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By David Howden, on 26 April 11
 The UK is in sorry shape today. The British can at least take comfort in knowing that things are still not anywhere near as bad as they were over a half century ago during the gloomy days of the Blitz. Yet in contemplating where Britain is today, and comparing it to other dark periods, it would be well-advised to keep everything in historical perspective.
The Blitz was terrible, but it was far from the worst that could have happened. While the constant fear of bombing, mandatory curfews and destroyed cities rendered a great tragedy on Britain, the steady supply of Nazi bombs saved her from another fate. While German bombers were busy emptying their destructive cargo onto Britain, they were unable to drop a different type of cargo that would have meant not just sudden impairment of the livelihoods of the British (as did the bombs) but their future prosperity as well.
Operation Bernhard was hatched in 1942 by SS Major Bernhard Krüger (whose claim to fame now rests on naming what would become one of the War’s most devious plots after himself). The plan involved flooding the British economy with £5, £10, £20, and £50 notes. In what was the largest counterfeiting operation in history, a team of 142 “counterfeiters” (i.e., inmates) at the Sachsenhausen concentration camp toiled for three years to amass a sizeable British fortune: 8,965,080 Bank of England notes were produced with a total value of £134,610,810.
The initial plan called for bombing runs to drop the currency from the sky. Britons know a good deal when they see one – pounds sent from heaven would be a ray of sunshine in an otherwise dreary wartime economy. As the counterfeit pounds were spent, inflation would be triggered. The once proud British economy would be brought to its knees as skyrocketing prices would foil entrepreneurs’ plans, destroy savings, and otherwise wreak havoc on the economy.
Luckily, the tenacity of the British paid off. The Luftwaffe, increasingly hindered as the war wore on, lacked the bombers to drop the counterfeit notes over the British countryside. Disaster was averted.
And yet today we have a similar plan in action. Mervyn King, governor of the Bank of England, has undertaken his own little “Operation Bernhard.” The base money supply of the United Kingdom – the notes and coins in circulation – has increased by over 75 percent over the last decade. That supply of dingy notes and tarnished coins that weigh down Britons’ pockets has grown by leaps and bounds that Major Krüger could only dream of.
While the Nazi’s could only produce £134,610,810 over the course of the war, this is about 7 percent of what the Bank of England was able to produce in 2010 alone! Even at the height of the operation it is claimed that about 1 million counterfeit notes were produced per month. Even if we concede that all of these notes were of the largest denomination printed (£50), this would still only amount to £600 million a year. Even this massive figure pales in comparison to the approximately 1.9 billion extra pounds of currency that the Bank of England put into circulation last year.
To put it in other words: In the last year the Bank of England pursued an operation that was over twice as effective as the Nazi’s could only dream of during the height of the war. Mervyn King and his colleagues have pursued an inflationary policy the likes of which Britain’s largest enemies could only wish for during the war.
I know that you are supposed to have love for thine enemies, but this all begs the question: Mr King, whose side are you on anyway?
By James Tyler, on 4 March 11
Another classic article, brought forward. This is a speech by James Tyler to the Adam Smith Institute Next Generation Group on 6 October 2009. This speech is also available on hedgehedge.com.
I have spent the best part of the last two decades pitting my wits against the market. It’s an unforgiving game: I’ve seen ups and downs, and many of my rivals buried under an avalanche of hubris, passion, illogical thought and unchecked emotion.
I have witnessed the sheer folly of the ERM crisis, the Asian crisis, the failure of the Gods at Long Term Capital Management and the insanity of the tech boom.
I have enjoyed the ‘NICE’ decade (Non-Inflationary Constant Expansion), and scared myself silly during the credit crisis.
I am a trader.
I risk my own money and live or die by my decisions, and face the threat of personal bankruptcy every time I switch my screens on. I get no salary – indeed I turn up at the start of the month with a large office overhead – a ‘negative’ salary. I have no fancy company pension scheme, no lucrative monopoly or franchise.
I eat what I kill.
Mistakes cost me my livelihood, so, above all, my decisions have to be rooted in practical and logical decision making.
Some have called my kind parasitic, but I would have said that I bring order, efficiency, predictability, stability and deep liquidity to a crucial process: a process that makes the whole world keep ticking.
I make money work.
I make the market in interest rate derivatives: a market born out of the neo classical revolution in finance fostered in Chicago during the 1970s. I am a child of Friedman, Fisher Black, Myron Scholes and the modern international financial system.
My analysis was steeped in the neo-classical, efficient markets paradigm.
Friedman’s ideal was working. Enlightened central bankers guided the free market with gentle nudges and short term liquidity infusions, free floating currencies gently adjusted themselves to the constant flow of new information and efficient and rational markets took all in their stride.
Credit flowed, people got wealthier, economies developed and all was well.
And then the crisis struck.
Continue reading “My Journey to Austrianism via the City”
By Robert Sadler, on 23 February 11
Recent economic data has convinced the Bank of England not to expand its Quantitative Easing program. According to the Office of National Statistics, annual CPI inflation rose from 3.3% in November to 3.7% in December, 2010 and is now currently 4%. The overall expectation is that CPI inflation will peak at 4.4% by the middle of 2011.
This increase in inflation coupled with poor economic data (with GDP contracting 0.5% last quarter) has come as something of a shock to the Bank of England. The Bank was apparently operating under the assumption that printing money was the way to get the economy going. They are surprised that the result has been a significant increase in inflation and a worsening economy.
Rather helpfully, on the Bank’s website there is an explanation of how Quantitative Easing was supposed to improve the economy. Quite clearly, the Bank explains that they purchased British Government bonds (gilts) and high quality (investment grade) bonds from private sector companies (banks, pension funds, insurance companies and non-financial institutions). The Bank’s concern was that there was too little money “circulating” in the economy. Using this method, the Bank was able to inject the much needed money directly into the economy and the companies that needed it. The idea was two-fold; a) asset prices increase, wealth increases and spending increases; b) more money, means more spending, bank reserves increase, meaning more lending, spending and income increases, inflation arrives at the magic 2% rate and we all live happily ever after, growing fat off of the magic wealth creation machine at the Bank. But there is a dark side to this fairy tale and at the risk of sounding clichéd, it is because in this case, more money really does mean more problems.
The problem is that the Bank is operating under the rather naïve assumption that printing money and rising prices mean that they are creating value. If this were true, none of us would need to work. The government could just issue us all with paper, ink and printing presses. Whenever we needed to buy something we could just print off some money and go to the shops and buy what we need. And of course, prices would rise, the shops would make lots of profits and apparent wealth would increase. There is one nagging doubt however. Who would make all the goods that we would buy, if we are all sitting at home printing money? Perhaps we could get the Morlocks to do it. Or maybe specially trained chimps.
Clearly, the Wizards of Oz, currently residing at the Bank of England, do not understand how value is created, how capital grows and how the wealth in society is generated. To create value one must produce something of value, a good that someone can use to improve their wellbeing or allow them to subsist. This good can be sold for money and the money can be used for consumption, held as a cash balance or to improve the tools needed to produce a greater quantity and quality of goods. Ultimately, all money will be spent on either a consumer good (like a loaf of bread or a new pair of shoes) or a capital good (like a baker’s oven or shoe-making machinery). The latter choice would result in an increase in capital (the value of all capital goods) and capital goods, and in the long run, a general increase in wealth. The increase in wealth occurs because an improvement in the quality and quantity of capital goods allows us to create a greater number of better quality consumer goods in a shorter period of time. This increase in the supply of consumer goods means that their price will fall resulting in a reduction in the cost of living for the society at large. We will all be better off. The important concept to take away is that for this increase in wealth to occur, somebody had to sacrifice some of their consumption to instead purchase a capital good (otherwise known as an income producing asset). This increases the price of income producing assets relative to consumer goods. From the perspective of a consumer like you and me, the goods we buy become cheaper and in a healthy economy, the prices of consumer goods fall over time.
The Bank of England does not believe that any sacrifice is needed today for an increase in wealth tomorrow. In the Land of Oz you do not need to sell something of value in order to get money in exchange, you can just print money instead. Obviously, printing up banknotes does not create anything of value. What happens instead is the reverse of the process described above. The increased supply of money, according to the fundamental laws of economics, will reduce its purchasing power, meaning that the relative prices of consumer goods will rise over time. This will increase the cost of living for people in general, meaning their real wages will fall. Because the cost of labour is now comparatively cheaper, rather than invest in an increase in capital goods, companies will invest in labour instead (Jesus Huerta De Soto, 2009). This means there will be a lower quantity and quality of capital goods and a reduction in the future supply of consumer goods. For the average person, this means a lower salary and a smaller selection of more expensive goods to spend it on. Most of us become poorer.
But not all of us will become poorer. By printing this money and handing it over to a favoured few in society (i.e. the banks) this is in one sense, handing them nothing and in another sense, pure and simple counterfeiting. This is because, in the case of Quantitative Easing, the banks will trade this money for real or financial assets, or to their employees in exchange for their services. This increased monetary demand for financial assets or banking services will bid up their prices. The assets can then be sold in the near term at a profit and the banking employees will spend their increased salaries and bonuses on consumer goods before prices start to rise. Bankers will certainly feel wealthier. In fact, this whole process represents a wealth transfer from one group of people in society to the banks and a shadow tax on much of the population. This is because the early recipients of the new money (the bankers and the Government) will get to spend this money before the prices rise significantly. Slowly this new money will be dispersed around the economy but the further you are from the source the less it will be worth when you finally receive it.
The main beneficiaries of Quantitative Easing therefore, are the Government and the banks. The banks buy gilts from the Government and then sell them to the Bank of England (just under £200bn’s worth) at a profit. The Bank of England pays for these gilts with freshly printed money. Thus the Government has a ready buyer for its debt and the banks become more profitable and apparently more stable. Because of their now greater reserves and new found stability, the official rationale behind Quantitative Easing was that banks would then lend out these reserves to businesses and households thus stimulating the economy. Except, in fact the opposite has occurred. The economy has contracted, inflation is continuing to rise, net lending is down and unemployment has risen.
With a firm understanding of the basics of how wealth is created the Bank of England would have known this would happen. Unfortunately, they operate under the Keynesian delusion of how the world works and their main objective would appear to be saving the banks (because we are all doomed without them) rather saving the economy. With inflation getting higher and higher one might wonder why Mervyn King, the Governor of the Bank of England, does not simply raise interest rates or resell the gilts. However, this would set the Bank of England’s plan into reverse, with higher rates leading to lower asset values, weakened balance sheets and an increase in mortgage defaults, leading to more bank losses and bankruptcies.
Clearly, the Bank of England’s plan is doomed to failure and has been from the start. Mervyn King would have greater luck trying to empty the ocean with a bucket. The problem is two-fold; a) the Bank of England views the recovery or liquidation stage of the business cycle as a problem to be solved and; b) it tries to solve this problem by doing more of what caused this problem in the first place. This “solution” has prevented the necessary liquidation of unprofitable projects and write-offs of bad loans, and has continued to subsidise inefficient operations. Quantitative Easing has resulted in a transfer of wealth from society at large to the banks and the Government, and has vastly extended the length of what would have been a short but sharp recession. Quantitative Easing has made us poorer while benefiting a select few in society.
This is a crime by any measure.
By David Howden, on 14 January 11
The One Hundred Twelfth United States Congress opened the year with a reading of the American Constitution. Though this was probably more of a show than anything, it does serve a useful function. For better or worse, this government has been elected to serve the electorate to the best of its ability and within the confines of what the law permits. The American Congress was originally granted territorial monopoly rights to make and change the law of the American land. It was not, however, given free rein in this regard. The power of the Constitution is that it delineates the extent of the power endowed to Congress by the people, and where those powers end.
While it is refreshing to see the political establishment paying at least lip service to its original grants and privileges, there exists one other set of territorial monopolists that must be reminded every now and again of their purpose.
The world’s central banks – the Federal Reserve in the States, or the Bank of England for the United Kingdom as examples – were granted a territorial monopoly right over the issuance and control of the money supply in their respective jurisdictions. This grant was not made without limits. These limits are what are widely recognized as keeping these monopolists free from outside interference, but also preventing them from unduly interfering with the events outside their domain.
Perhaps the governors of the Bank of England should start each New Year by gathering around Mervyn King while he reads the original purpose of the Bank. While its scope and mandate is now a little different than the original 1694 Bank of England Act, the Bank’s own website very neatly outlines what its principal objective is, namely “to safeguard the value of the currency in terms of what it will purchase”:
Rising prices – inflation – reduces the value of money. Monetary policy is directed to achieving this objective and providing a framework for non-inflationary economic growth. As in most other developed countries, monetary policy usually operates in the UK through influencing the price at which money is lent – the interest rate.
Two points become clear. First, safeguarding the currency’s value is the primary focus. Second, this will be done so as to promote non-inflationary growth.
The problem is that the Bank of England seems not to realize what the word “inflation” means. It is not only their confusion. The word “inflation” may be one of the most misunderstood and misused words in the English language. Murray Rothbard, on page 990 of his 1962 opus Man, Economy and State, defines in no uncertain terms exactly what inflation is:
The process of issuing pseudo warehouse receipts or, more exactly, the process of issuing money beyond any increase in the stock of specie, may be called inflation. A contraction in the money supply outstanding over any period (aside from a possible net decrease in specie) may be called deflation. Clearly, inflation is the primary event and the primary purpose of monetary intervention.
Any increase in the quantity of money outstanding constitutes inflation. While the Bank of England concentrates on the general price level, it ignores this very important point. After all, the price level can and does change constantly as resource availability alters the relative scarcities of goods, and our own preferences change the values (and hence purchase prices) that we assign to those same scarce goods. Only a definition of inflation grounded in the actual quantity of money gets to the root of the problem: changes in money’s quantity alter its purchasing power.
Second, the Bank seems to want to foster an environment of non-inflationary economic growth. Ignoring for the moment whether the bank is actually pursuing a “low-inflationary” policy, can we say that it is fostering a growth policy?
Given the current state of affairs, which seems to get worse by the day, the unequivocal answer is: no. The United Kingdom’s most pressing problem at this moment is crushing debt levels. The government alone has a little less than 70 percent of the country’s GDP tied up as debt. Interest payments on this debt alone eat away about 3 percent of British GDP each year. The payments on this debt load are stifling, and will only grow over time. One may ask what happened to create such an indebted nation.
The Bank of England’s inflationary policies, since it was nationalized in 1946, have been staggering. As the pound lost value through these policies, an environment where debtors were rewarded for borrowing at the expense of the more prudent creditors was bred. The home of the Industrial Revolution, a once-great source of exports to the world, now finds itself needing to borrow from the world just to meet the interest payments on its debt. This does not sound like a situation that promotes “economic growth”, as the Bank of England eloquently puts it.
Yes, Mervyn King and the rest of the Bank of England would do well to revisit their purpose and mandates at the start of each year. But they would also be well-advised to learn some basic economic theory while they’re at it.
By Toby Baxendale, on 21 December 10
Bankers’ Magazine Vol I April-October 1844 – H/T Sean Corrigan
The author of an interesting work published a short time since, entitled “Sir Robert Peel and his Era,” in which a lively sketch is given of the chief peculiarities, external and intellectual, of the leading members of the Houses of Parliament; refers to the assertion sometimes made, that Mr. Cobden is a man of only one idea, in the following terms,—” It is a mistake; Cobden is really a man of great talent, energy, and tact, though, of course, it has been by means of his one idea at the critical time, that he has become in the compass of a year and a half, a noted public character.” Most persons know little of Mr. Cobden, except in connection with the Anti-Corn Law League, and may, therefore, feel some surprise at recognizing him in the character of a financier. But long before the Corn Law League commenced its operations, his very clever pamphlets, “England, Ireland, and America,” and “Russia, by a Manchester Manufacturer,” had shewn him fully capable of appreciating and discussing with ability, any of the intricate questions connected with our monetary system. We purpose in this paper to lay before the reader, his views on the currency, because we think it by no means improbable, that they may have considerable influence, when the subject comes under consideration in Parliament; and, further, because they are the opinions of a practical man of business who speaks to facts. We must beg to be understood as expressing no opinion ourselves, either for or against the views he advocates, by thus drawing attention to them. He gave his evidence before a select committee of the House of Commons in 1840, and it is not a little singular that he only once, and then incidentally, spoke of the Corn Laws, as interfering injuriously with our monetary system.
In order to present, in a concise form, the subjects connected with the theory and practice of Banking, which were referred to in the course of his evidence, we shall arrange them under separate headings, commencing with his own statement of the character of the evidence he proposed to give.
His Opinions—those of a Practical Man.
I am here as a practical man, a merchant and manufacturer, and with a view to the scientific definitions of the terms to be used by bankers, I do not pretend to come here as an authority. It would very much prevent that confusion into which I fell at the close of my last examination, if I should clearly understand the practical bearing of every question, and it is only on practical subjects that I can afford any information. I make this explanation, because I find that in the attempt which I thought due to this Committee, to answer every question put to me on the last occasion, I have given some answers at the close of my examination which have been, by permission of the Committee, struck out, which are so unintelligible to me on reading them, that I think they must be incomprehensible to every living being. I do not understand the questions any more than I understand the answers at this moment, and I wish my examination to be of that practical nature, on which alone I can afford the Committee any information.
Evils produced by Fluctuations in the Currency.
My opinion is, that great evils have arisen to the trade and manufactures of the country from fluctuations in the currency; I believe great evils have been occasioned to the trade and manufactures of the country in 1836 and 1837, and the subsequent period, by fluctuations in the currency; greater evils, pecuniary, social, and moral, than by the direct failures of all the banks of issue since they were first established in this country.
I could adduce a fact derived from my own experience that would illustrate the heavy losses to which manufactures were exposed in their operations, by those fluctuations in the value of money. I am a calico printer; I purchase the cloth, which is my raw material, in the market, and have usually in warehouses three or four months supply of material. I must necessarily proceed in my operations, whatever change there may be, whether a rise or a fall in the market. I employ 600 hands, and those hands must be employed. I have fixed machinery and capital, which must also be kept going, and therefore whatever the prospects of a rise or fall of prices may be, I am constantly obliged to be purchasing the material, and contracting for the material on which I operate. In 1837, I lost by my stock in hand 20,000/., as compared with the stock-taking in 1835, 1836, and 1838; the average of those three years when compared with 1837, shews that I lost 20,000/. by my business in 1837, and what I wish to add is, that the whole of this loss arose from the depreciation in the value of my stock. My business was as prosperous; we stood as high as printers as we did previously; our business since that has been as good, and there was no other cause for the losses I then sustained, but the depreciation of the value of the articles in warehouse in my hands. What I wish particularly to shew is, the defenceless condition in which we manufacturers are placed, and how completely we are at the mercy of these unnatural fluctuations. Although I was aware that the losses were coming, it was impossible I could do otherwise than proceed onward, with the certainty of suffering a loss on the stock; to stop the work of 600 hands, and to fail to supply our customers would have been altogether ruinous; that is a fact drawn from my own experience. I wish to point to another example of a most striking kind, shewing the effect of those fluctuations on merchants. I hold in my hand a list of thirty-six articles which were imported in 1837, by the house of Butterworth and Brookes, of Manchester, a house very well known; Mr. Brookes is now boroughreeve of Manchester. Here is a list of thirty-six articles imported in the year 1837, in the regular way of business, and opposite to each article there is the rate of loss upon it as it arrived, and as it was sold. The average loss is 37 1/2 per cent, on those thirty-six articles, and they were imported from Canton, Trieste, Bombay, Bahia, Alexandria, Lima, and, in fact, all the intermediate places almost. This, I presume, is a fair guide to shew the losses which other merchants incurred on similar articles.
Conduct of the Bank of England.
The great instrument in the hands of the Bank, for effecting its changes in the value of commodities, is by creating a panic; it is a process the most disastrous to the trading community; it is the most profitable to the Bank proprietors; that process was resorted to at the end of 1836, in striking a blow at the American houses, in advancing the rate of interest, and by all those means which are resorted to in the London papers, through its organ’s of the press, for exciting apprehensions in the minds of merchants and traders, that a curtailment of its securities and credit generally was to take place. The Bank ought to have contracted its issues long before, at the commencement of the drain in 1836; there was a previous drain, which was but slightly interrupted, which began as early as 1834; in fact, the Bank appears to have departed from its principle, immediately it had obtained the renewal of its charter, of keeping one-third of its liabilities in gold. If the Bank had kept its securities at an even amount, and retained one-third of its liabilities in bullion, or about that (I do not complain of a million), I feel assured there would have been no panic; there could have been no panic if that had been the policy from the time of its obtaining its charter.
I consider the cause and effect in the contractions and expansions of the currency, and their influences on prices, are not to be measured in periods of six months, or even twelve months; the expansions of the Bank of England in 1835, and indeed its previous course of expansion (for I am of opinion that mischief was generating long before that), had given rise to an immense amount of speculation; and amongst other things, it had set in motion seventy or eighty joint-stock banks; forty-seven joint stock banks were established in 1836; those were in the course of formation at the very time when the Bank of England was, as it appears here, in the course of contraction, but it necessarily must have taken a considerable time to have checked the spirit which had been generated by the previous course of expansion on the part of the Bank of England.
Effects of an over Issue of Paper Money.
The conduct of the Bank, in inflating the currency, produces a rise of prices. The prices of all commodities gradually rise; that begets what is thought prosperity; it is in fact unhealthy excitement; this causes an extension of our commerce and manufactures; it causes an advance of prices abroad, in consequence of the advance in this market, which is the regulator of the prices abroad, and that begets a general system of over-trading. This overtrading inevitably leads in the end to discredit, and panic to a greater or less degree; it was through promoting this train of consequences by originally departing from its rule of keeping steadily to the amount of its securities, and keeping one-third of its liabilities in bullion, that the Bank, in my opinion, caused the over-trading; and the panic of 1836-7, which, I repeat, could not have happened had the Bank been true to its own principle of remaining passive, with the amount of one-third of its liabilities in bullion.
Bank of England can control Issues of Joint Stock Banks.
I believe it to be impossible for private and joint-stock Banks to expand the circulation, provided the Bank of England remained true to the principle it had laid down. We have had no instance of its having been so; even the Scotch Banks cannot inflate the currency, unless the Bank of England have previously set the example; that was the case from 1823 to 1825; the Scotch Banks increased their circulation from, I believe, 3,400,000/. to upwards of four millions and a half, up to the panic of 1825; I think that was about the increase of the circulation in Scotland; but the moment the screw (to use the common term) was placed upon the currency in London, that moment the Scotch Banks were compelled to restrict their issues, and the same operation went on with all the private banks of the kingdom. I have a pretty clear recollection of having seen that statement in Sir Henry Parnell’s work upon Banks. It is impossible to doubt that the Bank, having the entire circulation of the metropolis, having the privilege of a legal tender, its notes being alone receivable by the Government in payment of the revenue, and possessing altogether the prestige which the Bank of England possesses in the public estimation, and backed by the Government, it is impossible that an institution so circumstanced should be otherwise than in a position of absolute power over all other banks in the kingdom. I should not say that the country Banks contract their circulation instantaneously, on finding that the Bank of England is doing so; but the country Banks do what is of as much importance in the way of effecting a correction of the evils of expansion; they curtail their credits, they allow fewer facilities, they call up old debts, and take warning by the example of the Bank of England, to put a general restriction upon the operations of trade; I think it must be known to every one that the slightest movement on the part of the Bank of England, is watched with intense interest by every banker as well as merchant in the kingdom.
What Causes should regulate the Currency.
I hold all idea of regulating the currency to be an absurdity; the very terms of regulating the currency, and managing the currency, I look upon to be an absurdity; the currency should regulate itself; it must be regulated by the trade and commerce of the world; I would neither allow the Bank of England nor any private banks, to have what is called the management of the currency.—Have you not stated that the Bank of England ought to regulate its circulation according to the amount of its bullion? I have stated that that is the principle laid down by the Bank of England, and that that principle has not been conformed to; I have no faith in any man or any body of men ever conforming to any such principles, and, therefore, I remarked I should never contemplate any remedial measure, which left it to the discretion of individuals to regulate the amount of the currency by any principle or standard whatever; but the Bank having laid down that principle, and having obtained its charter in consequence of Mr. Horsley Palmer’s evidence, as to the views and intentions of the Bank Directors, they have departed from that principle, and I make the complaint and charge against them of having violated a principle laid down by themselves.
Upon what principle, in your opinion, ought the circulation of this country to be regulated? If we are to have paper money at all—but in the abstract I should be sorry to commit myself to the principle that there should be any paper money at all—but if we are to have paper money, it must be restricted to that amount which the precious metals would be if they circulated alone. I would not put it into the power of individuals to depart from the principle, as the Bank Directors have done, which they have once laid down; and, therefore, my idea is, that if there be a circulation of paper, the maximum amount of that paper should be settled, and that there should be such an amount as to leave still such an amount of the precious metals circulating, as would allow the operations of the exchanges to work tranquilly upon the precious metals, without ever occasioning any shock to trade or commerce.— The object you would propose is, that the paper currency should vary exactly as the metallic currency would do? I have stated that the maximum of the paper should be settled; and it should be of such amount as would require gold and silver, in addition to such an extent as would meet all the demands for exportation in case of adverse exchanges, which I maintain would never amount, in the course of trade, to any thing at all of magnitude, unless, through the operation of bad laws, such as the present corn law. I wish to be understood that the whole of the currency in circulation should vary precisely as if it were all gold and silver, and that the exchanges should operate upon the bullion,—upon the specie.
Do you mean, by the maximum of the paper, a certain fixed amount to be issued on security, the remainder to be issued against gold, and vary with it? Precisely; I think there would be no harm done, if you issued a certain amount on securities beyond the amount required on bullion.—You do not mean by a maximum that a limit should be fixed, beyond which paper should not go, whatever gold might come in? By a maximum I mean, a maximum amount to be issued on securities, and any thing beyond that, issued on gold, would be represented by the gold.—Do you conceive that that object can be obtained by any regulations of the Banks as now constituted in this country? No, decidedly not.—How would you propose to attain that object? I think the details might be worked out with great ease, so far as the alteration of such a bank goes, inasmuch as it would require only a few men of probity to see that the principles laid down were not violated, and that the bullion of of the Bank was secure.—Would that not, so far as the Bank of England is concerned, be attained, by a strict adherence on their part to the rule of making their paper vary according to their bullion? I should be sorry to trust the Bank of England again, having violated their principle; for I never trust the same parties twice on an affair of such magnitude.—Suppose they were to adhere strictly to their principle, would not the object be obtained? The Committee must excuse my taking a hypothetical case, to give a favourable opinion. I object, moreover, to a national Bank being managed by merchants, those engaged in extensive mercantile transactions. It would be impossible, looking to the Directors of the Bank of England, to impute a want of probity; for we have had abundant proofs that the Bank of England has been conducted by men of strict personal honour; but it is quite clear that such a thing may arise as for such a bank to be under the direction of individuals as merchants, whose personal interests may be in direct hostility to their public duty. I would take, for instance, such a case as merchants having a large amount of produce coming home, previous to a glut, and previous to a panic, when it might become exceedingly important to those gentlemen that they should delay an action of the Bank, which produced a fall in prices, until they had realized on certain shipments. Such a thing is quite possible; but at the same time I should wish to be understood as not imputing any thing of the kind to such a body of men.
Advantages of One Bank of Issue.
Is it your opinion that nothing short of putting down all existing establishments, and establishing a Bank administered by Commissioners, will regulate the currency of the country? I repeat what I stated before, that the affairs of private banks cannot be so far wrong as to effect prices abroad, provided a bank having the power the Bank of England has had hitherto, remains steady to its principle, and, therefore, of course I must also think that a national bank having such a monopoly as the Bank of England has, if conducted on that principle, would prevent any mass of serious evils arising either from our country banks in England, or banks in Ireland and Scotland. All the evils we feel as merchants and manufacturers, arising from the fluctuations in the prices of commodities, originate, I believe, in London, with the Bank of England.—Would it answer the purpose, so far as the Bank of England is concerned, if a separation were made into two parts, the one to manage the currency, on the principle you have laid down, the other to manage the banking department in the same manner as the private Banks, not of issue, are managed? Mr. Loyd’s plan, to which reference is made, would have many advantages over the present system; but it is not a plan I should approve.—What are your objections to it? Mr. Loyd uses the term managing the currency, and regulating the currency, which I consider to be just as possible as the management of the tides, or the regulation of stars, or the winds. I have seen no plan which places the thing wholly beyond the power of a body of men to increase or diminish the quantity of money, which power is as intolerable, as that a body of men should have the power of regulating the length of the yard periodically; and it is as reasonable in the case of merchants who may manage a bank like the Bank of England, as if they should be privileged to sell by the short yard, and buy by the long one. I object entirely to such a bank being in the hands of a body of merchants; I object to any body of men having the power to increase or decrease the quantity’ of money.—Is not that power possessed to a small extent, and for perhaps short periods, by any bank of issue in the country? Not to an extent to influence the prices of commodities throughout the kingdom . I am not prepared to say whether slight perturbations might not arise in particular localities, owing to the indiscretions of individual banks; but no general derangement to the commerce of the country could arise from any such cause, in my opinion, provided an institution, possessing the important privileges of the Bank of England, were administered upon the principle I have pointed out.—Are not those derangements, to whatever extent they go, in direct contradiction to the principle on which, in your opinion, the currency ought to vary? I should consider them so trivial that they could not have any effect beyond the mere moment.—Not even if a great many banks pursued the same course at the same time? No; from the circumstance that I have already referred to, that if prices are raised generally in any particular quarter, commodities, stocks, railway shares, and other securities would flow to that quarter for sale; if they would fetch a higher price there than they would in London, they would be sold there, and a bill demanded on London, or gold demanded to be transmitted to London, and so the thing would be almost instantly corrected.—Do you find the contraction of the Bank of England, even when made, produces so speedy an effect on the circulation of private banks? No, not when made under the circumstances, to which I nave alluded in 1837; but under ordinary circumstances, it would have the power to correct, such as Mr. Samuel Jones Loyd has alluded to; but time must be taken, as a necessary ingredient, in all its operations; a time for expansion must be considered as having been necessary, and time for contraction must be given.
If from any causes a disposition to speculate arose, might not considerable facilities for it be given by the issues of country banks, and considerable derangement in consequence be produced? No; I consider that no great over-trading can take place unless the prices of foreign articles are influenced; that would not be the case under the circumstances to which reference is made; at present, the Bank of England, in its variations, not only effects this market, but it effects all the markets in the world. I happened to be travelling in Turkey and Greece in the spring of 1837, and I saw in the little island of Syra, the Greek merchants there, with their telescopes in their hands, looking out as anxiously for the arrival of a vessel from Trieste, giving an account of the proceedings of the Bank of England, as a merchant on the Exchange at Manchester, would watch for the arrival of the mail, to know what the next step to be taken by the Bank Directors would be; and we know, that in the message of the President of the United States in 1837, and in the Addresses of some of the Governors of the States, New York in particular, the Bank of England was not only mentioned by name, but a considerable space given to the discussion of its policy. The operations of the Bank of England, therefore, can never be compared with the operations of a small country bank, such as have been supposed to effect the changes in the value of commodities; the country bank forms a little instrument for raising up a few more houses in a town, or giving an impulse to a small line of railroad, but it could never influence the prices on staple manufactures, provided the great Central Bank was governed by a principle precisely the same as if we had a metallic currency.
In the case of a central bank administered on the principle you have mentioned, on what footing do you think country banks ought to be placed? I am as much opposed on principle to country banks of issue, as to the Bank of England; I know, in talking of remedial measures such as we wish in Manchester, such as men of business wish, in order to be saved from losses such as we have experienced, we must be practical, and rather look to what is expedient than what is wholly desirable; and, therefore, I confine myself chiefly to the removal of the great grievance, the power of influencing the prices in the hands of the Bank of England; but I should be as glad to see the power withdrawn from every other bank in England, and I believe that is a rapidly increasing opinion on the part of the trading community among whom I am accustomed to mix in Manchester.
Do you conceive it to be an increasing opinion that all power of issue should be confined to one bank, under the management of Commissioners? I believe it is.
Do you contemplate that a bank so constituted should perform any other functions than those of the issue of money? None whatever; to remain wholly passive, and not to dream of regulating the currency.
You do not contemplate its making advances to Government or other parties? Oh no, not at all; there is an end to its usefulness if that illicit intercourse is kept up; there is money raised without the advances of bank notes in America, by means of post notes; and if the Government were in great distress they might borrow, perhaps, upon post notes from merchants, without going to the Bank of England for advances.
Exchequer Bilk.
I have been extensively engaged in business for twenty years, and I never saw an Exchequer Bill in my life; it is a singular fact, that I once mentioned the same thing at our Chamber of Commerce, in the presence of a dozen individuals, all very largely engaged in business, and not one of them had ever seen an Exchequer Bill; there is an immense amount of this paper afloat, but they do not enter into commercial transactions; and the reason they do not enter into commercial transactions is, that they pay interest, and, therefore, it is profitable to the holders to keep them, instead of passing them away.
Bankers’ Magazine Vol I April-October 1844
By Sean Corrigan, on 10 December 10
We all know the cliché about how to deal with panics – viz., ‘lend freely at a penalty rate’ – and the fact that this is taken as an endorsement of central banking, per se, but , in fact, Lombard St (1873) finishes with a much more fatalistic conclusion.
XIII.1
I know it will be said that in this work I have pointed out a deep malady, and only suggested a superficial remedy. I have tediously insisted that the natural system of banking is that of many banks keeping their own cash reserve, with the penalty of failure before them if they neglect it. I have shown that our system is that of a single bank keeping the whole reserve under no effectual penalty of failure. And yet I propose to retain that system, and only attempt to mend and palliate it.
XIII.2
I can only reply that I propose to retain this system because I am quite sure that it is of no manner of use proposing to alter it. A system of credit which has slowly grown up as years went on, which has suited itself to the course of business, which has forced itself on the habits of men, will not be altered because theorists disapprove of it, or because books are written against it. You might as well, or better, try to alter the English monarchy and substitute a republic, as to alter the present constitution of the English money market, founded on the Bank of England, and substitute for it a system in which each bank shall keep its own reserve. There is no force to be found adequate to so vast a reconstruction, and so vast a destructions and therefore it is useless proposing them.
XIII.3
No one who has not long considered the subject can have a notion how much this dependence on the Bank of England is fixed in our national habits. I have given so many illustrations in this book that I fear I must have exhausted my reader’s patience, but I will risk giving another. I suppose almost everyone thinks that our system of savings’ banks is sound and good. Almost everyone would be surprised to hear that there is any possible objection to it. Yet see what it amounts to. By the last return the savings’ banks—the old and the Post Office together—contain about 60,000,000l. of deposits, and against this they hold in the funds securities of the best kind. But they hold no cash whatever. They have of course the petty cash about the various branches necessary for daily work. But of cash in ultimate reserve—cash in reserve against a panic—the savings’ banks have not a sixpence. These banks depend on being able in a panic to realise their securities. But it has been shown over and over again, that in a panic such securities can only be realised by the help of the Bank of England—that it is only the Bank with the ultimate cash reserve which has at such moments any new money, or any power to lend and act. If in a general panic there were a run on the savings’ banks, those banks could not sell 100,000l. of Consols without the help of the Bank of England; not holding themselves a cash reserve for times of panic, they are entirely dependent on the one Bank which does hold that reserve.
XIII.4
This is only a single additional instance beyond the innumerable ones given, which shows how deeply our system of banking is fixed in our ways of thinking. The Government keeps the money of the poor upon it, and the nation fully approves of their doing so. No one hears a syllable of objection. And every practical man—every man who knows the scene of action—will agree that our system of banking, based on a single reserve in the Bank of England, cannot be altered, or a system of many banks, each keeping its own reserve, be substituted for it. Nothing but a revolution would effect it, and there is nothing to cause a revolution.
XIII.5
This being so, there is nothing for it but to make the best of our banking system, and to work it in the best way that it is capable of. We can only use palliatives, and the point is to get the best palliative we can. I have endeavoured to show why it seems to me that the palliatives which I have suggested are the best that are at our disposal.
XIII.6
I have explained why the French plan will not suit our English world. The direct appointment of the Governor and Deputy-Governor of the Bank of England by the executive Government would not lessen our evils or help our difficulties. I fear it would rather make both worse. But possibly it may be suggested that I ought to explain why the American system, or some modification, would not or might not be suitable to us. The American law says that each national bank shall have a fixed proportion of cash to its liabilities (there are two classes of banks, and two different proportions; but that is not to the present purpose), and it ascertains by inspectors, who inspect at their own times, whether the required amount of cash is in the bank or not. It may be asked, could nothing like this be attempted in England? could not it, or some modification, help us out of our difficulties? As far as the American banking system is one of many reserves, I have said why I think it is of no use considering whether we should adopt it or not. We cannot adopt it if we would. The one-reserve system is fixed upon us. The only practical imitation of the American system would be to enact that the Banking department of the Bank of England should always keep a fixed proportion—say one-third of its liabilities—in reserve. But, as we have seen before, a fixed proportion of the liabilities, even when that proportion is voluntarily chosen by the directors, and not imposed by law, is not the proper standard for a bank reserve. Liabilities may be imminent or distant, and a fixed rule which imposes the same reserve for both will sometimes err by excess, and sometimes by defect. It will waste profits by over-provision against ordinary danger, and yet it may not always save the bank; for this provision is often likely enough to be insufficient against rare and unusual dangers. But bad as is this system when voluntarily chosen, it becomes far worse when legally and compulsorily imposed. In a sensitive state of the English money market the near approach to the legal limit of reserve would be a sure incentive to panic; if one-third were fixed by law, the moment the banks were close to one-third, alarm would begin, and would run like magic. And the fear would be worse because it would not be unfounded—at least, not wholly. If you say that the Bank shall always hold one-third of its liabilities as a reserve, you say in fact that this one-third shall always be useless, for out of it the Bank cannot make advances, cannot give extra help, cannot do what we have seen the holders of the ultimate reserve ought to do and must do. There is no help for us in the American system; its very essence and principle are faulty.
XIII.7
We must therefore, I think, have recourse to feeble and humble palliatives such as I have suggested. With good sense, good judgment, and good care, I have no doubt that they may be enough. But I have written in vain if I require to say now that the problem is delicate, that the solution is varying and difficult, and that the result is inestimable to us all.
By Andy Duncan, on 20 November 10
There is a superb article in the Telegraph, this morning, by Jeff Randall. Alas, with his work for Sky television, Mr Randall can only deliver one article a month for us via the Telegraph, however what he lacks in current quantity he is making up for in distilled quality. The article even includes a Mises quote, which gave me quite a jolt this morning:
“Inflation,” wrote Milton Friedman, “is the one form of taxation that can be imposed without legislation.” Those being fleeced are ordinary families, pensioners on fixed incomes and people with savings. For them, the outlook is worse than the official data suggest. The regulators are praying that the rest of us won’t notice. This is a high-wire act. As the economist Ludwig Von Mises noted, when the masses finally wake up, “a breakdown occurs”.
Remarkable.
Ladies and Gentlemen; I do believe the sterling work of Toby Baxendale, Liam Halligan, and Steve Baker et al is actually starting to get us all somewhere. If outside the hallowed pages of Mr Halligan’s fine work we are finally starting to see Ludwig von Mises quotes in the Telegraph, and other mainstream media outlets, including even the Keynesian-Monetarist Economist, then progress surely is being made.
After reading the quote above, this morning, I almost expected Mr Randall to start talking about a potential crack-up boom.
Marvellous.
By Ewen Stewart, on 15 October 10
This report from Arden Partners was originally published on the 24th of September.
Why have house prices rebounded?
In 1776 Adam Smith described Britain as ‘a nation of shopkeepers’. Today, judging by the number of home makeover TV programmes, we are a ‘nation obsessed by property values’. This note seeks to examine the prospects for house prices in the medium and longer term.
Given our view of the likely prospects perhaps we should find a new TV pastime, for we argue that the best case scenario, which is our central case, is that house prices drift downwards, settling in three years time some 10% lower with continuing very low transaction volumes. We also see a tail scenario (25% probability) of a crisis-induced interest rate shock that could hit house values by up to 25%.
Notwithstanding signs of a recent slowdown in UK house prices, property values have confounded forecasts by rebounding sharply. According to Nationwide Survey data, average house prices have increased by 12.7% since the low in Q109. Average prices are now just 8.3% off the Q307 high and, in parts of London and the south east, are actually trading well above the pre-credit crunch high.
This note examines the survey evidence along with the macroeconomic environment and highlights our view of the likely trend in house prices. The chart above, however, in our opinion, neatly emphasises why this recovery has taken place and the dangers surrounding this recovery. In two words: interest rates.
Economics & Strategy
Although housing is credibly valued on the mortgage strain measure, this is only the case due to abnormally low interest rates. The chart on the front page demonstrates that, on more normalised interest rate assumptions, real estate is far from cheap. Further, all other major housing measures from simple house prices to average earnings, credit availability, first-time buyer affordability and, also, in our view, from a macroeconomic perspective, show significant risks exist. Our best case scenario, which is our central case, is for house prices, nationally, to subside by an average of 10% over the next three years. There is a tail possibility that it could be significantly worse. We see little prospect of further increases in property values.
Interest rates: Can they hold the line?
 It is well understood that interest rates are currently at their lowest level since the foundation of the Bank of England in 1694. What should happen, in our humble opinion, and what will happen are perhaps two different things.
In our view, what should happen is that interest rates rise at a relatively gradual pace. We believe this because, despite the steepest contraction in GDP since the Second World War, inflation has remained embedded. This has been the case for a variety of reasons: some technical, like VAT rises and some embedded like the depreciation of Sterling, rising food prices and some debatable and perhaps yet to be seen like QE. Needless to say, we see this current inflation as embedded; hence, our concern over current interest rate policy.
Nevertheless, our thoughts and prejudices matter little compared with the view of HMG and the Bank of England which argue that this recent bout of inflation is a little local difficulty that will subside as the mythical, in our view, output gap exerts a downward pressure on longer-term inflation. More QE is the probable response of the Bank of England to mitigate the risk of a slowdown resulting from required spending cuts. Although the Bank of England denies this, we suspect that it has quietly dropped its official remit, to maintain inflation around 2% with an emphasis on stimulating growth.
As it is the Bank of England that sets interest rates, and not Arden Partners, we believe every attempt will be made to keep rates very low for as long as possible. Our central case is that a rise in rates is not likely in 2011. Rates will only be forced upwards should the economy be hit by further sustained increasing inflation levels, renewed concern over the Coalition’s seriousness (which, incidentally, we do not materially doubt) in tackling the deficit, or some external shock. We ascribe a 25% probability to the rise in interest rates scenario, which clearly would have serious implications for asset values.
There are other tail risks as well. While the Coalition is unlikely to shift materially the tax burden towards property, elements of the Liberal and Labour parties are examining forms of property taxes. It is hard to ascribe a probability to political expediency, but any substantial change in the way property is taxed could have a very material, negative impact on valuations. This is a long term, not short-term risk and would almost certainly be directed at more expensive property.
The current abnormal interest rate policy, coupled with QE, has had the impact of pumping up real asset values well beyond where they would have been under more normalised interest rate conditions. Prospective house purchasers now need not only to consider current affordability, but also need to build in a risk premium for the unpredictability of the government’s and the Bank of England’s policy. Will they maintain QE or won’t they? Will they keep interest rates artificially low, ignore their inflation remit, or won’t they? What will the tax treatment of property be- will there be a mansion tax in a few years or not? Will there be two spoons of sugar in the tea or will it be bitter? Investment decisions are tough enough without having to second-guess policy.
The impact of this interest rate policy can be seen from the chart above. As all are aware, the cost of borrowing has crashed. This has doubtless been the primary factor in stabilising the housing market, in particular, and, also, consumer expenditure in general.
Many other factors are connected and interplay with real estate values. Unemployment and fear of unemployment is clearly a key variable. Again, UK unemployment has surprised many commentators in being relatively subdued. The relative resilience of the labour market has also been a prime beneficiary of the sugar rush of macroeconomic policy.
We remain concerned, however, that unemployment remains embedded. There are three primary reasons for this concern. First, we have argued that the UK economic performance, prior to the credit crunch, was not as splendid as often believed. Much of the growth was a public sector and debt-fuelled binge (see our note ‘A Game of Two Halves,’ February 2010). Secondly, public sector employment (formal and private sector dependent upon public sector) is set to fall sharply – some commentators have suggested by around 600,000 employees (which is still less than the one million increase in public sector employment over the last decade). Thirdly, we are growth sceptics: our 2011 and 2012 growth forecasts remain at 0.75%, which is well below consensus. If we are correct this is not a clement environment for the private sector to pick up the slack.
Unemployment may not spike up to 10% of the working population but it will, in our view, remain embedded and is likely to remain well above 8% until 2012. This is not helpful to housing market sentiment.
 A measure of confidence is the savings ratio. In times of collective confidence the perceived need to save is minimal. In times of despair the reverse is true. Later in this note we argue that the UK is addicted to debt and we have failed to save as a nation. However, the above chart demonstrates that UK consumers, despite lamentable savings rates, have started to save again. This is, in our view, positive and part of the ‘healing process’ although the savings ratio needs to remain elevated for years to have any appreciable impact on depleted personal balance sheets.
 Another manifestation of the pre-2008 boom and the UK’s propensity for low savings is equity withdrawal. Despite the current rebound in real asset values we see a return to equity withdrawal as highly improbable. Banks are likely to remain cautious on lending for equity withdrawal and we believe consumers, too, will be unlikely to use this as a significant form of funds in the medium term.
HMG has been chastising the banks for not lending. There are three primary aspects to lending: availability of funds; desirability of making the loan in the lenders view, and at what price; and the demand for loans.
In our view, HMG can bang the drum on this as much as it likes – and hang a couple of bankers in the process – but we believe this approach fundamentally misunderstands a) where we start (i.e. with too much leverage) and b) the attitude of consumers.
We see the problem (if it is a problem, which we doubt) as more a lack of demand. If you have a hangover you can either keep on drinking (might be pleasant in the short term but not very wise beyond tomorrow) or you can dry out. We believe consumers are drying out. The two charts above, coupled with the two below, provide some evidence of this, in our opinion.
The UK in an international context
The following chart below shows the Anglo Saxon countries addiction to debt. While one needs to be careful with international comparisons – for reasons of culture, politics and history – the Anglo Saxons do rather stand out with very high levels of personal debt relative to GDP. Not only are the absolute levels high but the direction of increasing leverage is also salutary.
This increasing level of indebtedness seen internationally is bucked by only one nation, from those selected below: Germany. The Germans, for a variety of reasons (perhaps low growth over the decade and the absence of a housing bubble), remain a cautious bunch. Although this is outside the scope of this note this, in our view, leaves them in good stead for the future.
It is also worth noting the low levels of consumer debt of the southern European nations. The Greek interest rate shock has certainly impacted the Greek economy and its public sector, but the impact on its private sector will perhaps be less pronounced than a similar shock would be to the UK.
The chart below also highlights the direction of house prices in a number of selected markets. There is a small prize for the first reader who spots the odd one out.
While the level of Spanish house prices also looks anomalous, given chronic oversupply, the UK does stand out with its sharp recovery. This contrasts with falls in house prices in France, the US and Ireland of around 35%. Can the UK really buck the trend?
UK house prices: the tea leaf
 The chart above looks at the Nationwide House Price index changes year-on-year and the real price of the average property: prices have rebounded. However, remembering the very first chart in this note, house prices have been pumped up by the extraordinary interest rate policy. Mortgage strain may be affordable at current interest rates, but on more normalised interest rate assumptions mortgage strain would be highly stretched.
 House prices on other measures are currently trading well ahead of their normal valuation ranges. The table above, according to Halifax data, highlights, for example, that the simple house price to average earnings ratio lies close to the 1987-crash high.
First-time buyers
According to research by the National Housing Federation (NHF), the average age of first-time buyers joining the property ladder without parental support is escalating. Research suggests that while the average age of unassisted first-time buyers has already risen from 34-years old to 37-years old over the past few years, it is expected to rise even further, potentially to a high of 43-years old for the next wave of first-time buyers. Worse news still for those looking to buy property in London, with the National Housing Federation forecasting that those wanting to live in the capital could expect to save up until the age of 52-years old to be able to afford their own property, unassisted. Recent research from the Council for Mortgage Lenders claims that eight out of 10 current homeowners under the age of 30, receive financial help from their parents in purchasing their first property.
Another recent survey by the property website Rightmove.co.uk warned that the proportion of first-time buyers was currently sitting at around half the level needed for a healthy housing market, with mortgage availability and deposit sizes being the top concerns of the demographic. With the days of 100% mortgages well and truly a thing of the past, the average size of deposit that first-time buyers are required to pay down has jumped from 10 per cent to up to 25 per cent of the property value in the last few years.
Even those who are able and or lucky enough to afford the steep deposit amounts are likely to experience further hurdles, with mortgage lenders being increasingly more selective with whom they lend to, tending to focus on those holding existing mortgages, or those holding mortgages with competing lenders, thus taking less risks.
Despite interest rates being at their all-time low since 1694, the market for first-time buyers remains particularly expensive with many deals for a first-time buyer at around ten times the Bank of England base rate: ie. 4.99%. With interest rates at such historically low levels and first-time buyers still unable to get on the ladder, when will they be able to afford a place of their own?
Taking account of the steep mortgage rates, coupled with the aforementioned deposit barriers, this equates to an almost impossible situation for those eager to own their first home. This is complicated further by the surge of newly-graduated twenty-somethings who are continuing to struggle to gain entry to the graduate job market – thus, pushing the expected age of home ownership even higher as the majority live at home with parents for an extended period.
The chart below illustrates that the elevated house price to earnings ratio is highest for London. Excluding London (Outer Met), the cheapest region is Scotland – calculated using the ratio to the nationwide FTB house price to mean gross earnings per region.
In terms of first-time buyer affordability, the chart below illustrates initial mortgage payments as a percentage of take-home pay for each region, based upon a 90% mortgage loan of the typical house price. Affordability is measured against the long-term average of 1985. The chart reveals that the least financially-affordable area for first-time buyers is somewhat surprisingly in the West Midlands, compared with the more affordable north of England. Towards the end of 2007 the UK average stood at 136.2 – suggesting it was 36.2% harder to access the market for the first time than when it was when the index started back in 1985. While the affordability index started to recover towards the beginning of 2009, with the UK average index value of 91.8 the index began steadily increasing again over the next year, with the most recent reading at the 92.5 level.
Further, while credit markets have improved, the demand for credit remains low. Transactions have picked up slightly but remain around 50% of the long-term average and close to 35% of the peak. The ‘recovery’ in house prices has been based on very thin volumes, few repossessions (as a result of interest rates, average unemployment and benevolent banking policy directed, in principal, by HMG).
Further, the supply of new houses remains at critically low levels as is demonstrated by the chart below. UK house prices have remained elevated partially as a result of the limited supply of housing and a planning policy that bumps up the value of land well above a true free market price. The most recent measure of around 75,000 UK housing starts in 2010, compared with the high of 1999 of around 220,000, represents a decline of 65% and given demographic trends stands well below the long term required equilibrium.
While there may well be positive reasons for controlling the supply of land (environmental and NIMBY etc.) for house building, the impact is clear.
Conclusions
In this note we try to explain why the UK housing market has rebounded so strongly. We also argue that on virtually every measure other than mortgage strain, UK property valuations are highly extended.
Our view is that the Bank of England will maintain interest rates at abnormally low levels in 2011, and possibly into 2012. Under this scenario, we believe house prices will subside by around 10% over the next three years. Transaction levels will remain very subdued and the first-time buyer will remain largely excluded.
We believe the problems faced by the first-time buyer, in particular, are likely to move ‘up the political agenda’. We are in danger of heading towards a real social predicament if the housing market continues in the worrying current trends. The Liberal and Labour parties appear to remain hostile to property-related wealth, and longer term some form of property tax is possible. This would most likely impact higher-end properties. This risk is very hard to quantify, and beyond the short-term investment time horizon as it is unlikely the current leadership of the Coalition would sanction such a change. But investors need to keep this at the back of their minds.
We ascribe a 25% probability to a shock that would force the Bank of England to have to raise rates substantially. Such a shock could come from renewed euro difficulties, concern on UK deficit reduction (unlikely in the short term, more likely on two to three-year view) or persistent and continuing domestic inflation. We estimate that if base rates had to rise to 5%, property values, in aggregate, would correct by at least 25% to reach any semblance of credible valuation. On balance we believe and hope that the authorities will be able to avoid such a scenario.
We find it hard to perceive any scenario where property prices can rise further, given that rates cannot go any lower than current rates, transaction volumes are liable to remain highly depressed and valuations on most measures are well ahead of the long-term average.
By Toby Baxendale, on 13 October 10
In September of last year, I placed this article up on our web site detailing the theoretical errors behind the policy of quantitative easing. Clearly, as the MPC has now been given the green light by our chancellor, we expect this currency debasement to be starting soon. All it will “achieve” is a wealth transfer from those lucky enough to get the newly minted money, from those not luckily enough. I aimed to expose the faulty crank-economics that lies behind such thought processes last year and did not think a Tory government would be so foolish to let this happen under their watch, especially as they condemned it under a Labour government. Sadly, articles like this one need to be reproduced so that a new set of readers can hopefully have influence on the present administration.
The mainstream economists hold that the volume of money in circulation, times its velocity is equal to the prices of all goods and services added up. This is the famous Theory of Exchange, MV=PT, or the mechanistic Quantity Theory of Money, where:
- M is the stock of money,
- V is the velocity of circulation: the number of times the monetary unit changes hands in a certain time period,
- P is the general price level,
- and T is the “aggregate” of all quantities of goods and services exchanged in the period.
It is held by the overwhelming majority of all economists, that if the velocity of money falls, the price level will fall and thus it is the duty of government, the monopoly issuer of money, the chief Central Planner of the Money Supply, to create more money to keep the price level where it is and thus preserve the existing spending habits of the nation.
Error One — the stock of money
It is held that if you can count the monetary units in the economy and their velocity, you can say what the price level is. As people find it very difficult to count the money in an economy, they cannot see the statistical relationship showing up mechanistically in the price level as expected: the authorities do not have a measure of the money supply which correlates to economic activity.
Working from a sound theoretical basis, I and my colleague Anthony Evans can show you how to count money exactly and how that measure of the money stock correlates to economic activity:
Note that changes in the mainstream measures — M0 and M4 — are quite different to changes in our measure — MA. However, it is MA which shows the best correlation to economic activity and not the measures used by the Bank of England and HM Treasury:
The monetary authorities do not have an adequate measure of the money supply.
Error Two — the velocity of circulation
Velocity is defined as the average number of times during a period that a monetary unit (I will call this MU) is exchanged for a good or service. It is said that a 5% increase in money does not necessarily show itself up with a 5% increase in the price level. It is argued that this is because the velocity of money changes. The trick is to measure by how much the velocity has declined and then create new money — cross your fingers, pray to the Good Lord, do a rain dance around a fire, and hope that the new money will be spent — to fill in this gap left by the fall in velocity.
When you buy a house, we do not say it “circulates”: money is exchanged against real bricks and mortar. The printer who sold me books would have had to sell printed things (i.e. real goods) and saved (forgone consumption) for the future purchase (act of consumption) of the house. Imagine selling your house backwards and forwards between say you and your wife 10 times: the mainstream would argue that the velocity of circulation had risen!
Yes as daft as it sounds, this is the present state of economics.
Thus, if the velocity has gone up by a factor of 10, the price level has increased by the same factor. Here is the suggested rub: therefore, when the velocity of circulation falls, if you increase the money supply by the same factor that the velocity of circulation has fallen by, the price level will stay the same.
Note, as explained above and in detail here, the mainstream do not actually know what money is. Well, let us be clear: it is the final good for which (all) other goods exchange. All of us who are productive make things for sale or sell services, even if it is only our own labour. We sell goods and services which we produce or offer for other goods and services we need. The most marketable of all commodities, money, is accepted by you and other citizens and facilitates exchange of your goods and services for other goods and services. Note that, at all times, money facilitates the exchange of real goods for other real goods.
Party one and a counterparty exchanging or “selling” the house between one another 10 times causing an “increase in velocity” and thus an increase in the price level as an idea is utter garbage. If one party had sold real goods and saved in anticipation of buying the house — real bricks and mortar via the medium of money — this would facilitate a transaction of something (the party’s saved real goods) for something (the counterparty’s real house). Printing money to make sure the price level stays stable to facilitate the “circulating” house in the first example will facilitate a transfer of nothing (the paper) for something (the house). This is commonly called counterfeiting.
This may be another helpful example of why velocity is utterly meaningless. Consider a dinner party: Guest A has a £1. He lends it to Guest B at dinner, who lends it to Guest C who lends it to Guest D. If Guest D pays it back to Guest C, who pays it back to Guest B pays Guest A, the £1 is said to have done £4’s worth of work. The bookkeeping of this transaction shows that £1 was lent out 4 times and they all cancel each other out! Just to be clear, £1 has done £1’s work and not £4’s work. No real wealth or value is created.
The velocity of circulation makes no economic sense.
Error Three — the general price level
Since the monetary authorities have no means to sum the price and quantity of every individual transaction, they must work instead with the “general price level”, ignoring the vital role of changes in relative prices.
As early as 1912, Ludwig von Mises demonstrated that new money must change the structure of relative prices. As anyone who has lived through the past year could tell you, new money is not distributed equally to everyone in the economy. It is injected over time and in specific locations: new money redistributes income to those who receive it first. This redistribution of income not only alters people’s subjective perception of value, it also alters their weight in the marketplace. These factors can only lead to changes in the structure of relative prices.
Mainstream economists believe that “money is neutral in the long run”. They do not have a theory of the capital structure of production which can account for the effects of time and relative prices. They believe increases in the money supply affect all sectors uniformly and proportionately. This is manifestly untrue: look at changes in the Bank of England’s balance sheet and your bank statement.
Hayek wrote that his chief objection to this theory was that it paid attention only to the general price level and not to the structure of relative prices. He indicated that, in consequence, it disregarded the most harmful effects of increasing the money supply: the misdirection of resources and specifically unemployment. Furthermore, this wilful ignorance of relative prices explains the mainstream’s lack of an adequate theory of business cycles, something Hayek provided.
The general price level aggregates away a vital factor: the relative structure of prices.
Error Four — the aggregate quantities of goods and services sold
Since the sum of price times quantity for every individual transaction is not available, the authorities must use the “aggregate quantity of goods and services sold”. This is nonsense: the quantities to be added together are incompatible. It makes no sense to add a kilogram of potatoes to a kilogram of copper to a litre of petrol to a day’s software consultancy to a 30-second television advert.
The aggregate quantity of goods and services sold is an impossible sum.
Error Five — the equation is no more than a tautology
Consider this, if I buy 10 copies of Adam Smith’s Wealth of Nations from a printing company for 7 monetary units (or MU), an exchange has been made: I gave up 7 MU’s to the printer, and the printer transferred 10 sets of printed works to me. The error that the mainstream make is that “10 sets of printed works have been regarded as equal to 7 MU, and this fact may be expressed thus: 7 MU = 10 printed works multiplied by 0.7 MU per set of printed works.” But equality is not self-evident.
There is never any equality of values on the part of the two participants in exchange. The assumption that an exchange presumes some sort of equality has been a delusion of economic theory for many centuries. We only exchange if each party thinks he is getting something of greater value from the other party than he has already. If there was equality in value, no exchange would happen! Value is subjective and utility is marginal: each party values the other’s goods or services more highly than their own.
Thus, while the mainstream believe that there is a causal link between the “money side” of the equation and the “value of goods and services side”, it is just a tautology from which no economic knowledge can be gained. All we are saying, if the Quantity Theory holds, is that “7 MU’s = 10 sets of printed works X 0.7 MU’s per set of printed works”: in other words, “7 MU = 7 MU”. Thus what is paid is what is received. This is like announcing to the world that you have discovered the fabulous fact that 2=2.
The mechanistic Quantity Theory of Money is not a causal relation but a tautology.
Conclusion
The mechanistic Quantity Theory only provides us with a tautology and every term of “MV = PT” is seriously flawed. Public policy should not rest on the foundation of this bad science.
If the money supply contracts as it has done so spectacularly since late 2008 (see the chart above), you will have less goods and services supporting less economic activity. This for sure is bad. We now have less money and less exchanging of real goods and services for other real goods and services.
The only way to get more goods and services offered for exchange is if entrepreneurs get hold of their factors of production — land, labour and capital — and reorganise them to meet the new demands of the consumers in a more efficient way than before. The only thing that the government can do is to make sure it provides as little regulatory burden as possible and the lightest tax regime that it can run in order to allow entrepreneurs to facilitate this correction.
Certainly in my business of the supply of fish and meat to the food service sector — www.directseafoods.co.uk — I have never witnessed such an abrupt change in consumption patterns as people have traded down from more expensive species and cuts to less expensive ones. Thus I have to reorganise my offer to my customers and potential customers. No amount of fiddling about with the level of newly minted money in the economy will help this reorganisation of my factors of production: they need to be retuned to the new needs and desires of my customers.
Quantitative easing, as I have said before, is firmly based on a belief in the so called “internal truths” held in the Quantity Theory of Money. I hope any reader can see that this belief is based on very faulty logic. Bad logic gives us bad policy. A policy of QE says that because the velocity of circulation has fallen, we can print newly minted money, out of thin air, at the touch of a computer key, and create more demand for the exchange of goods and services.
Money has been historically rooted in gold and silver because these cannot “vanish” overnight as we are seeing under our present state monopoly of money — fiat money, money by decree, i.e. bits of paper we are forced to use as legal tender. Remember, since 1971 when Nixon broke the gold link, money is just bits of paper, notwithstanding a promise to pay the bearer on demand. In the near future, this will no doubt remain the case. Indeed, anyone who dares to mention that the final good, for which all goods exchange, should be a real good that is scarce (hard to manipulate it, hard to destroy it) unlike paper and electronic journal entries (easy to manipulate, easy to destroy) is considered a lunatic!
On a point of history, it is worthwhile remembering that, as we have mentioned here, the 1844 Peel Act did remove the banks’ practice of issuing promissory notes (paper money) over and above their reserves of gold (the most marketable commodity i.e. money) as this was causing bank runs, “panic”, boom and bust. They did not resolve the issues of demand deposits to be drawn by cheque. Both features allow banks to issue new money — i.e. certificates that have no prior production of useful economic activity such as our printer printing books or my selling of meat and fish — while retaining real money — claims to the printing of books and selling of my meat and fish — only to a percentage of the deposited money, i.e. the Reserve Requirement of the bank. In the UK, there is no Reserve Requirement anymore as far as I am aware, hence banks going for massive levels of leverage. It is no surprise that the house of cards has fallen down.
Our proposal for a 100% reserve requirement is offered for discussion as the only sure-fire way of delivering lasting stability. Listening to economists talking about the “velocity of circulation” falling and thus suggesting that we should conduct large scale Quantitative Easing to hold the price level is not economics, but the policy of the Witch Doctor and the Mystic.
It is staggering that so much garbage, posing as sound knowledge, hinges on these grave errors.
Further reading
By Toby Baxendale, on 12 October 10
On the front page of the Financial Times of Saturday the 9th of Oct 2010, under the title “Osborne go-ahead for Bank boost”, we read the following;
Asked whether he would back a second round of quantitative easing, known as QE2, he said he would want to follow the practice of Alistair Darling, the former chancellor who always gave a green light for the MPC to act.
“If the MPC ask – I have said I regard the MPC as independent – if it makes a judgment, I would want to follow that judgment and continue with the procedures of my predecessor in dealing with those requests,” the chancellor said.
[ The report appeared online as "Chancellor backs Bank of England action" ]
Recently I responded to comments by noted journalist and uber-money-printing economist Tim Congdon, who supports QE2:
I would love to hear from AEP, or from Prof Congdon, exactly how creating money is supposed to create wealth.
If the Central Banks of the world buy private sector bank debt, they create new demand-deposit money that the private sector banking system can then lend. So more money units chase the same goods and services? Where is the new wealth?
Many people associate rising money supply measures with rising GDP and increased prosperity. Mistaking correlation for causation, they view an increasing money supply as the source of prosperity. This puts the cart before the horse.
Wealth is only created when entrepreneurs make better goods and services, satisfying more of the needs of consumers, in better and more convenient and cheaper ways, via more capitalistic and hence more efficient methods of production. Both the capital investment and the subsequent purchase of the new goods and services should be supported by real savings (forgone consumption).
If such genuine wealth creation occurs, it will prompt banks to increase lending, and under our current system of fractional reserve banking this will necessarily entail an expansion of the money supply. This expansion is the result, not the cause, of wealth creation. Artificially increasing the supply of money will not create wealth, any more than injecting mercury into your thermometer will cause a rise in temperature.
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