A good day for Barclays senior management, a bad day for the rest of us

Yesterday, the consumer price index was published, showing that prices are rising at 4 percent a year. The governor the Bank of England tried to explain this outrageous number by suggesting that higher prices are due to temporary factors. He must have forgotten that UK inflation has been consistently above the two percent target since 2006. Perhaps Mr. King operates on another temporal dimension, but nearly five years of above target inflation doesn't sound that temporary to me.

Under normal circumstances, a responsible central bank wouldn't hestitate to raise interest rates in the face such an appalling degeneration of the inflationary environment. However, nothing is normal about current UK macroeconomic policy management. Yet, even as the inflation numbers deteriorate at an alarming rate, Mr. King continues to resist the idea of raising interest rates.

How cheap dresses and shoes led to the financial crisis

Fashion has never been cheaper.

Since 2000, the ratio of clothes and footwear prices to hourly earnings fell by almost 60 percent. Around half of that decline was due to the direct effects of lower prices; the other half came from higher nominal wages.

This chart illustrates this spectacular fall in the real price of clothing. It also demonstrates the extraordinary structural change that has occurred in the world economy over the last 10 years. There was a time, and it wasn't so long ago, that Britain had a textile industry. That industry has all but disappeared. Instead, all our clothes are produced overseas, mostly in East Asia, particularly in China.

Credit card debtors generously help out the banking sector

The Bank of England may have cut interest rates, reducing funding costs for banks, but you won't see that generosity extended to credit card debt serfs. The spread between LIBOR and credit card interest rates has increased by well over 600 basis points.

It is probably a good thing, hopefully discouraging a further unsustainable increase in household debt. Also, the increased spread presumably increases the profitability of credit cards, and helps banks cover their huge losses speculating on those hopelessly mis-priced asset backed securities. In effect, credit card debtors are providing their very own bank bailout.

Personally, I am grateful to those credit card debtors for this generous assistance to our beleaguered banks. It means less of a burden for taxpayers.

MPC - there is no end to the madness...

Today, the MPC decided to leave interest rates unchanged. However, the bank will continue to pump out the cash.

The BoE's original money creation ceiling of £125 billion should be reached next month. Today's statement hinted that the Bank might want a further authorization to create even more cash.

In summary, there is no end to the madness.

From the BoE's press release....

The Bank of England’s Monetary Policy Committee today voted to maintain the official Bank Rate paid on commercial bank reserves at 0.5%. The Committee also voted to continue with its programme of asset purchases totalling £125 billion financed by the issuance of central bank reserves.

The Committee expects that the announced programme will take another month to complete. The Committee will review the scale of the programme again at its August meeting, alongside its latest inflation projections.

The race to the bottom

A simple question - have the dramatic cuts in interest rates worked? The evidence in favour is not compelling. The world is in recession.

I know; things would have been much worse if central banks hadn't acted.

Keep on doing what you are doing

There were many reasons why we got into this crisis; poor financial sector regulation, distorted incentives, bonuses, speculation, excessive risk-taking. However, there is one reason that doesn't get enough attention; the policy remit of the Bank of England.

When the BoE became fully independent, the government gave it an inflation target. It said to the bank "go chase down the consumer price index. Make sure it doesn't increase by more than 2 percent a year". Ominously, the government didn't say keep asset prices under control and avoid speculative bubbles.

The BoE happily went along with this new target. Keeping inflation under control would be easy. Moreover, the Bank added an air of modesty to their objection about preventing speculation. It echoed the claim by Greenspan that it could not properly identify bubbles. Speculation was something that could only be ascertained once the crash had actually happened, and then it would be too late.

For about eight years, the BoE claimed that it had beaten inflation. It met the target and told the rest of us that everything was under control. House prices, it occasionally acknowledged, were increasing at double digit rates. So too was the money supply, but this didn't matter because the CPI was nailed down. Furthermore, the BoE managed to do this with historically low interest rates. In short, they implicitly told us "sit back, relax and if you feel like it, take out a loan."

However, the truth was that the CPI was declining because of the extraordinary increase in the world supply of cheap manufactured goods, mainly coming out of China and other emerging market economies.

During these years, the CPI should have been negative; a fact that the BoE were happy to ignore. Domestically determined prices were increasing sharply. (If you want proof, just take a look at the price of UK rail tickets or the council tax.) Putting a cap on this hidden inflation would have required higher interest rates, which would have put an end to the housing bubble.

The rest of the story we know. Throughout the decade, Banks were taking on too much risk, households were borrowing silly amounts of money and the housing market was out of control. This sorry mess hit the wall in August 2007. So far, the UK taxpayer has been forced to pump in 90 percent of GDP into the financial sector, just to prevent it from collapsing.

Have policy maker learnt anything from this dreadful experience? It seems not. Later this month, the Treasury will publish a White Paper on financial services. In principle, this offers an opportunity to extend the BoE's target to stabilising asset prices and preventing bubbles.

However, for the New Labour radicals that manage the Treasury, this idea is too extreme. They want to keep things pretty much as they are. The BoE will continue to target the CPI and asset prices can do what they want. In principle there is nothing to prevent a recurrence of the current crisis.

It is very much a case of "keep on doing what you are doing". So, is everyone ready? We have a one way ticket back to Bubbleville.

Merkel attacks quantitative easing

At last, a European politician has stood up and denounced the collective madness that has gripped the developed world's central banks.

Speaking in a conference in Berlin, Angela Merkel, the German Chancellor, attacked the reckless money creation of the Fed and the Bank of England.

This is how she outlined the problem:

"What other central banks have been doing must stop now. I am very sceptical about the extent of the Fed’s actions and the way the Bank of England has carved its own little line in Europe.

Even the European Central Bank has somewhat bowed to international pressure with its purchase of covered bonds. We must return to independent and sensible monetary policies, otherwise we will be back to where we are now in 10 years’ time.”

Stress test results out tomorrow

It is like waiting for exam results; will the US banks get the grades they need to continue trading?

Actually, this stress test is turning out to be a bit like UK A Level results. Everybody passes with A grades, but only a select few get into Oxford. All US banks will be told that they aren't insolvent, but nevertheless, they need more capital. Only a select few will be told that they are fine.

Here is how the FT assessed the likely outcome of tomorrow's stress test announcement....

US financial stocks soared on Wednesday as investors expressed relief the capital shortfalls identified by the government’s “stress tests” at large banks such as Citigroup and Bank of America were not as big as some had feared.

The bank rally occurred as news of the capital needs of the 19 banks involved in the tests leaked out during the day, ahead of the official release of the results on Thursday.

Citi, BofA and Morgan Stanley were among the big names that will have to raise equity following the completion of the tests, while JPMorgan Chase, Goldman Sachs and American Express are among those that will not need additional capital, people familiar with the situation said.

Citi and BofA emerged as the banks with the biggest capital shortfalls, with Citi’s equity needs projected to be more than $50bn and BofA requiring about $34bn in fresh equity.

However, BofA’s capital deficit is more pressing because Citi has already agreed to bolster its balance sheet by converting preferred shares owned by the government and other investors and selling non-core businesses.

UK external debt - 400 percent of GDP

In general, I don't like posting other people's charts. I prefer to do my own, thank you very much. However, there are charts that are so important that they need to be produced in their original format. A recent chart on the Spectator website is such a chart.

The Spectator asks what is the true level of UK external debt, both private and public. The answer is horrifying. Britain owes the rest of the world. It is not 40percent (the level of public sector debt) but 400 percent of GDP. Furthermore, it is the highest in the G7 by some margin.

So what is the plan? Gordon "I saved the world" Brown wants banks to lend more, while the governments runs up an 8 percent of GDP fiscal deficit next year.

Make no mistake, we are on the road to total ruin.

UK investment collapses

Oh lordy, this means trouble. In the 3rd quarter of 2008, UK investment fell by almost 6 percent. Those early BoE rate cuts had absolutely no effect on capital formation.

Monetary policy is broken, my friends. The MPC have lost control.

Alice's Icesave bubble wrap special

Big chill hits Iceland's economy

British customers of Icesave are protected under the Financial Services Authority scheme which covers the first £35,000, rising to £50,000 with effect from tomorrow.

Icelandic Banks to Sell Assets; Government Guarantees Deposits

Wounded Iceland takes over No. 2 bank, seeks Russia loan

Iceland should turn to the IMF, not Russia

Icelandic saga spreads chill from freezer cabinets to soccer clubs

Iceland Seeks Loan From Russia, Pegs Currency

Icesave customers face anxious wait

Icesave collapse: Case study

UK Savers Face Cash Application

The true cost of the Icesave meltdown

Savers frozen out as Icesave website collapses

It is dark out there

It is a world of confusion; bank crashes, rising prices, housing shortages, falling sales, and a general lack of money. I can't make any sense of it. Read on and expect no enlightenment.

The Freddie and Fannie show

It is hard to overstate the significance of this story. Freddie and Fannie are central to the US mortgage market. The two quasi-state institutions are collapsing; their shares are plummeting and their borrowing costs are rising. So far this year, the two mortgage giants have run up $11 billion in losses.

The Bush administration is now considering a bailout. The cost will be astronomical.

Primark sales crash

In today's downtown, Primark can not shift their cheap and cheerful crap clothes. It is a watershed moment for me. We are in more trouble than I thought.

Danish Central Bank Bails Out Roskilde Bank

Soon, we will all be tired of these bank bailout headlines. The crisis is beginning to look systemic.

Housing shortage will "worsen" as UK construction collapses

According to the times, the bubble will be back:

Homeowners may be preoccupied with statistics on falling prices but the mothballing of housing schemes could exacerbate the shortage of homes, making another price spiral possible several years hence.

Is this good or bad news for homeowners? For some, the prospect of a renewed "price spiral" must look a lot like salvation.

Sugar prices soar

Should be good for the nation's teeth.

The world is running out of money

I always thought that Ambrose Evans-Pritchard was my friend. Normally, this Telegraph journist is spot-on in terms of his economic analysis. Today, he tells us the world is short of money, which obviously explains why inflation is accelerating. Stop writing this rubbish Ambrose.

The rate hikes begin

With each passing month, the inflation numbers are getting worse. As the numbers deteriorate, the options available to central banks are becoming narrower; either raise rates and take the inevitable hit on growth and financial stability, or let the problem slide and watch inflation slip further. With double-digit inflation hovering on the horizon, some central banks are beginning to act.

Does the idea of double-digit inflation sound too alarmist? Last month, the RPI inflation rate was only at 4.3 percent; at least 5 percentage points south of a double-digit rate.

Looking at today’s inflation rate is like trying to drive by looking in the rear view mirror. Inflation is a forward-looking phenomenon, and therefore central banks should assess future expectations when formulating policy. In the absence of a credible policy response to rising prices, private sector expectations are adjusting rapidly upwards.

People are not daft; they see what is going on, and they do not like it. So far, central banks have acted too slowly to counter the inflationary threat. People have noticed this growing cowardice in the face of the inflationary enemy.

Whatever economists might think, inflation is not a concept that tests the intellect. When prices start to rise, everyone quickly grasps that money in your pocket today buys less in six months time. Therefore, it is better to spend it before it loses value. Saving is futile when inflation rises above the bank deposit rates; each pound held in the bank will be worth less in the future.

Although inflation destroys the incentive to save, it does not generate a huge consumption boom. Rising prices erodes the value of fixed incomes, unless wage growth keeps up with inflation people become poorer. In fact, inflation is the mother of income inequality. It punishes those on pensions, and those who cannot push through inflation indexed wage increases. It favours the rich, who generally hold real assets and can diversify their wealth, and punishes the poor who cannot.

Inflation is a terrible thing; and ordinary people instinctively understand this. Therefore, once inflation expectations take off; they quickly run out of control. Imaginations run wild; people begin to expect the worse; and once the idea of double-digit inflation enters the popular imagination, it becomes almost self-fulfilling. If people think double digit inflation is possible; it will happen.

Already, 50 countries, including six of the 10 most populous ones, are now dealing with inflation rates in excess of 10 percent. Close to three billion consumers are currently suffering double-digit rates of price increases. If it can happen there, it can happen here.

Some central banks are waking up and starting to act. Yesterday, the ECB finally understood the dangers ahead and hiked rates by a 0.25 percent to 4.25 percent; Earlier, Sweden's central bank raised its benchmark interest rate a quarter point to a 12-year high. The Norwegian central bank raised rates earlier in the week.

Other central banks do not quite have the message yet. Notably, the Fed has been slow to notice the growing inflationary dangers. Its sudden post-credit crunch monetary easing is beginning to look positively foolish. It has not put a floor under equity prices, it has not prevented growth from slowing, and it has not stopped house prices crashing. The monetary easing has not even stabilized financial markets. It has, however, done wonders to excite inflationary expectations.

Here in the UK, the Bank of England did not go quite as mad as the Fed. Nominal rates have come down a little, while rates adjusted for inflation hover fractionally in positive territory. Nevertheless, over the last few months, the MPC repeatedly missed the opportunity to tie down decisively inflationary expectations. Instead, it relied on luck, hoping that a modest slowdown in activity might be sufficient to bring inflation back down close to target. So far, luck has not shined on the hapless MPC.

The MPC would find it easier in the end to try to contain inflation when it hovers at between 4-5 percent, rather than to attack it when it is approaching 10 percent. The mood is shifting, rate rises are coming; and the sooner they arrive, the less painful they will be.

Don't count on unemployment to reduce inflation

If the Bank of England think that there is a gentle trade off between inflation and unemployment, they should take look at the last time the UK went into recession.

Back in 1989, the UK had a raging housing bubble. As house prices increased, people felt richer and went out to the shops and spent like millionaires. Inevitably, inflation surged, and for one or two months, it reached 10 percent.

The chart above illustrates what happened next. The housing market crashed. People woke up and found out that they weren't as rich as they previously thought and stopped shopping. The UK slipped into a recession. Unemployment increased from around 7 percent of the work force to over 10 percent.

As the chart suggests, it took almost 4 years to bring inflation under control. It took 7 years for unemployment to return to the level reached in 1989. High levels of unemployment were not that effective at reducing prices.

There is a simple reason for this; so long as workers are not in any immediate danger of being fired, they will try to maintain the relal value of their earnings. When recessions fire up, only the most marginally profitable firms go under. Even in deep down turns, most people are not in any real danger of losing their jobs. Therefore, they keep demanding inflation adjusted pay increases.

The MPC thinks it can negotiate with inflation. Once inflation gets going, it doesn't pay much attention to unemployment. There is only one tried and tested way to reduce inflationary pressure; reduce monetary growth.

Name that bank

How well do you know your local bank?

Here are the share prices of three UK banks, starting from January 2007 to earlier this week. Can you put a name to each share price?

You can find the answer by clicking on the comments link just below this post.

Comparing bubbles, predicting the crash

During the last 20 years, the UK had the misfortune of living through two huge housing bubbles. The first was carefully nurtured under a Conservative government, while second happened under New Labour. Thus, it would seem that housing bubbles are non-party political beasts.

We see the current house bubble through the prism of the last one. Therefore, it might be useful to compare these two extraordinary periods. Before comparing them, it is important to date them. I will use a simple rule. Over the long term, there appears to be a steady relationship between house prices and average incomes. Historically, this ratio fluctuates between 2 and 3. When the ratio rises above 3.5, I assume that house prices have departed from long-run fundamentals and the bubble has begun.

In the case of the Conservative bubble, this happened in April 1984, and in October 2001 for the Labour bubble. Once I have the starting date, I set the price on that date to equal 100 and then superimpose one price series on top of the other. If I do this, I get the chart below.

Superficially, both bubbles seem similar. In terms of housing inflation, prices increased by 118 percent under the Conservatives, and 113 percent under Labour. The length of both Bubbles is also similar; the Conservative one took 63 months to reach its peak, while the Labour bubble took 70 months.

However, behind the superficiality lie some profound differences.

The Conservative bubble is an easier story to tell. After several years of steady price appreciation, prices accelerated in one last mad burst to the top. Once it reached the peak, inflation was raging and the government ordered the Bank of England to raise rates. House prices then began to tumble for the following 80 months.

The New Labour bubble was more front-end loaded. During 2001-05 price appreciation was extraordinary. By mid 2005, inflation picked up a little, and the Bank of England cut rates. House prices began to slip, and the Bank of England quickly began reducing rates. The policy reversal gave the bubble a second lease of life, and prices increased for a further 2 years.

The differences become much more apparent when one looks at price to income ratios. In the case of the Conservative bubble, the ratio only reached 4 in December 1987, and it peaked at 4.8. Therefore, for long periods, one could argue that house prices were only marginally detached from incomes. At the time bankers and estate agents used this argument extensively.

In contrast, the price to income ratio in the Labour bubble shot up rapidly, passing 4 within a few months, and almost reached six at the peak.

The reason for the different price to income ratios is straightforward. Nominal interest rates during the Labour bubble were much lower, which allowed people to take on much higher mortgages. Interest rates were low, because inflation worldwide was under control.

Real house prices point to another major difference. In real terms, the Labour bubble was larger. During the 1980s, real house prices increase by 60 percent, whereas the most recent bubble, prices increased by over 80 percent.

We can also see how house prices returned to fundamentals once the Conservative bubble finally burst. There was a modest reduction in nominal prices, but most of the adjustment came through inflation. Since inflation and average earnings move together, house prices became affordable because eventually nominal wages caught up. The real adjustment, during the 1990s, was dramatic. From the peak to trough, prices fell in real terms by 34 percent. From the beginning of the bubble in 1984, to the bottom in the late 1990s, house prices increased in real terms by just 10 percent.

What does this tell us about the likely adjustment facing today’s housing market? Today’s prices will need a much higher nominal fall to return the market to a more reasonable price-to-income ratio.

To understand why, it is important to recognize that in the 1980s both inflation and interest rates were well above 10 percent as the bubble burst. The higher levels of inflation ate away at the real value of housing and put a floor under nominal prices. Furthermore, as inflation subsided, interest rates came down reasonably quickly. This also helped cushion the nominal fall because housing affordability improved. Although the market still crashed dramatically, these two effects limited the size of the crash in nominal terms.

Neither of these two effects is present in quite the same way right now. Although inflation is rising, it is likely to fluctuate between 3-5 percent for the next two years. It is not enough to seriously dent the real value of housing or reduce the price-to-earnings ratio over the medium term. Interest rates, and especially mortgage spreads, are now adjusting upwards, reflecting higher levels of risk. As inflation picks up by 1-2 percent, it is likely to put a floor under interest rates and may even contribute to higher rates, and therefore keep housing affordability high.

The 1980s adjustment had other things going for it; a recession, a high repossessions rate, and the sterling crisis. However, I doubt there is much comfort here. In the fullness of time, the UK economy may also produce its own complementary recession, which will push up repossessions and unemployment.

Three things make the current housing market much more frightening than the one in the 1980s. First, it is incredible just how unaffordable house prices are today. The UK average price-to-income ratio is well over 5. In some parts of the country, like London and Northern Ireland, it is approaching 8. Second, personal sector balance sheets are in appalling shape, with many households holding crushing levels of debt. Finally, banks have lent out too much and they know it. They have abandoned the housing market and they are unlikely to return.

It all points in one direction. The UK housing market is facing a massive nominal price correction. As hard as it is to believe, this correction could be much worse than the one in the 1990s.

The shareholders begin to pay

Its the fashionable thing - a rights issue.

After weeks of denial, Bradford and Bingley finally admitted that they needed more money to shore up their battered balance sheet. They are looking for £300 million of new money. The news won't make their shareholders happy. The new shares will be discounted at 48 percent of the B&B's Tuesday's closing price.

However, the B&B are not alone. Other banks are lining up with similar offerings. The Royal Bank of Scotland wants £12 billion more, while HBOS is looking to raise £4 billion. Barclays might also follow the growing trend.

Shareholders have only themselves to blame for these losses. When the housing bubble was raging, and banks like the B&B were piling into the buy to let market, shareholders fell asleep. Rather than asking questions about risk, they offered huge bonuses. Now this negligence is being repaid with massive shareholder losses.

The experience will offer some grim but valuable lessons for every shareholder. Control the CEO, make sure you know what she is doing, and above all, don't reward her for excessive risk taking.

The job destroyer

This chart is destroying thousands of jobs in the financial sector.

Over the last couple of weeks UBS, Morgan Stanley, JP Morgan, and the Royal Bank of Scotland have all announced swingeing job cuts. As the Economist reported this week, the people most at risk of taking the long walk to the front door are those working in investment banks, and especially those working in fixed-income.

As the chart suggests, several important securitisation markets are now closed. Since last summer, residential and commercial mortgage backed securities volumes have fallen off the proverbial cliff.

These securities, especially the sub prime MBS, that were behind the huge losses recently suffered by virtually all major investment banks. It doesn't help your job prospects to be working on a product that loses huge amounts of money for your employer.

The FSA discovers excessive concentration

If the UK slips into a systemic banking crisis, we won't be short of people to blame. Top of the list of guilty institutions will be the FSA. Since the FSA took control of financial sector regulation back in 1997, banks and building societies have run amok. At times, the FSA's lack of capacity and judgement reaches almost comical proportions.

The FSA's naivety was again on public display this week. Hector Sants, chief executive of the FSA,was guest speaker to the Building Societies Association's annual conference. He took the opportunity to "warn" his audience about the dangers of "excessive concentration in the buy to let market."

Over the last ten years, the number of buy to let mortgages has risen from a smidgen above zero to over one million. The time to warn about "excessive concentration" was about five years ago, just as the market was taking off and it became obvious that banks and building societies were taking on a potentially dangerous level of risk. Warning the building societies today, when they are struggling with liquidity and rapidly depreciating collateral is just a little too late.

His wisdom didn't stop at warning about "excessive" lending concentration in housing speculators. Saints also gave the building societies some advice on funding strategies. He took particular aim at building societies' over dependence on the wholesale market for funding liabilities. "If wholesale funding is being utilised, it should be in a proportionate manner and the overall funding model sensibly diversified. In particular, the wholesale component should be diversified in term and maturity."

Hello!!! Is there anyone in there? It is the FSA's job to ensure that the financial sector has appropriate liability management. The FSA should be monitoring key financial sector indicators like maturity structure, credit and default risk. When banks step out of line, it is the FSA's job to hammer them with fines.

The FSA isn't an advisory service for the financial sector. The FSA should regulate these institutions. It should protect the rest of society from dangerous risk taking by greedy banks, blinded by the profit motive. It needs to prevent banks from pushing out loans to individuals who have a high propensity to default. It needs to ensure that banks behave.

It is time to call a halt the FSA. Financial sector regulation should be returned to the Bank of England. Mr. Saints should be cut loose from the public sector and allowed to pursue a career more suited to his talents, which appears to be some kind of low level management consultant working within the retail banking sector. It is time we had a financial regulator that knew what it was doing.

Who is the daddy

All the major central banks are now busy using their own assets to support their respective banking systems. However, which one has the most resources?

No surprises here; by some distance, it is the ECB. In fact, in terms of assets, it is over twice as big as the Fed, and over ten times bigger than our dear old Bank of England.

The ECB won't need any special liquidity scheme. They still have plenty of space on their balance sheets for any rotten Irish or Spanish banks that need a little support.

With a central bank balance sheet like the ECB's, UK banks must be wailing and gnashing. If only the UK had accepted the euro.