<li class="listFirst">Commentary <li>
By Alen Mattich
"My column last week on the zombification of the U.K. economy generated some interesting responses and criticism.
My thesis was that the Bank of England had allowed history's biggest debt binge to inflate the U.K.'s biggest housing bubble and that its efforts to defend house prices now had caused the economy to seize up. This is because agents do not trust asset values—people are unwilling and unable to buy at these inflated prices while banks are unwilling to lend against current values while at the same time are worried about the state of their balance sheets should values return to historic trend.
Because the Bank of England does not want those who made disastrous speculative judgments—both the borrowers and lenders—to have to face losses, it is forcing prudent savers to bear those losses through inflation and deeply negative real interest rates.
Gareth, one of my interlocutors, makes several important criticisms:
1. Why should savers who hoard the monetary base be given a risk-free positive rate of return?
2. Gilts have performed well.
3. The Bank of England did not cause the rise in oil prices or the increase in VAT which fuelled 5% inflation rates, and
4. How should the BOE have responded?
Others have added:
5. The debt frenzy did not cause a misallocation of resources because, unlike the U.S., there was not a frenzy of over building.
I'll see if I can answer these in turn.
1. Typically those hurt most have been the smaller savers who keep a few thousand pounds in liquid accounts against contingencies. In seeking to defend the interests of the wealthiest, the Bank of England has forced those on modest means to take the most punishment.
2. Gilts have indeed performed well, thanks to quantitative easing and financial repression—forcing banks and pension funds to hold ever larger quantities of U.K. government bonds. One day, when investors begin to realize that the BOE has every intention of using inflation to enforce a redistribution of resources, gilts will perform less well, which will cause yet more problems to the economy.
3. The BOE's chief economist Spencer Dale admitted that the scale of the first round of QE contributed to the inflationary overshoot. The BOE claims to know how to deal with its enormous and growing balance sheet. But I think this claim is as feeble as the one it made when it argued that it was acceptible for the U.K. to pile on debt because the BOE's brilliance at controlling inflation meant household balance sheets could handle the borrowings. And, oh, if anything went wrong, they had a cunning plan…
4. The BOE should have forced more creditor losses—by which I mean bank creditors—and allowed asset prices to deflate. Had the Labour government not run a pro-cyclical fiscal policy, the government's finances would have been in a much better shape to pick up the slack. One of the reasons the Labour government was allowed to run a pro-cyclical fiscal policy was because the BOE failed to use monetary policy to temper overheating during the go-go years.
Evidence of overheating, by the way, was all around, from the housing bubble, to mass migration from eastern Europe. Would this increase unemployment? Yes, though the trade off here is a sharp but short-lived rise in unemployment versus a steady increase in the trend unemployment rate over many years. Remember, the BOE refused to tighten monetary policy for fear of increasing unemployment (from 30-year plus lows), with the result the U.K. economy now has an even bigger unemployment problem to deal with now.
5. My critics say the housing bubble did not seem to create a misallocation of resources. Indeed, there wasn't enough building, and house prices now merely reflect a lack of supply, which suggests maybe there wasn't a bubble after all. Really? There may not have been over building (although looking at central Leeds and Manchester developments makes me wonder), but there was a housing bubble nonetheless.
Since 1983, the average gross house price to earnings ratio for first time buyers in the U.K. has been 3.4, according to Nationwide. By 2007, that ratio had hit an all-time high of 5.4 times, against a previous peak of 3.9 times during the late 1980s bubble. In the last quarter of last year that ratio was 4.4 times.
Bear in mind that this average of the past 28 years has been distorted by the bubble of the past decade. The average of the 18 years to the end of 2001 was 2.8 times.
Nowhere in the U.K. have prices dropped back even to the higher average. In London, prices are still 6.4 times earnings, 36% above the 28-year average and 64% above the pre-bubble average, and prices in prime London are at new peaks.
People have always justified property bubbles on the grounds that there just isn't enough housing to meet demand. Well, speculative demand anyway. Japan's bubble of the late 1980s was accompanied by a residential bubble, though not a notable amount of over building. People had access to debt, which they used to chase prices up to ridiculous levels. And when those prices could no longer hold they started to deflate. And, in Japan's case, only appear to have stopped a few years ago.
The problem is that asset values go away, but the debts don't.
You can force prices to adjust to economically sustainable levels, make agents take their losses and cause some deep but short-lived pain in the economy. Or you can create a zombie that lurches along for years, or even decades, with the hope that somehow, along the way, you can generate enough inflation to transfer wealth from the prudent to the feckless and restart things.
That is the BOE's agenda, whatever fairy stories it happens to tell."