A slight change in focus can produce a profoundly different understanding

Solving the Housing Crisis

Home ownership can be viewed as buy-to-let where you are your own tenant. There are many advantages to this arrangement, notably tax. You waive any rent so income tax does not enter the equation. Sale of the property is capital gains tax exempt. There are advantages with stamp duty. There may be a greater selection of properties to buy than to rent. You can be as good or as bad a landlord as you choose. You have security of tenure. The terms of an owner occupation mortgage are materially better than those of a buy-to-let.  There are also disadvantages. You are invested in a single property asset, in a single location. The specific risk is huge. The liquidity risk is huge. It is easier to get a buy-to-let mortgage. You are responsible for managing and maintaining the property.

In both cases you have great specific risk (unless you are a big landlord) and you are leveraged and this contributes to the high returns from single property investment. You put down 50k and buy a 500k property. The price rises 10% so you make 50k. That is 100% return on equity (the 50k deposit). This also illustrates the absurdity of the existing system of home acquisition. It assumes ever rising prices. For long periods this is a reasonable assumption, but punctuated by occasional crashes. The last  general UK crash was 1987-1994. Many have forgotten. Looking abroad one can find more recent crashes. Indeed within the UK there have been regional soft spots. If you owned a property in one of these locations then the property boom has passed you by.

The present system also favours those in larger and more valuable properties. A first time buyer will eventually need to trade up. The assumed steady house price inflation constantly transfers money wealth upwards because the absolute amount you need to spend to trade up increases with price inflation. If you pay too much initially the overpayments cumulate to a huge error over time. First time buyers think they have solved the problem by getting on the housing ladder. They have merely ameliorated the problem. Perversely, first time buyers should be hoping prices crash even after they have bought.

If I went to a bank and asked to borrow 500k to invest in a Real Estate Investment Trust they would probably show me the door. But let us assume they would listen first. I could show them my income and outgoings and that I could comfortably service the debt. The loan would be secured on the value of the trust. I could even let them choose the trust or a selection of trusts. These trusts invest in a wide range of property assets and pay out 90% of taxable income. They have high dividend yields, 4-5% not atypical. The loan interest would thus be more or less covered by the yield. Many trusts trade at large discounts to net asset value. So in effect I would be borrowing to buy a selection of assets at below what the valuers believe they are worth, generating a dividend income that will cover most if not all of the interest, on top of the fact that my income could service the debt in any event. Still I suspect they would show me the door.

One reason might be that REITs are already leveraged. But if the NAV is 30% more than the price of a share there is quite a buffer for the bank (assuming valuations are reasonable). The REIT generates income from rents but is not subject to corporation tax. In exchange it pays out 90% of net income. If the discount to NAV makes the bank nervous they can insist you invest in a REIT that trades at or above NAV. They exist as well. It logically makes no difference. Information is largely in the public domain so these discounts and premiums are probably accurate reflections of this information. If this is not the case then there are some serious anomalies in this sector that are hard to explain.

The purpose of this little diatribe is to highlight that owner occupation is a popular investment because of the tax advantages and the ease with which leverage is available. If the tax advantages are removed and leverage is equally available for diversified, liquid REITs then owner occupation looks less interesting. In this situation you could borrow to invest in a portfolio of REITs and rent somewhere suitable to live (perhaps owned by one of your REITs). If you change jobs, have a family, divorce, etc you can move to more suitable rented accommodation without the hassle and expense of selling up and buying again. The greater willingness to invest via REITs would expand the availability and range of accommodation as the demand and capital allocated expand. It is a different model of property ownership but everyone can still own property and have somewhere to live.

The solution to the housing crisis lies in creating a system of flexible accommodation units that allow people to move around without penalty. Council housing fixes people in one location and there may be no suitable work in this location. Owner occupation creates friction on movement and in some extreme regional cases may mean it is impossible. A system of flexible accommodation units providing good standard accommodation of the right type would allow friction free movement. It could be highly regulated according to standard and security of tenure. It could be coordinated with support services. It could be funded and managed by either public or private capital or both. It does not preclude owner occupation. It may however require that a system so biased in favour of owner occupation be reformed.

Happiness and the Media

The media, social and private, seem determined to undermine personal happiness. Quite why this the case is unclear. It seems negative news attracts more attention (gets more hits, sells more advertising) than positive news. The net effect is to make society, all societies, less happy. The constant stream of negativity creates an endless sense of anxiety and fear. Moreover, the response to this relentless anxiety creates behavioural responses that aggravate and validate the initial anxiety.

The problem is evident in all areas of life. My recent blogs How much should you save? and Pension saving and the lifetime allowance address the prevalence of this phenomenon in the context of making provision for old age. The press likes to state that you need to save some impossible amount to avoid penury in old age. The natural response is to get depressed and not save anything and throw yourself at the mercy of the state 40 years on. A different presentation of the same information suggests making reasonable provision for old age is quite possible and well worth doing. If presented correctly many more would make some provision and feel better for it as well as being better off in old age. However, the media has no incentive to present positive scenarios. The moral of this story is perhaps you should think for yourself and use media solely for information. This requires a little critical thinking but it is not too taxing. Let us try it.

A 30-year-old single person has to make some important decisions. Today they may or may not be in a stable relationship and are quite likely to be living at home. Living at home brings its own stresses and strains but is likely to be very specific to individual circumstances. Social convention frowns upon living at home at this age but unless the condition brings specific problems why worry about social convention? When I was young social convention expected one to be married by this age. This convention no longer applies. The first rule of happiness is live your life and not that of Joe Average. Why do you want to be average?

The future is completely unknown and the past is not much of a guide. Things change. So what strategy is best for you in this stark and frightening situation? It rather depends on who ‘you’ are. Someone living in the middle of a homogenous community with a wide social support group will view life very differently from someone living in a heterogeneous community with no reliable support group. In today’s multi-ethnic, multi-cultural, urban society, the ‘average’ conceals some serious dispersion. You do not need to think too deeply about who you are in this sense. Your emotions will reveal it. Trust your emotions and do what feels right today and not what the media tells you is right. In a world of an unknown future and an unhelpful past, the only thing you can control and optimise is how you feel today. But do not let the media tell you how you should feel.

So how does this odd dialogue translate into financial strategy? You could just live for today and let old age look after itself. It is 40 years or so away and a lot will change before you get there. The state may provide and even if you save the state may take it away from you. So why bother? It is certainly true that my retirement is nothing like I expected it to be when I was 30 years old. If I had known then what the situation would be when I retired I would have done a lot of things quite different. I was fearful of the future and sacrificed much happiness in the present trying to secure the future. It was in retrospect an unnecessary sacrifice. But then hindsight is 20/20.

The emotional message is thus think of the future but not to the extent that it makes you unhappy in the present. So try to save some money but don’t worry too much if it is not as much as the media are telling you that you need to save. In my blogs above I tried to illustrate that saving relatively manageable amounts can lead to meaningful long-term outcomes. It is the power of compound interest and averaging at work. I assumed a 2% inflation rate (the Bank of England target), 35bp charges, and nominal equity returns with dividends reinvested of 7%. All assumptions can be justified though they offer no guaranty. If you save £200 pm under such assumptions you will end up with savings of approximately £500k which will be worth roughly half in today’s money. Worth having. Of course this is illustrative not a recommendation. You can vary what you save every month and increase as your pay increases. The point is that regular saving in the right asset class over long periods can have meaningful results. It is the habit, and the asset class, that is important not the amount.



Financial Market Outlook

Financial markets have become a little disconnected in the last month or so. As a rule financial and economic variables exhibit stable relationships. These relationships can change but then they exhibit stability for sustained periods once again. This stable relationship is sometimes referred to as the macro regime. Changes in macro regime are typically preceded by periods of disconnection with prices and interest rates moving seemingly independently. My friends at Quant Insight can confirm that this breakdown of macro economic regime is now quite general. Such periods can be quite unsettling and quite dangerous.

The trigger for this breakdown in macro regime has, in my view, been the central banks. I have hinted at this in earlier blogs. The financial crisis is evidently over and the emergency policy rates and actions taken to restore financial stability are no longer required. Central banks are looking to raise rates not because of an imminent inflation risk rather despite the lack of one. Such low rates and aggressive QE are simply no longer necessary. The relatively well contained inflation environment means there is no rush to raise rates but the bias has now shifted to higher. The markets are adjusting to this and it is never a smooth process hence the disconnection. The only exception to this situation is Japan but regular readers of my blog will know Japan is a special basket case.

Although there is no imminent inflation threat the conditions for higher inflation are in place so the CB bias is sensibly forward-looking. Bank balance sheets are restored and more prudent practices are in place. The banks and regulators have fumbled their way to more confidence and this will enable bank credit to grow faster going forward. A rise in interest rates will generally benefit bank profits so this will act to increase credit capacity. The logic is that higher rates will also reduce demand but this does not necessarily follow (oddly enough) immediately. The immediate impact of higher rates may thus boost economic activity though if rates rise far enough and for long enough there will eventually be a negative impact. A gentle rise in rates is thus no immediate threat but the markets are never quite this subtle in their responses.They will either assume a rise is ill-conceived and will quickly be reversed or extrapolate way too many increases. Moreover the prevailing mood may shoot from one view to the other on a weekly basis until a new macro regime is settled on.

The disconnection is not solely down to the CB shift however. There are other issues for markets to digest. Trump is proving to be a problem for US policy with a state of paralysis setting. There are very visible geo-political changes taking place globally. Erdogan’s Turkey is not a good Nato ally and is breaking away from traditional loyalties and behaviours. Relations between the EU and Turkey are breaking down. Relations between the EU and US are breaking down. Russia seems to be influencing geo-politics despite efforts to isolate and contain via sanctions. Meanwhile China is quietly growing and asserting its presence everywhere but especially in the China seas. Middle-east states are turning on each other. North Korea is behaving like a naughty child seeking attention. Sooner or later someone is going to give way to the urge to reprimand it.

The markets themselves have reached levels that are making many nervous. Call it financial vertigo. No one quite believes the valuations but no one is yet willing to go against them. Everyone would be a little happier with a corrective test and is quietly adjusting positions to allay nervousness. The resulting price action adds to the sense of disconnection. Generally markets do not fail when there is this much nervousness but the next step is complacency. Markets always fail when they get complacent. It is hard to tell from where I sit when complacency has set in. It is evident in some quarters but seems not yet general.

If you have a sensible investment strategy the best thing to do in this situation is nothing. You might want to skew your portfolio towards stocks that benefit from rising rates (like banks) and reduce utilities exposure. You might want to reduce bonds in favour of cash. But your basic low risk/high risk asset allocation should not change. If you have chosen correctly then it is designed to ride precisely this environment. How do you choose the right allocation for you?

Let us simplify by talking in terms of cash and equity as the low risk/high risk asset classes. Ask yourself how you would feel if equities fall by 50% (can happen). If your response is to rub your hands with glee and mumble ‘opportunity’, then maybe a 40/60 cash/equity allocation works for you. If your response is heart palpitations then maybe 60/40 or even 70/30 is best. Of course you never know your true response until the 50% fall occurs but you have to try. In my experience most people are either in managed funds and have much higher equity allocations or in cash and have no equity. In other words they have never given the matter any thought. I suggest you do and soon.

Pension Saving and the Lifetime Allowance

Grim warnings about inadequate provision for old age abound. For the typical 30-year-old trying to make rent and save for a deposit on a home, such warnings will most likely have the effect of persuading them to ignore the whole pension saving issue entirely. They will do nothing. This a shame and rather unnecessary. It is all in the presentation.

Pension saving is a specific example of saving. The difference is you are targeting a pot to provide income 38-40 years hence ( I stick with my 30-year-old). Pension saving can get help from an employer through employer contributions and own contributions are relieved of tax. The amount invested on your behalf can be significantly greater than you give up in disposable income. If say you earn £25k and your employer contributes 3% (£750 pa) and you contribute 10% (£2500 pa) tax relieved at 20% (£2000 pa) then £3250 pa is invested on your behalf and you disposable income is reduced by £2000 pa or £166 pm. This is still a substantial sum for someone on £25k pa but not impossible. Moreover you could start with a £100 or less and increase later. The important thing is to start and get into the discipline.

The amount £3250 pa invested on your behalf might, on reasonable assumptions, enable a pension of £19500 pa in today’s money. This is worth having. The important thing to note is that it is not necessarily worth saving much more through a pension scheme. This is because of the lifetime allowance being set at £1m. If your pension pot exceeds this figure in 38 years then penal tax rates are imposed. To achieve £1m in 38 years may be easier than one might think. On my assumptions this would be achieved by investing £398 pm for 38 years. On more conservative assumptions it might require £617 pm for 38 years. Bearing in mind nominal salaries increase this could be achieved by starting lower and increasing saving over time. The message is there is not much point in saving more than say £500 pm through a pension scheme, including the employer contributions, as long as the LTA is £1m.

This does not mean it is not worth saving. ISAs provide a very useful savings wrapper. This is because everything within the wrapper is free of tax. If your pension contributions have you on course to achieve £1m LTA by retirement it is fruitless to invest more in a pension even if contributions yield tax relief. If you exceed £1m the excess will be taxed back. The constant complaint one hears is that people do not make enough provision for retirement and specifically through pension contributions. But the rational amount of pension contributions is logically capped at a fairly low-level. General saving still makes sense but this is subject to current needs.

My advice to young people is think about achieving a pension pot of £1m. You have a 40 year or so time horizon so you can start small. The important thing is to start and keep going. Invest in assets that have good growth prospects (not cash). Low cost passive equity funds are ideal. Keep the costs low. Keep saving and make sure you use an employer scheme, if the employer makes a contribution. Increase your contributions in line with income but remember you need only increase up to the point that makes £1m over the 40 years likely. If you have the correct investment strategy and are consistent then it is unlikely that you will need to contribute much more than £600 pm into a pension plan and part of that will be an employer contribution. And once you are a 40% tax payer (which happens quicker than you might imagine if inflation picks up), every pound you contribute only costs you 60p in deferred disposable income. Do not let sensation seeking journalists put you off saving for retirement.

Collective Choice and Social Welfare

The title of this blog is taken from Amartya Sen’s book. It was first published in 1970, the year before I became an economics undergraduate, and has recently been expanded. It addresses how societies an make social choices and how social welfare connects to the welfare of the individuals that make up society. It is a difficult area of economics and some argue it is not a legitimate part of economics. The relevance to current affairs is very evident. The HS2 rail link, the expansion of Heathrow, and, of course, Brexit are all collective choices that impact the welfare of individuals and thus of our society. Do these projects improve social welfare?

All three above decisions have been made through the democratic process. The UK has a specific example of representative democracy known as parliamentary democracy. Representatives are elected by constituency on a winner-takes-all basis. It is a pluralist system so each member of parliament has a duty to represent all constituents even if they did not vote for her/him. Campaigns are based on political parties which offer a particular political ideology and often make specific promises prior to election. The parliament elects a government based on the support in the House of Commons and the government can continue as long as it has the support of a majority on key legislation. There is a huge distance between the voter and what the government ultimately chooses. It is the government that makes the social choices that impact social and hence individual welfare.

The UK system allows for a government which may have only directly received a minority of votes. Moreover even those that voted for the party that formed the government may disapprove of specific social choices. It is possible in the UK system for substantial social choices to be made based on the preferences of a small minority of the population. The government of the day should take into account the impact on the whole population but is not obliged to do so. If it commands a simple majority in the House of Commons it can more or less do what it wishes. It can be harassed and delayed by the House of Lords but ultimately it can make the social choices it wishes to make. The population’s only legal defence is to vote for parties that promise to amend or reverse the unwelcome choices of the present government. Occasionally the public can resort to public disorder in order to assert the majority preference (Poll Tax Riots).

The Brexit outcome is a particularly interesting example of this process. The government of the day decided to take direct advice from the population on whether to leave the EU. The result was a (very) small majority of the votes cast in favour of leaving but a minority of those eligible to vote. The government of the day was happy to proceed to leave on this basis but was forced by private citizens to ask parliament through a vote. Parliament approved the government’s action even though there was a substantial majority of MPs that had openly supported remaining in the EU. This odd outcome validated the decision to leave. The government of the day decided to have another election and was allowed to do so by parliament even though the fixed parliaments act was designed to stop opportunistic general elections. The result was the two largest parties in parliament both being committed to leaving the EU even though there is strong evidence that most MPs did not, and the majority of the population no longer, support this commitment. The UK parliamentary system can throw up some social choices that are self-evidently suboptimal. Moreover, the cost of Brexit is high and reversing it is very difficult.

Social choice through voting systems does not make interpersonal comparisons. In all choice situations there are winners and losers. There is no attempt to compare winners and losers and say, for example, the winners gain more in individual welfare than the losers give up so it is a choice that increases social welfare. One of the purposes of Sen’s book is to explore the conditions under which such comparisons are possible. Economists have typically shied away from such comparisons. At best, they have applied the compensation principle. If the winners could compensate the losers and still be better off then social welfare is improved by the choice. This ignores the significance of wealth distribution in social welfare. Moreover, it reduces welfare to money values.

Interpersonal comparisons are not impossible. If a social choice will make a few rich people richer, and a great many poor people poorer, it could be argued that social welfare is being reduced even if compensation is possible. The welfare increase to the rich from getting rich is relatively small compared to the welfare loss of the poor from getting poorer. It might work if the poor are actually compensated but then the rich might not want the change. The point is, who is winning and who is losing is not unimportant in collective choice and social welfare but the electoral system alone may not take this into account. Indeed the system is inevitably biased towards those that have the most political power and know how to exercise it. They tend to be wealthy.

The purpose of this blog is to remind you that democracy is not a panacea. It can lead to outcomes that reduce social welfare. In particular all voting systems ignore interpersonal comparisons. It is possible to consider who the winners and losers are in all collective choices and this will influence the welfare judgements on such choices. It is important to look at each case carefully and not hide behind process and vague words. In particular, ” I’m alright Jack”  and ” Not in my back yard” need to be exposed and held up to scrutiny every time.

Tax, Inflation, and Yield

The recent pick up in inflation has been met by central bankers and politicians with a certain amount of relief. Deflation has many characteristics which politicians in particular dislike. It impacts tax revenues negatively. Inflation allows a surreptitious increase in tax revenue known as ‘fiscal drag’. As inflation picks up, nominal values adjust upwards, and so even with constant tax rates, tax revenues rise. If your pay goes up because of an inflation adjustment and the rise places you in a higher tax bracket then you are clearly worse off after tax. In effect, tax revenues are automatically inflation-linked whilst government expenditures are not, so inflation increases the net tax take without any change in rates. Nice!

Many investors also seem to welcome the rise in inflation, even those that typically hold nominal assets (like cash in the bank). This is because it raises the prospect of a rise in interest rates. This is of course somewhat naive as it is a rise in real interest rates that investors should welcome not simply nominal interest rates. If inflation and nominal interest rates increase at the same rate, the real interest rate does not change. However, the investor may be worse off because of fiscal drag. The investor may be dragged into a higher tax bracket because nominal income has increased. This can create some interesting investment quirks.

Gilts are a popular low default-risk asset for investors seeking a stable income and security of principal. Fixed coupon gilts pay a coupon twice yearly up to a fixed maturity date. They are issued in nominal amounts of £100 (which is what you get back at maturity) but on any day will trade above or below 100 depending on how bond yields are moving. If bond yields rise a lot, say because inflation is rising, then prices will fall and possibly a long way below the nominal or par value. During the recent period of very low yields prices have moved a long way above par. The return from a gilt can be looked at in two ways; the running yield and the yield to maturity (ytm).

The running yield is simply the annual coupon payment divided by what you paid for the bond. The ytm is a bit more complicated but think of it as the annual interest rate or return if you hold the bond until it matures. One of the quirky aspects of such gilts is that whilst the coupon is taxable as income, any capital gain or loss from buying and selling the gilt incurs no capital gain tax. This means that which issues it makes sense to buy depends on your tax bracket. The effective after-tax ytm on each bond may be quite different. In a rising inflation and  yield environment this creates problems and opportunities.

The Debt Management Office website offers closing prices on all gilts. Consider two issues. The UKT 1.5% 2047 and the UKT 4.25% 2049. The running yield on the UKT1.5 is 1.66% and the running yield on the UKT4.25 is 2.71%. The ytm on the respective bonds is 1.92% and 1.88%. The prices of the respective bonds are 90.47 and 157.11. They will both get £100 back at maturity. The buyer of the UKT4.25 makes a loss at maturity but has effectively been repaid every year in a higher coupon and running yield. In a zero tax world which bond one chooses rather depends upon needs and circumstances in relation to cash flow. But the world is not zero tax.

What if the investor is a 40% tax payer at the margin. The after-tax running yield on the two bonds is now 0.99% and 1.62% respectively but the after-tax ytm is 1.28% and 0.61%. The low coupon bond offers a much better return to maturity. The reason is that £9.53 per bond is returned at maturity tax free. The high coupon bond effectively has £57.11 returned over the 32.5 year period each year and is taxed at 40%. A 40% tax payer is thus well advised to avoid bonds trading above par and seek out bonds trading below par. The interesting thing is that as inflation and bond yields rise, there will be more such bonds (as prices fall) and the discount to par will get deeper and deeper creating even greater tax advantage for the high rate tax payer. The deeper the discount the more of the bond income is returned at maturity free of any tax.

The latest CPI reading is 2.9%. The highest one year fixed rate interest rate I have been able to find is 1.7% (Masthaven) so we are looking at -1.2% real, at best. The latest RPI is 3.7%. This index is discontinued as an inflation measure but is still used as an index in index-linked gilt calculations, on Index-linked certificates, and many pension and insurance contracts. If you have a NS&I Index-linked certificate you can roll it (no new certificates are being issued) at essentially the RPI rate, which compared to the CPI gives you, bizarrely, a positive real yield. Similarly, index-linked gilts which post real yields based on RPI are, compared to CPI, less negative than they might seem. If your pension is going up by the RPI then you are getting real pension increases. Of course, this presupposes that CPI is a better inflation measure than RPI.

The period of deflation and low-interest rates has been good for the wealthy. Not only has it inflated nominal asset values but it has enabled the wealthy to hold wealth in nominal assets (like cash) without the risk of surreptitious inflation taxes. A jump in inflation with a lagged jump in interest rates is particularly bad for wealth. However, even if real rates are stable, fiscal drag will hurt nominal incomes. The tax treatment of gilts and the CPI/RPI difference creates some interesting opportunities for the watchful.


I used the Candid Money yield calculator and adjusted coupons down by 40% to obtain after-tax yields.

Origination, Trading, and Investment

Consumers spend a great deal of time researching durable purchases such as cars, computers, and white goods. They read reviews and articles by independent consumer organisations such as Which? magazine. Nobody goes into a car showroom and buys the car the salesperson pushes. When it comes to durable consumer goods people seem pretty savvy. Why then, when it comes to financial products, are people so careless? At best they pay for expensive independent advice and leave the judgement in the hands of someone who assesses their needs and risk profile from an intrusive questionnaire. They let someone else tell them who they are in financial terms. At worse they take the first financial product they come across without much thought. They do not buy the first computer they see so why the first mortgage or ISA?

Part of the problem seems to be lack of ability and/or willingness to think about personal finance. You earn £x after tax and NIC. You have liquid savings of £y (where y might be negative). You have net assets of £z ( again z might be negative). This defines your basic budget constraint. You have fixed outgoings each month (things you must pay, like mortgage payments, rent, food etc). Is it really so challenging to sit down and put this all all on paper (or a spreadsheet) and look at it. I suspect most that do not do this fail to do so not because they are incapable but are frightened of the reality it presents. Denial is the most common cause of financial myopia.

Another problem is fear, specifically fear of making a mistake. Occasionally this is overtaken by fear of missing out which can lead to even more catastrophic decisions. This fear is compounded by the plethora of financial products available and the alien language in which they are presented to the public. A systematic and patient approach can overcome these psychological problems (because that is what they are) and put you in control. Step one is to eschew the visit to the pub or club one weekend and sit down and write down your basic budget constraint and non-discretionary outgoings. This will define what you need and what you can afford. You may not like what you see (95% of the population will not) but it is the starting point of being in control.

Once you have determined what you need then, and only then, do you begin a search of what is available to find the most suitable product. This search must be a continuous exercise and not something you just once. Not only will your circumstances change but so does the range of products and the terms on offer. It is a continuously evolving market place. The purpose of this blog is to explain how this market place evolves in simple terms in the hope that it might help those that can help themselves. The example to be used is the mortgage market.

The range of mortgage products is huge and this has to be multiplied by the number of providers. You can go to a broker and present your budget constraint and outgoings and the property you wish to buy and let the broker present you with options and even recommend one. The broker may not of course look at all providers (they should tell you this). Moreover, once a product is selected the process may end there (to your relief) but if the house purchase is delayed a review might be expedient. Things change and in particular the lender that blanked you one week might be keen the following week. Why is this so?

The mortgage market should be seen as consisting of originators, traders, and investors. The originator is the institution that initially sets up the mortgage loan and that you deal with directly. However, the originator may not want to keep the loan on its balance sheet and may include it in a package of mortgage loans which it sells into the secondary mortgage loan market. Traders buy and sell these loan packages as a business (it may be another section of the originator organisation) and investors buy mortgage packages from traders and directly from originators. The three agent categories overlap and the distinction is made only to emphasise that the functions exist in some form. Secondary trading is very important because it provides investors with liquidity and the existence of investors helps originators offer mortgages beyond their own capital base. The world of finance, of which many are so contemptuous, is what makes your mortgage possible, and the choice available.

Mortgages involve interest rate, prepayment, and default risk. Packages are often sliced up into these risk categories and sold to different investors. So whilst you may pay Barclays a mortgage payment each month, the money may end up in many different hands. Barclays may have sold off the mortgage in a package and have no beneficial ownership or liability, beyond servicing the cash flow. Barclays, and other originators, are constantly reassessing the demand for mortgages (and demand for the individual component risks) and this drives the product range and mix on offer. The mortgage terms are not determined solely by the Bank of England base rate. To understand what is on offer you would need to know the sterling swap curve out to ten years and this moves continuously.

Banks no longer make loans which simply sit on their balance sheet until you repay or default. They act as originators and managers of packages which are sold on and make secondary markets in these packages. This has greatly increased the flexibility to offer mortgages though as we saw in 2007, it can go horribly wrong. One assumes lessons have been learned and it will not all go wrong again (and least not in the same way). This is the regulator’s problem. My concern is with the borrower.

Denial and fear do not help. The best way to be in control is to confront your finances and face up to their reality. If you need advice you will need to do the basic arithmetic in any event to inform the advisor and lender. You may as well think about what you need at the same time, as this will help you understand the advice and outcome of attempts to borrow. If you understand what you need it may be you can check the market for yourself and you can keep checking it to see if terms are changing. This will confirm if you have a good deal or can get a better one. Actively engaging in your own finances is the most important thing you can do. It will tell you if you afford the car you spend so much time researching.




Wealth Inequality and the Production Function

Wealth inequality as a subject is sadly absent from mainstream economic theory. It is regarded as an ethical issue and one to be settled by political choice. Economics manages to develop a complete theory of choice without saying much about wealth inequality. Indeed the theory of choice takes the form it does (in my view) in order to avoid the subject of wealth inequality. Much of this is understood and forms the basis of many critique of economic theory. What is less well understood is that the absence also has implications for production theory.

Economics likes to treat production as essentially an engineering issue. A (closed) economy has so many people, and so much capital, land, natural resource, and a given state of technology. One can conceive of a surface that delineates the maximum amount of every combination of goods that it is possible to produce. The economics problem is then set as to how to ensure the economy operates at this surface. To operate within would be suboptimal, states every textbook, as if using up every natural resource as fast as we can is a good thing! In a world of man-made climate change these textbooks could do with some revision methinks. However, this is not the central issue of this blog.

The engineering solution to the maximum (not optimal) production surface ignores wealth distribution. It assumes maximum production levels are independent of wealth distribution. The only textbook in which I recall this was acknowledged is Theoretical Welfare Economics by J. deV. Graaf. This was first published in 1957 and reprinted in 1971, when I bought a copy as an undergraduate. Unusually I also read it and noted this observation about wealth distribution and production surfaces. It is not difficult to see the point. Better fed people with medical care are likely to be more productive. The principle that wealth distribution must affect maximum production is not difficult to establish. Hence there is no single maximal production surface. There is one for every possible wealth distribution. It is not hard to see why economists assumed this problem away. It is a shame that they did as it must have some profound lessons for developing economies.

A related concept to maximal production surfaces is potential output. This is likely to be within the physical limit of production (for a given wealth distribution) and is defined as the point of GDP growth when inflation begins to accelerate. If production surfaces are wealth distribution dependent then it is most likely so is potential output. This is a profound observation. It has always been understood that wealth distribution affects aggregate demand and hence the economy’s location relative to potential output. If it also affects the level of potential output, the problem of macro demand management becomes more complex but also much more interesting. If it is possible to raise the level of potential output and demand for this output simply by varying the distribution of wealth, then redistributive policies become macro economic tools and not simply ethical or political judgements. One can definitely see why conventional economic theory ignored wealth distribution.

This said it is as well to add that pursuing maximal growth may not be socially optimal. The issue of man-made climate change is one consideration but also the welfare benefits from more work and more consumption should also be reviewed. Maybe less is more…

A Rock and a Hard Place

Parliament now consists largely of MPs from two parties, both equally committed to leaving the EU. Irrespective of the views of individual MPs and individual voters, this is the democratic reality. Somehow an illegitimate and unconstitutional referendum has been legitimized and made constitutional. Parliament endorsed the triggering of article 50. However this process began, leaving the EU now has constitutional validity.

During the general election I had some ‘debates’ with Remain supporters about the logic of tactical voting. They seemed so overwhelmed with their hatred of May et al that they managed not to register the position of Corby and McDonnell. These two visibly sabotaged the Remain position during the referendum campaign. They enabled the triggering of article 50. They enabled the general election. The Labour manifesto is quite clear in its commitment to leaving the EU. A vote for Labour was not a vote against austerity or more social justice. It was a vote to leave the EU. Many tactical Remain voters appear to have lost sight of this.

The EU offers a pluralist liberal democracy. It offers social justice. It offers equality before the law and upholds consumer and human rights. It is clumsy and slow and could use better public relations, but it is basically a good institution. It offers a huge single market, a customs union, and various other institutional arrangements. It is moving towards a common, non-aggressive, foreign policy. Each state has a veto over big issues and there is a qualified majority voting system in place for lesser issues. The European Parliament is democratically elected, more so than Westminster in some respects. Otherwise, how is it UKip has so many MEPs and no MPs? The EP is also becoming increasingly powerful. The European Commission, the bête noire of the leavers, is just the civil service. It’s only real power lies in introducing legislation. it cannot pass it or impose it.

Events are about to remove us from this set up and leave us between a rock and a hard place. The two polar extremes of my youth have returned. A fascist, racist, Tory party and a Stalinist Labour party. During the campaign of the 1975 EEC referendum (I was 22 and a recent economics graduate) I watched Enoch Powell and Tony Benn argue against the EEC on a common platform. One of my arguments in favour of remaining in the EEC was that these two unsavoury characters both supported leaving. The political heirs of Enoch and Tony now run the Tory and Labour parties. After 43 years of liberal, pluralist, democracy, and prosperity (albeit unevenly distributed), we have arrived exactly where I feared we would end up in 1975. Well, I guess we will always have the last 43 years (here’s looking at you, kid).

The LibDems seems on the verge of electing Vince Cable as leader and he is edging towards accepting the need for freedom of movement restrictions. The LibDems typically adopt a what-is-best-for-the-country approach but the electoral consequences have been devastating. They will now put the interests of the party first, it seems. Remain voters have nowhere to go even if they have sufficient intelligence to go there (though few, it seems, do). So what hope for remaining in the EU?

Probably better than anyone realises. The election has left the Tories hostage to the Democratic Unionist Party. This unsavoury alliance, and its price, has cost the Tories popularity. The momentum (pardon the pun) is with Stalinist Labour. The Tories will not be calling another election anytime soon (Labour would love that) and Labour cannot force one. This parliament will run for 5 years. This means the exit negotiation will be conducted by a very weak government with the clock ticking. Either a very bad deal or, more likely no deal, will emerge in two years, when the UK falls out of the EU. If the country is unhappy about leaving on these terms then these self-serving power seeking political parties may think again. Never say never….

Monetary Policy and Financial Stability

Yesterday (29/06/2017) we saw a minor perturbation in the asset markets. It was a response to a series of coincident but somewhat ‘hawkish’ statements from central bankers. Hawkish, for the uninitiated, is market-speak for inclined to tighten monetary policy and raise official interest rates. There was, as many noted, a whiff of coordination about the statements. This is unlikely in the strict sense but central bankers do talk to each other. Moreover, they all play from the same rule book and tend to react in much the same way to environmental stimuli. The implication is that they all see the same environment. If they are coincidentally all talking hawkish the environment that they perceive has changed. This is the interesting take from this otherwise small perturbation.

Cheap money has been the rule since 2009. It has not however necessarily been easy money. The central banks have flooded the system with liquidity but this has not led to a credit explosion. This is because banks have tightened credit requirements in response to the 2008 crisis. In part they were required to do so but it has also been a prudential response. Those deemed a good credit have had access to plenty of cheap credit. This has channeled the liquidity through specific routes and had some very noticeable outcomes. Those with capital, the already rich, have been able to expand and get richer.The expansion of pay-day lending, charging usurious interest rates, car loans, and mortgages, are all symptoms of a distorted credit structure. In the UK we have also had huge expansion in peer-to-peer lending and challenger banks. Things are not what they were.

The challenger banks are particularly interesting. They need a banking licence and as such must come within the FSCS compensation scheme. This has expanded the availability of risk free assets. Each separately licensed bank offers a secure deposit facility up to £85k. One of the consequences of the 2008 crisis was to focus attention on the fact that deposits above the protected amount (it varies) are not secure. They are not the same as cash in hand. The deposits may be easy to access but they are no more secure than the bank and the willingness of the state to bail it out. After 2008 bank credit worthiness has become an issue and the willingness of the state to bail out banks has diminished somewhat. The only case of unsecured depositors being ‘bailed-in’ (losing their deposits) is Cyprus in 2013 and this was in exceptional circumstances (the state could not bail-out the banks) but the principle that bail-ins are possible is now well understood. Leaving more than £85k in a bank is risky. The proliferation of challenger banks has increased the number of the £85k deposits that is possible.

It has been my contention that the newly perceived insecurity of large deposits effectively reduced the money supply and contributed to the deflationary forces evident since 2008. The demand for risk free or near risk free assets such as government debt has grown dramatically just as states were working hard to contract supply through tighter fiscal rules (aka austerity). The central banks exacerbated this excess demand by buying large quantities of government debt in the open market as part of the so-called quantitative easing programmes. This has increased liquidity (cash) at a time when what was required was (risk free) assets. The result was that risk free interest rates fell to zero (or negative). Cash has sought a return and a safe home and has typically found it in property.

Property values have exploded since 2008. The idea that inflation has been low is nonsensical. The cost of accommodation, the largest single cost in any household budget, has risen dramatically. The owners of accommodation have done well. The users have done less well. The monetary policy has had distributional effects. It has increased wealth inequality. A small two bed-room flat in a shoddy ex-council estate in Islington might set you back £19200 per annum. The median gross annual wage in inner london is circa £34k. Take home pay after tax and national insurance is £26,334. This means two sharing are paying 36.5% of disposable income each in rent alone. Not everyone earns the median and those living in this kind of accommodation typically earn much less. How does one save for a mortgage in these circumstances? The cost of credit to those on low insecure income and with little capital is also much higher than the headline interest rates. Someone is doing well and it is the already wealthy.

Another group that has been disadvantaged by the low yields and low-interest rates is the retired. Those in defined benefit schemes are arguably much better off because they have secured pension incomes, typically index linked. The transfer values of these pension benefits are very large. The problem is that, outside of the public sector, these schemes are the liability of corporate entities. The low yield has made it very expensive to fund the benefits. This has led to a threat to the continued provision of such benefits. Those in defined contribution schemes understand the issue very well because they have to generate the income themselves just like the corporate plan sponsors. Low yields have made annuity levels pitiful and forced retirees into risky assets, or property, to generate an income. But many have simply sat in cash in order to preserve capital. This has not been too serious as this group typically have homes and the cost of living has been contained through low goods price inflation. But this has changed.

Inflation has picked up. In the UK this has been exacerbated by the Brexit induced decline in sterling. The phenomenon is however more widespread and relates in part to some bounce in oil and commodity prices. It is unclear how far this bounce can go and it has recently reversed somewhat. The central bankers have the capacity to look through such cyclical events so it is surprising how much the pickup in inflation seems to have shaken their easy money resolve. The implication is that there is more going on. Employment has increased sharply though wages have yet to follow suit. It may be the expectation that wages will pick up that is being signalled. This has some validity as, with increased barriers to labour movement, the flow of cheap labour to high demand areas may abruptly cease. Mexico walls, Brexit, and increased resistance to refugees in Greece and Italy speak to this.

It may also be that central bankers speak with false bravado. They speak of looking through inflation trends but when confronted with higher inflation they become unsure of themselves. It may be that in all the years that they have claimed to adopt easy money to return inflation to target what they were really doing was pursuing easy money for other reasons and could do because goods price inflation was below target.  Now they must either move the goal posts or back-off the easy money. Maybe the other objective was financial stability and restoration of the capital adequacy of banks. This, it seems, has largely been achieved and with goods price inflation now a little uncomfortable they are getting nervous. They were quite happy to see asset price inflation when bank stability was in question and this has had consequences for the standard of living of many (distributional effects). I surmise that the coincident hawkish tone of central bankers is signalling that financial stability is no longer an issue. Expect the more conventional reaction function of central banks to return.

If financial stability was the central issue and is no longer sensitive then we should expect monetary policy to be tightened more quickly than might be expected simply from observable macro variables. Central bankers are not comfortable with low nominal interest rates. Expect the word ‘normalisation’ to increase in incidence. It has already had a good outing in the US. Expect such ideas as ‘preemptive’ to pop up more often. The financial markets may continuously be surprised by monetary policy developments and this could shake asset prices some. There will be real economy effects. They may not all be negative though. The easy money era made the rich richer and the poor poorer. If this is reversed it may actually boost aggregate demand. Nothing is ever quite what it seems when partial static analysis is applied to general dynamic equilibrium systems.  But I may be wrong…

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