Financial Regulators are as fallible as the rest of us

John Redwood, in defence of the banker’s, asked whether the regulator’s in the part four years has engaged in socially useless activity.

Unusually, I came to the defence of the regulator.

Regulators, even if nominally independent, work within the current political & economic climate. They would not have called for increasing capital requirements during the boom, as there was no visible reason to do so. After all, we had “ended boom & bust” – due to the prudent handling of our economy by the then Chancellor. Where was the risk factor that justified such a measure?

 If a Regulator had called for tougher rules, he would have been lambasted by the press, and criticized by most expert economists. Financial Experts would say capital requirements could be lower, as risk was now diversified throughout the global financial system.  Politicians would have said that such unilateral action would jeopardize London’s position as the World’s No.1 financial centre. If the Regulator had sufficient stature, then the £ would have gotten a bit jittery, and some shares in the banking sector would have taken a tumble. A government spin doctor would have come out we a speech saying “what I think you will find the Regulator actually said was .…” – and then say something that was the opposite, or renders the comments meaningless.

After a few days of ducking the issue, the Chancellor would have given his full support, followed the next day with the Regulator’s “voluntary” early retirement (or movement sideways).

A similar picture was with the Central Banks. By cutting interest rates after the dot.com bubble burst and again after 9/11 we obtained an asset price bubble. The US or the UK were not going to call a halt by raising interest rates, as it would have been both politically unpopular and raised exchange rates. The normal market adjustment, with a mild recession was averted. The long-term consequence was system imbalances becoming so large that the eventual correction nearly wrecked the financial system.

 The lesson to be learnt is not tougher and/or more detailed regulation. It should be a humility concerning our powers to intervene, as they can have consequences that we cannot foresee. Furthermore, markets have rushes of exuberance that will, sooner or later, be corrected. Avert the market correction and you build up trouble for the future.  Interventionism does not cure the problem of imbalances, merely delays it.

MARKETS WILL ADJUST. BEFORE OVERRIDING TO COUNTER FLUCTUATIONS,  YOU SHOULD FIRST BECOME OMINISCIENT.

Alan Greenspan convinced everyone that he had achieved this status, but turned out, in the long run, to be wrong.

The biggest current imbalance is in the housing market. The slide has been halted by near zero interest rates, but will resume when those rates get back towards normality. Why do I say this when average house prices are around the long-term average of four times average earnings? Because interest rates are well below their long-term average for existing borrowers. When they revert to around 5% that new borrowers are paying, and when unemployment peaks at 3 million plus (with some coming from the state sector), then the supply of houses will exceed demand.

Socialist Economics

 

Tim Worstall has a blog today on the socialist calculation problem. Here he concentrates on the impossibility of collating the data necessary for inputting into computers. This is the only a part of the problem.

 

1. The Relevancy Problem

Mises said (in Human Action). “Knowledge is about the past, decision is about the future” Past information can only be a guide to future decisions. But if any actor acts differently then past information becomes imperfect, unless the changes follow regular patterns – move along known demand and supply curves in economics language. If there is a structural change, then that past information becomes outdated.

 Example – the credit crunch

A major feature concerning the credit crunch is that we have “entered uncharted territory”. That is, the previous macroeconomic models approximations of the economy are incorrect. The relationships that economists have spent years refining are now irrelevant. This is why the government is going to get things wrong in tackling the credit crunch. There is no past data to model, so they are just guessing. Even if they chose the best policies (unencumbered by ideology or political spin), choosing the optimal combination of quantity, time and place is impossible. However, solving for the macroeconomy is much simpler that the millions of products making up the microeconomy.

 

2. The Disequilibrium Problem

To solve the price problem mathematically is to find the solution to the simultaneous equations.

 P = -x1D+a1

P = x2S+a2

 Where P = Price, D = Demand quantity, S = Supply Quantity, x1 = Elasticity of demand, x2 = Elasticity of supply.

 In the real world, the market is rarely in equilibrium. There are so many things changing that a best you can only characterize the “solutions” as transitory and approximate. At worst, they may be a long out. These equations are for each of many millions of products available, and have to be all solved to produce a general equilibrium. If individual calculations are out, then the relative quantities will be out, having a knock-on effect to all other products. If the relative prices are out in one period, then the information for the next recalculation will be out.

 3. The Philosophy of Socialism

 But even with these problems sorted out, socialism is about equality and “fairness”. In other words, the price of labour is not market determined, nor the price of many items – e.g. healthcare, education, food etc. No Socialist Government is going to suppress the democratic will of the masses, to that a dictatorship of a computer. The “socialist solution” means suppressing the very values in which socialists believe.

 Example – Social housing

A socialist system might hold that people should be allocated housing on the basis of need, rather than ability to pay. So a single person would get much smaller accommodation than a large family. If the rent was controlled or housing was free at the point of consumption, people would want to trade housing. A retired couple, whose children had left home may want to trade for a smaller property in a more desirable area. Someone may be willing to pay more rent for a property near to friends, or to their work, or for a something more desirable (with a garden, near to the country, near to the train station etc.). A socialist may want to override these signals with other aims.

 

Climate Change – An opportunity for the UK to benefit humanity

In March, Phillip Salter, on the Adam Smith Institute blog, suggested that we should also open up peer reviews in climatology.  My response was

 

Dr Alister McFarquhar is right in that the opening up of peer reviews will not help.
There are is a way that the closed world of the Climate Change Lobby can be changed. Steve McIntyre of climateaudit.org campaigns for the datasets behind articles to be published. In Economic Theory this already happens, which means that debate is actively encouraged. That is careers are made more through disputing established opinion than reinforcing that opinion. Such an approach should appeal to those on both sides of the debate. Those who believe in anthropogenic global warming should be in favour of optimal policies, so must want to see challanged the more eccentric views based on poor scholarship. It would also appeal to those are searching for answers, or who believe that proper debate brings greater understanding.

 

I would go further.

 The Government is looking for opportunities for investment to get us out of this depression. That is spending of money now that will lead to far greater returns for the economy in the future. In the area of the universities, this means promoting the UK as a world-leading centre of original research. Financing the launch of a new journal (say “Critical Perspectives on Climatology”) is one area where there is a huge gap in the market. The Government can justify it for the following reasons.

  1. The promotion of better science will give a new lease of life to the historical role of the UK as a fountainhead of great intellects.
  2. Reducing the risks to the poor. Extra measures to combat climate change will hurt the poor the most. For this reason, more objective analysis will reduce the risks that we will get policy wrong.
  3. Proper stewardship of the Earth means proper democratic debate, where all views are heard. This is another reason for Britain’s historical pre-eminence in science.
  4. When funding investment one should look for high returns. Most government-backed investment does not get back the money invested. This one could generate huge returns.

MP’s Expenses – Being Machiavellian to tackle the bigger financial issues

Yesterday I wrote a comment on John Redwood’s blog that

  1. That MPs costs are an insignificant part of public expenditure.
  2. David Cameron should take a decisive (Machiavellian) approach to this, providing a clear precedent for the government to follow.
  3. We should then move on to sorting out the economy.

 

This drew two responses. I repeat them hear, with more fulsome responses than I posted earlier on the blog.

Lynne Gill Reply:
May 12th, 2009 at 6:44 am

If you think the furore over MPs’ expenses is a mere distraction you have no idea of the outrage felt by the rest of the population. Removing the party whip and asking for admissions and apologies from these miscreants is only the beginning of the process.

Their behaviour is morally repellent and conniving, and in many cases criminal – but I guess it’s going to be deemed ‘not in the public interest to prosecute’, eh?

The very least they should be expected to do is pay back what they have stolen from the tax-payers pockets. How about putting their ill-gotten gains into a fund for, oh, lets say refurbishing the almost-slums some of our service personnel are living in, between putting their lives in danger at the behest of these gross pieces of work.

 

 I profoundly disagree with your comment. I believe that in politics, as in other areas, you should give people a chance to make amends and move on. This is what David Cameron has done today, setting a precedent for the government to follow.

If we start an inquisition it will go on for months. At this time when we need better government to sort out the economic mess we are in, not to turn parliament into a Roman Circus to watch good people being thrown to the lions.

Further, most MPs have acted within the existing rules. They have not “stolen” money, but that have acted dishonourably and immorally. For them, the conformance has been to the letter of the detailed rules, rather than to the spirit of why they were laid down.

 

Donna W Reply:
May 12th, 2009 at 8:33 am

Sorry, but it is going to need much more than punishment of the 3 worst offenders.

This is Cameron’s chance to clear the Party of the Old Guard – the Squire-ocracy who have no understanding of ‘normal’ peoples’ lives.

If he let’s them get away with claiming expenses for swimming pools, moats, chandeliers, horse-manure (how apt); domestic servants etc ….. then the Tory Party will sink like a stone.

He should be demanding they all pay back the money they have mis-appropriated, seek resignations – and if they’re not forthcoming, withdraw the Whip.

 

Your comment about Cameron demanding that money should be paid back is valid, and is exactly what Cameron has done today. However, Cameron has broadly followed my line. Draw a line in the sand to those who recognise their error and apologise, then move on. Indeed he has improved on my suggestion, as he has set a clear set of rules for those wishing to retain the Conservative Whip. To do as you suggest – essentially sack those the toffs, or those you disagree with – is poor leadership.

Political parties are essentially coalitions, and the leaders need to keep a large range of people on board, who are loyal to that leadership. Machiavelli wrote in 16th century Italy that when a Prince takes over a city he should kill a few and then clearly state that peace should ensue. This way, the new subjects have a clear decision – die or become loyal. For Machiavelli, going after all the vanquished enemies would be counter-productive. It is better to transform the majority and make them loyal subjects, for given that chance most will become loyal subjects. If you are continuously crushing the vanquished, then they will have reason to rise up against the Prince.

 Being “Machiavellian” in the modern political context, is about delivering a clear message in times of crisis, sacking those who do not conform, but then offering a clear way forward to those who wish to mend there ways.  

          As John Redwood has stated, the Conservatives in power will have much bigger battles to wage. Today Cameron has shown he can fight those battles more effectively than the current Prime Minister.

MPs Expenses – Cameron should be Machiavellian

Just posted the following comment to John Redwood’s Blog

MPs Expenses are (highly symbolic) distraction. If each MP’s cost us £300k each, 650 MPs cost £195m, or 0.03% of total government expenditure. A 50% saving on MP’s costs will be less than 0.1% of the total we need to save. Conservatives should be Machiavellian on this. David Cameron should remove the party Whip from the 3 worst offenders (according defined criteria, including failure to recognize their waywardness), forgive the rest (after appropriate admissions and apologies) and move on. That would set a clear precedent for the Prime Minister to follow.  

Further, it would also show David Cameron to be able to make decisive and bold moves for the sake of the country, even if it means losing some friends on the way. With unprecedented cuts to be required in public expenditure when he enters office, this would increase his stature for much bigger battles ahead.

Gordon Brown – The blinkered General

I got tot to thinking that the Labour Government’s strategy in dealing with the credit crisis can be compared with an Eighteenth Century Military Campaign.
Imagine the Grand Old Duke of York of nursery rhyme fame, for years believing that all that his troops were for was to make him look impressive. So he concentrated on spending on shiny uniforms and the latest equipment, and plenty of retinue. Further the troops were trained in drill, but not how to fire their muskets, or fix their bayonets.

Then the general has to face a critical battle. Fearing for his personal safety, (and distrusting his generals), the glorious general sends his personal valet to inspect the area. The valet spots a nice hilltop, with trees for shade where the area can be surveyed in safety. The troops on the low ground, so the general can view them. When the enemy is sited, he gets the cannons and muskets to fire a series of salutes to impress the enemy of the importance of the mighty general that they face. With the ammunition depleted, the order is given for the entire army to advance, with the band at the head, playing a victory anthemn. When the enemy give a warning shot, suddenly the general is no where to be seen….

Gordon Brown a ManicBeancounter?

The Prime Minister spoke today in St. Pauls Catherdral of the need for common values to underpin the world economy. I thought at first that Gordon Brown was coming round to my approach – of having a principles-based approach. However, I was disappointed. The following is the relevant text, from the Number10 website

 

And today he and I want to discuss with you not the details of specific or technical financial programmes or policies, but instead enduring values – indeed the enduring virtues – that we have inherited from the past which must infuse our ideals and hopes for the future.

And I want to suggest to you today that this most modern of crises, the first financial crisis of the global age, has confirmed the enduring importance of the most timeless of truths – that our financial system must be founded on the very same values that are at the heart of our family lives, neighbourhoods and communities.

Instead of a globalisation that threatens to become values-free and rules-free, we need a world of shared global rules founded on shared global values. I know it’s hard to talk about the future when you’re having a tough time in the present. You don’t redesign a boat in the midst of a storm.

I am disappointed. The disappointment is due to this being ambiguous (to appeal to a large audience), whilst at the same time going against the very things that we need for future stability and prosperity. The ambiguity comes in exactly what are the family values? The laissez-faire attitudes of same-sex parents or the authoritarian attitudes of the militant Islam?

I wrote a posting on John Redwood’s blog that is relevant to approach we should be taking, especially when speaking a house of God.

 

1.     In Matthew 22, after Jesus says that the Greatest commandment is love of God and the second is love of neighbour as oneself, he then says “In these two commandments hang all the law and the prophets”.  For the financial system, what is most important is the general objectives of regulation, with the detail following from that.

2.     In Jesus’s conflict with authority was because he put love of neighbour before upholding the laws and cultures of the time (such as healing. In other words, where the detailed rules conflict with the major objectives, it is the regulations that must be amended. When it is a choice between maintaining a boom with low interest rates, or suffering a mild recession to avoid a bubble, then it is the mild recession that must be endured.

3.     Jesus had strong words for the Scribes and the Pharisees (Matthew 23), the religious leaders of the time, who dogmatically upheld the complex laws and customs. Like the modern day financial regulators, they made sure that everyone ticked all the boxes, but lost sight of the purpose of the exercise. The spin doctors ensured that in was only others perceptions that were important and not substance.

4.     In the Old Testament, the importance is stressed of avoiding risk and stewardship of ones property. The authorities lost sight of this – whether Government’s going on a spending spree or Central Banks in keeping interest rates too low.

 

 

That is what is needed is a principles-based approach to the world economic order. To have clear, and unambiguous, general rules globally, to allow markets to develop in unexpected ways, whilst being able to change the general direction when required. It is a value-based approach based on love of one’s neighbour and good stewardship of our resources. Our reliance in detailed rules has failed, as the general direction (particularly in Britain) has been determined by political expediency and spin.

Forecast for UK House prices – 6th Jan 2009

Using a composite of the Nationwide and Halifax indices, I forecast average house prices will fall a further 30% from December 2008 levels to £115,000.

 

One of the big uncertainties for the economy at present is the appropriate level for house prices. With the Halifax just announcing a 2.2% fall in house prices in December alone we apparently have no reasonable forecast of how low that prices can go. I therefore will try to forecast the following

 

  1. The value of the lowest house prices.
  2. When they will bottom out.
  3. When we can expect to see an upturn.

 

I will revise my forecast as new data emerges.

 

A simple forecast is to look at the levels to which house prices fell in the last bust. The Nationwide, and the Halifax use different methodologies, which amount to similar things.

 

Using the Nationwide methodology

 

The Nationwide believes that the long-term trend is for a 2.9% real growth in house prices per annum. Using this methodology they produced the following graph for their November 2008 report.

 image0013

 

At the in Q3 2008, average house prices were £165,000, or 109% of trend. The peaks were 132% of trend in Q3 2004 and 131% of trend in Q2 and Q3 2007.

This compares with the previous peak of 134% in Q2 1989. The low point relative to trend was not until nearly 7 years later in Q1 1996, when prices dipped below 70% of trend.

The actual low was in Q4 1992, when prices were 81% of trend.

Let us assume that house prices bottom out at 80% of trend, but do so after 10 to 12 quarters, instead of the 14 previously. That means house prices will reach around £127,000 at the end of 2009 to 2010. That is a 23% fall on end of November levels.

 

Using the Halifax methodology

 

The Halifax index recorded an average house price of £160,000 in December. This represented 4.44 times average earnings. The long-term average is around 4 times earnings, which would imply another 10% fall. However, the housing market bottomed out last time at 3.10 time average earnings. If this is reached in at the end of 2010 (with average earnings 6% higher), then the average house price will be 26% lower than December 2008 levels (27.6% lower than November) at £118,000.

 

An Opinion

 

The average of these two estimates s for house prices to fall a further 25% from the end of 2008 levels. This assumes we have the same pattern as the previous slump. This is a bold step to make. The previous slump in house prices was caused by a sharp rise in interest rates to combat 10% inflation, with interest rates reaching 15%. The differences are as follows.

 

  1. The current slump is much sharper. Using the Halifax index, in the first 17 months of the previous slump average house prices as a ratio of average earnings slumped 15%. In the 17 months since the peak in July 2007 the decline has been 24%.
  2.  In the last slump, much of the decline in employment was in that first 17 months of the decline in house prices. In this slump, much of the decline in employment will be in 2009. It will therefore prolong the period of decline as supply of houses onto the market continues to exceed supply. Furthermore the number of repossessions will increase the supply, unless banks (or the government) let the houses rather than sell.
  3. The Nationwide calculation is based on an underlying trend of 2.9%. The magnitude of this trend could be exaggerated as

i)                   The last few years have seen increased competition in the market, leading to more products and the ease of switching (with discounts).

ii)                 It would include the sustained 10 year increase in prices. This boom has been unusually prolonged.

iii)               There would have been a one-off effect from the end of inflation. Although the real cost of a mortgage would reminded unchanged, a high and fluctuating rates of inflation (as in the 1970s and 1980s) did mean higher real costs in the early years and volatility of repayments as a percentage of income. Also, if people moved to a more expensive property before the mortgage was paid off, then would end up missing out on some of the devaluation in the repayments as a consequence of the inflation.

 

All this leads to the conclusion that basing the cost on some multiple of average income is better than having a notional long-term trend. This would make the peak of 5.84 times earnings 146% of trend. The Q3 2008 price is therefore 119% of trend, not 109%. Therefore a slump to 80% of trend would give a house price of £111,000, or 33% lower than in Q3.

 

The average of my two estimates therefore becomes a fall of 30% on end 2008 levels to around £115,000. This is conditional on the banks stabilizing, and unemployment peaking in around 12 months time, or at least most of the uncertainties in the economy clearing in that time.

At present there appears to be more negatives, that could make this lower than the last time, than there are positives.

 

Why the forecast may be too optimistic.

  1. The current slide has occurred prior to the increase in unemployment that the recession will bring. A long period of uncertainty will leave both potential buyers and lenders cautious about entering the fray.
  2. A 30% slide will leave a great number of people with negative equity. They will therefore be unable to move without having first made considerable payments
  3. Inflation will be near zero, whereas in the early to mid-nineties it was in the 3-5% range. The real cost of housing and of the debt will not by reduced so quickly by inflation this time.
  4. A feature of the past boom was the large number of people who bought-to-let. Many houses were bought not for the return from letting, but for the return from appreciating value. For instance, in Manchester a three bedroom semi-detached sold for around £150,000 at the peak, yet could be rented for £600 a month. This would only fund a mortgage of £70,000 to £90,000. There is potentially a lot of people who would like to realize their investments, so any upturn in prices, or even more buyers coming to the market may lead to a huge increase in the supply of houses for sale.
  5. There is a prediction of 70,000 repossessions in 2009. This could be much higher if unemployment goes higher than forecast.
  6. In the past 5 years, interest rates have been much lower than historically. Once the economy stabilizes, it will be necessary to raise interest rates to levels of the 1990s of 5% to 7.5% range. Will real rates higher, real house prices will be suppressed.
  7. The lack of available credit may be prolonged, especially with banks being required to hold more capital. Banks will probably become much more conservative anyway in their lending for a few years. Also with a thinner market and flat house prices, the same risk policy may mean that banks would only lend at 80% of the valuation, whereas they would lend with less risk at 105% of the valuation is a booming market, with over 10% annual inflation and large volumes. The reason is simple. In a booming market, someone in financial difficulties can manage a quick sale for more than they paid for the property. With a flat, thin market, a quick sale can only be achieved at a considerable discount.

 

Why the forecast may be too pessimistic.

  1. The upturn will arrive when unemployment has stop increasing, or at least when the job uncertainties have much reduced. In the 1980s, house prices started to rise in 1983, three years before the numerical peak in unemployment.
  2. The very low rates on mortgages will enable people to make overpayments to quickly bring down the value of their debt. If they have repayment mortgages, the lower interest rates will mean that repayments will have a much larger element of capital repayment. Therefore negative equity may not be as prolonged as in the previous slump. For instance, before the UK crashed out of the ERM, interest rates were over 11%. Even after, in the late 1990s they were still 7% to 8%. Although with inflation at 2% to 4% real rates were lower, they are still considerably above the 4.5% currently quoted for a new mortgage, or around 3.5% for exiting mortgages.
  3.  Government actions to help support people with difficulties meeting mortgage repayments could stop the sharpness of the dip. However, this may conversely prolong a slump. A deep slump may reinforce the impact of a general economic upturn in making housing much cheaper for new entrants to the housing market, or for those wishing to move to more expensive housing.

 

 

 

UK House Prices – How Low Will they go?

During my Christmas I tried to forecast house price movements – I reckoned they would fall a further 30% from the level of November 2008 to around £115,000, or just over 3 times earnings. This was based on:-

 

         Looking at both the Nationwide and Halifax indexes, looking at the long-term trends.  

         Assuming the current slump will be as deep as in the mid-nineties. That is, it will bottom out at just over 3 times earnings.

 

This is published straight after this posting.

 

Since then I have become more pessimistic. Before you dismiss this as the ramblings of a dour protestant  beancounter with a background in the dismal science, please hear me out.

 

  1. Today the government took over bad debts of the Dunfermline Building Society. Maybe only £600m of liabilities this time, compared with around £500bn from the banks. However, it is indicative of a government that does not know when to stop.

 

  1. Interest rates will have to rise sharply in the medium term (18 to 48 months), to enable the government to cover the huge borrowings, whilst competing for funds against other countries. We are heading for budget deficits well in excess of 10% of GBP at the same time as other economies are heading into deep recession. Furthemore, there will be no increase in

 

  1. The government appears to be hell bent on borrowing more, and not saying “we cannot afford it!”. For instance, the Teacher’s Unions demanding a 10% pay rise. This is despite the warnings from the Governor of the Bank of England that we cannot afford more.

 

  1.  Taxes will have to rise substantially to cut government borrowings. Cutting government spending, which would mean cutting public sector jobs and pay, is not politically feasible for either Labour or the Conservatives. This will cut available income for borrowing. When we last emerged from a housing slump in around 1997 to 1999, taxes has been falling for a while.

 

  1. Regulation of the financial system will increase, as will the capital ratios. In 1997 regulation was sidelined to box-ticking, and capital ratios were decreasing.

 

This is despite the Bank of England saying that mortgage approvals up by 19% last month (they always do at this time of year – but this is from a really low base) or the rate of decrease is the lowest for a number of months (ditto).

We have yet to see repossessions peak and unemployment still has another million to go.

The Credit Crunch and the Bible

John Redwood MP wrote yesterday in reply to comments made by various Christians on the current crisis. The simple tale about greedy bankers lending too much is very much one-sided. There is also immorality in the borrowers as well. Whilst agreeing that some of the church leaders have rather shallow and misguided opinions of the current crisis, I believe there are much stronger analogies that can be drawn between the Bible and the current situation.

  1. In Matthew 22, after Jesus says that the Greatest commandment is love of God and the second is love of neighbour as oneself, he then says “In these two commandments hang all the law and the prophets”.  For the financial system, what is most important is the general objectives of regulation, with the detail following from that.
  2. In Jesus’s conflict with authority was because he put love of neighbour before upholding the laws and cultures of the time (such as healing. In other words, where the detailed rules conflict with the major objectives, it is the regulations that must be amended. When it is a choice between maintaining a boom with low interest rates, or suffering a mild recession to avoid a bubble, then it is the mild recession that must be endured.
  3. Jesus had strong words for the Scribes and the Pharisees (Matthew 23), the religious leaders of the time, who dogmatically upheld the complex laws and customs. Like the modern day financial regulators, they made sure that everyone ticked all the boxes, but lost sight of the purpose of the exercise. The spin doctors ensured that in was only others perceptions that were important and not substance.
  4. In the Old Testament, the importance is stressed of avoiding risk and stewardship of ones property. The authorities lost sight of this –  whether Government’s going on a spending spree or Central Banks in keeping interest rates too low.