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The UK is in a liquidity trap - say no to more QE on planet ZIRP

Last week, the Governor of the Bank of England said This is the most serious financial crisis we have seen since the 1930s, if not ever. Well is it? Just like the 1930s the UK is in what we call a liquidity trap, a situation where monetary policy is unable to stimulate the economy either through lowering of interest rates or increasing money supply.   

Liquidity traps occur when rates are reduced to the zero bound or thereabouts and cannot be reduced further. In real terms UK rates (base rate minus inflation) are negative 4% plus.

The liquidity trap is compounded when expectations of adverse events, either deflation or in the current situation, a lack of aggregate demand, are manifest. Firms are loathe to invest, households are constrained to spend, government spending is limited by a desire to resolve a fiscal debt crisis.

In the UK, the first round of Quantatitive Easing or asset purchases was essential to improve liquidity in the banking system at a time of crisis. 

Inter bank lending was dessicated, LIBOR spreads were extending. The central bank was becoming not just the last lendor of resort but the only lender of resort. Action had to be taken to inject cash into the economy by undertaking a series of asset purchases predominantly gilts. The programme of some £200 billion was equal to 14% of GDP it had to be done.

This is not an argument for more asset purchases, for the exercise came at a price. QE forces up bond prices, pushes yields lower, punishes savers, places more pressure on sterling, increases import prices, leads to higher inflation, greater pressure on real incomes, a reduction in household spending, actually reduces demand and leads to lower growth.

Ten year gilt yields have fallen to 2.4% and thirty year gilt yields have fallen to 3.4%. But what does that mean? Gilts are mis priced, the real risk return on ten year gilts is negative. Effectively investors are paying the government to hold bonds.

Policy makers assume that lower interest rates at the longer end of the curve will lead to a higher level of investment. This is not the case. Any return on investment or payback calculation is a function of cash flows from a determined demand horizon. 

Cost of capital does not feature in the basic investment model. Until the uncertainty about the forward level of demand and growth is cleared, investment plans will remain on the shelf. 

The Bank of England suggests that QE increased GDP by between 1.5% - 2.0% but also led to an increase in inflation of between 0.75% and 1.5%. [Joyce M et al in the September Bank of England Quarterly Bulletin.] This is a highly speculative analysis.

If it were right, this would mean, that at best, the QE2 round of £75 billion would kick growth by just over 0.5% but increase inflation by over 1% on a pro rata basis according to the banks own figures.

One cannot be entirely confident in the bank’s hypothesis. QE led to a fall in gilt yields as a first round effect but thereafter the relationship between QE and the effect on growth and inflation is tenuous. The argument for further QE is intellectually weak and at best the potential economic impact minimal. The risks outweigh the return.

In fact I would argue that a further round of asset purchases merely oils the liquidity trap, digging a deeper hole, increasing the inflationary impact and reducing growth as investment plans are reigned back and household incomes are placed under greater strain. Sometimes the correct action is to do nothing, especially when it is more of the same toxic solution.

In 2008, writing about a zero interest rate policy, I wrote “Welcome to planet ZIRP. Unfortunately, we do not have a handbook, or fully understand the terrain. Our process of quantatitive easing, the plan to helicopter money may work but as a fire fighting option, it may be like dropping water into a desert, such are the fissures in the financial system." We just don’t really know what is achieved. So in the meantime we should say no to more QE and or asset purchases.

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Why more QE is the wrong policy option for the UK ...

The UK is in a liquidity trap, a situation where monetary policy is unable to stimulate the economy either through lowering of interest rates or increasing money supply.  Liquidity traps occur when rates are reduced to the zero bound or thereabouts and cannot be reduced further. In real terms UK rates (base rate minus inflation) are negative 4%.

The liquidity trap is compounded when expectations of adverse events, either deflation or in the current situation, a lack of aggregate demand, are manifest. Firms are loathe to invest, households are constrained to spend, government spending is limited by a desire to resolve the debt crisis. 

The first round of Quantatitive Easing was essential to improve liquidity in the banking system at a time of crisis. Inter bank lending was dessicated, LIBOR spreads were extending. The central bank was becoming not just the last lendor of resort but the only lender of resort. Action had to be taken to inject cash into the economy by undertaking a series of asset purchases predominantly gilts. The programme of some £200 billion almost 14% of GDP had to be done.

This is not an argument for more asset purchases, for the exercise came at a price. QE forces up bond prices, pushes yields lower, punishes savers, places more pressure on sterling, increases import prices, leads to higher inflation, greater pressure on real incomes, a reduction in household spending, reduces demand and leads to lower growth.

Ten year gilt yields have fallen to 2.4% and thirty year gilt yields have fallen to 3.5%. Policy makers assume that lower interest rates at the longer end of the curve will lead to a higher level of investment. This is not the case. Any return on investment or payback calculation is a function of cash flows from a determined demand horizon. Cost of capital does not feature in the basic model. Until the uncertainty about the forward level of demand and growth is cleared, investment plans will remain on the shelf. 

In 2008, I wrote :  Welcome to planet ZIRP. Unfortunately, we do not have a handbook, or fully understand the terrain. Our process of quantative easing, the plan to helicopter money may work but as a fire fighting option, it may be like dropping water into a desert, such are the fissures in the financial system."

In 2004 a Bernanke paper  “Monetary Policy Alternatives at the zero bound” concluded :

“Despite our evidence that alternative policy measures [QE} have some effect, we remain cautious about relying on such approaches. We believe that our findings go some way to refuting the strong hypothesis that nonstandard policy actions, including quantitative easing and targeted asset purchases, cannot be successful in a modern industrial economy.  The effects of such policies remain quantitatively quite uncertain”.

The Bank of England suggests that QE increased GDP by between 1.5% - 2.0% but also led to an increase in inflation of between 0.75% and 1.5%. Joyce M et al in the September Bank of England Quarterly Bulletin.

A QE2 round of £50 billion would kick growth by just 0.4% and inflation by over 1% on a pro rata basis according to the banks own figures.

One cannot be entirely confident in the bank’s hypothesis. QE led to a fall in gilt yields as a first round effect but thereafter the relationship betwen QE and the effect on growth and inflation is tenuous. The argument for further QE is intellectually weak and at best the potential economic impact minimal. The risks outweigh the return.

In fact we would argue that a further round of asset purchases would merely oil the liquidity trap, digging a deeper hole, increasing the inflationary impact and reducing growth as investment plans are reigned back and household incomes are placed under greater strain. Sometimes the correct action is to do nothing, especially when it is more of the same toxic solution. 

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The views expressed are my own and in no way reflect pro.manchester policy. In no way should the comments be considered as investment advice or guidelines or reflect political bias. UK Economics news and analysis : no politics, no dogma, no polemics, just facts. JKA is a visiting professor at MMU Business School, an economist and specialist in Corporate Strategy, educated at LSE, London Business School with a PhD from Manchester Metropolitan University.

 

UK Economics : Is the march of the makers, a case of lions led by donkeys?

"Lions led by donkeys" is a phrase used to describe the British Infantry of the First World War and to condemn the generals who commanded them. The contention is that brave soldiers (lions) were sent to their deaths by incompetent and indifferent leaders (donkeys).

"The English Generals are wanting in strategy. We should have no chance if they possessed as much science as their officers and men had of courage and bravery. They are lions led by donkeys." According to the German Command Headquarters.

Strategy in business and in war is key. Which battles at which time, with what resource. SWOT profiling, constant benchmarking is key to success. Understanding this makes it more difficult to understand the present coalition strategy in expecting so much of the manufacturing sector and denying the contribution of the business, financial and professional services sector, especially banking,  to the British Economy

The march of the makers, rebuilding the workshop of the world to finance the big society is  a battlefield folly. The march is faltering, the trade deficit continues to expand. The analysis of forty years of UK trade amply demonstrates the UK needs a strong service sector to finance the trade in goods deficit.

According to a recent paper by Yiping Huang and Bijun Wang, 2011 China’s manufacturing sector accounts for 41% of output compared to just 12% in the UK. With a world average of 13% China’s relative share is 3.2 compared to the UK’s 0.9. That’s tough competition.

China’s revealed comparative advantage for manufactures is 1.13 compared to the UK’s 0.79. A larger competitor, tough competition, with a significantly higher competitive advantage will provide a difficult challenge.

In financial services, the reverse is true, China’s revealed competitive advantage is 0.03, compared to the UK’s 3.01. The world average is just 0.5. The UK is the strongest player in the world of exports in financial services with the highest revealed comparative advantage. So why not promote and support the sector instead of suggesting an evil imbalance exists within the economy?

Why place so much hope in an ill equipped manufacturing sector in trend decline long before Gandhi promoted homespun? The renaissance just will not happen. Play to your strengths may sound facile in terms of strategy but it should be something even donkeys can grasp.

Notes
The revealed comparative advantage was first proposed by Balassa (1965).The comparative advantage of a country's industry could be revealed by the ratio of the share of an export sector's exports in total exports to that share  for the world. Balasa, Bela 1965 Trade Liberalisation and revealed comparative advantage" Manchester School of Economic and Social Studies Bulletin Vol 33 No 2 pp 99 - 117

Yiping Huang, Bijun Wang Chinese Outward Investment: Is there a China Model. China & World Economy Volume 19 No 4 Jul - Aug 2011

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The views expressed are my own and in no way reflect pro.manchester policy. In no way should the comments be considered as investment advice or guidelines or reflect political bias. UK Economics news and analysis : no politics, no dogma, no polemics, just facts. JKA is a visiting professor at MMU Business School, an economist and specialist in Corporate Strategy, educated at LSE, London Business School with a PhD from Manchester Metropolitan University.

China's Foreign Direct Investment : which way does the Renminbi river flow?

Which way does the Renminbi river flow, is it east or west?  An analysis from US based heritage.org into China’s global foreign direct investment between 2005 and 2008 provides interesting reading.   

We have long argued China’s FDI is determined by three issues, access to markets (ATM), access to technology (ATT) and access to resource (ATR). By far and way the greatest determinant is access to resource. 

Consider that Australia is the largest single country destination for China’s direct investment according to heritage.org using data from a report first by Scissors [2011]*. Investment is valued at $34 billion and 15% of the total, according to the data.

This investment could be motivated by the market of some 23 million people (ATM) , or possible access to technology (ATT) represented by boomerang flight dynamics perhaps. Far more likely is access Australia’s thriving resources sector particularly minerals and petroleum. Australian coal, liquefied natural gas, iron ore, copper, diamonds, zinc and many other minerals provide the essential incentives for the FDI direction. In 2006–07, over 80 per cent of Australian output was exported, accounting for approximately 49 per cent of total goods and services exports.

Nigeria, Iran, Brazil, Kazakhstan, Canada, Indonesia, Algeria and Venezuela all rank above Britain in the foreign investment rankings. China invests almost twice as much in Nigeria as it does in the UK mainland. Unless copper deposits in Cornwall or zinc in the lakes are discovered, the UK will remain outside of the top ten destinations for Chinese investment.

China is the second largest economy in the world growing at 9% per annum. With a population of 1.3 billion it struggles into the world top 100 in GDP per capita parameter. With $3.2 trillion of reserves, it has the financial resource to lock up the finite resource of world commodities and continues to do so at a vast rate. Almosty eight per cent of investment is into the food, energy and metals sectors.

The challenge for the growing China economy is to secure resource. It is acquiring and developing the technology. It already has the market, the export growth model abandoned post 2008 in favour of domestic expansion. Europe and the West may yet pay for the occupation of Peking. The price is lower growth and higher inflation as demand for resources grows in the East at the expense of the West. 

So which way does the Renminbi flow? The renminbi flows East, West, North and South but the resources flow back just one way. JKA 2011

Scissors Derek, 2011 China's Investment overseas in 2010 Heritage Foundation.

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The views expressed are my own and in no way reflect pro.manchester policy. In no way should the comments be considered as investment advice or guidelines or reflect political bias. UK Economics news and analysis : no politics, no dogma, no polemics, just facts. JKA is a visiting professor at MMU Business School, an economist and specialist in Corporate Strategy, educated at LSE, London Business School with a PhD from Manchester Metropolitan University.

UK unemployment data : Is the UK heading back into recession?

This week has been a horrible weak for economic news, retail sales are flat, inflation CPI basis has risen to 4.4% and the minutes of the MPC meeting in August reveal the doves are back in the coop with no one voting for an increase in base rates.

Worse still the unemployment figures were revealed on Wednesday. The claimant count increased by 37,000 to a level of 1.564 million. This is the largest monthly rise since April 2009 and matches the level of August 2008, the beginning of the dreadful recession. 

Last month the claimant count increased by 31,000 but unemployment LFS basis actually fell allowing some to dismiss the alarm signal as noise, “recording different things at different times”.

The latest release allows for no confusion in the message. Unemployment LFS basis in the three months to June increased to 2.494 million from the 2.455 million in the three months to March.

Employment in the three months to June increased by 220,000 but at a much slower rate than earlier in the year. 

The claimant count gives cause for greater alarm. The unemployment measure provides a valuable signal as a coincident indicator to trends in GDP. As the chart demonstrates, inverting the claimant count and lagging by one quarter provides a high correlation and signal of trend.

If the claimant count increases at a similar rate over the third quarter, the message is clear, growth is off track, the recovery is slipping away and the UK is heading back into recession.

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The views expressed are my own and in no way reflect pro.manchester policy. In no way should the comments be considered as investment advice or guidelines or reflect political bias. UK Economics news and analysis : no politics, no dogma, no polemics, just facts. JKA is a visiting professor at MMU Business School, an economist and specialist in Corporate Strategy, educated at LSE, London Business School with a PhD from Manchester Metropolitan University.

Strategic Management Guidelines : Top Management tools from Bain and Co.

I like Bain & Company, I had the chance to work with them as a client for several years in the 1980s. As one of the world’s leading business consulting firms they publish an annual review of top management tools. The latest report is out now.

Since launching the first survey of Management Tools & Trends in 1993, Bain and Company have tracked executive attitudes and behaviors through a wide range of economic cycles. In the current cycle, there is a profound fear the world has deteriorated forever. Executives are concerned the consumer spending levels won’t bounce back to pre recession levels anytime soon and revenue growth is the main challenge given the low growth economic environment.

The phase of cost containment, cost reduction, downsizing and outsourcing appears to be over with executives well prepared for the challenge of securing top line growth. For those who have survived the downturn, company positions have been strengthened and the future appears to be brighter.

Almost two thirds of executives believe they are emerging from the recession in a stronger competitive position with a greater emphasis on growth particularly overseas growth and international expansion.

Nearly all executives believe innovation is vital to their company’s success but few feel they have learned to harness its power effectively. Many executives have serious concerns about how their organizations gather customer insights and manage decision making. Many are beginning to experiment with social media.

Looking at the top ten chart, benchmarking remains in the top slot for 2008 and 2010. The guideline, find any metric and model it, whether balance sheet, profit and loss account, market share, segmentation, KSFs, key success factors, name that metric, manage and model it.

Strategic planning appears in second slot, having written up the Apple Case study from the iPod to the iPad as a classic example of strategic management, it is good to see the old favourites still in fashion. Most strat man is still locked in conventional 2D profile but borrowing techniques from the structural engineers, we have developed 5D models for strategic management which are very exciting.

Mission and value statements appear in the third slot. Some people are cynical about M and Vs but they are essential in committing any team or organisation to a common goal. Drafting is key. JFK’s call to action to “put a man on the moon”, was headlining but would have provided more comfort to families had it included something about “getting him back”.

CRM appears fourth in the list which is concerning when many executives struggle with how the process is managed. Outsourcing and supply syndication remain high on the list. The lessons from Apple so appropriate.

The balanced scorecard, from Kaplan and Norton, I never really understood to be other than an extension of benchmarking with a wider checklist. Segmentation appears at number ten. Far too low, it should be at the heard of any market profiling and strategic planning process.

Total quality management number three in the list in 1993 has slipped out of the top ten list altogether. So much for 6 sigma and the pioneering work of Deming and Juran. I well remember them all.

For those who want a quick collection of buzz words, the Bain Management Tools publication is a quick guide. For those who want to understand the key levers in strategic management it is an essential handbook. JKA

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The views expressed are my own and in no way reflect pro.manchester policy. In no way should the comments be considered as investment advice or guidelines or reflect political bias. UK Economics news and analysis : no politics, no dogma, no polemics, just facts. JKA is a visiting professor at MMU Business School, an economist and specialist in Corporate Strategy, educated at LSE, London Business School with a PhD from Manchester Metropolitan University.

UK GDP - if the recovery is on track, I am on the wrong train!

On track delivering the growth plan to rebalance the economy. I have just been watching the Faisal Islam interview with the Chancellor of the Exchequer and everything is OK. The economy is rebalancing, the supply side is improving, the Chancellor is not for turning because there is no alternative. The borrowing figures are on track and growth in the British Economy is welcome.

If this recovery is on track, then I am on the wrong train. Growth in the second quarter was just 0.8% year on year compared to 2.5% in the third quarter of 2010. The economy is slowing and it is difficult to see the impetus to growth in the second half of the year. Slow growth is already impacting on government borrowing and the targets for the year will not be achieved.

The UK economy has grown by just 0.2 per cent (quarter on quarter), with the Japanese tsunami, Royal Wedding, and April bank holidays all having an impact, according to the ONS.

“The latest gross domestic product figures for the second quarter of 2011 suggest the economy has grown by just 0.2 per cent following an increase of 0.5 per cent in the first quarter of 2011. The April bank holidays, the royal wedding, and the effects of the Japanese tsunami, all had an impact on the growth rate. These estimates are broad brush and illustrative. There can be no certainty as to the impact of the special events and there may be other factors at play," the ONS said.

The ONS is beginning to sound like a beleaguered sales team under pressure to hit targets. Too hot, too cold, too wet, too dry, Christmas too early, Easter too late. Missed sales targets that’s our fate, the old mantra.

According to the ONS in Q4 there was too much snow, in January not enough snow, April was too warm and the bank holidays and the Royal Wedding hit the growth figures in the second quarter. Heaven knows what would have happened to GDP if it had snowed on the day of the Royal Wedding.

The march of the makers, rebuilding the workshop of the world, is beginning to slow with manufacturing growth up by 2.3% compared to a high of nearly 5% last year. Service sector growth was just 1.2%. We are no longer a nation of shopkeepers, we will become a nation of online traders. This recovery is not on track, it is slowing badly. The economy is not rebalancing, it’s slowing down.

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The views expressed are my own and in no way reflect pro.manchester policy. In no way should the comments be considered as investment advice or guidelines or reflect political bias. UK Economics news and analysis : no politics, no dogma, no polemics, just facts. JKA is a visiting professor at MMU Business School, an economist and specialist in Corporate Strategy, educated at LSE, London Business School with a PhD from Manchester Metropolitan University.

UK retail Sales June - slow death on the high street

The ONS released the sales figures for June on Thursday, retail values were up by 4% compared to June last year but underlying volumes were up by 0.4%. For the second quarter sales were flat at 0.3%. No wonder the sales signs are out all over the high street. A combination of high inflation, the VAT rise, real income falls, higher energy, utility bills and food costs are hitting consumers and retailers badly. 

Household goods store volumes were down by 3.7% but non store retail sales particularly on line internet sales were up by 24%. Retail is facing a “disruptive” challenge from the swing to more “clicks than bricks” in consumer buying patterns. Internet retail sales volumes accounted 9.9% of all transactions compared to 6.8% in June last year. 

What is happening to food retailing? Volumes were down by over 4.2% in the month (See inset). This has been a trend over the last two years. Either we are becoming a nation of slimmers are a greater and greater proportion of conventional food retailing is moving on line.

In the second half of the year, it is difficult to see why retail fortunes should change. It’s tough on the high street and it looks like this could continue for the rest of the year. Christmas cannot come early enough. For many, it will be too late.

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The views expressed are my own and in no way reflect pro.manchester policy. In no way should the comments be considered as investment advice or guidelines or reflect political bias. UK Economics news and analysis : no politics, no dogma, no polemics, just facts. JKA is a visiting professor at MMU Business School, an economist and specialist in Corporate Strategy, educated at LSE, London Business School with a PhD from Manchester Metropolitan University.

Public Sector Borrowing in June - are we heading back to the brink of bankruptcy?

Public Sector Finance figures for June were released on Thursday, borrowing was actually up compared to June last year, are we heading back to the brink of bankruptcy? The Chancellor of the Exchequer was keen to herald the austerity measures as a move back from the brink of bankruptcy following the Labour profligate years. But are the figures really moving in the right direction? 

In the first three months of the year, borrowing was down by just £0.4 billion from £39.5 billion to £39.2billion. Extrapolate this for the year and the borrowing forecast would struggle to drop below £140 billion for the financial year. This would equate to 9% of GDP and well above the OBR forecast for the year.

 

The problem is that despite the austerity measures, total receipts have increased by  4.6% but spending over the first three months of the year has increased by 3.4%. The interest bill in the first quarter is up by 14% and social security payments are up by nearly 5%. Reducing spending in a low growth economy presents significant difficulty.

 

Revenues present a mixed picture. Mugging the high street with the VAT rise has yielded spectacular results with receipts up by 17% in the first three months adding £4 billion into the coffers. VAT receipts could contribute an additional £20 billion in a full year if the rate of gain continues. Income and capital gains receipts on the other hand are up by less than 2% at 0.5 billion and taxes on production are up by less than 3% at £1.4 billion,

 

At first glance the figures are a Keynesian delight. Rebalancing the economy by cutting spending and increasing taxes will result in low growth economy with resilient spending and sluggish revenues. It is difficult to balance the books when breaking the backbone of recovery. 

 

The Office for budget responsibility offers some hope by pointing out that revenues last year included £3.5 billion from the bank payroll tax which was not repeated last year. If this element is excluded revenues are up by 8% and “close to our full year forecast”. Sounds better but the BPT is not a surprise item and hardly a credible apologia.

 

Next week the GDP estimates for the second quarter will be released. They will make dismal reading with growth year on year likely to be less than 1%. The economy is slowing, the public finances are not recovering as planned, essential imports continue, there is no net export growth, no march of the makers, no rebalancing of the economy, we are a few steps further away from the brink of bankruptcy but the precipice is still in sight. 

 

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The views expressed are my own and in no way reflect pro.manchester policy. In no way should the comments be considered as investment advice or guidelines or reflect political bias. UK Economics news and analysis : no politics, no dogma, no polemics, just facts. JKA is a visiting professor at MMU Business School, an economist and specialist in Corporate Strategy, educated at LSE, London Business School with a PhD from Manchester Metropolitan University.