Tuesday, 17 September 2013

The Right Type of Recovery

The doomsayers in the British media, having been unable to call the timing of the recovery in the UK, are venting their frustration on the type of recovery we are ‘enjoying’.  A short while ago these same experts were screaming that we were on the edge of a triple dip recession and they blamed risk adverse banks and frightened consumers, who were both rebuilding their reserves and savings.  In six short months we have metamorphosed from ‘triple dippers’ to the ‘northern tiger’– growing at a rate not seen since the 1990s.  In a typically display of British pessimism we have been unable to take this good news at face value and the icons of our ‘thoughtful media’ the BBC, the FT and The Telegraph all tell us that we are in having the ‘wrong type of recovery'!  These doomsters say that at some point, the bond markets will bite us in the backside and that, house prices will fall, the cost of borrowing will rise and we will be back in recession. The overall indebtedness of our economy is the thing that worries these media luminaries and the numbers are quite frightening - currently we owe 300% of our GDP.

Is private debt the problem it's cracked up to be?
Our indebtedness is split roughly into three equal parts– private debt, corporate debt and public debt.  The good news is that over the last three years corporate and private debts have fallen from 232% of GDP to 207% and this in a period when our economy has been shrinking in real terms.  We should expect this improvement in the private sector liquidity to continue at this gentle rate as Mark Carney believes that we have at least 2-3 years of low employment rates, low interest rates and low inflation to come.

Nobody can tell us what the supportable level of private sector debt is, and in any event it will depend on the level of interest rates.  It’s not easy to stress test an entire nation but it’s obvious that there would be a significant impact if rates were to rise from the current 0.5% to 5% or beyond.  This stress test will be easier to pass if debts are lowered and this seems quite likely in the near run.  If the economy grows at 2% annually over the next three years and the private sector continues to re-balance, at a similar rate to the last three years, our private debt ratio would be back to the same level as it was in 2003 or around 170% of GDP.  Clearly ‘if’ is a big word, but there are reasons to be confident that debt levels will continue to fall.

  • Firstly, the banks are still in the process of improving their liquidity and the new Basel 3 regulations will ensure that bank lending is still is short supply over the next few years.  
  • Secondly, bank lending secured at the height of the credit boom will be being paid off at an exponentially increased rate over the next few years as lending terms expire and inflation takes its toll. 
  • Thirdly, the middle classes have been scared by the events of 2008 and will take many years to rediscover the profligacy that was endemic prior to the credit crunch.  History tells us that it takes consumers at least ten years to move from bust to boom mentality – we are only 5 years down the track!

So we should be confident that debt levels and the ratio to GDP will continue to fall even when the government is tipping small amounts of credit into the housing market through the ‘Help to Buy’ scheme.  The Cassandra’s will ask the question – “if increased debt is not driving the recovery what is the magic ingredient that has made the difference” – what are the other factors that could have sprung us from the liquidity trap that had us so tightly pinned down earlier this year?  Well, there are a couple of important things going on that have made a big difference:  The first of these is that we have been on the receiving end of huge capital inflows, these flows have come from emerging markets that are in a panic induced by the thought of higher long-term interest rates, a by-product of the Fed’s QE tapering.  These in-flows have provided the much needed liquidity that the UK economy.  The UK has benefited because we are out of the Eurozone and the Pound is better value than the US Dollar.
The second reason for our unexpected recovery is related to our flexible labour market.  During the credit crunch companies in the UK were able to cut costs by reducing pay without losing staff.  Bonuses were cut, salary increase were banned, over time was restricted, commission weren’t paid and zero hour contracts were implemented.  After three years of declining wages public sector companies have started to add back the flexible element of staff pay, this feeds through to the real economy very quickly.  I expect that we will see a big jump in take home pay this year when the numbers are out.  It is this extra cash that is driving consumer spending not increased borrowing.  The official figures only measure basic pay so much of the earning increases are unaccounted for.  Recent figures show basic pay, excluding bonuses, in the private sector pay was up 1.2pc rose May and July.  Actual income is rising much faster, and for the first time in a while, faster than inflation.  Importantly this extra cash is going to families who have the propensity to spend significantly – families and the working middle classes.
The third reason for the recovery has been the rise in employment since 2010 the British economy has created over 1.3 million private sector jobs and overall employment hit another record this quarter with 29.84m in work.  Despite the fact that productivity is still very low employment is now up 275,000 on a year ago.  More families have two wage earners, more young people are living at home and this is driving up household disposable income.  As increase demand flows through to our economy productivity should rise and disposable incomes will move in the right direction - a virtuous circle. The firm evidence for some of this good news is still in the pipeline but we can expect to get data in the near future that confirms our recovery is indeed the right type of recovery – fueled by affordable consumer spending and improved productivity.

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