Guido Wrong, shock.

Guido has a great story today. He notes that the Bank of England Pension Fund has moved 70% of it’s assets into inflation linked gilts, a bet on inflation. As he puts it:

Hold on, if deflation is (as the political elite and their client media commentators claim) the big threat, why is the Bank of England’s pension fund betting 3/5 of the £2.2 billion pot on hedging against inflation? This is their personal pension fund. Money talks.

It’s a shame he didn’t read the report itself.

The Trustee received formal notice in February 2007 of the proposed termination of the in-house investment management services provided by the Bank under the existing Investment Management and Custody Agreement.

In other words, the Bank no longer manages it’s own fund.

Surgeon Blamed After Smoker’s Lung Cancer Death…

Meanwhile; ‘FSA faces heat over bail-out of Dunfermline’.

We can, and should, debate at length the terms Nationwide is getting, what the failure of a mutual says about ownership structure and indeed why the FSA wasn’t more on top of this.

But to focus on the ‘bailout’ totally ignores the key question – what on Earth were management up to? Building an £800mn ‘toxic’ loan book from a smallish mutual in Scotland? Buying sub-prime assets from GMAC and Lehman’s?

In related news Barclays have turned down taking part in the Government’s asset protection schme. Good for them. I hope they are right and they don’t need the insurance. I hope Soc Gen are wrong and they don’t actually have problems. I hope they are selling Barclays Global Investors because they don’t want it anymore, rather than because they need the money. I hope their $45.7 trillion nominal derivative book is all fine.

Because if there are any problems and it turns out management have rejected help becuase they think restrictions on pay and bonus are too a high a price to pay, then I’m going to be very angry. Especially as the press will probably report ‘FSA blamed after Stress Tests on Barclays Inaccurate’.

Cars

I was musing on Friday about the difference between structural and cyclical shifts. It occurs to me that the car industry might be a good example of this.

The recent problems have been well publicised, this BBC piece is well worth a read.

There are currently about 26.9mn private cars in the UK. According to government figures, the lifespan of a car is around 14 years (from first registration to scrap).

Given this then, to simply replace the current stock of cars (and not including any overall increase in the number cars) , then annual sales should run at about 1.92mn (26.9/14).

Currently the SMMT is forecasting that annual sales this year will be 1.72mn. Or about 10% below what they ‘should’ be for simple replacement of the existing stock .

Most observers seem to think that this is a normal cyclical downturn. But what if this is a structural shift?

What if easy credit to fund car purchases isn’t returning any time soon? One likely effect would be a fall in the absolute number of cars on the road. Currently 26% of households in the UK have 2 cars and 6% have 3 or more. Only 24% have no car.

If finance is not as available and consumers do not feel as rich as previously then it is perfectly possible that the trend towards ever more ownership will reverse. Is it really that difficult to imagine that we go back to, say, 30% of households with no car and only 20% with two cars? That was the situation as recently as the early ‘90s. Assuming 26mn households in the UK, that means the stock of cars would fall by 3.1mn to 23.8mn (roughly the level of 2001 – not a big change). If we have a car stock of 23.8mn then the annual level of replacement sales would fall to 1.7mn, roughly where we are now.

It may be the case that the fall in car registrations is simply a cyclical downturn, in which case it will bounce back quickly next year. If, however, it is structural shift, we can’t expect a quick rebound.

Public policy must be aware of the potential structural nature of this change and be guided by it. I still think people (in the industry and outside of it) are underestimating what is happening.

The Past is Another Country

We all know we are in a recession, and today came the news that last quarter was worse than originally though. But we also all realise the recession will not last forever. Few seem to be discussing post-recession Britain. The assumption seems to be that it will resemble pre-recession Britain: house prices will continue their march upwards, the FTSE will quickly ascend to its old highs, consumers will rush back to the high street and business will return to normal.

I’m not so sure. Psychologists have a term called ‘recency effect’, a cognitive bias whereby if someone is exposed to something for long enough they tend to think of it as ‘normal’. It strikes me that many are suffering from this. The last two decades were not ‘normal’.

Fund managers like to differentiate between ‘cyclical’ and ‘structural’ shifts. A cyclical movement is a typical recession – the business cycle which is an ordinary part of capitalism. A structural move is something bigger, the slow but significant turning points of economic history.

Whilst most observers seem to think that Britain is only undergoing a cyclical downturn, I believe the movement is structural. The cyclical downturn will end – maybe at the end of this year, maybe in the next. The structural shift is more long lasting.

Without capital flows from Asia Britain will have to learn once again to live more within its means.

So what will the post-recession world look like? If I were to hazard a guess I’d suggest the following: permanently lower house prices, much less credit availability, less of a dominance of financial services and property in the economy. Consumer spending will simply not grow as quickly as we have become accustomed to. We’ll have to manufacture more. Savings rates will be higher.

The economy will simply not be as buoyant as in previous years. Although the economy will grow, if consumer spending does not grow as quickly as previously, people will not feel as well off. This has profound political implications. One that all parties must accept.

The agenda must be based about managing the transition. The Tory record on managing such structural shifts is terrifying, a legacy of destroyed local economies across the old manufacturing and mining communities. Labour will need to embrace a more active industrial policy, something Lord Mandelson seems to understand. We will need a rigorous focus on re-training and re-skilling. We will need to counteract the potential effects of what economists dub ‘Hysteresis’, the fact that a short term rise in unemployment can have more permanent effects.

All of those issues need to be engaged with in the next manifesto.

Reading lists

Labour and Capital notes that the FSA, in the Turner Review, has provided a good reading list for the crisis.

Here it is:

John Maynard Keynes – General Theory (1936).
Hyman Minsky – Stabilising an Unstable Economy (1986).
Charles Kindelberger – Manias, panics and markets (1978).
Robert Shiller – Irrational Exuberance (2000)
An institutional theory of momentum and reversal – Vayanos and Woolley LSE, (November 2008).
George Soros – The new paradigm for financial markets (2008)
Kahneman, Slovic and Tversky – Judgment under uncertainty: heuristics and bias(1982)
The Great Contraction in Friedman and Schwartz – A monetary history of the United States 1867-1960 (1963).
Benoit Mandelbrot – The Misbehaviour of Markets(2004)
Nassim Nicholas Taleb – The Black Swan: the Impact of the Highly Improbable (2007)
Andrew Haldane – Why banks failed the stress test (February 2009)
Frank Knight – Risk, Uncertainty,and Profit (1921)
Adair Turner – Uncertainty and Risk: reflections on a turbulent year
Daniel Tarullo – Banking on Basel (2008)

There’s a couple there I don’t know and will try and look up.

If I was to strongly recommend one, it’d be Minsky’s ‘Stabilising an unstable economy‘.

Minsky is a vastly unappreciated economist, well worth a read. Good wiki article here.

Does anyone have any other good reading suggestions?

Gilts, again.

I ranted about the ‘failed gilt auction’ yesterday. Please forgive a second, hopefully brief rant today.

As is entirely predictable Fraser over at the Spectator has become a excited and is once more preaching doom.

More reasoned commentary can be found at the FT:

Most analysts believe Wednesday’s failure was due to a combination of unfortunate circumstances, suggesting it was more of a one-off than the beginning of a damaging trend.

John Wraith, head of sterling rates product development at RBC Capital Markets, said there was a danger that the auction failure could be repeated. But, he said: “I think we can be relatively relaxed about it, particularly as the DMO and most analysts have expected an auction failure at some point.

“There were a set of circumstances that undermined demand, and the auction did not fail by much.”

These unfortunate circumstances included comments on Tuesday by Mervyn King, Bank of England governor, that the government should hold back from announcing another stimulus programme in next month’s Budget, which coincided with poor inflation figures published on the same day.

And at Bloomberg.

But, again here are my thoughts.

(i) Getting away £1.6bn of debt, on forty year terms, at 4.5% is not a failure.

(ii) The yield on 10 year gilts is still sub 3.5%. 3.32% as I type.

(iii) As long as we can keep selling 10 year gilts at anything below 4.5% we do not face a funding problem. Remember yields were over 12% in the early 90s.

(iv) The Governor’s comments on Tuesday directly contributed to the failed auction.

I still think we need a fiscal stimulus. I still think we can fund it. People from all wings of the party, from John McDonnell to Luke Akehurst recognize that a fiscal stimulus is necessary and desirable. The coming budget needs to be bold.

Calm Down Fraser

Fraser Nelson is getting very excited over at the Spectator blog about the ‘failure’ of a gilt auction today. I say ‘failure’ as the Debt Management Office did manage to issue £1.6bn of forty year debt at an interest rate of 4.5%. Not bad.

I suspect the auction ‘failed’ (i.e. sold only 93% of the allotted £1.75bn) for two reasons. First off it was a forty year issue. Second, Mr King’s comments yesterday.

Fraser says:

But given how dependent Brown is on being able to bum money from the City, a so-called buyers’ strike (ie, when investors say ‘we don’t want your crappy debt’) will be hanging over him like the sword of Damocles.

I’m not seeing this ‘buyers’ strike’. The yield on ten year government debt – which I keep saying is the think to watch – did rise after the ‘failed’ auction. It then fell back to its previous level of 3.32%. At the time of writing it is now down on the day – i.e. it is cheaper for the UK government to borrow now, than it was yesterday.

Sorry Fraser, don’t think we’re calling the IMF.

What is Merv up to?

I am concerned about Mervyn King’s comments yesterday. Not really so much about the headline grabbing ‘we can’t afford another stimulus’ noise. I think we can afford one, and we need one. And as Andreas says, Mr King is not infallible and always therefore correct. I do find it slightly worrying that a central bank Governor should be speaking out on fiscal policy (imagine how he would react if the Chancellor started saying ‘the BOE must do x’), but again this is a side point.

I’m more worried by the back tracking on the issue of quantitative easing. Mr King wrote yesterday in his letter to the Chancellor how the UK still faced the prospect of inflation ‘below the government’s target’. We are not out of the deflation woods yet. Given this there is a vital to maintain plausibility. Quantitative easing will only work, and can only work, if the market plausibility believes that it is a genuine ‘medium/long term’ policy . As market participant Macro-man observes this morning:

Less than three weeks into QE, and Merv was already talking about the possible need to hike rates aggressively at some point. He also suggested that the BOE might not deploy its fully alloted £150 billion of buybacks should the program prove effextive. While there was nothing technically wrong with these comments, they were the wrong thing to say to a teetering Gilt market, and were received with all the pleasure of a swift kick to the groin from an iron-tipped boot.

In other words much of the positive movements in the government debt markets, achieved through the announcement and start of the QE programme, are now unwinding on the back of the Governor’s comments. This is silly. And far sillier than anything he said about a fiscal stimulus.

Tories on the BOE

I just read David Cameron’s speech on financial regulation.

I don’t fully follow it. I am especially bemused by the fetishism of the role of the Bank.

Gordon Brown took away from the Bank of England the power to regulate the overall level of debt in the economy?

That’s why with the Conservatives, the Bank of England will be back and we will restore its role in regulating the level of debt in the economy.

…

We will put the Bank of England back in charge of regulating the overall level of debt in the economy, and allow it to make judgements on what is sustainable and what is not.

I speak from an apparent position of complete ignorance here, I only worked there for a couple of years and my knowledge of economic history may be failing me… but when exactly did the Bank have this power? Seriously, I would be very, very curious to know.

Also how is this that different from the Bank’s current ‘core purpose two:

Core Purpose 2 – Financial Stability
Financial stability entails detecting and reducing threats to the financial system as a whole. Such threats are detected through the Bank’s surveillance and market intelligence functions. They are reduced by strengthening infrastructure, and by financial and other operations.

That aside I especially enjoyed learning that the FSA neglected

entirely a bank’s business model and what they were buying, at what price and with what debt.

So I just want to clarify, the party of free markets now wants a regulator, I assume the BOE, to authorise each and every purchase on any given banks’ balance sheet? We’re going to need a lot of regulators…

Inflation

Inflation (CPI) is up, driven mainly by weak Sterling. RPI inflation, is flat year on year for the first time since 1960. But deflation, for the moment, is avoided.

The exchange of letters between the Governor and the Chancellor is well worth reading.

As Mr King says, inflation will fall likely fall:

Despite the increase in CPI inflation in February, we believe that the sharp decline in CPI inflation since its peak in September is likely to resume in the coming months. This reflects two main factors.

First, a number of major gas and electricity suppliers have signalled a reduction in tariffs in response to earlier falls in global energy prices. On its own, we expect that this will act to reduce inflation in the coming months by around a percentage point. And there could be a further round of tariff reductions later in the year.

Second, the growth rates of money and nominal demand have slowed sharply. The contraction in economic activity in recent quarters has created a substantial margin of spare capacity in the economy. Output contracted by 1.5% in the fourth quarter of 2008 – a substantially larger contraction than the MPC expected in December. And indications suggest that the economy will contract at a similar rate in the first quarter of this year. This picture of very weak activity in the UK mirrors the pattern of demand in other countries: GDP contracted sharply in the Euro Area, US and Japan in the fourth quarter of 2008, and is likely to continue to fall in early 2009. And 54 out of 57 countries for which data are now available registered falls in industrial output in the fourth quarter of last year. In 32 of those countries, the fall was larger than that in the United Kingdom.

The outlook for global activity will constrain UK demand prospects and, as a result, the margin of spare capacity is likely to build in the coming quarters, pulling down on CPI inflation. Consistent with that outlook, wage pressures are muted.

As a result of these factors, and notwithstanding the inflation outturn for February, it is likely that over the next year CPI inflation will move below target, although the profile of inflation could be volatile, reflecting Ihe reversal of the temporary change in VAT on CPI inflation.

Whilst the avoidance of deflation is a positive, the news is not all good. Food bills and heating bills are both still rising at over 10% a year, this hits the poorest the hardest.

One final thought. The real interest rate in the UK is now -2.7% (0.5% nominal base rate minus 3.2% CPI inflation). In the Eurozone the real interest rate is +0.3% (1.5% base rate minus 1.2% inflation). Which raises the question, what on Earth is Jean Claude Trichet talking about?