year or so, poking up above the line.

Now do the same thing but with corporate profits instead of GDP. It looks fine, the valuation now doesn't appear out of whack or too high.

In other words, stocks only look fairly valued (at last October prices, mind) if the share of GDP going to corporate profits - currently at all time highs - is sustainable. Well, if recent outsized financial company profits fall, it won't be.

So, yes, I expect finance to first take a hit, and then become boring. Boring finance will be sounded finance, and that is all good. But at the same time, in the recent boom period it was the outsized earnings of the financials that made the market look reasonably priced. Take that away, and it simply doesn't.

We had an epic bull market peak in 2000. It is perfectly normal for it to take 15 years to come back from one of those. (1929 took that long, 1968 took that long). In the recent boom, we got back above 2000 levels faster than that. But by the above analysis, that was probably temporary itself and not sustainable.

It might be another 3-5 years before all the real estate stuff shakes out, and I would be completely unsurprised if it were another 7 years all told, before the market permanently clears the 2000-1 peak levels, such that the next subsequent low (not just a temporary local high) is above that level.

One man's noodling, consider with care and salt...

$100 oil and $950 gold isn't exactly inflation staying fallen.

And rentals got out of whack with prices purely because low IRs encouraged speculative holds for capital appreciation without regard to current income. Which is never sustainable, in any asset class, and always ends with a reversion to mean.

The expanding class of renters have all the votes. They aren't going to pay to keep property prices permanently in the stratosphere. If rents rise to values, they will simply stop asking and take. If values fall to rents, your wealthy property owning class won't be quite so wealthy anymore. In the long run, only actual ongoing income from useful services to the whole society can sustain a class position. No mere financing arrangement or price level can.

Disclaimer: Opinions posted on Free Republic are those of the individual posters and do not necessarily represent the opinion of Free Republic or its management. All materials posted herein are protected by copyright law and the exemption for fair use of copyrighted works.