Living beyond our means

“Our enemies are innovative and resourceful, and so are we. They never stop thinking about new ways to harm our country and our people, and neither do we.” – George W. Bush, August 5 2004.


*Please note: there are a number of graphs in this article. Readers are encouraged to download the full, graphically enabled PDF piece, below.*

“What have we done with two decades of prosperity ?” asked Mark Pragnell of the Centre for Economics and Business Research at a recent Citywire seminar. Good question. His rhetorical remark relates specifically to the UK, but many of the conclusions have commonalities in the US economy too. UK citizens have – until recently, at least - enjoyed the lowest cost of living increases on record (the contributing factors are highlighted in yellow):

 

..with monetary conditions (the volatility of Bank of England policy rates, or rather the lack of such volatility) offering unprecedented financial stability; the number of employed has risen to over 25 million; and average earnings have grown with impressive strength, with annual growth in average earnings, according to the Office for National Statistics and the CEBR, oscillating around the +4% level since 1993. Which is where the good news starts to dry up. Other trends have been more ominous; symptomatic, perhaps, of a gathering economic storm. Household spending has been paid for by abandoning savings (US householders will be well acquainted with the principle of using the home as an ATM machine):

 

Manufacturing industry has been hollowed out, with annual growth in investment showing an alarming negative long-term trend:

 

As Mark also points out, the UK has seen a growing number of either “can’t work” or “won’t work” potential employees (the ONS refers to them, more diplomatically, as “working age economically inactive”), from under 7 million in 1972 to just under 8 million in 2007. An awkward statistical companion is that those with jobs have seen recent falls in hours worked. Without foreign migrants, getting plumbing or housework done in recent years might have been impossible. Of the 2.9 million extra “jobs” created in the UK in the ten years from 1996, half have been in the public sector:

 

And note that two thirds of the “jobs” created by the public sector have disappeared from manufacturing. There has been significant growth in red tape and taxation (Mark cites figures from BBC News and LexisNexis: the number of pages in Tolley’s Yellow Tax Handbook has risen from 6,000 in 2001 to almost 10,000 in 2007; the 2007-8 edition required a smaller font size to make it into print). Welcome, says Mark, to the “something for nothing society” where citizens expect or want:

 

• A family and the right to stay at home to bring them up
• Flexible working hours and a shorter working week
• A decently funded National Health Service and state education system
• A decent wage
• A pension and a comfortable retirement
• The state to pay for it all.

 

Mark’s carefully worded conclusion: the long term challenge is making Britain competitive after two decades of living beyond our means.

 

There is a broader problem. The financial sector, including commercial banks and investment banks, and more recently including members of the so-called “shadow banking sector” such as hedge funds and structured investment vehicles, has grown comparably fat, stupid and lazy after decades of access to easy credit and leverage. Instead of adding value, financiers have simply taken to trading financial assets, sprinkling “innovation” (not least, securitisation) upon them, and hawking them around, irrespective of suitability, morality, or “know your client” concerns. Thanks to the implosion of the US residential property market, that game is now up – though not everybody appears to have recognized the fact, judging from some of the recent rallies by stock markets on otherwise terrible news from the banking sector.

 

Here are the inconvenient truths for the bulls:

 

• 70% of US GDP is accounted for by consumer spending
• The US consumer – the “spender of last resort” – will be unable to maintain historic spending levels when the prices of residential housing are falling at their fastest level in at least 40 years: Anglo-Saxon consumers are going to have to rediscover the lost art of saving. For more, anecdotally, on the apparent self-interested desperation of US homeowners, see the Wall Street Journal story from 2^nd April, “Some homeowners leave pets behind in foreclosure”
• Ongoing credit contraction and banking writedowns can and will have only one effect on western economies, and it cannot logically be positive
• Further capital support for the banking system may have to come from the taxpayer, which carries stark implications for already imperilled government finances. Assuming it does not come from existing shareholders, those shareholders remain in danger of being diluted painfully or fatally in the event of longer-lasting widespread deleveraging.

 

As James Ferguson of Pali International points out, the equity market downtrend “has been littered with sharp, double-digit, contra-trend short squeezes”. The chart below shows the recent downtrend of the US S&P 500, but it could just as easily be showing the FTSE 100 or Japan’s Topix (or China).

 

In short, one day’s rally does not a bull market make. Whether the S&P 500 – or other key indices – make technical breakouts from their range, or not (we have to respect the price action, but it may be wholly irrational and therefore unsustainable longer term), the bulls will still have to justify how western economies can withstand widespread weakness in residential property prices, a related slowdown in consumer expenditure, an ongoing liquidity and solvency crisis amongst undercapitalised banks, and more general fears relating to a possible sea change in the macro-economic environment. To return to and paraphrase Mark Pragnell’s earlier thesis, the long term challenge is making banks relevant after two decades of living beyond their means. If the age of easy credit is indeed dead, what might possibly replace it ? For many, though not all, “smart” financiers, hedge fund managers (particularly in leveraged credit strategies), private equity players (again, hitherto using easy leverage as a replacement for more difficult decisions) and associated capital markets flotsam and jetsam long used to the zero sum trading of paper rather than generating real and sustainable economic value, the future may involve having to do some real work for a living. For all investors, a degree of expectations management may be in order. The 1982-2000 period (and the period of ultra-easy interest rates that followed, combined with a huge buildup of imprudent leverage and property-related speculation) looks like being a huge anomaly in market history. Perhaps the rational response to current conditions – it certainly has been for the last twelve months - would be to refocus on capital preservation and worry a little less about what to do with all those wondrous anticipated investment profits.

Download living_beyond_our_means.pdf

Comments

[Jean-Marc]

'Something for nothing' is a trend within sections of the population, but for thousands of those with nothing they're only looking for at least the 'something'.
The con of 'flexible work' has left many people completely at sea. It might be beneficial to gap year students and cocky young professionals, but when you're simply hoping to wake up and know you don't have to go job hunting on a weekly/bi-weekly basis, it is a nightmare.
People see crooked brokers getting rich and wonder why they have to pay more for food. Under these circumstances the 'Something For Nothing thesis is a joke.

[tim price]

I think you're conflating two wholly separate trends. Yes, the younger generation in the UK has been mis-sold lifestyle flexibility by a socialist government that says that all shall have prizes. 50% in higher education ? Please. And at the same time there are undoubtedly crooked brokers out there. Not that I make any defence of venal behaviour, but it takes two to tango. Greedy brokers implies greedy (or gullible and stupid) clients. Both will, with any natural justice, get washed out of the system. The nature of the Fed and central banking "liquidity support" suggests, though, that greed will get plenty of second chances. Not a pleasant outcome for anybody - least of all taxpayers.