Chris Watling: Britain is headed for the wilderness if we borrow more instead of saving

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The Independent Online

Once again, the Bank of England has brought interest rates down. This time it was a 0.5 percentage point cut, taking rates down to 1.5 per cent – their lowest since the central bank was established in 1694.

With interest rates at a 315-year low, it seems pertinent to ask what's so special about this crisis that hasn't already been experienced during the wars, famines, depressions, deflationary bouts, economic crises and currency crises of the past three centuries? Why did previous governments not feel the need to cut rates to such a minimal level? Why do policy makers feel it is necessary to do so now, and is it sensible?

The short answer is that it is not different this time. Yes, this is a severe crisis but no more so than many of the past convulsions. Interest rates at record lows are not the answer. Indeed, two big problems are associated with them. First, people who put money by are unduly penalised. British savers were receiving interest as high as 6 or 7 per cent at the start of 2008 (in line with historical norms). Now rates are as low as 2 to 3.5 per cent and likely to fall from these levels. With deposits as high as 80 per cent of UK GDP (that is, not much lower than mortgage debt, which is 82 per cent of GDP), excessive rate cuts merely represent a wealth transfer from savers to borrowers: borrowers get relief on their debt service payments while those who live off the interest on their savings income either have to speculate with their capital in order to try to make up for the lost interest, or they have to dip into that capital.

Second, unduly low interest rates will not encourage any more capital to be channelled into long-term wealth generation (the entrepreneurial backbone of an economy), but will instead encourage more speculation. Ultimately, the purpose of the financial system is to direct savings into productive investment, not to channel savings and credit borrowed from abroad into housing, financial speculation and excessive consumption. The UK's current problems stem not from a lack of borrowing but a lack of money put by. The household sector's savings rate has fallen from 9 per cent a decade ago to almost zero today. The Government – which, after all, is just a steward of householders' current and future money – has also been living beyond its means since 2001. Consequently, as a nation, we've had to borrow £152bn (10 per cent of GDP) from the rest of the world to fund the shortfall.

More worrying, the impact of all this borrowing and illusory wealth has been an enormous fall in British households' aggregate net wealth (calculated as all financial assets – mostly pensions, life assurance reserves and bank deposits – less all financial liabilities – primarily mortgages). Our net financial wealth, relative to the size of our economy, is at its lowest since 1992. This is the product of very low interest rates and short-term illusory wealth creation.

To understand the questionable nature of the current policy response, we need only look back to the start of the decade, the last time the economy was stoked up with aggressive rate cuts and a fiscal stimulus. From 2001 to 2003, after the bursting of the global stock market bubble, the Bank cut base rates to 3.5 per cent from 6 per cent in 2000 (already down from 7.5 per cent in 1998), while the Government enacted a huge, multi-year spending programme on schools, hospitals and other projects.

The consequence of those ultra-low interest rates was an acceleration of the housing boom that had been going on since the mid-1990s. Property prices, on the back of cheap, easy credit, rose by a cumulative 167 per cent (inflation adjusted) from their trough in 1996 to their peak in 2007. This was more than double the size of the 1980s boom (up 67 per cent, inflation adjusted, trough to peak), which in turn was more than double the 1970s boom (up 26 per cent).

The most recent boom was fuelled by cheap credit from the commercial banks, coupled with lax regulation and facilitated by the low Bank base rate. An analysis of the history of speculative financial bubbles shows that cheap money was always a component. As banks' lending standards slackened and mortgages were granted to housebuyers with no deposit and at high multiples relative to salaries, property prices rocketed. So too did the size of the commercial banks' balance sheets as they lent money at aggressive rates to fund residential and commercial property acquisitions. It should be noted that our crisis was not born out of America's sub-prime lending, but was of our own making. As the five big British banks made loans at a rapid rate, their combined balance sheet ballooned from a mere one times GDP in 1999 to four times by 2007. While not as bad as in Iceland, where banks' balance sheets reached 10 times GDP, it is still a frighteningly large number. While some of that growth reflected global and domestic acquisitions, most related to domestic lending.

Policy makers do have a choice in all this; it is not merely an inescapable global phenomenon. Just look at core Europe (Germany, France and Italy). Yes, they have injected money into their banks, and yes, two of those three economies did experience house-price booms. But the damage to their banking systems has not been nearly as severe as in the UK. The reason is the tougher regulations in those countries, which prevent mortgages being granted with minimal or no deposit. Total credit to the private sector in the eurozone has continued to grow in 2008.

So what should UK policy makers do? Ultimately, we will need to start saving again; leverage is not the magic of economic growth. It is productivity driven by innovation that leads to genuine, long-term wealth creation. That requires a rise in domestic savings rates to fund investment, which means lower domestic consumption.

How that outcome evolves depends on the policy response. Continued efforts to encourage over-indebted consumers to borrow more will just prolong the pain. Overly low interest rates or indeed the printing of money risk serious long-term inflationary problems. A (relatively) short, two-to-three-year recession now, or even a depression, will enable a rapid adjustment and a brighter future for Britain. Our ancestors understood the concept that once the party's over, the hangover has to be endured. If we don't grasp that, our economy will be condemned to its own Japanese-style lost decade.

Equities could soar, after a 12-year sideways shuffle – but timing is vital

All big western stock markets have gone sideways over the past decade. The FTSE 100, at around 4400, is at the same level as when Labour came to power, while the Dow Jones and eurozone indices are also around their 1997 levels. Such poor performance, rather than the 7 per cent a year ad infinitum some expected, makes people wonder if it's appropriate to invest at all.

Long sideways moves are, however, the norm. The US peak in 1929 was not revisited until 1954. The Dow Jones made an all-time high of 995 in 1966. It wasn't meaningfully passed until the start of the 1982–2000 structural bull market (one which rises gently over a long period, as opposed to a cyclical bull market, the boom side of boom-and-bust). The UK market shows similar patterns – the 1929 high in the FTSE all-share was not passed until 1944. In between, equities perform better than the traditional 7 per cent. The trick, as always, is timing.

In the short term (one to three years), the next cyclical bull market may have begun, or is likely to start in the first half of 2009. Importantly, the best equity gains typically come at the start of a cyclical bull market when annual returns of 20 per cent, and as high as 40 per cent, are the norm. Today, equity markets have discounted a considerable amount of bad news, yield curves are steep, foretelling economic recoveries while equities are cheap – our valuation indicator has generated its first "buy" signal since 1990 and its strongest since 1978.

In the long run, though, we'd be more cautious. This seems likely to be a cyclical not a structural bull market. Structural bull markets in equities coincide with structural bear markets in commodities. While commodities have given back a lot of their gains since their July highs, we expect a resumption of the long-term commodity bull market. Ultimately, that would preclude a new structural bull market and suggest that timing, not a buy and hold strategy, will remain the key to trading equities over coming years.



Chris Watling is chief executive of Longview Economics

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