Uncharted Territory

October 31, 2009

“Carbonomics” Critique, Part 1

I began reading “Carbonomics” by Steven Stoft late yesterday. I’m only just starting Chapter 3 (of 31) but I can already reach a conclusion.

My very first impression was that “Carbonomics” brings some logical thinking to the debate. I see no reason to change my view: there is no doubt a lot of good material in the book.

But within minutes I could see that Stoft’s overall prescription, sadly, is in dreamland.

I’m posting my initial thoughts immediately whilst I am still in a state of shock.

The history of thought is littered with discarded, but complex and sophisticated, bodies of knowledge, from scientific theories – the Ptolemaic universe perhaps, to political programmes – communism, for example; indeed more than bodies of knowledge, entire institutions, even civilisations, all built on foundations that later proved to be constructed of no more than intellectual straw.

Some of the foundations of “Carbonomics” consist of no more than straw.

I am indeed stunned. I started reading and first came across some encouraging comments in the Preface (a chapter which should never be skipped). The author notes the inefficiency of current policies to improve energy security and global warming and promises to “fix energy policy”. He will be guided by the story of physics, and produce Mr Tompkins in Wonderland for economics. “The hardest part of learning new ideas is giving up misconceptions”, he writes.

I must admit that by this point I was already starting to feel a little uneasy. I don’t, for example, believe that “physicists have a tradition of explaining advanced ideas to the public just because they find the concepts fascinating.” No, they do it to try to prove how clever they are (except for a small number who simply have Asperger’s syndrome). And, given that their belief system doesn’t hang together (relativity and quantum physics are as yet unreconciled) they hope that the more positive feedback – or pats on the back – they can extract from their audience, the truer what they have told them will become. Stoft notes that Einstein “found the uncertainty of quantum mechanics… so disconcerting that he never accepted it”. Quite right. Einstein was a holistic thinker. That was his genius. All the facts had to be taken into account, however alien a theory eventually resulted. He understood that all may not be as it seems, but he could not accept contradictions into his world view, even if others could live with them. So in asserting that “God does not play dice”, Einstein was not being a stick in the mud, but demonstrating he was on the side of the good guys. Even if he didn’t have the whole answer, at least he knew there was a question.

I labour the point because it soon became apparent that Stoft’s thinking is not sufficiently rigorous. He is not prepared to accept inconvenient truths.

It’s a shame, because Stoft starts so well with an excellent account of the effects of the 1970s oil price spike. When the Great Depression is so often mentioned as the worst of economic times, I often feel that the discourse is US-centric – cultural domination perhaps. For the 1970s was as decisive for modern Britain as the 1930s was across the Pond. Inflation and unemployment, a pervasive sense of decline tinged with incipient anarchy. The Punk Era, swept away by the Thatcher Revolution.

Never mind, my point is that Stoft’s prescription will fail. Reading his first chapter I assumed Stoft would urge measures to keep the oil price high. But it suddenly dawned on me that his prescription is the precise opposite!

There’s a why Stoft is wrong, which owes something, I feel, to a US-centric world view.

And then there’s the how Stoft is wrong. I’m afraid to say he has not followed his own prescription in the last line of his Preface, to “pay close attention to the way governments and markets really work”.

Stoft, it seems, still bears grudges against OPEC. On page 4 he explains how he wants to avoid “paying OPEC another trillion dollars in tribute”. He writes of how, by 1986 “OPEC had been crippled”. On p.5 he notes how he will explain “how to crush OPEC again”. On page 6 he reminds us that “conservation… crushed OPEC in the early 1980s”. There’s a bit of a lull while he advocates a “consumers’ cartel” to counter OPEC and worries about how to deal with “free rides”…

Powerful stuff. Where have I heard this sort of thing before? Oh, yes, I remember now – it’s eerily reminiscent of Russia railing against NATO. Yes, that’s right, Russia’s demon is a mutual-defence pact. To many in Russia (unfortunately many of those in positions of power), the idea of Ukraine or Georgia joining NATO – to ensure, as sovereign nations, their own defence – is little short of an invasion of the Motherland itself. I wonder, I just wonder, if OPEC members feel the same way. Let’s just step into Wonderland for a moment. Maybe they feel they have a right to the riches under the desert (or wherever). I know, I know, I’m of the view that oil wealth is a fortunate (or often not so fortunate) windfall. But the actual state of affairs is what we have to deal with – and de facto those countries endowed with generous fossil-fuel reserves are determined to maximise the value of those reserves.

In solving the problem of global warming (and energy security) we have to deal with the world as it is, not how we would like it to be.

Maybe I can lay down something of a more specific principle here. Short of war, there will only be progress in international negotiations if win-win situations are created. Sorry about the cliche. Maybe I can get rid of it. Because, actually, we’re in a multilateral situation and we need win-win-win… in fact a win superscript n, win raised to the power of the number of interest groups.

Stoft is writing from the US. Let’s put to one side that he hasn’t even convinced his own country’s body politic to take the problem seriously yet, let alone of his particular approach. Let’s pretend he manages to do that. Even if that were to happen, I’ve got news for him. The world out there is not full of buddies who will be happy to participate in a “consumers’ cartel”. In fact, it may be unfair only to Canada & Australia to say that the US has only one reliable sidekick with any clout at all on the world stage. Yeap. Be nice to the UK. OK, I’m being facetious – there is some alignment of national interests, at least with the EU and Japan. But the problem is that several populous developing countries show no clear sign of wanting to play ball.

I feel I’ve written moreorless enough for a first reaction, so it’s fortunate that how Stoft is wrong has already been touched on in previous episodes of Uncharted Territory.

The general problem is the Displacement Fallacy, though I appreciate that Stoft intends to avoid this through international agreements, starting with China. Good luck, mate, but I don’t think you’ll manage it.

Reflections on Oil supplemented by Reflections on Reflections on Oil considers how the oil market will react to attempts to choke off demand. The important point is that the oil producers themselves will act as buyers of last resort.

Before I sign off I should mention that Stoft’s discussion of a tax on fossil-fuel and an “untax” (general distribution of the tax revenues) will not work as he seems to expect for imported products. Stoft is clearly unaware of the Man in the Wardrobe fallacy. Oil at $80 + $20 tax (Stoft’s example in ch.2, on p.21) will not have the same outcome as oil at $100. In the first case, the importing country still has $20 to spend, perhaps on more oil imports or perhaps on other goods, the sellers of which can themselves then afford to import more oil.

I haven’t read enough yet to determine whether Stoft is aware of the rebound effect or Jevons’ Paradox, whereby using a resource more efficiently can actually increase consumption in the long term. The signs aren’t good, though.

Although I’m disappointed with Stoft’s overall vision, I will read on, because large parts of Stoft’s analysis are sound. The first part of chapter 2 shows, for example, how cheap it would be to move away from reliance on fossil fuels.

Watch this space.

As an unreferenced endnote, I admit hypersensitivity to inaccuracies or ambiguities and two have been particularly irritating:
– in Ch.2, footnote 1, p.19 Stoft writes of a policy “that would ‘cap the long-term concentration of greenhouse gases [GHGs]… at 450 [ppm]’. We are now just over 380 ppm.” CO2 alone is at “just over 380 ppm”. I can only guess whether the policy proposal referred to is to keep all GHGs at a CO2 equivalent level of 450ppm or to keep CO2 below 450ppm – which, it’s now becoming clear, would be too high.
– at the start of Ch.3, on p.21 Stoft remarks that: “Back in the 1800s… Jevons predicted peak coal in England”. Maybe it’s a cultural thing, but to me “the 1800s” refers to the decade 1800-9, inclusive. Stoft means “the 19th century”, here. Jevons in fact wrote “The Coal Question” in 1865 (Wikipedia). And, btw, he was probably talking about Britain, not “England” (Wikipedia thinks so). No offence taken.


The Grandmother Of All Stealth Taxes

Filed under: Credit crisis, Economics, Media, Moral hazard, Rights issues — Tim Joslin @ 9:19 am

As the nights were drawing in this time last year I detailed how the UK’s “bailout” of the banks is in fact the Mother Of All Stealth Taxes. Well, I underestimated the greed of our politicians.

In March this year the government had obviously not yet done a good enough job of convincing the world’s speculators that the UK financial system was safe. They therefore proposed an insurance scheme in case Lloyds’ losses on specific assets (some £260bn worth, mostly commercial property and mostly acquired when Lloyds took over HBoS) amounted to more than £25bn. For this insurance scheme Lloyds would be required to pay a notional amount of £15.6bn in shares as I described at the time.

I say the amount is notional, because no-one knows what the shares would have been worth in the future. Presumably existing shareholders think the shares are worth more than their current price or they would sell them. Furthermore, the price of the shares granted for the insurance scheme was set when the bank was in difficulty. Since pre-emption rights of existing shareholders (i.e. their right to buy shares on the same terms as the new investment in the bank) were not respected we have no way of knowing how many would have bought shares on the same terms as the UK’s Treasury was offering.

Since Lloyds would have to incur losses of £(25+15.6) = £40bn or so before it even broke even on the deal, their executives started looking into ways to make themselves strong enough to insure themselves against these potential losses. The situation is not straightforward, but Lloyds’ management must have considered that they could manage the assets to incur less than £40bn in losses.

Lloyds now believes it can raise enough money by selling new shares to existing shareholders and issuing some bonds (mandatorily convertible to shares in certain circumstances, I gather) to insure itself, which is, after all, a large part of what banks do.

But as is being widely reported, the Government is demanding a £2.5bn break fee. This has no logical justification whatsoever.

The febrile media reaction to the banks is typified by Dan Roberts in the Guardian. His commentary begins:

“Another day, another few billion pounds of our money is on its way to cheer up Britain’s banks. Today it was the turn of Lloyds to stick its hand out – indicating it wants an estimated £5bn to support its latest restructuring wheeze.”

and which descends into complete incoherence by the end:

“All in all, it’s like taking out house insurance during a fire, refusing to pay for it once the fire is out and sending the insurance company a bill for a new sprinkler system. The real irony is that behind all the complexity, the APS and this associated exit strategy boil down to something very recognisable to bankers by now: a credit derivative, the most toxic yet invented.”

In actual fact a capital raising by Lloyds is a welcome simplification of what looked like becoming a labyrinthinely complex relationship with the UK government. It’s not the role of the taxpayer to guarantee the dodgy property loans Lloyds inherited when it took over HBoS – when, we shouldn’t forget, the bank’s executives were denied the right to conduct thorough due diligence on behalf of Lloyds’ shareholders – so Lloyds raising capital itself so that it is strong enough to bear the potential losses of the assets now on its books represents a return to normality which pundits like Roberts should be welcoming.

What Roberts seems to object to is the government’s participation in the rights issue. But this is what happens when you’re a shareholder. The government will be better off compared to underwriting the losses on a £250bn dodgy loan portfolio. The cost to the Treasury of keeping its/our shareholding to 43% will be around £5bn whereas they could otherwise have had to pay out, we have to assume, perhaps somewhere around £25bn in insurance in return for increasing their holding in Lloyds from 43% to 62% according to calculations done back in March. Let’s be generous and assume ~20% of Lloyds raises £15bn when the taxpayers’ stake is eventually sold (valuing the whole bank at £75bn). Even then the taxpayer is at least £25bn – £5bn – £15bn = £5bn better off under the rights issue plan than writing the APS insurance, assuming £25bn losses, after excess.

The reader may ask why a deal being done at all. The answer is that obviously Lloyds’ management think they can keep losses somewhat lower, but the Treasury surely has to take a more cautious view – note that because of moral hazard, the level of losses could depend on whether or not they’re insured by the Treasury! Since the sensational news has just come through this morning that RBS is to exit the scheme as well, I suspect that all involved – particularly in government – have realised that the scheme is in fact unworkable. It distorts the two banks’ incentives so much that it is impossible for them to do their job of managing the bad debts.

But what of this £2.5bn fee? There are two sorts of justification. One is that the government “saved” Lloyds by proposing the APS. But if the government had done nothing either the whole banking system would have collapsed in March or the banks would have faced down the short-selling speculators and recovered (as Barclays did, its shares having risen 6-fold since then). I would have thought it was part of the normal responsibility of government paid for by all our taxes, not an optional extra, to ensure the existence of an orderly banking system.

Then there is the financial justification. Roberts suggests in his fire insurance analogy that:

“The catch here is that we haven’t been paid yet for providing this insurance when it was needed most (ie, during the crisis) and are having to haggle to get the premium paid retrospectively.”

For what the government deserves another £2.5bn (making them at least £7.5bn better off than before this latest deal) is not exactly clear. The point is the insurance scheme had a £25bn excess and was to run for 5 years, so Roberts’ fire insurance analogy is inappropriate – the insurance policy would have had to pay out nothing for at least the first couple of years. Logically, if there’s going to be a fee of this kind it should be offset against losses and writedowns to date against a scaled-back excess of ~£5bn, i.e. a fifth of £25bn, since about one of the 5 years will have passed since what I understand to be the baseline for the insurance policy of last December by the time the Lloyds fund-raising is complete. Furthermore, the FT this morning provides details of RBS’s losses to date on assets that would have entered the APS. I don’t know where such data for Lloyds could be found, but they are likely to be comparable. RBS has already absorbed losses of £23bn! Even if we take a figure of £15bn for Lloyds, then the loss after the excess is £10bn. The government pays 90%, so owe Lloyds £9bn. Fine. We’ll offset the £2.5bn against that amount!

The £2.5bn break fee is just an opportunistic tax, ultimately falling largely on UK pension funds. There’s no financial justification for this amount.

Lloyds shareholders are likely to be understandably aggrieved that the fee is much higher than the figure of £1-1.5bn that has been touted in the media for some time now. There has to be the suspicion that the government’s negotiators have ramped the price at the last minute. If so, this reeks – I would have thought government had a duty of fairness.

With another £13bn from a rights issue, Lloyds shares are in total worth around £40bn, tops, right now, so £2.5bn represents an arbitrary tax of at least (2.5/40)*100 = 6.25%. There is still an upside, but it’s not looking stellar. I gave a guesstimate earlier that, with a fair wind, Lloyds may eventually be worth £75bn or about double the value shares are currently trading at. But this might not be for 5-10 years. A lot of investors are going to consider that they can much more easily double their money in a “global return to growth” scenario by investing it in emerging markets – where the political risks these days seem no worse – instead of in the UK. Does the government want that to happen? Especially as they may want to sell a lot of bank shares in a few years!

I have owned Lloyds shares since I worked for the bank in the early 1990s. When I was given a few shares as part of my remuneration, I certainly wasn’t warned that the government would levy arbitrary taxes whenever the country’s finances hit a patch of turbulence.

October 30, 2009

The Great Carry Trade II: more on the Problem of China

Filed under: Concepts, Credit crisis, Economics, Markets — Tim Joslin @ 9:03 am

Yesterday I explained why I consider that we’re in the midst of an era that could be termed the Great Imbalance. I go along with the the view apparently held by Nouriel Roubini that the so-called “Great Moderation” – the period of low inflation – is/was a mirage.

The point is that there is more than one tectonic shift taking place: low inflation has been caused, not by monetary conditions alone, but primarily by a historic reduction in the power of labour to raise wages and hence prices. Inequality is rising, full employment in developed countries is a half-forgotten phenomenon, jobs move around the world as part of globalisation; whereas the disruption of this supposedly happy state of affairs is caused by, well, trade imbalances.

A year ago I reported how the FT’s Martin Wolf had put his finger on the button (in fact, he’s written an entire book on the topic). Today I open my FT and see the argument outlined again, this time by Martin Feldstein in a piece titled “Why the renminbi has to rise to address imbalances”.

Feldstein argues that the US must increase household savings and China must increase domestic demand and “exchange rates must also adjust”. But this logical relationship is wrong. Exchange rates are the driver here. If the renminbi is allowed to rise against the dollar, American household savings and Chinese demand will adjust automatically.

Feldstein correctly notes that in the next phase of the Great Imbalance the euro will be drawn into the fray. The renminbi has dragged the dollar down. We’re going to start to see imports from Germany substituted by domestic Chinese (and American) products. (Europe will likely blame protectionism, and if they retaliate that would be a self-fulfilling diagnosis). Of course it will all be explained as due to the development of China, things they’re doing right that we’re doing wrong. The low dollar will be easily explained as a shift away from the dollar as a reserve currency since China will naturally hold more euros – a counterpart of its trade surplus with the region. But in fact all this will be the result of misaligned currency exchange rates!

Perhaps we should ask ourselves why China follows this policy when India does not. One problem India may avoid but China must face in the future is the sustainability of their industry. It’s all very well making things cheaply in external money terms, but we also have to consider whether they are being made efficiently in terms of physical real-world resources: labour, energy, the cost to the environment and so on. If these are being systematically mispriced – and it’s difficult to see how they could not be – then there will eventually be a reckoning, a crisis in China and a Great Rebalancing.

At the risk of oversimplifying, the difference with Japan, perhaps, is that, through successful industrial policies, Japan achieved export-led growth more by greater efficiency (such as quality) compared to the competition. This was sustainable even in the era when Japan was popularly termed “the Land of the Rising Yen”.

Feldstein’s conclusion is that:

“Fortunately, the Chinese economy is expanding rapidly and its growth is becoming less dependent on exports. When it has the confidence to allow the renminbi to rise, we will be on the path to reduced global imbalances.”

I don’t know. I think they need to start now, or maybe not to be starting from here at all. It seems to me that, in the real world, economic shifts are marked by destructive crises. We’ve probably got a few years before the wheels come off again. Or, if governments use the time wisely, maybe the train can yet be switched to a level track. Interesting times.

October 29, 2009

Deserts vs Roofs, Round 2

Filed under: Energy, Energy policy, Feed-in tariffs, Global warming — Tim Joslin @ 7:38 pm

Following Scientific American’s foray into the arena of grand, green projects, which I looked at a couple of days ago, I see that, in New Scientist, Fred Pearce has been looking at the Desertec plan to bring solar electricity from the Sahara to Europe.

Fred’s article compares Desertec with the feed-in tariff fueled PV roofing of Germany.  My immediate observation is that it’s hardly a case of either one or the other.  The Desertec plan, which is backed by “20 major German corporations” aims to raise €400 billion to meet (only) “15% of Europe’s electricity needs by 2050”.  And unless I was asleep when I read the relevant chapter in David MacKay’s book, PV panels on roofs alone can’t provide all our electricity. The quote from Germany’s rooftop PV champion is therefore rather puzzling:

“Some of the opposition to Desertec comes from an unexpected quarter. Hermann Scheer, the German member of parliament who masterminded the programme that has put solar panels on 100,000 of the country’s roofs, declared Desertec to be an unnecessary and expensive distraction that would divert investment from projects in Germany itself. Europe could generate as much solar energy as it needs domestically with more rooftop PV panels, Scheer says.”

Maybe he’s joking.

Pearce rather confusingly compares PV in Germany with solar thermal in the Sahara. That’s one two many dimensions for me. The argument is confused by the need, for example, to use water for the solar thermal. If we do a quick thought-experiment comparing PV in Germany and the Sahara the economics becomes obvious. PV in the Sahara would generate at least twice as much electricity per area of PV panel on German roofs, because of the lack of cloud in the Sahara, more overhead sun (reducing losses in the atmosphere) and lack of any tracking ability whatsoever and much greater possibility of being shaded at the ends of the day of fixed panels on roofs (I could say 3 times as much electricity – though I would then have to check my facts more thoroughly, since 3x might be per area of land, which is a slightly different matter – but don’t need to). So if we give a €400bn budget to each location we would have to spend only €200bn on panels in the Sahara.

But we have to allow for transmission losses – let’s say 20% (the article gives 10% for the high-voltage direct current (HVDC) links from Africa to Europe but let’s be pessimistic). So for the equivalent of €400bn of rooftop PV we need to spend €240bn in the Sahara.

HVDC is a proven technology and the article says we need 20 links from Africa to Europe. Let’s be pessimistic again and price these at €5bn a pop [Postscript: I’ve now found that David MacKay gives £1bn for 2000km of HVDC + £1bn for the cost of the land it uses (p.216), so my guesstimate implies he’s a hopeless optimist!]. That’s $340bn we have to spend on our Sahara project.

And maybe another wodge – say €10 billion (I’m basing this on a rather generous €1000 per rooftop worth, estimating rough equivalence with Desertec – and market saturation of suitably angled roofs – at 10 million chunky 1kW average output rooftop systems, 100 times as many as at present) – to enable tracking of the sun to ensure we achieve at least double the output of the German rooftop PVs. I’ve managed to get us up to €350bn.

OK, let’s add on 10% extra capacity to allow for the accidental disruption of supply, political risk, bribes, earthquakes cutting the cables, outages caused by sandstorms and so on. That gets us to €385bn.

I’m really trying to push up the cost here. I’m not even making an allowance for ease of installation and maintenance, the ability to standardise and optimise panel dimensions, the lower labour costs and so on, of arrays in the desert compared to on German roofs.

Even being really pessimistic, we’re €15bn up on the deal. I’ll take that. Plus we have the option of expanding the project further, exploiting economies of scale, after 2050 – whereas in comparison we’re running out of roofs in Germany.

The reason why the Desertec guys have gone for CSP, of course, is it’s even cheaper than PV [something like 8 times cheaper on an average power delivered basis according to David MacKay, p.216]. As Fred himself says: “The clincher is cost. Building a power-station-scale solar thermal installation costs only a fraction of PV generators with the same output.”  And it comes with integral energy storage (read the article) whereas the German rooftop panels will generate most energy when it’s not needed (OK they can sell it to parts of Europe where they have a daily air-conditioning peak, but Desertec can do that too).

Look, feed-in tariffs to roof-owning Germans was a way of funding the early development of PV technology. It’s just not a sensible financial mechanism for rolling out PV. And German rooftops are not a sensible place to put the things.

CSP in the desert wins hands-down over PV on German roofs. If there really is a choice between the two, I don’t know why we’re even discussing cost.

But Fred’s article raises some other strange objections to Desertec:

  • “…it could make Europe’s energy supply a hostage to politically unstable countries” say critics.  Nein, nein, nein!  It’s trade.  And trade cements peaceful international relationships.  It’s when trade breaks down – like in the 1930s – that wars start.  Compare the relationship of the West over the last 30 years with, I don’t know, Afghanistan (little trade) and Saudi Arabia; or North Korea and South Korea.  I find it rather strange that a global problem – climate change – is spawning a retreat to local solutions.  Maybe it’s some kind of innate human response – akin to cowering in Mother’s skirts – when bad things happen.  We need collaborative, mutually beneficial solutions if we’re going to crack this one.  Any doubters should just pretend we’re facing some other kind of common threat – a 1km asteroid hurtling towards us at 40,000kph, say.  We’d need to work together on that, wouldn’t we?  Same difference with global warming. In any case, building Desertec diversifies Europe’s energy supplies compared to where they are now, reducing reliance on any one regime. The theoretical problem of supplier-power will be lessened for at least 30 years, until we switch off the gas, by which time we might have come up with other energy sources. Even in the worst case, it’s difficult to imagine reliance on renewables being worse than reliance on dwindling fossil-fuel supplies. So why don’t we just get on with it?
  • “Europe should not be exploiting Africa in this way”.  What?  Make your mind up.  How is it exploitation?  You help us make some electricity, we give you some euros and you can buy stuff.  What exactly is the problem with that? This “argument” is hand-wringing liberalism gone mad.
  • “But capital cost is not the end of the story. While a solar thermal power plant requires a round-the-clock crew, PV installations pretty much run themselves.”  I seriously doubt this.  Think about it.  You’ll have a few maintenance teams in the desert each looking after a vast amount of output.  Compare that with the army of bureaucrats alone needed to manage millions of rooftop PVs and the owners’ accounts, sort out disputes, investigate fraud (what if they just sell normal electricity back to the grid and put a piece of cheap plastic on the roof?) und so weiter, together with the thousands of small businesses fixing the things when – like any domestic appliance – something goes wrong.  Not to mention the army needed to get up on people’s roofs every now and then to clean the birdshit off the things.  Someone’s in fantasy-land, and it’s not me.
  • “What’s more, PV power plants can grow piecemeal: they can start generating power for the grid from the day the first panel is installed, while solar thermal mirrors are useless until the entire power station is completed.”  So?

I’m sold on Desertec. How can I invest?

The Great Carry Trade

Filed under: Concepts, Credit crisis, Economics, Housing market, Inflation, Regulation — Tim Joslin @ 4:08 pm

I was much taken by one of Larry Elliott’s pieces for the Guardian a couple of weeks back. Larry identified several eras: the Great Depression; the Great Compression, the period of strong growth and increasing equality after WWII; and the Great Moderation, the period of low inflation from the late 1990s to the early 2000s. We’re just ending the Great Recession (as this term was overused to describe 19th century episodes, I prefer “the Great Crunch”, which I think has a more modern flavour, but let’s go with Larry’s nomenclature today). I’d like to add to the mix the Great Inflation of the 1970s and 1980s. The question Larry asks is: What now? The Great Escape?

I’d like to argue that we’re likely to enter a period that we might call “the Great Imbalance”, reserving, on second thoughts, the title I’ve chosen – “the Great Carry Trade” – for the underlying cause. In fact, you could argue that the Great Moderation and the Great Recession are merely episodes in the history of the Great Imbalance.

Let’s first consider the causes of some of these various eras. Here’s my simplification of some complex phenomena:

  • The Great Depression is so-called because growth stagnated in large part because of a breakdown in trade.
  • After WWII trade resumed, but crucially without the Soviet Union and satellites, China and India. Larry’s Great Compression resulted from the growth in this era, together with, crucially, greater bargaining power on the part of workers, as collective bargaining reached its apogee. This combined with a squeeze on that critical resource, oil, to produce the Great Inflation.
  • In 1989 the Berlin Wall came down. China and India have since become global players. This has locked in the reduction in workers’ power that occurred when unemployment resulted from the Great Inflation, permitting rapid non-inflationary growth – the Great Moderation.

Now, Larry writes that:

“One feature of the Great Moderation was the build-up in debt that allowed consumers in the US and Britain not just to live beyond their means, but to mop up the excess output from the low-cost factories in Asia. Debt is now being paid back, and it will continue to be paid back as the monetary and fiscal authorities withdraw the emergency stimulus packages of the past 12 months.”

But I’d argue that, far from “the build-up in debt” being a “feature” of the Great Moderation, it is a result of the fundamental cause of the Great Imbalance, that is of the Great Carry Trade.  And the Great Imbalance is not over, because international debt is not, in fact, being “paid back”.  And the Great Carry Trade itself has a cause: the false idol of export-led growth.

Larry also suggests that:

“The Great Moderation … could only be temporary, since its reliance on levels of debt that were only sustainable provided asset bubbles continued to inflate meant we were buying stability today at the expense of instability tomorrow. As such, Alan Greenspan created a housing bubble out of the wreckage of the dotcom bubble, thus disguising the structural problems in the US economy.”

I disagree: the cause of the Great Moderation phase of the Great Imbalance was not the debt, but globalisation. Larry is also writing in the UK, which somehow sidestepped a recession after the dotcom crash, so perhaps sees more stability than Stateside commentators. Regardless, I suggest that the conditions are already in place for the next bubble, because the underlying imbalance has not been addressed.

Larry titled his piece “Eastern promise holds little hope for west”. But why should this be? Growth based on trade is mutual – it’s not a zero-sum game. If I buy Chinese toys for pounds, the only way to zero out the transaction is for British products to be purchased with those pounds. The cash acts as a store of value. That’s the point of it.

But what’s happened is that the pounds and dollars used to purchase goods from China and other countries following a similar strategy has not been spent on imports from UK or US. The ramifications seem no less serious now than when I wrote nearly a year ago. Since then there’ve been a few developments:

  • The worst recession for a generation.
  • A fall in the value of the dollar (and pound) against the euro.
  • A massive recovery in emerging markets in particular, fuelled by investment flows.

But no change in the value of the renminbi against the dollar.

So what’s going to happen?

Let’s consider trade first.  The eurozone was until recently in rough trade balance.  Now, though, the US trade imbalance with China (and others), which is an inevitable result of the currency pegs, will be shared by the eurozone.  Additionally, the eurozone will see a deteriorating trade position against the US (and UK).  In short, the next phase of the Great Imbalance will see the addition of Europe to the debtor countries.  This is inevitable with current policies.

But there’s another feature of what’s going on which leads me to highlight the Great Carry Trade.  Investors – ironically as a result of articles like Larry Elliott’s – see the big opportunities as in the developing countries.  What was a minor part of portfolios is becoming mainstream, egged on by the investment industry.

Why do I talk about a “carry trade”? Well, the effect of investment in higher-yielding currencies is – whether or not one organisation carries out all parts of the transaction – borrowing in the low-yielding currency (the dollar or pound, say) at low interest rates to lend (or invest) in a high-yielding currency (such as the rouble or renminbi).

A key point is that all the dollars or pounds invested come straight back. Think about it: to invest in China, you (or an intermediary) have to sell your dollars to a bank to buy the local currency. These dollars are then available to lend on the international money markets, depressing dollar interest rates. The carry trade is self-fuelling, reinforcing the trade imbalance.

With free-floating currencies, the capital flows will eventually force up the currency of the destination country, and investors will no longer see the opportunities they did. There’ll be some kind of correction, quite possibly an “emerging market crisis”.

But with pegged countries there are fewer ways out. Obviously there is a possibility of investor confidence becoming undermined and an asset (e.g. stock market) bubble bursting, but failing that, either inflation could occur or the currency peg could break. But both of these tend to help the foreign investor, by increasing the value of their assets. The pegging country is likely to find itself in a policy straight-jacket. Increasing interest rates to cool the economy simply encourages the carry-trade. Hinting at appreciation, or a limited appreciation, of the currency is likewise a red rag to a bull. They could try to directly control the capital flows, like Brazil did recently, or try to manage asset values directly. But such policies are difficult to implement. All very unsatisfactory.

I can only conclude that unless emerging market currency pegs are abandoned we will simply have a repeat of recent history, with a slightly different flavour.

Much depends on what happens in the deficit countries. Current policies suggest that governments will try to rein back on their borrowing. That leaves even more potential for bubbles in the property and the corporate capital (equity and bond) markets.

It now seems to me that in the UK, at least, property prices will resume their upward path. This will be driven not by low-income owner-occupiers, and maybe not even by the recent type of buy-to-let investor. Rather corporates will invest, which will increase construction rates (because such investors require large numbers of properties), which will help fuel the economy, sucking in more imports, of course. Foreign buyers will also continue to stoke the market, particularly in London. Interest rate increases to choke this off will have limited impact as they will tend to push up the pound, encouraging the very imports and capital flows that are fuelling the Great Imbalance.

In an even world, investment flows into UK equity and bond markets should, over time, exactly counterbalance flows out. But we live in an uneven world. Furthermore, when capital returns to the UK (or US) it has had the risk taken out of it. Companies, just as in the dotcom boom, will, even when raising equity is possible, still over-leverage.

Where the next gasket blows is anybody’s guess. Remember, excessive capital flows will once again be a global phenomenon. Governments will try to shore things up, but will simply have not enough thumbs to stick in all the dykes that could burst.

October 28, 2009

NHS Nutters

Filed under: Healthcare, NHS, Politics, UK — Tim Joslin @ 10:48 pm

The British electorate would be well advised come next June to forget about traditional political affiliations and whether or not we “need a change” and choose their next Government on the basis of the apparent sanity of its leadership.

Unfortunately, the British electorate is unlikely to take my advice and will instead elect a party which admittedly does boast some front-bench talent. But the wit of William Hague and wisdom of Ken Clarke will have to play second-fiddle to the Etonesque eccentricity of Messrs Cameron and Osborne. The key word in their bizarre philosophy is “localisation”.

Here’s a headline: “Tories vow to save money by scrapping national NHS database“. Having spent billions so far, this would seem a remarkably drastic step. The Tories are responding mainly to concerns about patient confidentiality, it seems. Instead of a centralised database, “Stephen O’Brien, a shadow health minister, said that the Tories would instead decentralise IT provision in the NHS, allowing trusts to buy their computer systems provided that they were compatible with others in the health service.”

Now, it seems to me that one reason the NHS IT project has overrun is because it is so monolithic. It would have been much less risky in many ways to set standards so that disparate systems could communicate, and implement them locally. But I see why a “key part of the programme involves the clinical records for every patient being stored on a ‘personal spine information service’.” If you have local systems, the data exchange issues are much greater.

One of the major benefits of computerisation is that patients’ records can be called up wherever they happen to be. And there’s also a huge benefit of computerisation in that the data is so much easier to “mine”. I read today of a careful study on migraine-sufferers. “Link between migraine and stroke” said the Independent. Worrying, so I read further:

“Young women who suffer from migraines with visual disturbances and who smoke and take the contraceptive pill are at a higher risk of stroke, research suggests.

Migraine doubles the chances of a stroke if accompanied by aura (temporary visual or sensory disturbances) according to the research, published online in the British Medical Journal.

Other factors that heighten the chances of a stroke include being younger than 45, a smoker and using contraceptive pills containing the hormone oestrogen.

Researchers led by a team from Harvard Medical School said there was no evidence of an increased risk of stroke among people having migraine without aura.

About one in five people suffer from migraines, with up to a third having an aura. The authors pooled the results of nine previous studies on the link between migraine and stroke to come up with the findings. “

Maybe the drugs prescribed for the migraines have caused the strokes – especially as my impression is that not so many years ago you needed the aura to call it a migraine and qualify for the drugs. Who knows? Hopefully the medical sleuths are on the case.

Anyway, my point is that with a comprehensive national database – however it’s implemented – you wouldn’t need elite medical professionals to determine correlations of this kind. School-level statistics skills would be sufficient. The big pay-off from an NHS database is this sort of data and the resultant medical progress. You want to work the database. That, I suspect, is why a centralised design was chosen. (And I haven’t even mentioned Shipman – detecting similar individuals would surely be worth the cost of a few computers).

How do the Tories deal with this issue?, I wonder. This is what their report has to say (apologies on their behalf that parts of the key passage are barely comprehensible gibberish):

“In order for patients to reap the benefits of information technology in relation to their healthcare, there must be a change in the way information technology is supported: the Executive must not regard health informatics [they’re using this grandiose term confusingly – to me at least – to mean all NHS IT services, whereas I’d use it specifically to refer to knowledge engineering] as a tool to extract data [as if it’s being stolen – isn’t language great?] from the National Health Service but as a way of organising health and social care information around the needs of the patient [as if sharing data across the system isn’t in patients’ interests]. Systems must be able to deliver clear benefits to the care of the patient and the work of the clinician in delivering this care. They must not be seen by clinical staff as solely [sic – really, would they?] systems for data collection. The dataset mentality – where the bulk of data collected bears not [sic, I presume they mean “no”] relevance to patient care – should be abandoned. Clinical systems should be built to focus on the patient, not the disease, procedure, specialty or service providing care. These requirements should be met by developing appropriate views on the patient-focused record according to the context in which the patient is seen.”

Actually, it’s not just the words I’ve highlighted which are gibberish, the whole thrust of this paragraph is completely barmy. Call the men in white coats. Several of the individual sentences make little sense, but I can find no way of avoiding the conclusion that the Tories want to throw out many of the enormous benefits of computerisation. Cameron apparently elaborated the full mad starey-eyed “vision” at the Tory Party conference:

“Now I want you to imagine how we’d have gone about [updating NHS computers], if we’d had the chance.

We would have said: today, you don’t need a massive central computer to do this.

People can store their health records securely online, they can show them to whichever doctor they want. [I love this bit – not if you’re in a coma, you can’t].

They’re in control, not the state. [Puerile, absolutely puerile].

And when they’re in control of their own health records, they’re more interested in their health, so they might start living more healthily, saving the NHS money. [Yeah, well, now I know the doctors are going to wait for me to come round so I can log them on to my medical records, I’m certainly going to do everything I can to avoid entering hospital horizontally].

But best of all, in this age of austerity [oh, please], a web-based version of the government’s bureaucratic scheme services like Google Health or Microsoft Health Vault cost virtually nothing to run. [Probably ‘cos they’re crap as Gerald Ratner would have said].

So this is where some really big savings could be made.”

Well, exactly. I can save the tube fare if I walk 8 miles to central London.

David Cameron, of course, is a direct descendant of Thatcher – as if through the intervention of some kind of incubus – and for her “there was no such thing as society”. This is now dressed up as a philosophy of “localisation” – the heading in their report is “8 action points to bring about localisation in NHS IT” – who could possibly be against that? Well, I am, if it means that I don’t benefit from the medical experience of others, and the outcome of any treatment I have is not used for the common good. Hey, why not go the whole hog and give up on the blood transfusion service? We could all have our own private blood-banks.

My experience is that the NHS is already far too localised. GP surgeries are a law unto themselves. Take registering. My local GP, first of all, only accepts registrations up to 4pm, despite being open until 5; they require two proofs of address + photo-id; and, worst, refuse to let you take a form to fill out and bring back when you get there and find you don’t have the right id, so you find when you eventually do come to fill it out that you don’t have all the information required (NHS number and former GP surgery address). Plus, they’re just plain rude with it. Our taxes are paying for an army of these receptionists, who have no medical training whatsoever. This is where we should find our first cost-savings when we finally get our records out of the 1940s, off paper and onto magnetic media.

My recent experience of trying to register with a new doctor (having moved recently) agitated me so much that I thought I’d try to find out how I should be treated.

Well, try as I might, I could find nothing on the NHS website. Surely, I thought, GPs surgeries benefit hugely from being part of the NHS, there must somewhere be a detailed set of obligations as to how they should go about their business. In the end, I thought, I’ll drop them a line. But this is what I found:

“Since April 2009, the NHS has run a simple complaints process, which has two stages.

1. Ask your hospital or trust for a copy of its complaints procedure, which will explain how to proceed. Your first step will normally be to raise the matter (in writing or by speaking to them) with the practitioner, e.g. the nurse or doctor concerned, or with their organisation, which will have a complaints manager. This is called local resolution, and most cases are resolved at this stage.
2. If you’re still unhappy, you can refer the matter to the Parliamentary and Health Service Ombudsman, who is independent of the NHS and government. Call 0345 015 4033”

This is simply not fit for purpose. Neither of these options is appropriate.

Here’s the first paragraph of “Things to think about when you’re complaining” (from the NHS complaints page):

“If you decide to make a complaint it’s important to consider what you want to happen. Are you content with an apology, do you want action to be taken against a member of staff, or do you want a change to the system? Whatever action you’re seeking, make this clear.”

Well, someone, somewhere has realised that I might want “a change to the system”. So why has my ability to complain been “localised”? My only recourse it seems is to write to the Department of Health.

For the record, I would have thought the GP surgery registration process should follow a clear set of rules so as not to exclude those unable to attend during the day and expedite the registration of new arrivals to the area.

Otherwise, the right to choice in the NHS is somewhat limited.

October 27, 2009

Scientific American’s Sustainable Future

Scientific American’s customer management is appalling. When I first subscribed to the print edition, the magazine’s online presence was trumpeted as one of the benefits. I therefore understood I would also obtain access to the Scientific American Digital (how quaint!). Nope. I got no more online access than I had previously and ended up paying a Scientific American Digital subscription on top of the print subscription. Someone should call the Advertising Standards Authority! (Annoyingly my online subscription has now expired, and, I see from the correspondence page – which publishes letters on topics in the edition, I kid you not, 4 months earlier, like we’re still in the 1950s – that I appear not to have received the July issue at all).

Just lately – in the midst of a UK postal strike – I can find no way to notify my address change or even log on at http://www.scientificamerican.com. The site recognises none of the several numbers on the address labels of the magazines I’m sent. The contact email address intl@scientificamerican.com simply doesn’t work. Mind-blowing. Scientists, eh? Hardly surprising there were dodgy solder-joints at the LHC, was it?

Nevertheless, I persist with Scientific American. It’s worth it for the quality of the articles. And, I have to say, its old-fashioned feel.

The lead article in the November issue is titled: “A Plan for a Sustainable Future”, by Mark Z Jacobson and Mark A Delucchi . It discusses how the entire world could be powered by wind, water and solar power by 2030. And it’s well worth a read.

The authors note that building “millions of wind turbines, water machines and solar installations” is not without precedent. For example, “during WWII the US retooled automobile factories to produce 300,000 aircraft”. For clean energy the numbers are feasible: the list includes 490,000 tidal turbines, 3,800,000 5MW wind turbines, 49,000 concentrated solar power (CSP) plants and 40,000 solar PV plants.

I’m afraid I have some quibbles:

  • The authors quote a US Energy Information Administration projection of 16.9TW of global energy demand in 2030, compared to 12.5TW now.  I suspect 16.9TW will prove to be a massive underestimate.  As well as a greater population and higher living standards, there’ll be new sources of demand in 20 years, for example, for large numbers of desalination plants to produce fresh water.  I’d be amazed if we aren’t using twice as much energy by 2030 as we are now.
  • On the other hand, ruling out wind and solar power production “in the open seas” is suspect: I would have thought there was a lot of scope to generate power there, e.g. on floating islands, which I’ve seen proposed, probably in Scientific American itself.
  • Nuclear power is dismissed because of the “carbon emissions” caused by “reactor construction and uranium mining and transport”, but no explanation is given as to why these activities couldn’t be powered by clean energy.
  • Interestingly, the authors are concerned about all forms of pollution, so rule out carbon capture and sequestration (CCS) and biofuels on the grounds of air pollution other than CO2. I’d have liked to see at least a nod to the other problems with these primitive technologies: principally the difficulty of capturing all the CO2 in a coal-fired plant, the cost of burying the carbon and the risks; and, for biofuels, the land use problems – not just food vs fuel, but that the land would store carbon quicker if left alone!
  • I doubt that geothermal energy is “renewable”.  There may be a lot of it, but the rocks will reheat only very slowly.
  • The authors suggest that we deploy 1,700,000,000 – yeap, 1.7 billion – “rooftop photovoltaic systems”.  I think this is nuts.  First off, I’m really struggling with the numbers – the 0.003MW – or 3kW – size of each system must refer to average (mean) output to be consistent with the rest of the article.  But, according to my mate David MacKay (print edition, p.40), 20W/m2 is going some for solar PV in the sort of countries where there are a lot of roofs. So these systems would have to be 150m2 each. They have big roofs in America, I guess. But my more fundamental objection is that the output of 100,000 of these babies only adds up to 1, yes one, of the 40,000 PV power plants. What’s easier, do you think, fit solar panels on every roof in a medium-sized town, such as Southampton where I come from, or stick them all in a big field outside of town (perhaps a long way outside, like in North Africa, where funnily enough you need far fewer panels)? I’ll give you a clue: let’s be pessimistic and say it takes 1/2 hour to put a panel in a standardised array in a field and optimistically 2 days to put the scaffolding up so you can get on the roof without a health and safety violation – before you start the pretty much bespoke installation process. Barmy idea, isn’t it? I worry that the inclusion of the rooftop PVs owes more to some kind of philosophical belief in the virtues of localism than to sound scientific (or economic) reasoning. And of course the article concludes by advocating the dreaded feed-in tariffs. What better way of transferring money to those with big roofs from those, um, without big roofs?

Nevertheless, notwithstanding a few hints that it may be informed by countercultural ideology, I recommend taking a look at “A Path to Sustainability by 2030”.

But the November 2009 Scientific American is worth buying for another article alone. No, not more minute analysis of the “Hobbits of Indonesia” (not read that one yet, but – to go all Iain M Banks for a moment – does the obsessive human interest in the details of our family tree perhaps represent some kind of species-level insecurity?), but “The Rise of Vertical Farms” by Dickson Despommier. The author should perhaps have credited “The World Without Us“, but he makes the point that we should farm indoors and leave nature to absorb the excess carbon we’ve been stuffing into the atmosphere.

The key argument is that you can grow so much – so much less riskily too – in controlled climate conditions indoors: “4 growing seasons, double the plant density, and 2 [or more, surely, of many crops – judging by a photo I once saw in the Guardian of a hydroponic indoor vegetable farm in Tokyo] per floor”, so that, excusing the quaint American units, a “30-story building covering one city block [5 of these ‘acre’ things] could … produce 2,400 acres of food”!

Despommier worries about how his vision can be made to happen, but in fact it’s simple. As soon as a realistic price is put on ecosystem services, there’ll be a huge economic incentive to invest in “vertical farms”.

October 26, 2009

Mad Mortgage Rules – and Miles Brignall

Filed under: Credit crisis, Economics, Housing market, Regulation — Tim Joslin @ 5:06 pm

Jay Rayner’s review of the Eastside Inn in today’s Observer magazine includes an unforgettable comment about its owner, “chef Bjorn van der Horst, who has the name of a porn star and the palate of an angel.” My partner wondered how Rayner comes up with something like that. I suspect it’s not that difficult – though it is a very good line – if all you have to do for a living is stuff your face and write about it.

Because clearly the restaurant reviewer has not been keeping up with the London Evening Standard newspaper (“the ES”). Rayner expresses surprise that fewer London restaurants have not “gone to the wall”. He goes on: “according to Harden’s, a fine restaurant guide in so many ways, London closures have actually been slightly down over the past year, at just 64 – the lowest rate since 2000. Openings are up 9%.” But a few weeks ago the ES revealed that because so many of the sorts of people who patronise upmarket eateries have had a mortgage windfall, takings have survived the downturn.

The point is that many mortgages have reverted (from a fixed rate) to banks’ standard variable rates (SVRs) which in many cases are tied to the Bank of England’s base rate. Tracker mortgages are again tied to the base rate.

Presumably the Guardian’s Miles Brignall is either not a gastronome or is simply insufferably smug, so has not accompanied Jay Rayner on any of his restaurant trips. If he had, Jay would be well aware of how Brignall has an interest-only mortgage, for which the monthly payments have decreased from almost £900 to £150.

In what must rank as one of the most irresponsible pieces of financial journalism I’ve ever seen, the Guardian ran a short piece by Brignall in Saturday’s Money section, perhaps to provide “balance” to a report on the FSA’s proposals to discourage interest-only mortgages.

Journalists often introduce “balance” when in fact there is no widely-held alternative position. The classic example is climate change. Approximately 999 out of 1,000 scientists working in the field broadly accepts the consensus view of the warming effects of human greenhouse gas emissions. But the crackpot 1000th all too often gets a platform. Result: the public believes there is a fundamental debate when in fact there is no such thing.

The FSA pointed out that (1) if someone takes out an interest-only mortgage when they could not afford a repayment mortgage for the same amount then they are likely to have a problem paying the principal at the end of the term of the mortgage and (2) it would be a good idea for people taking on interest-only mortgages to demonstrate that they have an investment vehicle for paying off the principal, e.g. an endowment policy. Such endowments were of course very popular back in the 1980s.

What the FSA says is very sensible.

But Miles Brignall appears to have committed both the cardinal sins. He writes that:

“By going interest-only, nice houses with gardens (well, vegetable-growing area) suddenly became affordable – all for the same monthly repayment had we gone for a smaller home, with a tiny garden – but funded with a repayment mortgage.”

And Brignall’s scheme for paying back his mortgage? Arbitrage:

“The pay rate on our mortgage is 1.24% – courtesy of the Bank of England – and yet I’m getting 3.01% on my Manchester Building Society Isa. You don’t need to be Mervyn King to know that that’s a good state of affairs.”

This is absolutely nuts. It is a pure cock-up that mortgage rates are lower than the rates paid on consumer deposits. The banks simply did not expect the Bank of England’s base rate to go down to 0.5%. Stupid. What the banks should have done, and will do in future is tie all mortgages to LIBOR – the cost of money in the interbank market – so this situation will not recur.

In bailing out mortgagees and other borrowers in general, by reducing interest rates dramatically, the Bank (the Bank with a capital “B” refers to the Bank of England) has, likely unintentionally, given a massive windfall to hundreds of thousands of borrowers with these daft mortgages for which the payments can drop to virtually nothing. A lot of them are spending their fortunate gains in restaurants, so we haven’t had a shake-out to separate the decent restaurants from the salmonella-factories.

From the Bank’s pov (point of view) reducing the rate so low doesn’r make sense in the long-term. Since in future fewer commercial rates will refer to the base rate, the Bank has got its powder wet.

The other recommendation by the FSA is less sensible. They want to ban self-certification mortgages. These have pretty much disappeared already, but the FSA seems to be keen to lock the self-employed and those with irregular income out of the mortgage market altogether.

All this will do is move the problem. Those unable to pay a mortgage would be unable to pay private rent either, so landlords would find themselves in difficulty.

This observation set me thinking. Here’s my suggestion. Mortgages should simply be provided to those who, regardless of their employment situation, can demonstrate that they have been able to pay a comparable private rent. This wouldn’t apply to everyone – some may live with their parents or pay a very low rent in a shared house while saving a deposit, for example – but would help a lot of people get on the housing ladder. Some legislation would be required – but the private rented sector is under review anyway – to require landlords to provide receipts for all rent paid in full. This would be good news for landlords as the need to collect such receipts would give a further incentive for tenants to keep up with the rent. Certified receipts would likely prove more useful than references for tenants seeking to move to new rented accommodation, but they would also demonstrate that a potential mortgagee can afford a certain level of mortgage payments. This would translate to a given size of mortgage. Mortgage lenders would require proof of rent payment for a number of years (at least 2 or 3) – this might vary for different offerings (e.g. depending on the deposit the buyer is able to put down). Some slack would be required. There are a few extra costs (e.g. maintenance and insurance) which property owners have to pay but tenants don’t. The big problem, though, is that interest rates can increase (and mortgages may be at “teaser” rates, liable to revert in the future to a higher rate, such as the lender’s SVR), causing difficulties for mortgage holders, so the government (or perhaps an independent regulator) would have to advise the rate for which affordable payments should be calculated, which may be somewhat above the market rate at any particular time.

An example is in order. Let’s say someone has been paying £1200pcm in rent for a few years. A lender might then assume they could pay a mortgage of £1050 a month to allow for other homeowner expenses. They may also allow for future interest rate rises, so accept the application only for mortgages requiring monthly repayments of £900. Got it?

What we’re trying to do is establish what outgoings a mortgagee can afford, so it is much more logical to establish what outgoings they have been able to afford in the past than to simply examine their income.

Postscript: Miles Brignall’s mortgage

Miles lets on that he’s paying 1.24% interest at the moment and that this works out at £150 pcm, or 12*150 = £1800 pa. Therefore on a house he tells us is worth £390K (or is that what he paid for it?) the mortgage is (100/1.24)*£1800 = ~£145,000. From a lender’s pov, £245K equity (reasonably plausible if, say, they bought their previous flat in the mid 1990s – they might have taken out a mortgage back then of well under £100K, with even less than that outstanding 3 years ago) is reasonable security, so they’re not the ones likely to get their fingers burnt.

Miles was paying “almost” £900 pcm before rates started tumbling or 6 times as much as at present. He may have paid off some of the mortgage, but at £250 a month for at most 3 years, not very much (no more than £9,000). This means his rate was getting on for 6*1.24 or over 7% (check: 900*12/154,000 = ~7%. Quite expensive, it seems to me.

How the rate has dropped by ~5.75% is difficult to explain, as base rates haven’t fallen that much (they were 4.75% in late 2006, rising to 5.75% in late 2007). Maybe the “almost £900” was a reasonable bit less and the £150 is rounded up (or perhaps includes a fixed amount – e.g. insurance of some kind) or maybe he’s paid off a bit more than I’ve reckoned.

Anyway, most worryingly, Miles says he is only putting £250 a month into a savings account, so he’s getting used to having £400 extra to spend each month (£400 comes from the £900 mortgage payments less £150 he’s paying now, less the £250). I hope Mrs B doesn’t get too used to all those meals out!

Be very clear: the reason Brignall was able to obtain a mortgage on a £390K property was not because of the affordability of the monthly payments – it was because he had so much equity the lender didn’t consider him much of a risk. It’s the same as the logic behind sub-prime lending when banks thought they couldn’t make a loss because the value of the property would rise. Miles can presumably afford even £900 a month, but, in fact, he’s described exactly the sort of lending which concerns the FSA because it is in the interest (no pun intended!) of the lenders and not necessarily of the borrowers.

Someone with an interest-only mortgage like Brignall’s who couldn’t afford £900 each month could easily find their debts gradually increasing over time, as they were forced to put other spending on credit cards or take out personal loans.

October 23, 2009

Virgin on the Ridiculous – and All Tied Up

Filed under: Concepts, Consumer gripes, Economics, Markets, Regulation — Tim Joslin @ 8:30 pm

Richard Branson had an entertaining comment piece in the FT today. He was complaining about Sky’s dominance of the premium pay TV channels – predominantly sports and movies. Quite right too, the UK TV market is a big mess. Both the BBC and Sky stifle competition.

One point Branson made tickled me. If the market were functioning better, he claimed:

“Those who do not wish to commit to a 12-month subscription but are willing to pay for some TV channels will be more readily able to do so.”

Readers will remember that one of my whinges about Virgin Media was that they locked me into a 12-month contract. I presume Branson won’t mind if Virgin Media as well as Sky have their wings clipped in this regard.

But what really had me rolling around on the floor was the Bearded One’s description of Ofcom’s proposal, which, naturally, he wholeheartedly supports:

“Ofcom has proposed … making Sky sell its premium channels to other operators at a fair, wholesale price. This would be an excellent result for consumers because it will enable each pay-TV operator to com­pete based on its different strengths. Services will be developed that appeal more closely to the preferences of different customers. For instance, those who do not want, or cannot have, a satellite dish will not need one. … New market segments and more innovative and compelling consumer offers will appear. And they will cost less. Under Ofcom’s proposals, some operators could plan to retail Sky Sports 1 at a price more than 20 per cent below the lowest price that channel can currently be bought from Sky.” [my emphasis]

Absolutely hilarious.

Basically I support this vision – but this isn’t the way to go about changing the industry.

The point is that if Ofcom do this (and how they dream up the wholesale price is beyond me), then it makes no sense whatsoever for Sky to remain as both a service-provider and a channel-provider.

Separating these functions (for all broadcasters, BBC take note) – i.e. splitting Sky up into a service-provider and a separate channel/content-provider – should be the starting point of regulation, not a consequence of it. Breaking down vertical integration in this way is a central pillar of “managed markets”, part of my new political-economic philosophy of “constrained capitalism”.

The central argument is that if I can choose the technology that delivers my TV service and the channels I purchase as entirely separate steps, as Branson describes, then I have 2 dimensions of choice, not one.

There are numerous markets where our dimensions of choice are limited by dominant suppliers. Supermarkets is one. I gather from the hits on my rant complaining about the Cambridge Sainsbury’s misguided promotions and on my wide-ranging discussion of attempts to reduce competition by blocking Tesco in Mill Road and of self-checkout tills in supermarkets, that supermarkets are what the world wants to read about. Back in March when I wrote those pieces I meant to add some further comments complaining about how the Cambridge Sainsbury’s in particular has been gradually replacing branded products with subtly inferior own-brand goods. In my opinion, the texture of Kelloggs’ Sultana Bran is somewhat more dissimilar to that of cardboard than is Sainsbury’s equivalent product. If Kelloggs’ product is good enough for Chris Hoy, then it’s good enough for me. Besides, the Kelloggs box fit in the space in my cupboard in Cambridge and the Sainsbury’s one did not. It was very inconvenient to have to make periodic trips to Asda to stock up on Kelloggs’ Sultana Bran when Cambridge Sainsbury’s decided to just stock their own brand.

The point is that when supermarkets used to stock only branded goods, you had two dimensions of choice: where to shop and what to buy when you got there. The supermarkets specialised in the business of retailing and their suppliers in making the best products.

But what the supermarkets have done over the years is reduce the choice to one: where to shop. Larger stores, the institution of the weekly shop by car and a battle to monopolise the best locations have made it very difficult for shoppers to choose different products at different stores.

Own-brand products are a way of capitalising on “owning” the customer. Why let suppliers have some of the profits? Even if an own-brand alternative is slightly inferior shoppers are unlikely to go to a rival just for one or two items. And after a while they may forget they preferred the brand. Of course, it may not be necessary for the supermarket to ditch the branded product anyway. The threat of introducing a generic alternative may be enough. It must, surely, allow the supermarket to improve the terms of supply and increase their profits.

In the news this week, though is the OFT’s ruling in favour of the status quo on tied pubs. Clearly the practice must increase the landlords’ profits, since, as the FT reports:

“The OFT ruling on beer ties, which obliges pub tenants to buy their beer supplies from their pub landlords at often above-market prices, boosted shares in Punch Taverns and Enterprise Inns by 14 and 23 per cent respectively.”

I doubt the stockmarket is mistaken: if the practice is good for the landlords it must be bad either for the tenant (i.e. the pub manager, referred to in common parlance as the “landlord” – don’t get confused) or the customer. Probably both.

It seems to me fairly obvious that restricting the degrees of choice by the customer must allow the landlord to improve profits. Not all customers are going to go elsewhere for a different pint of beer, though they may well buy something different if it were on offer in their local.

Different industries may have the same feature – an anti-competitive form of vertical integration – but there are peculiarities to each. In the pub business, the landlord is a monopoly supplier to the tenant. It is therefore beyond me how we can find a Simon Williams, “senior director of the OFT” saying, according to the FT, that:

“… it [is] not in the pub owners’ interests to overcharge landlords for their beer. ‘Any strategy by a pub-owning company which compromises the competitive position of its tied pubs would not be sustainable, as this would result in a loss of sales. Pub-owning companies are not therefore protected from competition by virtue of the supply ties agreed with their lessees.’ ”

No, no, no! This is mindblowingly dumb. 101 economics (again): a monopolist does not maximise profits by fully satisfying “demand”. A few seconds thought verifies the sheer mindblowing dumbness of the OFT’s assertion: by their logic the pub owners would reduce beer to a fraction above cost to sell as much as possible. No. The pub owner has an incentive to increase the price of beer until the additional profit is outweighed by the sales that are lost. As I said, many people choose their pub on criteria other than the beer stocked and its price, so the tied pub owner has much more scope to increase prices than an independent beer producer. If customers don’t like it they have to go out in the rain: they can’t simply choose a beer from a different pump.

The Guardian, I now see, also reports the OFT’s decision. As well as the quote above they report some more absurd statements from Simon Williams:

” ‘The interests of the pubco and lessee are aligned.’

This is a bizarre thing to say. In any supply-chain there is competition to capture the available profits. The interests of the pubco and the lessee cannot possibly “be aligned”.

Anyway, let’s go on:

“[Williams] pointed to pub industry closure statistics, suggesting they showed the greatest number of boarded-up sites across Britain’s ailing pub industry were free houses, not ‘tied’ premises.”

Ah, but there’s an explanation for this (well, several actually – the article notes that it is easier to replace a tenant landlord of a tied pub than a free-house landlord). My different point, though, is that, because the pubcos buy in bulk from a small number of brewers you’d expect them to be able to undercut free houses, except the big chains like Wetherspoons.* Damningly, though, Williams notes that:

“…the difference in bar prices between tied and non-tied pubs was very small — lager being about 8p, or 4%, dearer per pint in a tied house — suggesting competition was working well.


And finally:

” ‘The market can deliver better than any state intervention,’ he said.”

My philosophy is that the state needs to intervene to manage markets. No-one’s talking about setting prices or anything. Yet another ridiculous statement from Simon Williams.

Until recently the state of British pubs was a long way from the top of my list of the world’s wrongs to be righted. But no sooner had I noticed that the legendary Tumbledown Dick is boarded up than I saw the Paper Moon in the same sad state.

We’re losing our history.

And a large part of the reason is because we apparently don’t properly understand competition.

* Note: The buyer power of large organisations is a separate problem in the pub as well as supermarket and many other industries. I’ll discuss this another time.

October 22, 2009

Lucky we had Lehman’s!

Filed under: Concepts, Credit crisis, Economics, Moral hazard, Regulation — Tim Joslin @ 5:28 pm

So banks are to be forced not only to hold more capital but also to make “living wills” in order to prevent another Lehman’s. Everyone seems to think this is a good idea. The arguments centre around the practicality of the measure.

But was Lehman’s collapse such a bad thing?

Let’s remember that the interbank money markets seized up in August 2007. Lehman’s collapsed in September 2008. It was only then that governments were galvanised into taking decisive action to recapitalise the banks.

What are the counterfactual scenarios?

Well, let’s not spend too long discussing what would have happened had there been no credit crisis at all. Remember that inflationary pressures were building. Oil might now be at $200 and we could be looking at another decade of 1970s style stagflation. Lucky we had all those sub-prime mortgages!

Let’s consider a little more, though, what would have happened had Lehman not collapsed. Maybe the investment banks would still be limping along after a few more ad hoc injections of Middle Eastern capital and a few asset sales. But the interbank money markets would still be dead. And mortgage defaults would have continued and would have continued to have knock-on effects. Likely we’d still have had a recession and banks around the world would be facing secondary losses.

The dominant paradigm suggests some banks should be allowed to fail. Otherwise we run risks of “moral hazard”.

But if lots of smaller banks do fail, as in the 1930s, how do we stop the cascade of bankruptcies? Every failure puts other institutions at risk. Where do you draw the line?

To look at it another way, consider the collective pool of bank shareholders’ capital. Ultimately this risk capital supports lending. Whenever banks collectively start to lose money this pool shrinks. Regardless of the structure of the banking industry. Inevitably positive feedbacks develop as banks reduce lending, in what has been termed the “deleveraging” process, causing further personal bankruptcies or loan defaults and business failures and the need to rein in lending still more…

What happened after Lehman’s was that a number of government steps and some private recapitalisations arrested the deleveraging process after a few months.

The question is how else would this have occurred had Lehman’s not failed? I strongly suspect that we would have had a longer, more drawn-out recession. This would have allowed more time for adverse economic and social consequences, such as protectionist steps and the rise of xenophobic extremist political parties.

I put it to you that we need to retain banks that are too big to fail, so that when they do fail everyone is scared shitless and overcomes the ideological obstacles to radical steps to solve the problem!


I add some codas:

(1) Market lore is that financial crises only bottom out when there is the failure of a systemically important institution. There’s a reason for this. It’s only then that governments take actions they would not previously have contemplated.

(2) We’d all be in a much better place if there were better ways of getting private capital into ailing financial institutions.

(3) We’d all be in a much better place if we abandoned the ridiculous idea that “moral hazard” is best applied to corporate entities. We don’t want any banks (or other public companies for that matter) to fail – because this simply propagates a bankruptcy cascade. What we want is for them to raise additional capital and for the shareholders to fire those responsible for destroying value.

(4) Having observed recent events closely, I’m highly sceptical that mandating banks to hold more capital “in the good times” is going to work. The problem is that no government will relax the capital limits as we head into a crisis. The 2008-9 recession has broken all records. When the next downturn starts, no-one will know how deep it will be. Governments will keep their powder dry and banks will reduce lending to restore their balance sheets. Again.

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