Inflation or Deflation… or Both?

As Samuel Brittan notes in today’s FT economists and financial market participants are currently divided over whether the greater threat is inflation or deflation.

As I’ve made pretty clear over the past few months I’ve been more concerned about deflation.

But Graham Turner’s excellent book is making me seriously consider a third option: deflation & inflation .

Now this seems as first sight preposterous – is deflation is falling prices and inflation is rising prices, how can we possibly experience both at once?

The answer can be found in Peak Oil.

Peak Oil is simply defined in Wikipedia as:

Peak oil is the point in time when the maximum rate of global petroleum extraction is reached, after which the rate of production enters terminal decline. The concept is based on the observed production rates of individual oil wells, and the combined production rate of a field of related oil wells. The aggregate production rate from an oil field over time usually grows exponentially until the rate peaks and then declines—sometimes rapidly—until the field is depleted. This concept is derived from the Hubbert curve, and has been shown to be applicable to the sum of a nation’s domestic production rate, and is similarly applied to the global rate of petroleum production. Peak oil is often confused with oil depletion; peak oil is the point of maximum production while depletion refers to a period of falling reserves and supply.

Andreas too has been showing an interest in this issue. The Oil Drum is the leading website on this issue.

This might all seem a little arcane and distant but by many people’s estimate we are at or very near to the Peak in terms of oil production. Once the Peak is reached, so the theory runs, oil prices will soar. The current price of around $65 a barrel will appear ludicrously cheap and the high price of $147 hit last year would easily be exceeded.

There is a direct link between oil prices and food prices (note how the two moved together last year) driven by the use of bio-fuels. As oil prices become higher, farmers are likely to shift crops towards bio-fuel production driving up food prices.

Rapidly rising food and fuel prices act as a tax on the world economy, as the price elasticity is low – people need to travel and eat. If anything this would reinforce the deflationary trend on manufactured goods and services as customers had even less free cash to spend.

We would in effect experience the worst of both deflation and inflation. Falling goods and services prices driving down corporate profits and leading to increasing unemployment but rising fuel and food prices which would hit the poorest the hardest.

I don’t know enough about geology to comment on how accurate Peak Oil theories are. But I can see an awful lot of clever people citing what seems to be compelling evidence. If this is true it is very worrying. Indeed I would go as far as to suggest it is a more immediate threat to the world than climate change.

At the very least Governments need to look into this issue seriously and, if it turns out to be correct, than we need a massive shift to low carbon technology even quicker than I have previously feared.

The Real Middle Britain – Taxes, House Prices & Debt

Last week during a debate on tax, my regular commentator Newmania said:

This now completely disenfranchised section are often found on the internet getting angry and these are the people Duncan wishes to tax into penury .Ordinary working people , who have no right ( says Duncan) to independence or even to keep much of what they earn. People who go to Garden Centres , save for holidays , convert their lofts , worry about their children.

He was wrong. These are not the people I want to tax. And he knows that. But he does, I believe, refer to what he thinks of as ‘Middle Britain’. ‘Middle Britain’, a concept beloved of both political strategists and the media at large, has always been a somewhat imprecise term.

No longer.

The TUC have today published a superb pamphlet, defining and polling ‘Middle Britain’. Go read it.

Middle Britain has become shorthand for the conservative, well-todo
citizen. Subtly and gradually, it is this different Middle Britain that has come to dominate cultural and political debate. But the original and real middle is still with us and they will still play a crucial role in the next election as a group of swing voters who will determine whether the Labour or Conservative Party forms the next government.

They define ‘Middle Britain’ in a very precise manner:

Throughout this pamphlet we assume ‘middle Britain’ to be synonymous with the group clustered around the median income in the UK. To distinguish the group from its more common use we refer to middle Britain as ‘Middle Income Britain’. To some extent the actual size of this group is arbitrary. For the purpose of this pamphlet – and to enable comparisons with other groups – we have taken ‘Middle Income Britain’ to be equivalent to the middle fifth of the population.

I can’t think of a fairer, more objective definition. Tom notes some characterisitics of this group:

*Much less likely to have had a university education
*More likely to have experienced unemployment
*Much less likely to enjoy a final salary pension scheme
*Much less likely to hold shares and have significant levels of savings

As the TUC note they tend to be:

concentrated amongst white-collar and skilled manual jobs, including; customer service administrators, dispatch clerks, retail managers, IT workers, landscape gardeners, site maintenance engineers, teaching assistants, librarians, receptionists and shop assistants.

This then is our working definition.

Two things leap out from the report.

First, how has this group faired since 1997?

They enjoyed annual rises in real take-home pay of just 1.6 per cent, well below the annual rate of economic growth over the period. This compares with 2.1 per cent for those on mean incomes and 3.9 per cent for the top one per cent. This means that over the 18- year period of Conservative governments, the real incomes of the top one per cent doubled while the incomes of households on mean incomes rose by 45 per cent and those on median incomes rose by a third. In effect, successive Conservative governments neglected the very constituency that had put them into power.

No surprises there.

Under Labour, Middle Income Britain has fared better in relation to higher income groups than under the Conservatives. Over the decade from 1996/7 to 2006/7, real median household income grew by 20 per cent while real mean household incomes grew by 23 per cent. These correspond to annual rates of 1.9 and 2.1 per cent respectively.

There is an important exception to this more even pattern of growth across incomes. Since 1997, the richest one per cent has continued the upward rise that began in the early 1980s. Over the three decades from 1979, the richest households outstripped all other groups, while households on mean incomes moved ahead of those on median incomes.

Better under Labour then, but still more to be done.

Second, what do these people think? I.e. what does actual ‘Middle Britain’ think, rather than the mythical ‘Middle Britain’ so often discussed?

They, in common with ever other quintile of income group (except the top, and then only narrowly against), support a more progressive taxation system.

To me, this is key. The TUC’s ‘Middle Britain’ and Oxfam’s Freds (roughly the bottom quintile) together with quintile inbetween represent 60% of Britain. The quintile above too support progressive taxation policies. That’s 80% of the country that can be mobilised on this basis. This is crucial in light of the important debate on how we pay for the debt we are incurring in fighting the recession, the question is ‘who pays?’

There is too the broader point of why has ‘Middle Britain’ been left behind? The answer to this is unquestionably related to the buildup in consumer debt over the past decades. As the report notes:

Despite the deceleration in the rate of income growth from 2002, households, on average, maintained rising living standards at least until the end of 2007. From 2000 to 2007, consumer spending by individuals grew by £55 billion more than their income. Over the same period, the Government’s index of retail sales by volume grew by no less than 35 per cent in constant prices, more than three times as fast as disposable incomes.For a while Britons – across income groups – embarked on a mass spending spree while much of the nation appeared to drip with affluence. New shopping malls sprouted across Britain. The giant Westfield Centre in West London is the biggest urban, indoor retail outlet in western Europe, boasting no fewer than 50 restaurants and 255 shops, including flagship stores for leading designers including Dior and Tiffany. Yet in a telling symbol of the consumer bubble that was bursting across Britain, it opened its doors in November 2008, a few days after the Government announced the first quarterly downturn for 16 years.

So how was it possible to maintain spending when rises in purchasing power were slowing? The answer is by a sharp and unprecedented rise in debt.

I am increasingly thinking that there is something in Graham Turner’s argument about the power of capital and the buildup in debt. Footloose global capital and the outsourcing of jobs to lower cost countries has had the effect of driving down wages in the West.

The price of goods may have fallen as result but, as the data clearly shows, real (i.e. adjusted for lower inflation) wages have not risen as much as many expected. Capital, with ever increasing production, needed consumers to buy its goods. Workers, with lower wages, needed to maintain their consumption and way of life. The answer to both problems was simply to borrow.

One manifestation of this borrowing can be found in the rapid rise in house prices of the past decade. As I have argued before, higher house prices do not benefit society. ‘Middle Britain’ (despite being 77% home owners) would be better served by lower house prices, as would the Freds. They could borrow less to buy homes, they would be more competitive internationally, inequality would be lower, social mobility would be higher.

For all of these reasons I would offer a ringing endorsement to the conclusions of the report.

Tax:

• The Government should restate a commitment to the principle of
progressive taxation – that tax should be related to ability to pay, with
the rich paying a higher proportion of tax than the poor and the middle.
This would mean reducing the share paid by the lowest earners, a war
on tax havens and loopholes, ending higher-rate tax on pensions and a
reform of council tax.

• To reduce the excessive concentration of wealth, a higher proportion of tax revenue should come from capital taxation with a reform of inheritance tax and the realignment of income tax and capital gains tax rates.

In recent times, British society has become increasingly aspirational, with individuals aiming for improved living standards and opportunities for themselves and their children. Yet many, if not most, of those on low and middle incomes have been denied the opportunity to fulfill these extended ambitions – in housing, education and work. For many, relative opportunities in these areas have declined.

Successive governments have set out to fuel aspirations without willing the means. Now is the time to set out a new agenda that closes the gap between rising aspirations and the means to fulfilling them.

The Government is moving the right direction here, the 50p rate signals that. The Government has succeeded in raising aspirations, now we need to help meet these raised aspirations.

How bad it is

The International Energy Agency now expects the first fall since 1945 in global electricity use.

This is a serious global recession.

Why Europe Matters

Next week sees the European Parliament elections and there has been a distressing lack of debate about Europe.

I want to be clear here – many of the expenses claims are simply outrageous and I understand the public anger but this shouldn’t be the issue on which people vote in the Euros.

Gordon Brown has an article in the FT today, arguing the case for a sustainable recovery in Europe. It’s actually very good.

The euro area is expected to be hit harder than the UK this year and next, despite the disproportionate initial impact on Britain of the banking crisis. So I will be working with European leaders in advance of the European Council to advance on our decisions at the Group of 20 with a more focused Europe-wide strategy for growth.

…

EU states dealing with car industry problems should work more closely together to find sustainable solutions. Europe also needs a clear determination to avoid long-term unemployment.

Bringing this issue to the fore is another story in today’s FT, ‘UK seeks to secure Vauxhall’s fate’.

Britain is lobbying to prevent the German government from bowing to election-year pressure with a pledge to protect domestic jobs at the expense of Vauxhall’s UK plants. “We’re pedalling hard to get a commercial solution and not an overtly political one,” a senior government insider said.

The fate of two factories in Luton and Ellesmere Port (around 5,000 jobs) now dependent on our ability to work together with European partners. So whilst the expenses issue can’t be ignored, it should not be the major factor when voting in the European elections.

Bank of England to reform monetary data

I wrote a long post on money and credit about a month ago.

One point I noted was:

Basically the growth of the shadow banking system and the use of Special Purpose Vehicles (SPVs) in securitisations has potentially ‘broken’ the monetary data. Simply put there are now lots of quasi-banks which are not technically banks and so not treated as banks in the official data. Their holdings of money are included in the monetary data and have the effect of inflating the numbers – even when it will have no effect on economic activity in the traditional sense.

Excellent news out of the BOE. They are moving to reform the data to ‘fix’ this problem.

In order to improve the quality of the monthly measures
of underlying money and credit, the Bank will collect an
industrial breakdown of deposits and lending data at a
monthly frequency from July onwards. A monthly
version of M4 and M4 lending excluding intermediate
OFCs – covering data for the month of July – will then
be published for the first time on 1 September 2009, in an
additional table in the Sectoral breakdown of aggregate
M4 and M4 lending.

The whole article from the Bank is well worth a read.

So many Austrians…

Reading various economics blogs I’ve noticed that the internet seems to attract a lot of economists of the Austrian School.

This confuses me and I hadn’t relaised there were so many out there.

This makes me think of Tom Harris’s point on why Gudio may be so popular.

But I’m drawn now to the conclusion that, certainly as far as libertarian readers are concerned, the blogscape offers them an outlet and a range of opinions which the mainstream media have never provided. If you’re “mainstream” Left, Right or Centre in your politics, then the blogscape doesn’t really offer much that isn’t already found in newspapers or TV news. But if you’re a libertarian, the blogscape has become your first port of call.

I’m wondering whether the same holds of Austrian Economists.

Anyway, I’m currently writing a long(ish) post on why Austrians are interesting but also why I think they are wrong.

S&P Downgrade

There’s no way to be modest about this.

Here’s me discussing the downgrade on t’telly.

Preventing Collapse…

Support from unlikely places today.

 Lombard Street Research are an independent macroeconomic forecasting company.

 As they say:

Lombard Street Research was founded in 1989 by Tim Congdon CBE and quickly established its reputation as a leading provider of independent macroeconomic research.

Our consistent aim has been to provide accurate economic forecasts in order to improve the investment thinking and strategic decisions of financial institutions, banks and corporations worldwide.

And

The key foundation of our research is monetary economics. Fundamental analysis of trends in money and credit, banking systems and flows-of-funds provide unique insights into economic developments and into likely movements of financial asset prices.

We also employ proprietary leading indicators to help generate forecasts for economic growth in all of the major economies of the world.

The key point here is that these guys are monetarists.

 So, I was delighted when this landed in my inbox:

 Savaged by a dead S&P/sheep

WE SUGGEST: Yields on Treasuries, Bunds and Gilts are attractive

SUMMARY: US/UK deficits are the only way of stopping global economic collapse until savings-glut countries cut their excess saving. For the foreseeable future, this is unlikely to happen. If and when it does, the Anglo-Saxons should and will cut their deficits.

 I’ll say that again, ‘US/UK deficits are the only way of stopping global economic collapse’.

So, there you go… We now both Keynesians and Monetarists arguing to run a deficit. Who exactly are the Tories being advised by?

UK Downgrade?

S&P, the ratings agency, has placed the UK’s AAA bond rating on ‘negative outlook’. This means they are ‘considering’ downgrading it in the future.

 In the context of the large expected rise in public sector debt, this is not surprising.

 The full S&P statement is here.

 First off – let’s not panic.

 They are talking about moving us, at some point in the future, to AA, the second highest rating. They are not saying we are heading for bankruptcy/the IMF whatever. Let’s keep some perspective.

 Second at 10.30am this morning (after the negative outlook), there was bond auction. We sold £4.5bn of 5 year gilts at an average interest rate of only 2.91%. Clearly the markets are not as paniced as the right is about to suggest they are. We received £13bn of bids, in other words there were plenty of people willing to lend to us.

 Third, it’s worth reading the actual S&P release (my emphasis):

 We note that there is support across the political spectrum for additional fiscal tightening. However, the parties’ intentions will likely remain unclear until the next administration is formed after the general election, due by mid-2010. How quickly the government can stabilize and then reduce the government debt burden will also depend on the timing and shape of the economic recovery and whether the cost of government support of the banking system is higher than we currently assume, areas where we also see continued downside risks.

 …

   “The rating could be lowered if we conclude that, following the election, the next government’s fiscal consolidation plans are unlikely to put the U.K. debt burden on a secure downward trajectory over the medium term,” Mr. Beers said. “Conversely, the outlook could be revised back to stable if comprehensive measures are implemented to place the public finances on a sustainable footing, or if fiscal outturns are more benign than we currently anticipate.”

 This downgrade, if it happens, will not happen until after the election. At that point it will be imperative for the government to set out a credible plan to return the finances to balance, I favour doing it mainly through tax rises, the Tories through mainly spending cuts. Either way, the new Government will be forced to act very quickly in setting out plans.

 I am not trying to ignore the significance of all this.  But let’s keep some perspective.

Chrysler

I am very interested in the recent goings on at Chrysler. I think Obama administration has handled this situation incredibly well and it may even provide a workable model for other governments.

 To briefly summarise the situation before last month; the outlook for ther US ‘Big Three’ auto firms was pretty grim. As I have noted there may be a structural fall in Western car sales, in addition cars can be made far cheaper elsewhere and the Detriot firms were hamstrung by ‘legacy costs’ of pension and healthcare obligations. Now the best way to remove many of these ‘legacy costs’ is with a functioning welfare state…. But that’s another topic. All Three were placed on government life support, in the form of loans, late last year.

 The problems faced by each of the Three are different (and Ford looks like it will be fine), but Chrylser (80% private equity owned) was also weighted down by large debts.

Newsweek did a very good summary of the situation last November.

To many there seemed to be three realistic options.

• Allow it to go bankrupt. Supported by many free market types. Personally I don’t think such a large bankruptcy (with knock effects on the suppliers and dealers) would have been helpful, given rising unemployment is the core issue facing the US.
• Bail it out.This would have been achieved by large soft ‘loans’ from the government, probably dressed up as funds ‘to support the development of green technology’. I think this do, supported by many on the left, would have been a bad idea. It could have become a bottomless pit of public money (which could be better spent elsewhere) and the actual problems would not be addressed. Although I support policies aimed at holding down unemployment, I don’t support permenant life support for corporates.
• Find a buyer. Not realistic unless the buyer was given very large government loans on soft terms to support it. In other words the State takes the downside risk whilst the buyer takes the upside. Far from ideal.

What the Obama team have actually settled on is a fairly innovative structure. As the BBC summarise:

• Fiat will take a 20% stake, with the possibility of it rising to 35% if performance targets are met. It could reach 51% by 2016 if Chrysler’s government loans are fully repaid

• The Treasury will have an 8% stake, a union-run trust fund VEBA will take a 55% stake, and the governments of Canada and Ontario will gain a combined 2% stake

• Current owner Cerberus will forfeit its 80.1% stake

• Daimler will give up its remaining 19.9% stake in Chrysler

• Chrysler bondholders will receive $2bn (£1.35bn) in cash in exchange for forgiving their $6.9bn debt

• The new company will be run by a nine-person board, with six picked by the government and three by Fiat. The board will pick a new chief executive.

So, top management who were responsible are kicked out and new team from Fiat are put in place. Fiat has successfully restructured itself over the past few yearsand the team have a great record in achieving corporate turn arounds. Additionally Fiat has very good products – smaller, more fuel efficient cars but no distrubution and production netwrok in the States. Chryler has a strong production and distrubition and production netwrok in the States but no good products: the perfect match.

The Treasury keeps an 8% stake and partakes on the upside.

But the clever but is giving the unions a 55% stake, which they will presumably eventually sell to Fiat if things go well, to pay for healthcare/pensions etc.

The creditors are of course complaining, although this rings hollow to me. How much would they have got if the firm had failed?

Charlie is less impressed. I can see his point that workers should be less than happy when capitalists walk away and leave the obligations on them. I disagree.

If Chrysler succeeds then the unions will get what is due to them, if it fails then they wouldn’t have got it anyway.

Let’s be clear here, the US auto industry is too big and has to shrink. In the end jobs will go at Chrysler, but I am very impressed that the process is being effectively managed by government, the unions and Fiat rather than being allowed to happen in one ‘big bang’.

 

(And in the interest of disclosure, yes I do hold Fiat shares).