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On the Budget Housing Stimulus

The Government is planning to loan people significant money in order to find the deposit on a new-build house. Now. I think the major problem with the UK economy in the long-term is Britons’ habit of seeing a house as an investment, assuming “bricks and mortar” can beat inflation in the long run. Of course, if the supply is held below the growth in the number of households, as it is in the UK, this will be true. The result of this endless house-price inflation is no-one can afford a house big enough for their family, unless they quit work early enough to get on the Council house waiting list.

Thus house-price inflation keeps the existing rich, rich as wealth is transferred from non-home-owners to home owners. It also helps Labour’s client state, as they can never hope to afford to be free of the welfare state, thanks to the cost of putting a roof over your head.

The young, and those in the middle income brackets are forced to spend enormous percentages of their income on housing themselves. In response, houses have got smaller, people are more likely to share. In short, house-price inflation, like all other forms of inflation makes people poorer.

If you’re on the Right, you might point to the massive subsidy at the bottom distorting the market, housing benefit, which mainly transfers taxpayers’ money to private sector landlords. You might see cutting HB as a solution. If you’re on the left, you won’t see beyond Social Housing – basically demanding the council build more estates and manage them as a letting agent.

The real solution is to build more houses, so many in fact that house prices rise by less than inflation and keep doing this for a couple of decades. Unfortunately the two metrics on which a UK government is judged are unemployment and house-prices. Home-owners are vastly more likely to vote than renters, and are enormously exposed to this one metric. For this reason, and others all home-owners always vote against all development, anywhere, ever. So any politician who espouses the policies which will result in enough houses being built, will get voted out.

I am not sure subsidising lending to people with marginal deposits is the right way to go. But at least it’s only for new-build. And the fact that there’s no restrictions – aspiring private-sector landlords CAN apply for this funding (at least until they U-Turn on this) it might actually work to encourage a few more developments at the margin.

Of course what is really needed is a big easing of planning regulations, and a removal of the need for such huge percentages of new developments to be earmarked for Labour’s client state to be provided at cost (for this is what social housing is) which is holding back so much development. Without social housing, building would be more profitable, which means more would be done, without waiting for the land value to rise due to scarcity.

This is being SOLD as a means to “stimulate” the housing market and help buyers with a deposit. What it actually is, is a subsidy for developers and banks who’ll be able to lend at lower risk. I will result in a few more houses being built at the margin. It wouldn’t be my way of doing it. But it isn’t totally insane.

Labour Plans for Capital Gains Tax

One idiot, Ed Balls, has asked another idiot, Sir George Cox, for ideas to tackle “short-term” thinking in British business. Or maybe I’m being harsh to Sir George. Perhaps he’s just realised there’s good money in telling lefties what they want to hear, and in doing so removing corporate oversight by shareholders. The state, big banks and corporate “business leaders” in a massive conspiracy against the rest of us.

“Short-term thinking” is one of those problems which exists more in the fevered minds of left-wing politicians looking for something to justify state planning, than in reality. And how did that work out every time it’s been tried? Even though state intervention in industrial planning is an idiotic idea, it has been successfully placed into the mouths of “almost three fifths” of “business leaders”. Wow! Just over half of “business leaders” think we should think “longer term”. I am frankly underwhelmed at the support of “business leaders”.

There are problems in some businesses that are too focussed on the next half-yearly report. This is better than the US system where quarterly earnings are the norm. To my mind, 6-months gives shareholders the right level of detail to make decisions. Any company that feels their share price is too low can buy-back shares. Any company that thinks it’s too high, can issue shares. And in practice this is what happens. And in any-case  keeping your shareholders informed of expectations through trading updates and so forth means shareholders are likely to be pretty tolerant of short-term trading problems. The outlook statement is often a more significant driver of the shareprice than the numbers.

Some businesses fail. These problems are not problems caused by “speculation”. Speculative share-buying is an issue looking for a problem. Lefties, like Ed Balls don’t like the idea that someone can buy shares and sell them at a profit. Companies sometimes don’t like the fact that shareholders can run from a company on a profits warning. Chief executives hate the fact they are overseen by thousands of unaccountable people. But good companies, with good products and high barriers to entry get bid up and trade on high multiples (which means their cost of capital is low) and bad companies who’re likely to ask their owners (the shareholders) for more money, or who are likely to go bust trade on low multiples. This means the system is working. Speculators drive this process. They don’t kill companies, they’re the canary in the mine.

Speculators also create liquidity in the market. Liquid shares trade on higher multiples, meaning lower cost of capital, meaning more business investment. If you limit the speculative money, you make markets more illiquid, reduce the price of shares, and increase the cost of equity capital.

Debt interest comes out of profits BEFORE tax and shareholders’ dividends AFTER tax, so built into the tax treatment of companies is a big tax advantage to debt finance. The beauty of  equity finance is that the shares can go down, but the company can go on regardless. Debt can rapidly spiral out of control. Both sorts of finance have their place – I like to see an appropriate level of gearing – but capital gains have, in effect already been taxed at the corporation tax line. If a company has no immediate need for capital, it can ignore shareholders and the share-price. This is not true of debt finance.

So by increasing CGT, you will increase the level of debt carried by companies. You will make companies MORE focussed on short term results, because you can bet your bottom dollar your bank is NOT thinking long-term (and especially the state-owned ones). They are at the moment absolutely focussed on their bad-debt numbers and they will pull the plug on viable businesses long before the end. This is why debt-financed businesses are riskier than equity financed businesses and equity finance better than debt for speculative, risky or long-term projects. One miss of a target, the bank pulls your loan in. Shareholders cannot do this.

Lets look at some examples: Is RBS, a government owned and operated business, whose remuneration policies and semi-annual results are the stuff of breathless news reporting more likely to be thinking for the next headline than, say ITM power, who have spent a decade on primary science and innovation around the fuel cell and electrolyser, but who only started making commercial sales recently?

The proposal to tax capital gains between 50% and 10% depending upon how long they’re held is just stupid, and will reduce the ability of ordinary people to buy into the likes of ITM power. The idea that long-term shareholders are somehow better than short-term shareholders is risible, and bears no scrutiny. Long term shareholders tied in by CGT rules will not be able to influence the company at all. Short-term shareholders vote on the company by buying and selling the stock. Liquid stocks are less volatile.

All this stupid, facile, imbecilic proposal will do is further increase debt finance over equity finance. Any influence small shareholders have will be lessened. This is just the state regulating for the benefit of big corporate bosses who prefer to deal with large institutional shareholders. This is just mindless corporatism that will worsen corporate governance, increase costs and decrease liquidity and therefore increase volatility of stock.

An aggressively tapered CGT regime will at a stroke make worse the problems it is meant to solve, and anyone thinking it’s a good idea should be sedated and kept away from sharp objects. Of all the ideas to come out of the Labour party, this is the most obviously stupid for some time.

Growth is NOT going to end.

In “Perfect Storm” the head of Research at Tullett Prebon, Dr Tim Morgan predicts the end of Western Growth arguing that the last 250 years were an anomaly of the industrial revolution, which is now over.

To summarise the argument, Morgan identifies four trends which will mean Growth is going to be anaemic or non existent for the long-term, all coming together in the perfect storm. These trends are 1) The benefits of the move away from human muscle as a primary source of power have been largely spent, and there are no further equivalent gains to be had. 2)We are at the end of a credit super-cycle which has been inflating a bubble for the last 30 years. 3) Policy-makers have been blind-sided by rubbish data, and 4) the west is vulnerable to globalisation.

He’s not even half right.

Let’s look at his trends in detail: First he suggests that the debt bubble is equivalent to the south-sea bubble or the Tulip-mania. The UK and US are enormously endebted. There was not just a vast increase in public debt, but also private debt too over the past 30 years.

Gordon Brown, for example, proclaimed an end to “boom and bust” and gloried in Britain’s “growth” despite the way in which debt escalation was making it self-evident that the apparent expansion in the economy was neither
more nor less than the simple spending of borrowed money. Between 2001-02 and 2009-10, Britain added £5.40 of private and public debt for each £1 of ‘growth’… Asset managers have a very simple term to describe what happened to Britain under Brown – it was a collapse in returns on capital employed. No other major economy got it quite
as wrong as Britain under Brown, but much the same was happening across the Western world…

While he is, of course right our economies are more indebted than ever before, the damage to the economy (or at least growth) from this has already happened. There was almost no private sector growth during the Labour years. Almost all the growth was due to immigration and increased public spending. Brown’s “boom” was merely a public spending spree, masking a recession which was already happening.

Much is made of the collapse of investment returns over the period. It’s almost as if that huge increase in public debt sucked investment out of the private sector!

That process reversing would explain the no growth, but rather solid employment numbers that we’ve seen recently. Meanwhile the private and corporate sectors have been busily using the low interest rates to deleverage faster than at any time in history. The good news is the UK and USA are not going to go the way of Japan, because instead of committing to ever more “stimulus” we’re all agreed on Austerity. Japanese debt now stands at 250% of GDP and they’ve enjoyed little growth in the last 20 years as a result. The Anglo-Saxon economies, in contrast have instead purged the bad debt from bank’s balance-sheets (incompletely, but better than Japan in the 90’s), refinanced, and hit the monetary nuclear button (Quantitative Easing) after 6 months, not 6 years.

Yes there’s a 30-year asset bubble to unwind. That’s not what drives real wealth. There is capital for innovative technology, so this isn’t going to stop the long-term driver of growth: productivity. Yes, we’re at the top of a 30-year bond bull-market driven by falling interest rates and falling risk appetites, and yes, interest rates will rise over the next few years. But the overall debt burden (including public, private and corporate) has already started to fall. Let’s not forget the South-Sea bubble and Tulip Mania didn’t derail western growth because the shape of balance sheets don’t ultimately drive long-term growth. Technology does. There’s no reason to suppose the credit crunch will do so in the long-run.

Next up, Dr Morgan channels the Socialist Workers’ Party by suggesting globalisation is a disaster for the west because it’s sucked “production” out of our economies. This is pure “manufacturing is special” wibble. Globalisation has, of course been a boon for Chinese wages, and as a result the phenomenon of offshoring jobs has run its course. Western manufactures now cost about the same, when the extra transport and extended supply-chain of Chinese manufacture is taken into account. Meanwhile, the Chinese, vastly wealthier than they were a decade ago thanks to offshoring, are now clamoring for Jaguars. We’ve created a market for the high-value manufacturing and services which never existed before. We in the west aren’t producing less – the UK is a net exporter of cars for example – we just employ fewer people to make more.

The big problem with globalisation was that Western countries reduced their production without making corresponding reductions in their consumption… 

Morgan makes the standard pessimist mistake. Making things we can drop on our feet with fewer people means those people not hammering metal in Birmingham car-plants can train to be lawyers, or web-designers instead. We get cars AND websites. We’re richer. We don’t need to cut our consumption, or at least not as much as Morgan thinks we do.

In the interface between these first two trends Morgan identifies, there is a glimmer of truth. Because much of the growth in the noughties was debt-financed and ephemeral, we simply weren’t as rich as we thought we were in 2008. The recession is the process by which we cut our expenditure to meet our income. Great. The economy is healing itself, and has been doing so for the last four years.

Any economic historian could tell you that recoveries from balance-sheet recessions are always slow. The credit crunch was the mother of such, and so the slow growth subsequently is not exactly unexpected, however unwelcome. The enormous private and corporate deleveraging, combined with public sector Austerity should, if the Keyensians are right trigger a depression. The fact that growth is merely flat should be grounds for optimism.

Trend 3) is that the financial statistics used are a grand exercise in self-delusion.

The critical distortion here is clearly inflation, which feeds through into
computations showing “growth” even when it is intuitively apparent (and evident on many other benchmarks) that, for a decade or more, the economy has, at best, stagnated, not just in the United States but across much of the Western world. Distorted inflation also tells wage-earners that they have become better off even
though such statistics do not accord with their own perceptions. It is arguable, too, that real (inflation-free) interest rates were negative from as long ago as the mid-1990s, a trend which undoubtedly exacerbated an escalating tendency to live on debt.

I’ve long argued the current recession’s seriousness is the direct result of Governments’ efforts here in the UK and in the USA to use public debt to prevent a recession which should have happened in response to the .com crash in 2000. There has been little private sector growth in the UK from when Gordon Brown turned on the spending taps in 2000, to the crash of 2009. Furthermore, the use of CPI (which doesn’t include house-price inflation in the inflation number) and failure to deal with the known problems with RPI, left were handy fictions in the public data. This probably massaged the true figures down, helpful to government, which stealthily cuts people’s real incomes. There’s more: open abuse of the disability benefits and education system was used to massage the unemployment numbers.

But you’re not really surprised that I’m sympathetic to the idea Government and bureaucracy will indulge in self-serving self-delusion, are you? The good news is the Coalition has addressed some of these problems.

Because of this tendency for bureaucracy to indulge in self-serving lies, they pose the biggest risk to western growth. Increases in wealth are, as Morgan correctly observes, all about productivity growth. Where is productivity growth weakest? In the public sector which operates without competitive pressure. And which part of the economy has been growing the most for the last 15 years? That’s right: the Public sector. It may take a decade of cuts and austerity for this trend to be reversed, but that’s why I’m optimistic. Europe, the USA and UK have all made a start on trimming the burdens a much-derided but absolutely correct policy of Austerity. The EU is imposing Austerity on the nations with the biggest deficits, and the US fiscal headbangers of the Republican party are using the debt ceiling to impose a modicum of sanity on an unwilling president and the coalition is making cuts to services.

Shrinking public sector headcounts may be hurting GDP growth in the short term, but this is bringing the economy back from the debt-financed insanity. It may take a while, but unlike Japan, we seem to be willing to face the reality. Japan’s experience shows clearly the party cannot be made indefinite.

It’s the final trend: that the growth engine is winding down which is the weakest in the whole piece, yet forms the basis of the conclusion. Morgan suggests the growth which started with the industrial revolution is spent. He’s wrong. The heat-engine: Steam and internal combustion power, hasn’t even been fully deployed around the globe when a billion people are still using the ox-plough or digging stick. We’ve not deployed the technology of the 18th century to the world. There’s still economic growth from crop-rotation, something which was cutting edge when Europe was recovering from the Black death.

Furthermore Morgan suggests there is no further equivalent growth to come. He’s wrong. We’re only just scratching the surface of what telephones for example can do for growth, let alone computers. Less than 10% of humanity has access to the internet, and that 10% hasn’t yet worked out how to use pocket devices with access to all the world’s knowledge available generate money.

The idea there’s no growth to come is just laughable. The agricultural revolution and industrial revolution aren’t even over. The telecoms revolution has barely started, and the information revolution is just a glint in the milkman’s eye. There’s two-centuries of growth for humanity right there. And that’s before we start harnessing fusion power, driverless cars, abundant solar energy or whatever we come up with next.

Anyone who says “this time it’s different” on the way up is wrong. The same is true on the way down.

The only unlimited resource is human ingenuity. That’s why I’m an optimist, tempered by cynicism about Government’s motives and competence. Simply by applying what we already know to those who don’t, we can drag the billions currently in poverty out of it. Even better, when Governments facilitate rather than control the process, we can all get rich doing so. Globalisation isn’t a zero-sum game. Innovation is happening. The credit super-cycle is being addressed (everywhere except Japan). The only thing I’ll agree with  Morgan, is that the public data is rubbish and so too was Gordon Brown.

The Economics of Online Dating, Poker & Bingo.

One of the things that interests me about economics is how people make money out of new technology. The printing press was used at first for political pamphleteering  one sheet arguments, easily produced and distributed; and Bibles in the vernacular. This led directly to the reformation and the subsequent two centruries of war, as the people, rather than just monks, debated how many angels could, in fact, dance on the head of a pin.

This power to distribute ideas, previously the preserve of an ecclesiastical and political elite, was enormously disruptive. The same is true of all other information distributive technologies – Radio and TV were at first controlled tightly by the powers that be, then regulation relaxed. People started hearing what they wanted – rock and pop rather than what the authorities wanted them to hear. The same is true with TV. ITV started the rot, and we’re complete with the broadcast of ‘Celebrity wedding planners’.

Finally we come to the internet. And the triumph of the medium over the message. The money is made by the owners of the forums, not the people producing the content. Other than that it’s a free-for-all with a distinct winner-takes-all flavour. Why did Amazon win the battle of the online retailers? Probably more luck than judgement  Why did Facebook beat MySpace? What happened to Friends re-united? Once dominance is established though, can we really predict how long it will last. Perhaps the cool kids are already migrating to Twitter. Perhaps the dominance of Facebook is already over. Who knows? The shares have certainly responded to Facebook’s challenge to Google in search, so perhaps even Google’s dominance there might be ephemeral.

I suspect the real losers of the internet will not be the established newspapers and retailers, whose online brands may well survive, and whose brand equity will be useful in maintaining market share in a ‘goods unseen’ environment. The real losers will be casinos, crippled by regulations which simply don’t apply to online poker or bingo. Interesting the cost of doing business is probably the cost of acquiring players. You can tell this by the amount of advertising they do. Once scale is achieved, then payouts can improve, in a virtuous circle of scale vs. relatively fixed costs. Judging by the adverts for online Bingo in particular, I guess the barriers to entry are low.

The other joyous thing about the internet is that much of the stuff that makes money – online dating, gambling, networking, and advertising does so without much interference with regulations. They provides a beautiful resource for economists and sociologists to see what people actually do, rather than what the powers that be or enforced social norms want them to do. We can explore people’s propensity to take risk – financial and otherwise – with huge volumes of anonymised data. We can see what people’s mating preferences are as opposed to what they say they are. Possibly the greatest gift the internet will give is the data to better understand ourselves.

Starbucks, Tax and Idiocy.

On my local high-street, which leads up to a market square there is an independent coffee shop, Cafe Rouge, Thorntons, Greggs, Costa Coffee, and on the Market square there is an independent next door to Starbucks and another selling coffee from a trailer in the middle of the Square. All of these are within 300m of each other. All of them sell coffee, as do the 5 pubs and two other restaurants which you would pass were you to walk from one end of the high-street to the other. That’s before you consider the 4 sandwich shops which also sell coffee to take away. At nearly half the premises in the high-street, you can buy a coffee.

Is anyone surprised that Starbucks is not making money in the UK?

The UK’s corporation tax rate is 28%. Starbucks paid a rate of 31% globally. Surely they should be declaring profit here if they can?

Once again, the UK uncut crowd are simply wrong; but that didn’t stop MPs jumping on the bandwagon. What must be especially galling for a company making little profit in a brutally competitive market-place is being hauled in to face questioning by a new-Labour parasite like Margaret Hodge. Hodge, herself a multi-millionaire whose family business, Stemcor also pays its tax globally, at a global rate of 41%, (which suggests they need a better accountant) but pays very little of that in the UK. Hodge may not be an expenses cheat, but that’s probably because she was born into the fabulously wealthy Oppenheimer family and doesn’t need to be.

What’s really pissing me off is the reporting of tax as a proportion of revenues in order to give a low number. If your margins are low, as in food and beverage retail, you can have huge turnover, off which you’re skimming a little profit, after wages, payroll taxes, overheads, materials, property and so on. Taxes as a percentage of revenues is an utterly meaningless number, yet this is becoming the dominant ratio in the idiot left and the mainstream media.

So here’s a little guide. Revenues is the money you take from customers. Corporation Tax is NOT calculated on this number, Value Added Tax is, and no-one’s suggesting VAT is being avoided. Then there’s costs of sales, which represents all the things you do to make those sales such as employ people, buy materials and stock, rent or buy premises. You also include your central functions, such as HQ staff and buildings. Revenues less cost of sales is known as ‘operating profit’, or sometimes ‘profit before tax’ or ‘pre-tax profit’. You then apply the tax-rate to that number.

Please don’t report tax as a percentage of revenues and call it tax-dodging because that marks you out as an utter moron.

 

Compliance and the Myth of Goldilocks

So far, in the last few years, there have been a number of co-incident enormous financial scandals, which reached from the macro, to the micro, top to bottom. You have various mis-selling scandals. Zero-Dividend preference shares, Endowment mortgages and PFI insurance to name a few. You have LIBOR rigging. You have sub-prime mortgages in the USA, and “liar’s mortgages” in the UK. You have a BASEL II capital adequacy regime. You have mega-mergers and the growth of international financial institutions with liabilities so large, they bankrupt the states which stand behind them.

All of this happend despite the rise of the most intrusive compliance regime the financial industry has ever had to endure. There were rules from everything to the type and amount of assets to be held on the balance sheet, measured in billions, to how quickly any given institution answered the phone. To argue therefore the catastrophe which has engulfed global finance since the 2007 is the fault of de-regulation, is absurd. 

I argue the opposite. I argue the strict compliance regime is the ultimate CAUSE of the crisis. Because banks went bust occasionally in the past: BCCI, and Barings, as the result of fraud or rogue traders, but they did not pose the systemic risks of RBS or Lloyds.Why not? 

To understand, we need to go back to  The US savings and loan crisis of the 90’s, which triggered the recession of 1990-1991. The end of the recession in 1992-1993 following the state bailouts of large numbers of institutions may have made the recession less severe, but it sowed in the mind of the people lending money, that the Government would ride to the rescue. Having ridden to the rescue, Government for it’s part decided to interefere in the lending decisions of banks.

Bureaucrats have tidy minds. To them, the chaos of the market is riskier than the ordered marching of Giants. Since 1990, the number of financial institutions lending money, halved. Regulators encouraged mergers. Savings and loans and regional banks were gobbled up into behemoths. A process which was repeated with equal enthusiasm on our side of the pond. Slowly, the institutions grew. The housing market picked up steam, and ushered in the Clinton “goldilocks” economy of the 90s. 

Almost every financial asset class became more expensive. Bonds had been enjoying a bull market since the late 70’s carried on running, and the yields kept falling with low interest rates. On those, more later. Equities ran up towards the bubble, which eventually popped in 2000. Property rose steadily from the early 90’s. Money flooded into Government coffers. People felt wealthy on their rising property and took on more debt.

Regulators and politicians congratulated themselves on this state of affairs. They responded to the Stock-market crash of 2000 with lower interest rates, to keep the economy going as investment from the private sector dried up. Instead of allowing the mal-investment in the lastminute.coms and other businesses valued on insane multiples of EBIDAWM (Earnings before Interest, Depreciation, Amortization, Wages and Marketing, AKA “sales”) to be purged, that mal-investment was replaced by Government spending, most of which disappeared into lower productivity and higher pay. Low interest rates stoked a property boom all over the world. Banks kept getting bigger, with more liabilites. And with scale came Government interference.

In the USA, banks were instructed to lend to poor credit risks, through the community re-investment act. Bush senior and Clinton allowed banks to securitise these mortgages, and other non CRA “sub-prime” (which then had a more positive meaning – just below prime, ie good). Slowly institutions relied on the prop of the rules. The packaging and re-bundling of debt was a creature of the abnormally low interest-rates driving a frenzied demand for credit, right through the income spectrum. UK banks relied on wholesale markets rather than their depositors. Anything which was allowed was OK, without any real understanding of the risks. Everyone assumed, just like those selling endowment mortgages in the 90’s that the assets would just keep going up.

Volatility was taken as a proxy for risk. The CAPM and VAR measures took volatility for previous years and fed it into a model, which spat out acceptable numbers. Of course, as Naseem Taleb explains so elequently, Returns are not normally distributed, the key assumption behind CAPM. Tail risk, the risk of massive unforseen losses are orders of magnitude more likely than predicted by Gaussian mathematics. “6 Sigma Events” like black Wednesday, the LTCM crash and the .com bust which should happen once every 100 million years or so, happen every decade. Just because the distribution of natural phenonomena from penis length to life-span obey Normal Distributions it does not follow that financial markets do so.

However with the regulator happy with ever increasing risk, and everyone from individuals to Governments frenziedly gearing up with debt, the regulatory bureaucrats were applying box-ticking metrics without really having any deep understanding of the businesses they were regulating. Banks got on with making money, but like all institutions became too big to manage effectivly. And they were making money in an environment where the political pressure was entirely RISK ON! While CRA mortgages in the USA were not the worst from a default point of view, the environment in which the legislation was created was one where the politicians encouraged banks to lend in order to get voters onto the property ladder. The because the politicans had achieved growth without inflation, they thought they could “eliminate boom and bust” and encoruaged the banks and regulators to behave as if they had.

Certainly that’s what Gordon Brown thought as he, most egregiously, spent the tax-recipts from a booming economy, and borrowed even more, and spent in the assumption that his genius would keep the wheels turning, turning the most solid balance-sheet in the developed world into a social democratic Euro state with fat welfare and soggy competitiveness, like Germany (who in the mean-time was keeping interest rates up, and wages down, marching in the opposite direction).

Of course the .com bust in 2000 heralded the end, though it took 7 years for the ever lowering interest rates, which was the inevitable response to every piece of poor investment or GDP data, to lead to a crash, it is this that is responsible for the property boom, the government overspend and the catastophic finanacial crash. And this was made all the worse for because a system with a few large, systemically important institutions may appear easier to regulate, but is in fact more vulnerable to the storms.

The .com crash caused a recession that never happened as private sector investment dried up, to be replaced by government spending on war and diversity outreach co-ordinators. The boom continuing on Government spending and consumer debt. Debt that ultimately sat on banks’ balance-sheets either as “capital” – Government bonds, or as books of loans.

And because of the tight regulation, they were all carrying the same assets, in the same proportions according to the same risk metrics as each other, funded largely from wholesale markets. And when HSBC announced that a surprising number of its US mortgages were going bad in 2006 (about when “sub-prime” took on its current meaning), the writing was on the wall. Those books of loans propping up the system were not worth what people thought they were worth.

Financial markets are prone to panic. It is a chaotic system, and as such does not lend itself to regulation, especially if that regulation is based on volatility. Beta, in a crisis, tends towards 1. This means all financial assets, however diversified in normal times, crash toghether as everyone tries to unload them at the same time. It takes two views to make a market. Regulators, however insist on one view in a catastrophe, and often make things worse. Instead of attempting to remove risk by making entrepreneurs and risk-takers behave like civil servants (they won’t), better to let them face the consequences of their actions. Regulation should instead focus on making the system resilient to the inevitable storms. And that means smaller institutions, and more acceptance of differing approaches, the absolute opposite of 15 years of financial regulatory practice. Instead, every bank in the world tried to do the same thing at the same time and the finance system dried up.

No-one is suggesting NO regulation, but ultimately the best regulator is the market. Perhaps a bit more diversity in the system, and more but smaller institutions would be more resilient? The only thing I am sure of is what ever the answer may be, regulators do not have it. Unfortunately they think they do, and seek to impose the same solutions on everybody.

At present, my little corner of the industry is undergoing a bout of regulatory hyperactivity. The retail distribution review is busy setting out what can be sold to whom. Customers are being categorised by risk appetite. Those with low risk appetites are expected to invest almost entirely in Government bonds.

I am being made to sell Government bonds yielding 0% at the 2-year point guaranteeing a 3% annual loss to inflation because Government debt is RISK FREE. Of course we only believe that because we’re at the end (inevitably…) of a 30-year bull market. Just as the misselling scandals and credit crunches are a creature of the regulatory environment, I can see the howl of pain when interest rates start to go up again, from Governments paying the interest, and those investors whose “advisers” have  been forced to sell them shitty Government stock. I can see the misselling scandal on the horizon.

Retail financial regulation should be someone slapping customers with a fish, while shouting “CAVEAT EMPTOR” through a loudhailer. Macro-regulation should ask one question: “how fucked are we, if this bank goes bust?” If the answer is “very”, then break the bastard up, and say “NO!” When it tries to buy NatWest. Regulators should not try to run banks or investment portfolios. They should protect the investor from fraud, and the tax-payer from “too big to fail” and that’s it.

Instead, why are people still getting paid out on RBS bonds? Why does RBS even still exist to pay Hester his bonus? The only people who should have been bailed out, are the depositors, not the management caste. QE? Only benefits the banks, whose top executives are still being remunerated in bureaucratic style, according to headcount. The only guy to crash through the system and save his bank from the tax-payer in spite of the idiot regulator, was Bob Diamond, a hero and worth every penny of $20m. Yet he’s painted the villain!

Why not try a helicopter drop? defend depositors, smash investors in banks. Instead of supporting institutions which failed, why not support people? In every instance, the regulators favoured the tidy, mega-institution, rule-based status quo, when they should have let the market do its savage work. Markets encourage diversity and strength. Regulators create a monoculture, vulnerable to the first illness. 

Markets kill bad banks. Regulators prop them up. Here endeth the lesson.

Stella Creasy & The Loan Sharks

Let’s take a chap, me, who’s overspent in a month (on mandatory, regulator-imposed exam-fees, as it happens but also on a holiday for the bird, a bike for me and a really rather extravagent piss-up in which I lost all sense of proportion, and mistakenly let my ‘friends’ loose on a tab). The Fee from the bank to go over an overdraft limit: £25 plus additional fees of £5 PER DAY over 9 days, this would be nearly £70. by comparison, the cost of a £200 loan from Wonga.com for 9 days £23.74.

Stella Creasy can work out that the £23.74 fees & interest on a £200 loan is an APR of 481%. This she thinks is terribe. By comparison, if the payday lender were not there, the APR to the chap who’s overspent is 1,419%, which he would have no choice or ability to avoid. Yet again, the tighter regulation suggested by fucking morons drive people into the tender embrace of the banks who make an absolute killing. One may be paying an APR of 481%, but I’m saving £46.26. Of course the solution is to not go over your limits, but when you do, would you rather pay £23.74 or £70?
Regulation favours the banks, over insurgent competition. Again.

Update. I had a conversation on Twitter about this with the MP in question, who came accross as ill-informed and rather smug. OF COURSE, FINANCING YOUR LIFE USING WONGA IS STUPID. The assumption that this service is bad, and exploitative is made a-priori, without considering the costs of offering a £200 loan for 2 weeks for less than £30 to people who are, by definition struggling for money. Meanwhile Twitterer, @rfrst was trying in vain to make the point that 1% a day plus a fiver is a HUGE APR, which in no-way reflects the cost of borrowing. Wonga for exampe, don’t compound the interest, so APR is an absurd measure. I pointed out that other short-term lenders do not enjoy a big return on equity, so they’re not making abnormal profits. It’s true, a lot of money is spent on advertising. But that’s inevitable in a new sector with low barriers to entry.

All I got from the MP from Walthamstow was ad-hominem and a-priori statements not backed up by argument, logic, reason, or economic rationale. Worse, she refused to admit that limiting the cost of credit would affect supply. Finally, she seems to think credit unions are a solution. They are, to those on the carousel of debt, or who are looking to finance purchases more effectively than store credit. They are not a replacement for Payday loans, because the money isn’t instant, and so cannot be used to avoid bank debt.

Rather than going after the reputable, and reasonably well-known Wonga, it would be better to go after the less reputable lenders who do overcharge, make multiple claims against an account in a day. Better still, go after the banks, with whom APRs of over 1,000,000% are possible.

How Financial Regulation “Works”.

So, you’re a stockbroker, and you’ve been in the game now for over a decade. You’ve got some fairly serious book-learning under your belt, and have experience across a wide range of businesses including buy and sell-side analysis, sales-trading and futures trading. You’ve been at your current desk for 7 years, and you guided your clients through the crash with some success.

You’re not unqualified. The business is not unregulated. There was no systemic problem in the private-client stockbroking business.

However there was a crash. And lots of people lost money and are looking for someone to blame. The economy is stagnant (though this is mainly due to pre-crunch crowding-out coming home to roost). Everyone in the financial services industry without a regional accent and a job in a call-centre, is a “banker”, and so “a cause of the crisis”.

Something must be done“, said the politicians, without having the vaguest notion of what it was they wanted to achieve. So they asked the FSA to “do something”. So the drones of the FSA, who regulated the banks so successfully over the past decade, asked the Professional bodies like the ‘Chartered Institute of Investment Management’ and the like, whether further regulation of the investment advice industry was needed.

YES!” screamed the professional bodies. “All brokers need to be a member of Professional bodies [us]” they said with a straight face, “and they must all take lots of Exams [provided by us, for which we will charge many hundreds, knowing these people have no choice but to take them or lose their jobs]”

Anything else?” Asked the failed banker with a 2:2 in media relations from Hull, who was rejected by the investment banks he really wanted to work for, instead of the FSA.

Certainly. the brokers need to spend many hours logging their ‘continuous professional development’ on our system, so we can sign off their competence each year, by issuing an annual piece of paper called a ‘Statement of Professional Standing‘, but only if they take lots of courses [provided by us, for which we will overcharge]”.

That seems a lot of work” said the FSA-wallah, overcome with sympathy for the non-problematic part of the financial-services industry which forms his bailiwick “won’t that take them a lot of time they could spend blogging tending to their client’s needs?

No” lied the professional bodies. “This will improve the customer experience. All exams are good [even though we’re STILL teaching them the CAPM which is, put simply, bollocks]”.

The FSA-wallah reports back to the politicians that the regulation of investment advice is in hand. “This is something“, say the politicians. “Let’s do it“.

Thus financial regulation gets more onerous, time-consuming and expensive. Clients will see higher bills, and find it harder to speak to their broker as he will be doing his mandatory 35 hours of logged annual CPD or inputting it into his chosen Professional body’s computer system. It not being worthwhile to go through the process above for small clients, if you want advice, you’d better have serious wedge to invest, or you’re on your own.

If you want a perfect example of regulatory capture working against the interests of (especially less-wealthy people), this is it.

The Retail Distribution Review is the most counter-productive piece of legislation I’ve ever seen. It’s a Vicious, savage, bureaucratic, insane, corrupt over-reaction to a problem which doesn’t exist. It will virtually ban those on average earnings from receiving decent financial advice. They will be driven instead into the arms of the Banks who will sell them “products” whose performance is utterly opaque, larded with fees which will be virtually impossible to get out of. The banks will call this “advice”, but you will never see or hear from the hair-gel and bri-nylon school-leaver who sold you the “product”, ever again.

You think the Banks fear tighter regulation? No. They want it. They lobbied for it. They NEED it. Regulation protects them from the likes of me. Wicked.

Filthy Lucre

Of course, following the bust in 2000, over a decade of poor returns means those excitable investors who got into shares following ‘Big Bang’ and the privatisations, got burned and left. While share ownership is a bit broader than it was pre-1986, it is being seen as increasingly the preserve of the rich or institutions which manage pension funds. Companies are increasingly eschewing a listing on public markets, preferring to tap other sources of capital. The Economist is in no doubt as to why.

The burden of regulation has grown heavier for public companies since the collapse of Enron in 2001. Corporate chiefs complain that the combination of fussy regulators and demanding money managers makes it impossible to focus on long-term growth.

I’ve also seen the bleat from the left about companies like Boots being taken private. Suddenly the left is reaping what it sows. If you make it difficult to raise risk-capital on the stockmarket, you cause people to seek other, less onerous sources of capital. This means the returns available to the private equity industry (which haven’t been all that good) are not available to the private investor, or his pension fund. This benefits no-one except the caste of city/wall st. insiders.

In the name of equality, share transactions and dividends are taxed, further promoting debt finance over equity. Executive pay is being regulated, further weakening any incentive to go public. The left through rhetoric and regulation is destroying a means by which ordinary people can take control of their lives through investment.
It’s not just at the level of the company. In the name of protecting investors, regulations ensure it’s difficult to give advice, especially on small amounts of money. So the poor are vulnerable to the bucket-shop, leading to poor strategies and lost money even where there is not outright fraud. Private investors are encouraged by tip-sheets into wildly inappropriate stocks because their broker isn’t allowed to point them in the right direction. Banks are the most complained-about sector on the high-street. They are also absurdly tightly regulated, selling investment “products” larded with fees with opaque performance measurements designed to comply with regulation and keep the customer in the dark thereafter. If that same person wanted me to suggest a share for him to dabble in the stockmarket, I would be breaking the law. The bank can chuck his money into a crappy fund and forget about him drawing commission every year for doing so.
The greatest engine for investment has been broken, not by excessive risk-taking (that’s what the stockmarket is FOR) but by over regulation based around the foolish notion that a chaotic system can be rendered safe. What’s left is the kind of big, regulated utility which doesn’t offer the returns to attract the hot money (utilities) massive hype businesses whose owners want to cash out (glencore, facebook) or crappy aim-listed mining juniors whose shareholders are ultimately betting on the financial equivalent of three-legged bob in the 3:15 at Epsom. The rest are there out of habit, until they’re taken over or taken private.
Regan’s epithet about the Government’s view of the economy is aposite:

If it moves, tax it. If it still moves, regulate it. If it stops moving subsidise it.

Big business still needs the stockmarket. But only just, and not as much as you, me and your pension fund need it. The Government needs to let it breathe. This is how regulation makes us poorer without making us safer.

Stamp duty (our very own Tobin tax) needs to go. Restrictions on advice need to be softened. Taxes on dividends need to be cut. Share ownership is a means to the ownership of capital open to the masses and it needs to be encouraged, not tamed.

A Layman’s Guide to the Euro Crisis.

There is a lot in the news about the crisis in Europe, and a lot of the coverage is filtered through political lenses as people project their beliefs onto what’s going on. Eurosceptics are enjoying saying “I told you so!”. Left-wing parties are blaming the banks and the political right is seizing an opportunity to ‘shrink the state’. It’s often difficult to separate fact from journalistic wishful-thinking. So what’s really going on?

The EuroZone is a ‘currency union’ without a ‘fiscal union’. ‘Currency union’ means sharing the same currency. The 50 States of the USA are in a currency union with each other, and so are the nations of the UK. The EuroZone is a currency union between some European Union nations.

A ‘fiscal union’ is where a central government makes spending decisions for a currency area. Despite devolution in the UK or the American states’ tax and spending powers, the USA and UK are ‘fiscal unions’. The American Federal government distributes funds from a central pot to the individual states to spend on things, such as roads or law enforcement. In most fiscal unions, richer areas pay more tax, but don’t get more state spending per head than poorer areas, resulting in a ‘fiscal transfer’. Some ‘entitlements’, what people in the UK would call ‘benefits’ for example are paid out of a federal pot. In the UK, the greater South East subsidises the poorer areas of the UK by this method.

In the EuroZone, many thought this union would cause problems, and indeed the designers of the currency knew this too, but considered the problems would act as a driver of ever closer union, their ultimate end aim. The Euro was a political, not an economic construct.

What precipitated the crisis around Europe was the inability or unwillingness of Northern Europe to subsidise the periphery in the way London and the South East subsidises the rest of the UK. As the periphery ran out of money, and succumbed to financial crises, one-by-one the markets lost faith in the ability of these governments to meet their debts.

Governments issue debt as bonds. If investors think the risk is low, they will be willing to pay a high price, resulting in a low yield to the investor and low costs to the borrower. If the risk goes up, the price falls, and the yields rise. Countries afflicted by the financial crisis saw bond yields rise as investors sold. The money investors raised by selling this debt flooded into the good risks at the core – especially Germany, which has seen yields fall sharply as a result. The UK and Switzerland have enjoyed a similar effect, being perceived as safer-havens. This rapidly became a self perpetuating downward spiral for the bonds of the afflicted governments.

The problem with the Euro is that small countries or those which had poor track records of paying back debt, suddenly saw their borrowing costs fall when they joined the Euro. This is because the markets initially thought all EuroZone bonds ranked equal, or nearly so, to those of Germany. Because the peripheral governments’ borrowing costs fell, so too did those for business and consumers. This resulted in banks lending and people borrowing much more than they would otherwise have done. Some governments, notably Greece, fell into the same trap too.

In Ireland and Spain in particular, this very low interest rate resulted in a huge speculative property bubble as a flood of new money inflated property prices. People got rich very quickly, and numerous new developments were built. However all bubbles must burst, and the oversupply of property meant there was insufficient demand for all the new flats and houses. The market crashed. The bad loans secured on overvalued property created losses which overwhelmed the banking sector. The Irish government, despite the fact it had been ‘fiscally prudent’, by running large budget surpluses during the boom was also overwhelmed. In 2007, Irish debt was just 25 per cent of gross domestic product (GDP) – a measure of the size of an economy. Despite this, the Irish state, unlike that of the UK, simply didn’t have the line of credit to finance the enormous banking losses, and needed help from the EU and UK. Because of the banks’ losses assumed by the Irish state, debt to GDP ratio has now risen to nearly 100 per cent.

Portugal, however did not suffer such a crisis, as it lacked a big banking sector of its own, so much of its property bubble was financed from across the border in Spain. However the Portuguese government didn’t run significant surpluses in the good times, and when the economic crisis came, tax receipts fell, and the market lost confidence in the government’s ability to pay its debts. As the country was running a large deficit, when interest rates hit 7 per cent, a burden totaling 80 per cent of GDP, the market considered this unsustainable. The EU & International Monetary Fund was forced to ride to the rescue.

Spain, being a larger economy than Ireland, took much longer for the bubble to deflate. Its banks were also sounder, carrying more capital than Ireland’s. Like the Irish, the Spanish government ran a prudent surplus during the boom, but it too may now struggle to raise sufficient money to bailout its banking sector, which has suffered the same fate as Ireland’s. As a result, Spain needs a bailout. And the EU has made €100bn available. Because it is not clear whether this is from the European Financial Stabiliity Fund (EFSF) or European Stability Mechanism (ESM), existing holders of Spanish debt are unsure whether the new creditors are ahead of them in the queue for repayment. Investors fear they have been ‘subordinated’ by the new line of credit. As a result, after brief euphoria on the markets, borrowing costs in Spain and Italy rose on the news.

Italy did not have a property bubble, nor did it have a banking crisis. Instead, it enjoyed a cheerfully chaotic political system which was incapable of balancing its books. Short-lived governments had little incentive to save money, finding it easier to buy off supporters without taking long-term decisions. Their problem as a result is simply an enormous debt burden of 130 per cent of GDP. Currently, Italy is running a ‘primary surplus’, that is, it is able to meet its costs – public sector wages and so on, and would be able to balance its books, were it not for debt interest. Italy’s budget deficit is therefore a direct function of the yield on its bonds. Perversely, this is the moment countries are most likely to default, as they will not need to tap the bond-market to meet existing expenditures. As a result, investors have fled Italian debt in a self perpetuating downward spiral in their bonds and increasing the likelihood of default.

Greece’s problems can be summed up as ’all of the above’, and then some.

As a result, everyone in the EuroZone is seeing their borrowing costs rise, except the dwindling core of Northern European AAA rated countries. Even France isn’t safe – they haven’t had a balanced budget since the early 1970’s, and borrow at nearly twice the price of Germany.

The UK’s debt burden is 80 per cent of GDP or so (worse than Ireland in 2010), a deficit in 2010 of 11 per cent (the worst in the developed world) and an enormous banking sector relative to GDP. So why doesn’t the UK have a massive economic crisis like Ireland, Italy and Spain? Why is UK 10-year debt yielding a paltry 1.8 per cent when equivalently indebted countries with far smaller deficits find their debt yielding over 7 per cent? Ultimately, it’s because for the time being, the debt markets have confidence the UK can meet its obligations, if necessary by printing money. This option is not open to the EuroZone, who have subcontracted this to the European Central Bank. Furthermore, the UK’s government debt has a much longer maturity than many equivalent countries, so does not need to access the bond market to ’roll over’ maturing issues, giving the UK’s government time to bring the finances under control. Finally, and this is almost certainly the least important effect, the UK’s government is committed to gradually cutting the deficit.

The EuroZone therefore is suffering from the logic of a ’currency union’ without ‘fiscal union’. As the breakup of the EuroZone looks increasingly possible, bank depositors in Greece (most urgently), Portugal, Spain, and Italy do not want to risk waking up one morning to find they’re holding Drachma, Escudos, Peseta or Lira instead of Euros. So they open bank accounts in London, Geneva or elsewhere in currencies – Euros, Dollars, Swiss Francs or Sterling which they trust to remain ‘hard’, and where their cash-strapped governments can’t get at it.

This causes a collapse in the money supply – often a cause of deep recession. Unlike in a ’fiscal union’, this money is not replaced by transfers such a grants paid out of EU pooled funds, which are simply not large enough to do this job. As the economies of the EuroZone periphery shrink, so do tax revenues. With no corresponding shrinkage in obligations, the deficit can only rise. Spending cuts cause further short-term pain as public-sector workers get laid off, and the economy risks spiraling down. Wages, for those who retain jobs get cut and living standards fall. This is the mechanism by which ’austerity’ is accused of driving economies down.

Unfortunately, for the citizens of the EU, from an economic point of view this fall in living standards and wages is exactly what is needed. The underlying problem is competitiveness. Italian workers are just more expensive than Germans per unit of output. Italians’ wages have to fall by around 20 per cent to regain competitiveness, Spaniards by 30 per cent and Greeks by 50 per cent.

The Italian economy was never really as large as the UK’s, nor were Italians as rich as Germans. They just got access to Germany’s credit card for a decade and so thought they were. Bringing the economy back to reality will be a painful process. This is called an ’internal devaluation’. It will be miserable, and scar the people forced to endure it for life, and result in a flight of talent and capital, from places suffering its effects. An internal devaluation on the scale needed may not be possible without violence.

Devaluation of the currency means most countries overcome these effects, and make their exports and workers competitive. It’s worked for the UK many times, but for the periphery, this means leaving the Euro. A new Drachma would probably fall by 50 per cent almost immediately, achieving competitiveness with the German worker in a matter of months rather than years. This is no easy option though, either from the point of view of the Greeks who will see imports, even of staples become prohibitively expensive; or the rest of the EU. Once the market has forced one country out, the next one (Portugal or Spain) looks more likely to go too, creating a cycle of instability. It is this EuroZone policymakers fear the most.

If Southern Europe is to remain in the Euro, and yet avoid grinding recession for a decade or more sudden economic catastrophe, it is going to need vast injections of cash to pay the bills. It also needs its productivity and wealth to catch up with that of Germany and Northern Europe. For an idea of the scale of cash transfer needed, look at fiscal transfers from the North to the ex-Confederate states after the US civil war, or from West to East Germany after unification. 10-20 per cent of GDP. It is unlikely the (West) Germans can be persuaded to pay on that scale again. Nor do Germans seem willing to underwrite the deposits in EuroZone banks (a so-called banking union) or underwrite the bonds of the struggling EuroZone states (the so-called Eurobond).

People describing themselves as ’Keynesians’ think the death-spiral of austerity and internal devaluation can be averted by governments injecting demand into the economy by borrowing huge sums in order to spend. Who is going to lend to these peripheral governments? The German government seems unwilling to let the European Central Bank print enough money and the open market has already said “no”.

It is not a binary choice between ’growth’ and ‘austerity’. Even if these governments could raise the money, they may not achieve the necessary growth. There is evidence that the negative effects of increased public spending can cancel out any stimulus to the economy. Public debt often ‘crowds out’ private investment. High debt burdens may also cause people to anticipate future tax rises and rein in spending and increase their savings which will hurt the economy. These negative effects seem to become greater than the positive when the debt burden reaches 80 per cent of GDP, though this is not a hard and fast rule. Furthermore, economies seem to find any growth at all very difficult to achieve if public debt reaches 120 per cent of GDP. Thus, attempting to spend your way out of recession, an indebted Government risks fruitlessly adding to the debt burden, to no effect on overall GDP growth.

It seems the money for stimulus has probably already run out.

In my opinion, the best thing to have done is to not join the currency union in the first place! The UK’s ejection from the European Exchange Rate Mechanism in 1992 and Iceland’s experience since 2008 seem to bear this out. ’Austerity’ and the devaluation in place is painful, so ’stimulus’ is superficially attractive, but it risks creating a bigger problem for the future for little gain now. The unfortunate conclusion is what is necessary is impossible, and what is possible is unappealing. There are simply no easy answers. The Euro crisis is likely to form the backdrop to investment decision for some time to come.