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The first quarter...

might have averted our gaze, but some rather interesting statstics were relased this morning that more or less complete the picture we have of the economy in the first quarter of the year.

The two main headlines for me: real household disposable incomes (i.e. incomes after tax and inflation) fell for the second consecutive quarter. And (probably as a resuilt of that) savings collapsed to their lowest proportion of income since 1960.

Putting these in numbers, households were 0.3 per cent poorer in the first quarter of the year than they were three months before. And they saved a mere 2.1 per cent of their incomes. (It's not much if they aspire to retire on a reasonable income for a quarter of their adult life).

Consumer spending was robust, growing 0.5 per cent in real terms. The economy grew strongly, by 0.7 per cent in the quarter. It's three per cent bigger than a year ago.

How should we interepret the data?

It seems that the economy is still being to some extent sustained by consumers who are struggling to adjust to the fact that their spending power is not rising as fast as it was. They are still spending more even though their income has not been rising.

One wouldn't want to be too alarmist about this, but it slightly smacks of the cartoon character chased off a cliff - with the legs still running before the character finds the ground is no longer there and a fall is imminent.

The fundamental problem is that unless household incomes start rising quite fast again, some adjustment will surely have to be made to spending. Historically, we have saved about seven or eight per cent of our disposable income. A big economic question is how the economy will fare in the short to medium term, when we return to that normal level. (Alternatively, one might ask how on earth we would fare in the long term, if we didn't save at that normal level!)

The best hope for us is that real incomes improve, either through a large increase in our own producitvity and earnings, or through a fall in the prices we pay for things. Perhaps if the kind Chinese workers could supply us with yet cheaper goods, the adjustments that seem necessary would be more comfortable!

notes_on_real_life

Thought on a new chancellor

It must be scary taking over from Gordon Brown. The new prime minister knows where all the bodies are buried in the Treasury building, and will clearly still have a huge interest in what goes on there. He has also taken a handful of influential Treasury officials with him.

So Alistair Darling's first management task is to oversee the Treasury itself, where most of the staff now have only known life under Gordon Brown.

On policy, the immediate task is to complete the comprehensive spending review to be published in autumn, setting out budgets for the next three years. Mr Brown has bequeathed to Mr Darling tight spending limits, which his replacement will obviously have to stick to. It's a more difficult spending round than any this government has had to face.

But most significant for the new chancellor is the fragile economic background - we're adapting from life with interest rates at four point something, to rates at five point something; or maybe six.

The last decade has been one of low interest rates, low saving (and high borrowing), high consumer spending and high asset prices. This has all seemed to hinge on the gift to the UK of global dis-inflation - as China and others have exported ever cheaper manufactured goods to us.

The problem is that the China effect hasn't been working in recent months, or at least not sufficiently for us to carry on with an economy getting a low interest rate boost from the Bank of England.

Hence, rates have gone up and slowly, the British consumer seems to be adjusting. Fixed rate mortgages taken out two or three years ago at 4%, are being renewed at 5.5%.

While things may go very well over the next three years, and while we may be able to adapt to the higher interest rates very smoothly (indeed, that's where most economic forecasts see us going in the years ahead) things may go wrong too.

So we've gone from what Mervyn King calls 'the nice decade' - which, to some extent, coincided with the Gordon Brown decade - to the possibility of a slightly less nice decade. It doesn't have to be horrible, but we don't know what it will hold. And there may not be very much Alistair Darling can do about it.

But there will be one big change in government to cope with the challenges of the next few years. Under Blair and Brown, the Treasury has operated as a semi-independent fiefdom, at times at odds with Number 10. No longer. With Alistair Darling and Gordon Brown, you 'll know who's in charge, and they'll both be facing in the same direction.

notes_on_real_life

Benefits of events

Harold Macmillan famously said that it鈥檚 "events, dear boy, events" that make or break politicians.

I don't think he was talking about events in the way we use the word now - events managed by professional organisers, from the Olympic Games, to the Glastonbury festival.

But it is these big events that can make or break cities and towns.

Glastonbury festivalTake the Glastonbury festival, which in fact, occurs in the village of Pilton, population: 1,000 or so. The residents multiply by 100 during the festival.

The tickets generate 拢20m of revenue - so in fact, more money is probably spent by festival-goers during three days, than by the whole village for the rest of the year. Indeed, more sewage is probably created by the festival-goers than the rest of the village too.

This year鈥檚 Glasto will be the biggest yet. They've sold about 140,000 tickets at an average price of 拢145. The on-site power generator consumes about two tankers of fuel a day鈥 there are 23 bars, the biggest of which can serve 10,000 pints of beer an hour at peak times.

Mendip District Council is the licensing authority for the event. It's trying to carry out an economic assessment of it. Consultants have been employed, and the results will be put together later this year.

But for the village and the Mendip district, don't confuse the huge economic scale of the event, with the benefits to the local area. Just because a lot of money is spent, doesn't mean it makes local people rich.

The ticket revenues, the performers鈥 fees that are paid out, the beer that is brought in by van鈥 It all represents money that comes from outside Mendip, and goes outside Mendip.

In fact, the biggest beneficiaries of Glastonbury are probably the organisers, the participants and the customers.
So why then, do places like Glastonbury so love these events? Why do towns compete for events, sometimes even pay for them?

Well, the answer is that, even if the benefits are only a fraction of the total turnover of the festival, benefits there are.

The local hotels, garages, pubs, make hay while the sun shines, or rain falls, on the outsiders coming in. Plus local charities get support, some of the festival's profits are spent on cleaning and tidying in the village all year round.

In short, what the local district gets out of the festival are some of the crumbs dropped by the visitors - but because the festival is so huge, the crumbs add up to a tidy pile.

And in fact, what Glastonbury does, is a small scale example of what much of the modern British economy does - we host other people's activities, and pick up a portion of the money in the process.

WimbledonIt's what Wimbledon, the tennis tournament, consists of.

滨迟鈥檚 what the City does too. A lot of money comes and goes - but as a little more comes than goes, we can earn something.

So, these "events dear boy鈥 ", are not always as profitable as they sometimes seem. But profitable they usually are. And I suspect Glastonbury is a good deal more profitable for the community, than the proceeds of the dairy farm that occupies the space the rest of the year.

notes_on_real_life

Private equity: Some thoughts

滨迟鈥檚 , but is it as bad as people say?

For those that do not feel they know what private equity is all about, let me offer a few arguments on both sides.

First an explanation. Private equity is quite simple. Investors borrow money (from banks); they usually add a little of their own and use the cash to buy companies. Often the companies they buy were publicly-owned - in the sense that a large number of relatively anonymous shareholders buy and sell shares in them on the stock market - and once bought, they become privately-owned, in that their shares are no longer traded.

Three features tend to follow:

• First, private equity investors usually put the debts they have incurred buying a company, into the company they have bought. Thus they are increasing the debt portion of finance in the economy

• Second, they have a very big incentive to run the company well, because they stand to gain all the profits from so-doing. So they tend to be ruthless in the pursuit of efficiency and value.

• And third, after a few years, they tend to sell the companies they buy.

In fact, private equity does for companies what some builders I know do with houses: they get a hefty mortgage to buy one, do it up as fast as possible and then re-sell it at a profit.

Now most of the current discussion about arguments have revolved around tax.

These investors pay very little tax on the profits of their sale, because it comes in the form of capital gain, and capital gains are lightly taxed if made after two years.

I鈥檓 not sure I understand why capital gains should be treated more generously than other forms of income. But I鈥檓 assured by experienced entrepreneurs that offering a low capital gains tax rate is 鈥 in practice 鈥 an effective way of promoting a risk-taking start-up culture.

However, private equity is not about start-ups. Indeed, most of the people who used to be involved in financing start-ups now seem to have switched their efforts to private equity deals on existing companies.

Some entrepreneurs think a capital gains tax distinction should be made between start-ups and private equity investments, so that the lower rate is given to the one but not the other. But personally, I would need to better understand the reason for having any kind of capital gains tax concession at all, before choosing between subtle distinctions between 鈥済ood鈥 capital gains and 鈥渂ad鈥 ones.

So let me turn to the substance of the arguments about private equity.

It totally changes the way we run companies. Out goes the Anglo-Saxon version of stock-market capitalism. No more do executives get paid a salary for running companies on behalf of disparate shareholders who keep the profits which are generated. In comes a system whereby the managers are the shareholders, and they keep the profits.

The day-to-day risks of running a company 鈥 the profits that can go up or down - is transferred from the shareholders to the private equity funds who are closely involved in managing the companies they buy.

Because the managers themselves can鈥檛 buy whole companies outright, debt plays a much bigger part in financing corporate activity.

In fact, private equity arguably takes us a step towards the German model of corporate governance. Which is ironic, as in the 1990s, when Germany was still top nation in Europe, writers like told us that our capitalism with anonymous shareholders selling their shares when the going got tough in a company, worked very badly. We needed banks to be more involved in companies, with shareholders taking a long-term, involved, view of what companies do.

In practice, the Will Hutton critique of the stock market seems to have some resonance with lots of executives who really do think private equity work in releasing them from the tyranny of half-yearly profits statements, and makes it easier to take a strategic view of what they鈥檙e doing.

You might even say private equity is like the business equivalent of releasing politicians from the slavery of opinion polls. We want our leaders to listen to us, and anticipate our reactions to things. But we do not want them to be guided only by the latest poll ratings to the detriment of a sensible long-term view of things.

So there are potential advantages to private equity, in delivering focused, long-term management.

But there is also a less-benign explanation for the growth of private equity.

It could be to do with the fact we have given companies limited liability and have very forgiving insolvency laws.

滨迟鈥檚 all down to the crucial difference between debt and equity.

Suppose investors borrow 拢9 million to buy a company worth 拢10 million, and they put up 拢1 million of their own. Their investment is heavily geared. If they can create a 5% increase in the value of the company, they add 拢0.5 million to it. But because they keep the whole increase in value for themselves, their initial 拢1 million investment has not risen by 5%, but 50%. A fantastic return (particularly if it's taxed at 10%).

Fine. The principle of leverage through debt has been used by mortgage borrowers to make money out of home ownership for decades.

But in corporate life, there is a drawback to the arrangement. We have made the returns to the highly-geared investor asymmetric. The upside potential is enormous, but the downside risk is limited by insolvency law. If the company goes bust, they lose their million, but they cannot lose more than that.

Often, they have paid themselves generous management fees out of the company anyway, that covers a portion of their equity investment.

Now, it鈥檚 one thing to take risks. But deliberately loading debt on to companies in order to make risks more asymmetric is of less obvious social value than managing companies for long term value.

Of course, the people who should police this are the banks, as they stand to lose their loans if the company goes bust. But they too earn fees on the transaction, so they want the business.

And crucially, in many cases, the debt that they and the private equity buyers pile on to company books stands ahead of the other creditors in the queue, should anything go wrong.

So for example, I might lend a company some money because it is a customer of mine. I lend them a few tens of thousands pounds, which seemed a pretty safe to do that. Then, I find some idiot bank has lent some private equity buyers 拢100 million to gear the company up to the hilt. Much of the value for the bank and the investors derives from the fact that my previously safe loan now looks like an unsafe one.

This is a bit of a problem. And although there are some measures to prevent it from being over-exploited, they are apparently not very effective.

So, the worry about private equity is that at the more extreme end, it has just turned into a piece of elegant financial engineering that has succeeded in exploiting gaps in contracts and legal arrangements.

small_change

My prediction - June

I think the Bank of England will probably not raise rates when it announces its decision today, preferring a little more time to wait and see how far its four previous rate rises affect us. With that in mind, here are my (subjective) probabilities, rounded up to the nearest 1%.

Probability of no change: 75%

Probability of a rise: 24%

Probability of a cut: 1%

notes_on_real_life

Fixed-rate pickle

All good things must come to an end. And concern is brewing for people who took out fixed rate mortgages two years ago, and who are now coming off them to find rates far higher than they have been used to.

mortgage.jpgIn 2005, according to the , about 1.3 million people took out fixed rate mortgages, at an average rate of 5.18%. Most of those people will probably come off their fixed rate this year and fall on to a stinging standard variable rate (the current average is over 6%) or they will have to re-mortgage at today's rates.

There are many options for re-mortgaging, but typically a good new two-year fixed rate will charge around 5.5%. Better offers than that are available, but they typically come with high fees that offset the lower rate.

This phenomenon of the re-mortgage blues has already started to bite, but so far most people have been leaving fixed rates of above 5% and so their shock is not quite as extreme as it might be, particularly if they shop around and get one of the better deals available now.

But it will get worse as months pass, because it was later in 2005 that rates bottomed out. In November 2005, 148,200 people took out fixed rate mortgages at an average 4.95%. That was after the Bank of England cut interest rates in August 2005, (a poor decision in hindsight, analysed below).

But if 4.95 was the average, it means roughly half that number took out mortgages at rates below that. They will face a shock. Hopefully they have been anticipating it and saving a bit already.

While this of course matters to the many people who moved house or re-mortgaged two years ago, it is also of macroeconomic consequence. Sixty-one per cent of new mortgages in 2005 were fixed rate, while only 10% were on standard variable rates. This means interest rate rises may have a somewhat delayed effect, and that might justify a caution in over-doing it on interest rate rises too quickly.

Only when the fixers have re-mortgaged can we be sure where we are.

It is worth mentioning, however, several things that might mitigate the suffering of those coming off their fixed rates.

1. The mortgage market is becoming more competitive and lender margins are being squeezed, so the full cost of new offers may not reflect the whole rise in variable rates of the last year. It is not difficult to get a new fixed rate mortgage charging below base rates, with the bank hoping to make some money back from the customer once the fix expires. Clever buyers can avoid handing those profits to the bank by re-mortgaging quickly and not letting themselves pay for the full standard rate.

2. The banks are choosing to re-base their mortgage pricing away from interest payments, towards fees. Indeed, many of the rates have barely risen at all, with the fees soaring from a couple of hundred pounds up to a couple of thousand.

Now that is of no long term benefit to the customers, but for for cash-strapped fixers in an immediate pickle, the advantage of the fee is that it can be added to the mortgage rather than paid upfront. (In fact, Credit Suisse believe 80% of borrowers choose to postpone payment of the fee in this way.) , In the short term, a 拢1,000 fee added to a mortgage implies an extra payment of only 拢5 a month.

3. People re-mortgaging this year have probably enjoyed double digit growth in the price of their house in the past two years, and so can aim to get a mortgage with a lower loan to value ratio than their expiring one, on better terms.

4. People re-mortgaging have probably seen their income rise in the past two years - wages usually go up a per cent or two faster than inflation. That would mean there is a little extra money to help finance the new mortgage.

5. People who are desperate, can minimise monthly payments by switching to an interest-only mortgage to alleviate the pain, if they expect their income to rise over time. Indeed, The interest-only phenomenon is catching on - in March, 27% of home movers took out interest-only mortgages with no stated method of re-paying the principal. One assumes that there are unstated methods of re-paying.

For all these points though, even if the great fix-switch that is underway is tolerable, it will not be very pleasant.

Imagine someone who overstretched themselves two years ago, with a 4.75% fixed rate that amounted to 30% of their disposable income.

The mortgage payments will rise by 16% or so, (4.75 to 5.5), taking the payments from 30 to 35% of their old income.

If their income had risen by 8% in the two years, their new payments would be 32.2% of their enlarged income. They would have to have spend most of their last two years of pay rises on meeting their higher mortgage payments. Just at the time they were probably hoping the early-homeowner overstretch would be easing.

For a while we've said: "Why are these higher interest rates not having more effect?"

Maybe we just didn't wait long enough.

vital_statistics

The Bank's worst decision

Mervyn King, the Bank of England governor never comments on the past decisions of the .

He's often invited to admit to a mistake, or a regret, or even allow a moment of self-congratulation. But he generally declines to comment, explaining that the Bank has to focus on the next decision, not the last one.

He's right to remain silent. If he comments on one decision, he'll be invited to comment on another, and he'll soon be forced to comment on everything, which would be fine except his extensive commentary would then inevitably be over-interpreted.

But just because he doesn't comment, doesn't mean we can't.

And there is one decision taken by the MPC that deserves to be named and if not shamed, at least named and regretted.

It was taken in August 2005, and it was one Mervyn King himself did not agree with. Indeed, it was noteworthy as the first decision in the history of the independent Bank of England in which the governor had been overruled, and it was in retrospect probably also the worst decision the Bank has taken.

It was 4 August 2005, not long after the 7 and 21 July attacks on London. The Bank cut rates by a quarter point, from 4.75 to 4.5%, after a year of having held them constant, and prior to that having raised them from a low of 3.5%.

The upward swing in rates of the previous two years had actually taken the steam out of the economy and the housing market, and it had done so rather gently and rather successfully. I had personally described it as a "perfect slowdown".

So why cut rates in August 2005?

Well, the city expected a cut, and indeed another one to follow. Inflation was bang on target, the economy had slowed down to a 0.4% quarterly growth rate in the latest data, and there was a little concern that consumer spending would slow a bit too much.

mpc.jpgInterestingly, the people on the committee who voted to cut were the professional economists. Charlie Bean, the late David Walton, Kate Barker and Stephen Nickell, plus Richard Lambert. They are all competent and sensible people, worthy members of the MPC; they acted on their interpretation of the data, and were clearly fulfilling the expectations of other economists too (the Reuters poll of analysts showed a large majority expecting a cut).

But in hindsight, they got it wrong.

The signal provided by that cut in August 2005 sent people back out into the shops and estate agents, and made them far too relaxed about the natural limits of the economic cycle.

It made them think 4.75 was the highest rates needed to go. And in unwittingly sending that message, the lower rate enticed people to borrow amounts that now seem incautious. In stirring up the economy. it sewed the seeds of what we now face -- impending rates of 5.75%.

Cutting the base rate was an easy mistake to make. Hindsight was not available to those supporting the move, and it was nine months before there was a single vote to reverse it (it was David Walton who led the way in May 2006, a month before he died).

But it seems to me there are four lessons from the episode that any new member of the MPC might choose to draw.

1. The committee should not attempt to fine tune the economy. Trying to be too precise in steering a course for the economy in response to quarterly growth rates is a mistake. And it is even more of one if the goal is to get rates as low as possible as quickly as possible consistent with the inflation target.

2. The committee should not be a hostage to city expectations of rates. Unless there is a danger of serious financial turmoil, the fact the City thinks rates will be cut is of no relevance to the decision whether to cut them.

3. For good or ill, interest rate moves have some signalling value. But it is the public who are the important signalees - not the city.

4. It is worth looking more closely at the evidence that does not fit the theory you have of the economy, than at the evidence which does fit the theory. In the August 2005 case, money supply was providing the oddball data. (One monetarist hawk, Gordon Pepper, who sits on the Shadow MPC of the Institute of Economic Affairs actually supported a quarter point rise in rates at the time). Money's importance was too lightly dismissed by the MPC. For me, this is not an argument for monetarism, as an argument for looking at all the data more open-mindedly. We are all subject to the strong tendency to frame a view of the economy, and then to select the evidence we define as important, and unsurprisingly to then find it supportive of the view we first thought of.

The minutes of the discussion at that fateful meeting suggest several members of the committee had reservations about the decision, and thought the City was far too inclined to think rates were about to enter a new downward cycle, and thought it was worth waiting more than usual, to obtain more information.

Looking at the consequence of the decision, one can say that it had a benefit - in probably mildly contributing to the 2.8% growth rate we enjoyed in 2006.

But the cost has been a degree of overheating that we are now dealing with, and a degree of over-borrowing. Much of that borrowing was on two-year fixed interest rates, and so the consequences of August 2005 will only come home to roost later this year.

PS Given I'm arguing with hindsight, I think it is only right to re-publish my words on the subject at the time, which were a bit equivocal (as they would be from a 大象传媒 journalist). But among my comments on the Ten O'Clock News were these:

"Looking back over the last few years, you could say consumers had a bit of a party and the Bank of England tried to damp it down. They brought out the strong black coffees to sober us up a bit. Cutting the rate again, it's like discovering a couple of unopened bottles of wine in the fridge and saying we can carry on. "

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