Wednesday, 13 November 2013

Doing What’s Easy: The Unbalanced And Unstable 2013 Recovery

“We cannot go on with the old model of an economy built on debt. An irresponsible public spending boom, an overblown banking sector and unsustainable consumer borrowing on the back of a housing bubble were the features of an age of irresponsibility that left Britain so exposed to this economic crisis. They cannot be the sources of sustainable growth for the future…We will build a more balanced economy which does not depend so heavily on the success of financial services, and where all parts of the country share in the gains…In the coming months we want to unite the country behind this new British economic model” George Osborne (2010) ‘A New Economic Model: Eight Benchmarks for Britain’, p.1.

Back in February 2010 the Chancellor wrote the above as a preface to a document which outlined the Conservative vision of a new economic model for Britain. The theme of rebalancing featured prominently in the eight benchmarks outlined in the document, which were to provide the gauge against which the performance of a Conservative government might be judged[1]. But with our economy apparently on the mend, we seem much further from the kind of sustainable model described in Osborne’s 2010 vision. We have instead done what’s easy and embarked on a strategy of reflating the housing bubble, predominantly in London, creating all kinds of uncertainties going forward.  

The basic post-crisis story is one of a two speed economy. This can be seen in the regional breakdown of the UK’s GVA growth (GVA being the standard ONS measure of output). The two charts below show that in the pre-crisis period between 1997-2006, London and the SE accounted for 37.3% of all GVA growth. Post crisis, this figure rises to 47.7%. If we were to strip out inflation, the picture is even more bleak with many regions still below their pre-crisis peak, illustrating just how far London has pulled away from the rest of the UK economy since the crisis. I am fairly confident the 2012-2013 picture will, if anything, show London taking an even greater percentage of national GVA growth.

Figure 1

The regional GVA figures only run up to year end 2011. But it is possible to get a sense of the form and extent of the current recovery using output GVA by sector. Figure 2 below shows that by end of year 2012 only three sectors had recovered their pre-crisis output performance: i) Agriculture, Forestry & Fishing (which represents a negligible part of the UK economy in monetary terms and broadly reflects rising commodity prices) ii) Business Services & Finance and iii) Government & Other Services. And even here growth was concentrated in a few narrow areas: motor vehicle repairs, admin and support services and real estate (mainly in London, but more on that later). Meanwhile health and education spending kept government services on the up. However since 2013 there has been broader sectoral growth (figure 3), particularly in professional, admin and support services and also in the wholesale and retail trade. Some growth is to be expected as concerns about the Eurozone crisis recede, as pent up demand relaxes and business confidence improves. But the precise form of the recovery and its sustainability are shaped by government programmes. So are we seeing the kind of economy that Osborne envisaged?

Figure 2

Figure 3

The answer to that really depends on the way the economy moves. Growth in one market or region can unexpectedly transmit confidence, investment and job growth to other parts of the economy in ways that are difficult to predict. But I am not too confident about this scenario and the immediate signs do not augur well.

The particular form of the recovery in the UK has been shaped by three central interventions: Quantitative Easing, Funding For Lending and Help To Buy. First, QE which was supposed to (among other things) lead to more lending to the productive economy, fostering a ‘march of the makers’.  This was supported by Funding for Lending, which to date has pumped a total of £17.6bn into banks and building societies. Neither has met their perceived aims. Net lending to business has in fact been negative on an annual basis since QE began in March 2009 with little deviation from that trend as Funding for Lending was rolled out in July 2012 (figure 4). Corporates have instead paid back bank debt and bought back shares by issuing bonds to massage EPS figures and trigger bonuses for the board; meanwhile investment is still pretty insipid – hovering at around 20% below the August 2007 figure. Unsecured lending to individuals however has increased: credit card loans were up 4.5% on an annualised basis in August 2013, while other unsecured loans were up 4%. Secured lending has also been rising steadily since mid-2012, perhaps showing some benefits of Funding for Lending; but there is evidence to suggest that these mortgage-related loans have been regionally concentrated in the London area, pushing up prices above the already eye-watering pre-crisis highs – which takes us to Help To Buy.

Figure 4
Source: Bank Of England ‘Trends In Lending’ October 2013, p.4

Help To Buy equity loans and mortgage guarantees have effectively pump-primed housing demand (with negligible effects on supply). Via the equity loan, government lends homebuyers up to 20% of the purchase price of a new build house up to £600,000. The more controversial mortgage guarantee provides banks with free insurance on up to 15% of the value of any mortgage loans issued. All of this is geared towards top-down growth - encouraging the upper middle classes to dis-save in the hope that ‘dwellings investment’ (private new builds plus extensions on private houses) would restore confidence and kick start consumption spillovers. This is also why the government has also been so keen to relax planning regulation on building extensions.

The benefits of all three interventions have disproportionately accrued to London. Figure 5 shows an index of average regional house prices rebased to August 2007, illustrating just how far London has pulled away from the rest of the UK housing market: prices in the capital are now 14% above where they were back then. This has not just been driven by hot money from rich, foreign investors in the prime market where 60% are cash buyers. Despite the hullabaloo about prices in Kensington, the prime market in London is only around 7% of the capital’s total; in fact London is the region with the lowest percentage of cash buyers in the country by a distance (24% vs 39% in the SW). This means a greater proportion of buyers require borrowing in London relative to elsewhere. And although transaction volumes appear to rise and fall in lock step across the country, London’s volumes are now the highest relatively at around 62% of the August 2007 peak compared to other regions which run from the low 40%s to high 50%s from peak (figure 6). So London has a higher number of transactions relative to peak with a smaller percentage of cash buyers.

Figure 5

Figure 6

The house prices and the growing volume of transactions in London have been driven by an expansion of secured lending, under-written in various ways by government. This has been reinforced by an expansion of unsecured credit, also underwritten by recent interventions. These, in turn, have kicked multipliers into the London economy. But can this last?

It is difficult to escape the image of London breaking free from its moorings in the national economy, just as the value of its real estate becomes detached from any fundamentals. If London real estate is 14% higher than peak on just over 60% of volumes, then London houses look increasingly like a kind of (state-subsidised) collectors market bubble whereby it is the imagined attributes of the asset within a relatively small community of buyers that drives prices beyond underlying fundamentals. The fundamentals in question are wages. As figure 7 shows, median house prices are now virtually unsustainable at around 9 times FTE earnings in London; with the Midlands, North and Wales hovering around a more modest 5.5X to 6.5X. We should also not forget that intra-regional inequality is just as important as inter-regional inequality. London has rafts of low and modestly paid workers – and at the lowest paid end, those conditions are worsening (figure 8). These income constraints represent a kind of risk threshold – prices can continue to rise relative to income, but they can only do so at greater risk of collapse. Only this time when the bubble goes pop, the government and the Help To Buy generation who have invested some equity will be the ones who take the downside.

Figure 7

Figure 8

So here are some troubling questions:

1. London prices are 14% above the pre-crisis August 2007 level on just over 60% of the volumes. Can those low volumes support high prices over the longer term? Or alternatively can volumes increase without prices falling, given the income constraint? Either way, the sustainability of the price boom (and the multipliers that accrue during an uplift) look shaky.

2. If prices were to waver, how would government respond, given it has taken on a £130bn contingent liability – equivalent to 8% of GDP - through the mortgage guarantee scheme? Should it extend its equity involvement to 25% or 30% to make mortgage payments more manageable for households and bring in a greater volume of buyers? Should it extend larger guarantees to the banks to lubricate the wheels of debt issuance and ensure prices move upwards? What looked like an initial injection to spark the recovery, very quickly becomes mission creep.

3. Inflation is an inconceivable threat in the short to medium term, but what about in 5 to 7 years time? Government, as an equity holder in the UK’s housing stock and guarantor of banks’ mortgage loans, now has a vested financial interest in stable/rising house prices. Given that high house price to income ratios are only sustainable in a low mortgage interest rate environment, how might government respond if the Bank of England concludes that interest rate rises are necessary at some point in the future? Or what happens if ruptures in the interbank/money markets reappear and cause mortgage rates to rise? Even modest rate rises could lead to mortgage defaults, collapsing confidence, fire sales and falling prices when households are geared to the max in a low rate environment. By taking a directional bet on property, government is invested in a ‘close to zero’ interest rate regime, irrespective of what uncertainties lie ahead. This stores up all kinds of potential economic and political tensions going forward.

Through Help to Buy and other interventions, government has gone long Britain. That may sound like a good thing, a patriotic thing even, but it is not. This is an all-in move by the Chancellor, which is a problem. Like any complex system, an economy needs buffers and release valves to prevent overheating or interference in one area that might cause total seizure. His interventions have done the opposite. What if Eurozone problems resurface? What if another bank is hit by unexpected losses, and LIBOR rates rise? This growth model is not built with what ifs in mind; there are few system redundancies to deal with the unexpected. We are long house price growth, long low interest rates, long consumer appetite for debt, long the Eurozone, long bank stability, long consumers’ ability to transcend their financial constraints and keep buying more expensive houses.

Finally, what of Osborne’s noble ambitions set out at the top of this post? When push came to shove he bottled it. He did what was easy: state intervention to help rebuild fractured supply chains and invest in growth requires skill, guile, political and economic nous and courage to fend off the vultures. The de facto part-nationalisation of the private housing stock (and that’s what Help To Buy is, in effect) to prop up an over-heated property market and save the banks from further write-downs is the easiest thing you can do as a Chancellor in such times, with an election looming. This recovery looks much less like the new model promised by Osborne, and much more like an unstable version of the old one.


[1] Although the original link to those eight benchmarks has disappeared from the Conservative website, it is possible to access the whole report via the search function.