|Name / Sign / Code||Pound Sterling / £ / GBP|
|4 / 165|
|Used in|| United Kingdom
British Territories: 9
|Pegged by||8 Currencies|
|Central Bank||Bank of England
|Interest Rate||0.5% (July, 2012)|
|Inflation Rate||2.40% (July,2012)|
|Correlated Class||FTSE 100|
The official currency of United Kingdom, the British Sterling (sign:¥; code: GBP) is the fourth most traded currency after the US Dollar, Euro and Yen, accounting for 13% of the daily global trading. GBP/USD is the third most active pair after the EURUSD and USDJPY, accounting for 13% percent of the daily global trade volume, according to the 2010 BIS survey, while the GBPJPY is the second most popular Yen cross. The Pound is also widely used as a reserve currency after the US Dollar and Euro.
|1||US Dollar||USD ($)||84.9%|
|3||Japanese Yen||JPY (¥)||19.0%|
|4||Pound Sterling||GBP (£)||12.9%|
|5||Australian Dollar||AUD ($)||7.6%|
|6||Swiss Franc||CHF (Fr)||6.4%|
Currency Reserve Status: The Pound only represents 4.1% of the world’s currency reserve, on par with the 4.1% held in Yen, both of which fall in third place after the 62% held in US Dollar, and 24% held in Euros. See global currency reserve table.
Unlike Japan, however, the UK does not hold much foreign currency reserve: it holds $134 billion, nearly on par with the $150 billion held by the US, both of which are nothing next to the $1.27 trillion of Japan or $3.3 trillion of China. List of countries by foreign exchange reserves: here.
In most broad currency baskets, the Pound has a high weighting.
|Basket Index / Currency||Weighting|
|USD Dollar Index||EUR (57.6%), JPY (13.6%), GBP (11.9%), CAD (9.1%), SEK (4.2%), CHF (3.6%)|
|IMF Special Drawing Rights (SDR)||USD (41.9%), EUR (37.4%), GBP (11.3%), JPY (9.4%)|
In terms of pair popularity, USD/JPY is the second most active pair, accounting for 17% of the daily global trade volume, according to the 2010 BIS survey.
Central Bank: Bank of England (BOE)
|Headquarters||Threadneedle Street, London, England|
|Created||July 27, 1694|
|Mandate||Maintain Price and Financial System Stability|
|BOJ Governer||Sir Mervyn King|
The Bank of England (BOE) (est. 1694, second oldest central bank) is the central bank of the UK, and the model of most modern banks. It was privately owned and operated from its foundation and then nationalized in 1946. In 1998, it became an independent public organization, wholly owned by the Treasury Solicitor on behalf of the Government, with independence in setting monetary policy.
The Bank has three primary goals:
- Support the economic policies of the British Government to promote economic growth. Usually this means Keynesian economics of “easy money” and low interest interest rates to support aggregate demand and GDP/job growth.
- Maintain price stability with a CPI inflation target of 2%. If inflation overshoots or undershoots the target by more than 1%, the Governor has to write a letter to the Chancellor of the Exchequer explaining why, and how he will remedy the situation. I find this interesting: while inflation greater than 2% is definitely a problem, what is wrong with inflation less than 2%?
- Maintain financial stability, which means protecting against threats to the whole financial system (which means that in exceptional circumstances the Bank the Bank may act as the lender of last resort by extending credit when no other institution will. After the global financial crisis of 2008, the BOE has been printing money in unprecedented amounts to bail out the heavily indebted banking system and government. This money printing activity has ultimately led to higher inflation, much higher than the inflation target of 2%.
- For such a small country, the UK has a sizable GDP of 2.4 trillion dollars, making it the seventh largest national economy (third-largest in Europe after German and France), with a per capita GDP (PPP) of $28,000, eighth-largest in this category (second in Europe after Germany). The British economy comprises (in descending order of size) the economies of England, Scotland, Wales, and Northern Ireland.
- The first country in the world to industrialize, it was once called the “workshop of the world” for a few decades in the 19th century as UK share of world manufacturing stood at 23% in 1880 (enhanced by improvements in technology, productivity, specialization and cheap labor). By 1913 this figure dropped to 14% to become third place, with the US and Germany moving ahead, and 100 years later by 2012, it had dropped to 2.59%, moving to 11th spot, with China moving to first place with 10.4% of total world exports. Meanwhile, from the moment that the UK came off the gold standard in 1931 and simultaneously became less competitive in world trade, the Pound story has been marked with devaluations once every generation in at attempt to price uncompetitive exports back into global markets: officially in 1949, 1967 and 1992; as a result of market forces in 1976, and again in 2007, when the global financial crisis helped depreciate the Pound by 30%.
- Britain lost much of its wealth and empire after WWI and WWII and eventually ceded global power to the US, but it still maintains a sizable financial empire centered in London (the City), which has become one of the world’s three financial centers, dominating the slice of the day after night falls in Tokyo and before day breaks in New York. Apart from geography, the reason for this financial empire is one of history: it enjoyed one of the first central banks, and most successful banking center, at a time when it was an industrial and commercial center of the world and the legacy continues forward to this day. Today the center of UK economic gravity has shifted back to the capital, with increasing reliance on leverage and debt, foreign direct investment and speculation in overseas and housing markets, to bolster a current account that has chronic trade deficit since 1972. The financial sector and the housing market became two debt bubbles that helped prop up GDP from 1990 to 2008, and their joint popping in 2008 thrust the UK economy into what is now called “the Great Recession”.
- The UK entered into a long boom from 1990 to 2008, two decades of annual growth rates averaging 2.66%, before it was plunged into a depression caused by the global financial crisis and the popping of the housing bubble. The popping of the housing bubble revealed that part of the annual growth rate was propped up by the seeming wealth that this debt bubble created, and the growth of the finance sector to provide credit to feed the debt habit. House sale prices increased more than 115 per cent in excess of inflation between 1996 and 2010. Many banks who were heavily involved in lending mortgages and reselling them on capital markets collapsed soon after the bubble burst in 2007 and had to be partly wholly or partly nationalized, such as Northern Rock and Royal Bank of Scotland Group (RBS).
- The central bank came to the rescue to drive interest rates to unprecedented low levels, in the hopes that its people can borrow and spend yet still more to keep its economy afloat. The central bank also helped print money in quantitative programs to help take over toxic mortgages of its banking friends and finance the government deficit that had grown to unprecedented proportions.
- The Government came to the rescue to increase spending, if not for the benefit of its people, at least for the benefit of its banking friends. Public debt had a stable upward trajectory prior to 2007 that was disrupted and shot markedly upwards when the economy entered the Great Recession and the banking sector was recapitalized by tax payer’s money. Debt excluding financial interventions doubled since 2007, and when financial interventions are added back in, they have quadrupled. These debt numbers are unprecedented in peacetime.
- Events of the past five years has brought to a head the trends of the past hundred years: the problematic nature of fiat money (money backed by nothing) and fractional reserve banking, industrial decline enhanced by globalization, inflation outpacing wages, and the growth of debt consumption and the financial sector to provide credit to feed UK’s debt habit. In the last three decades the cracks in the UK economic edifice have been papered over by North Sea oil (now running dry), cheep imports, debt fueled consumption, imperial preference, European community membership, financial deregulation, asset stripping, and periodic property and house price bubbles. These cheap fixes have now all been used up.
As of July, 2012:
From 2008 to 2012, the GBP been trending lower against most of its major pairings — USD, EUR, GBP, CHF, CAD, AUD–as you can see from the chart below:
The Pound depreciated against its major competitors by 8-44% since 2008. It fell against the Yen by 44%, the Aussie Dollar by 31%, the US and Canadian Dollars by 20% and even fell against the troubled Euro by 8.4%. The pound fell across the board because the pricking of the housing bubble in 2008 revealed decades long structural weaknesses in the economy and currency.
Factors Driving the Value of Pound
|Indicator||Trend Stats||Graph Relative to Majors|
|Real GDP Growth Rate||1990-2008 Avg: 2.66%
2008-2012 Growth: -2% from 2007 peak
|Current Account||1980-2012 Avg: -1.9% of GDP (Chronic Deficit)||
|Total Debt||507% of GDP
Household Debt: 98%, 2nd (After Australia)
Corporations: 109%, 3rd (after Spain and France)
Financial Institutions: 219%, 1st
Government: 81%, 4th
|Interest Rates (Base)||2000-2007 Avg: 4.5%
2008-2012 Avg: 0. 5%
|Consumer Price Inflation (CPI)||2000-2007 Avg: 2.5%
2008-2012 Avg: 3.5%
|Asset Inflation||From 1996-2007:
+ 250% in nominal terms
+ 200% in real terms
+ 120% above average income
-Post 2008, cut rates to 0.5% to spur borrowing and spending in an economy already gorged with debt.
Money Printing (QE):
*Post 2008, prints money to buy UK government bonds (gilts) and forecast to do so indefinately.
Real GDP Growth
GDP stands for gross domestic product, and by definition, it is the sum total of the monetary value of all final goods and services bought and sold within the nation. It includes the totality of consumer, investment, and government spending, plus the value of exports, minus the value of imports. Real GDP growth is the GDP growth after inflation is taken into account.
Granted, the GDP numbers of the UK over the last two decades look great. From 1990 to 2008, the UK has enjoyed a real GDP growth of approximately 2.66%, a close match with the Eurozone (2.33%) and Canada (2.62%), a full percent less than Australia (3.33%), a tad less than US (2.92%). This GDP growth handily beat out the GDP growth of the export driven economies of Switzerland (1.56%) and Japan (1.5%). In cumulative terms, from 1990-2008, the real GDP in the UK had risen 48% over the 18 year period, in contrast to 52.7% for US, 42% for Eurozone, and 27% for Japan.
In the 8 years prior to 2008, the growth picture is even more pronounced : the UK achieved a remarkable 3.13% annual growth, only beaten by Australia (3.4%), but faster than its leading competitors (ex: US: 2.5%; Eurozone: 2.65%; Japan: 1.53%). In part because of the international perception that the UK was the fastest growing developed economy, the Pound outperformed its rivals (except Canada) by 4-22% between 2004 to 2007. But, as I will argue, much of this faster growth was built upon a mirage of debt bubbles, and when international investors discovered this mirage, the Pound was the fastest to sink against its rivals post 2008.
As an aside, I have to point out that the GDP has a number of inherent problems:
- It makes no effort to distinguish between transactions that benefit the nation’s health and those that subtract from it (ex: natural disasters add to the GDP despite the tragic loss to the population. Also money paid to clean up toxic waste adds to the GDP);
- It ignores everything that doesn’t take place under the rubric of monetary trade, such as the activities of household members or volunteers, which are worth money;
- Income distribution is ignored;
- Most relevant: borrowed funds spent on unproductive consumption increases GDP.
- GDP numbers can be statistically manipulated.
The GDP problem that most concerns us when looking at the consumer led economy of the UK is problem #4 above: borrowed funds spent on unproductive consumption increases GDP. The proportion of GDP accounted for by consumer spending on goods and services from 1980 to 2010 increased from 58% to 64%, showing that the engine of growth has been assumed by consumer spending. Consumer spending is fine so long as it is sustained by the savings from real production; instead, the real wealth-producing components of GDP (manufacturing, mining, etc) have been shrinking in their percentages of the total (manufacturing is now 12% of GDP, from 33% in 1970). Meanwhile, the savings rate has fallen from 12% to 2% from 1992 to 2007. If one is producing less and saving less, then one needs to consume a whole let less; instead, Britons consumed a whole lot more. The slack was taken up by Private Sector Debt (Household, Corporate, and Finance sector debt), which rose from 200% of GDP in 1992 to 450% of GDP in 2007, an annual increase of 15%– 5Xfaster growth than the 2.5% annual growth in GDP. Thus, the GDP share that is 64% consumption was not financed by money Britons have produced and saved, but with money they have borrowed. Consumption financed by debt and not supported by domestic production and savings, is a problem. British consumers, in debt up to their eyeballs and earning less income since they became a service-oriented economy 20 years ago, can keep spending only by borrowing, most recently (in the 2000s) against the equity in their homes.
When the Global Financial Crisis (GFC) struck the UK 2008, popping the housing (and private debt) bubble in the UK and elsewhere, the UK was plunged in a deep recession. Real GDP dropped a total of 5.5% in 2008-2009, a loss of wealth of approximately $122 Billion, which does not account for even greater loss of wealth from plunging home prices. Having enjoyed a steady unemployment rate of 5% for years, that rate has climbed up to 7.9% , or 2.6 million unemployed. The unemployment picture becomes grimmer still when you account for youth unemployment (less than 25 years), which is 22% (avg before GFC was 12%). Youth unemployment has reached the levels seen in the 1980s; outbreaks of social unrest are regular occurances. According to the Proust index (Economist Magazine), the clock in Greece was turned back to the 1990s, and in the UK, economic time in 2012 was turned back to 2004.
Like most developed countries, the UK has recovered somewhat by 2012, but its recovery has been slower than the rest. While the other countries have had close to 2% annual growth in 2010 and 2011, the UK has seen only 1.4% annual real growth. It has a ways to go to reach the GDP height of 2007 when unemployment was 5%. At 1.5% annual growth, the economy is not growing fast enough to find work for the young people entering the workforce and to soak up those losing their jobs in a shrunken public sector, and thus you have the 22% youth unemployment.
Historically, the UK has grown an average of 2.5% since WWII, so on that basis the level of GDP should be at least 12% higher than it was when the recession began in 2008, and yet it is still 1-2% smaller, an under performance of unprecedented proportions. The UK is stuck in its deepest, longest and toughest recession since WWII. Interestingly enough, the International Monetary Fund (IMF) is fairly upbeat about projected UK growth. It sees UK real growth steadily climbing to eventually reach the 2.5% historical growth by 2015. The question is: will that growth be predicated on more of the same debt fueled consumer growth, or will it be based on something more fundamental, real and lasting?
The answer to the above question can be found in the source of the mild recovery of the years 2010 and 2011. First, the mild recovery in 2010 and 2011 came about as a result of government borrowing and spending and central bank money printing (QE). There was not an increase in production, or an improvement in the overall trade balance and current account (which are both in chronic deficits). Instead, the recovery that we have been seeing is due in large part by another increase in debt, with the difference in WHO is doing the borrowing: underwater with debt, the private sector can borrow no more, so the government has been borrowing and spending at a record rate (see Public Debt below). And how is the government funding the borrowing? The Bank of England is printing money to purchase gilts (UK government bonds) in different phases of “quantitative easing” (QE- printing money). The QE purchase of debt is propping up the UK bond market, and that is the monetization of government debt.
The crisis was caused by excessive debt, and the “recovery” is founded on printing money and more debt. The cause of this indebtedness, and its forecast continuation, can be linked to a chronic current account and trade deficit.
Current Account and Trade Balance
The broadest measure of trade, the current account is the sum of the balance of trade (exports minus imports of goods and services), net factor income (such as interest and dividends) and net transfer payments (such as foreign aid). Typically, the balance of trade is the most important part of the current account and thus the current account and trade balance often move in lockstep. The UK has remained in a current account deficit since 1982, as we can see from the two charts below:
The UK has chronic current-account deficit (-1.9% of GDP, -£29 billion; 2011), which remains the average since it dipped into deficit in 1982. It shares a current account deficit with many other major economies (examples: US, Canada, Australia). A deficit on the current account means a country is importing more than it is exporting. The implication for the currency tied to a current account deficit is, long term, depreciation. The greater the deficit, the greater the fall. Reason: wealth is flowing out of the deficit country and into the hands of the surplus countries it is trading with. The surplus country then takes this wealth and invests it into the assets of the deficit country, but this investment is debt for the deficit country.
Cumulatively, the UK has a 700 billion deficit from 1980 to 2011, which ranks it near the bottom (deepest in deficit) of countries with cumulative current balance, just beneath Australia and above Spain and the US: Cumulative Current Account Balance. All these year to year deficits will have to be matched by a surplus on the financial and / or capital account, meaning that the UK’s assets (like its government bonds) are being purchased by the net export foreigners. This 700 billion deficit means the rest of the world owns 700 billion more of the UK than the UK owns of them: the UK’s trading partners have earned 700 billion over the last 30 years and have invested those sums into the UK, owning its stocks, assets and bonds. While some mainstream economists might think that this foreign investment into the deficit country is a good thing, it must be remembered that this investment is debt for the deficit country. The deficit country sells its government bond to the surplus country and that sale doesn’t make the deficit country any richer; instead it creates a liability.
Let’s look into the Current Account in more detail. Here is a nice picture from tutor2u.com showing the UK Balance of Payment on the Current Account (2011):
What you notice right away from the chart above is that the trade in services has been steadily going up over the years, while the trade in goods has been steadily going down. Ultimately, like most developed nations that have been de-industralizing, the growing trade in services has not been enough to offset the decreasing trade in goods. We will look at how the service sector has (and cannot be) enough in just a bit. First we will look at the causes of the current account deficit.
Why does the UK have a chronic Current Account Deficit these last two decades?
Quite simply, there has been a long term decline in manufacturing production leading to falling export of goods, conjoined with a long term rise in the consumption of imported goods.
Long term decline in manufacturing (=falling export of goods)
Once upon a time, 150 years ago, Britain was considered the “workshop of the world” and cornered 25% of global trade in goods. By 1914, it had lost its place to Germany and the US and represented only 12% of world trade. By 2000, it had had descended to 3% of world trade (5th largest in the world), edged out by US, Japan, China, and Germany. Ten years later by 2010, it had descended to 2.5% of world trade (9th largest in the world), edged out by 4 more countries (Italy, Brazil, Korea and France). The long term trend is down, and one can only wonder how many more countries will surpass the UK in the trade of goods moving forward.
Since the late 1970s, the UK manufacturing industry has become relatively less competitive, and the process of globalization has hastened the relative demise of the UK’s exporting sector. The UK hasn’t been able to compete with low cost countries such as China or higher productivity countries like Germany. There has been a shift of manufacturing to lower-cost emerging market countries who then export products back into the UK. Many UK businesses have out-sourced assembly of goods to other countries whilst retaining other aspects of the supply chain such as marketing and research within the UK. You can see this deteriorating manufacturing sector by looking at the ever widening deficit in the trade of goods component of the current account.
Employment wise, the manufacturing sector has shrinking: London manufacturing jobs have been in long term decline since 1971, declining over 75% since 1971. They have been replaced by service sector jobs, which do not contribute as much to exports and that do not pay nearly as well.
The historically strong exchange rate of the UK has not helped matters: the two decade strength of the Pound against the dollar has squeezed profitability of exports and made imports more attractive.
Despite the government’s claims that future growth will be export-led, the UK manufacturing base is now so shriveled at just 10% of the nation’s output that it simply cannot take advantage of a a depreciating currency. It exports as much to Ireland as it does to China, India, Brazil and Russia put together.
Too much was spent on debt-driven consumption and too little on wealth-producing investment. During the boom years, housing, construction, retailing and the financial sector did well. But Britain’s manufacturing output fell by a quarter, with its share of the economy falling from 17% in 2000 to just 11% in 2009.
Long Term Increase in Consumption of Imported Goods
Three decades ago the UK was a nation that saved, produced and created wealth and was a major exporter. Then it stopped saving, shifted from manufacturing to services, and has had to run up record national and personal indebtedness, borrowing money to finance excessive consumption of unproductive imported goods.
The savings ratio steadily declined from 12% in 1992 to 2% in 2007 at the same that consumption as a share of the economy grew. This increase in consumption was fueled by debt. Charted over time from 1997 to 2007, total UK household debt rose from 570 billion pounds to 1.5 trillion pounds, or three times growth. Incomes did not rise in proportion to those debts. The UK debt to income ratio ramped up from 100% to 160%, the highest of most developed countries. Most of this debt was tied to home prices tripling over this period, and consumers spending by borrowing against equity in their homes. Consumer spending strengthened by a rising housing market (and borrowing against home equity) caused an increase in spending on imports. Reason: incomes have not risen much over the last decade, and so its citizens are forced to consume cheaper foreign imports with borrowed money.
GDP growth that occurs in conjunction with a current account deficit reveals a nation that is willing to borrow its way to wealth or at least the appearance of wealth. Borrowing money to fuel investment in productive industries can be a way of building real wealth, but borrowing money to fuel unproductive consumption can only create the short-lived appearance of wealth. It is like the family that loses its job and in order to keep up appearances and maintain the same lifestyle, it resorts to borrowing and goes deeper into debt. But it is pure fantasy to think that a nation can consume and borrow indefinitely while the rest of the world saves and produces in their stead.
But what about the Trade in Services, which Seems to Always Trend Up, doesn’t it count toward reducing the Trade Deficit?
It is undoubtedly true that Britain has had 20+ years of a rising Trade in Services (intangible products such as Banking and Fiance, Insurance, Shipping, Air Travel, Tourism), helping to partly offset the concurrent decline in Trade in Goods. As you can see from the UK BOP of the Current Account, the annual surplus in services is 71 billion pounds (2011), and this goes quite a long way to earning foreign currency with which to pay for the trade deficit. But it can never completely offset the deficit of goods or be its replacement. In an economy shifting towards a consumer growth model, the import of goods will always exceed the export of services.
In fact, it can be argued that the shift from manufacturing to services caused the growing trade deficits in the first place. As the manufacturing base shrank, service economies expanded in its place. Service economies do not reduce trade deficits for a couple reasons: 1) they produce fewer exportable goods (ex: information technology is a great exportable product, but no country can export enough information to pay for the real goods that it imports); 2) they make the nation dependent on goods imported from economies that do save and produce. Another problem with an economy based mostly on services is that the service sector pays less than manufacturing jobs.
Below is a closer look at the sectors of the UK service economy that are strong:
The strength of the service balance is due, in the main, to the strength of two elements of the service sector: business services and financial services. As you can see in the chart on the right, Britain has a comparative advantage in high value business services, such as architecture and engineering, legal services, research and development, and advertising and market research. Business services is the largest employment sector in London, with 1.07 million workforce jobs in 2004, 24% of London’s total employment of 4.49 million, half of which are in the aforementioned high value business services. This is great, but there is a natural limit to how much business services can be exported, especially given the global financial crisis, the ongoing recession, and less available money on the part of foreigners able to afford foreign high priced UK business services.
But, in many ways more problematic, the UK is top heavy in financial services (banking, insurance and management consultancy), accounting for 7.5 billion pounds in exports, a sizable portion of the export in services, though a significant reduction from the 11 billion in 2007. London has an even stronger specialization in financial services, employing 326,000 in 2004. This top heavy financial sector is problematic because its growth and greed accounts for a cause of the global financial crisis. The growth of the finance sector in the UK corresponds, I would argue causally, to the inflating housing and private debt bubbles. The finance sector helped push debt (credit cards, car loans, mortgages) on to everyone, even if the people could not afford ever pay back these debts. Many banks who were heavily involved in lending mortgages and reselling them on capital markets collapsed soon after the bubble burst in 2007 and had to be partly wholly or partly nationalized, such as Northern Rock and Royal Bank of Scotland Group (RBS). Now that the party is over, and the collapse of the mortgage backed securities market created the global credit crunch, banks do not see the same extraordinary returns as before, and thus do not see the same need for legions of employees, and so in recent years have been laying off thousands in the financial sector. It is quite probable that the next few years will see more declines in the fortunes and employment of the finance sector; this will mean that the export of financial services will steadily diminish, which will widen the current account deficit even further.
Current Account Outlook Post 2013:
UK Current Account Deficit Remaining Below -2% of GDP, a continual drag on the real economy.
- Housing prices have fallen by 30% since 2007, which should have theoretically dampened consumer spending; yet imports decreased only marginally in 2009 before reverting back to their upward trend. Given that there is not the same local production as there once was and given that incomes are not keeping pace with inflation, people are forced to consume and import cheaper foreign goods. Moreover, the government has has lowered interest at record lows in order to spur its debt weary citizens back into borrowing and spending again.
- Manufacturing sector, being only 10% of the economy, cannot grow fast enough to have any significant impact. Ideally, the government could try to increase the productivity of the industry with supply side policies, helping UK exports to become more competitive and reduce the attractiveness of imports. But supply side policies are easier to said than done. Every government will say they are trying to increase production and productivity, but in reality there is only so much that policy can do to increase productivity of industry.
- Pound has fallen 25% since 2007, which should have theoretically given a huge boost to exports and made imports more expensive; yet exports of goods improved only marginally in 2009, only to revert back to the downward trend. Reason: The consumer driven economy is now being fueled by cheap money (low interest rates), and production continues to take a backseat to consumption. The current situation should naturally cause continued devaluation of the currency moving forward. There might be policy steps to accelerate the currency devaluation in an attempt to gain a competitive advantage with exports. Devaluation would make UK exports cheaper and imports more expensive, but it would take a long time to rebuild the manufuctured goods sector.
Razor Tip: Traders should watch to see if the trade balance continues to trend into the negative and if the current account follows suit. The currency of the country with a trade deficit, and/or Current Account Deficit, is usually more less attractive than one without. If UK’s trade balance continues to trend into the negative, and its current account follows suit, the Pound will gradually weaken relative to currencies with strengthening Current Accounts.
Total Debt Problem
The UK’s total debt (government, household, corporate and the financial sector) is the worst among the major Western industrial nations. According to leading consultancy firm
McKinsey, it is five times GDP (the country’s annual “income”). This is the equivalent of
£262,000 for each and every taxpayer.
UK total debt at 507% of GDP is at the level of Japan (512%). Notice that the total debt of other countries is much lower, such as USA (279%), Germany (278%), Spain (363%), and Portugal (356%). For government debt the UK is at 81% while Japan is much higher at 226%. For corporate debt, the UK (109%) and Japan (99%) are similar, though France is higher (111%). For household debt, the UK stands at 98% of GDP, similar to the household debt of other Anglo-Saxon countries like US (87%), Canada (91%), and Australia (105%), and well above European countries like Italy (45%), France (48%), and Germany (60%). The main debt problem for the UK lies with the financial sector at 219% of GDP, almost double the level of Japan, five times the US figure, and three times the level of most other countries.
See these maps on The Economist website for a quick comparison of our debt problem vs others. The OECD also carries figures for public debt for euro zone countries.
It is also worth checking out the growth rate of total debt (sector by sector) over the years:
You can see that all sectors increased their debt levels significantly but some far more than others. Let us look at slowest to fastest. The slowest increase had come from government sector, which had very little debt increase from 1987 to 2008, changing from 48% to 53%, but then added 30% during the recession. The household sector had gradually increased its debt from 51% to 103% at 2008, only slightly decreasing debt to 98%. The corporate sector had steadily increased its debt from 43% to 122% at 2008, and had striven to reduce debt therafter, bringing down debt to 109%. The financial sector is the worst offender for debt, jumping from 47% to 209% at 2008, and increasing its debt load thereafter the recession to where it now stands at 219%.
According to consultancy McKinsey, “deleveraging in the United Kingdom and Spain is proceeding more slowly.The ratio of UK debt to GDP has continued to rise and UK households have increased debt in absolute terms…UK and Spain have made less progress [than US] and could be a decade away from reducing their private-sector debt to the pre-bubble trend. ”
We will now briefly take up the three important debt sectors: household debt, finance sector debt and public sector debt.
For household debt, the UK stands at 98% of GDP, similar to the household debt of other Anglo-Saxon countries like US (87%), Canada (91%), and Australia (105%) and double that of many European counterparts. This is a big deal. Put in currency terms, Britain’s household’s owe £1.5 trillion in mortgages, overdrafts, loans and credit cards. Charted over time from 1997 to 2007, UK debt rose from 570 billion pounds to 1.5 trillion pounds, or three times growth, now representing the country’s annual GDP.
If we turn to household debt as a percent of disposal income, we can see that the UK is in worse shape than US (2009):
From 1999 to 2009, US debt to income ratio increased 93.4% to 119%, and in the UK it ramped up from 100% to 160%, the highest of most developed countries.
Why this massive household debt increase?
Rising household debt levels in Britain resulted in house prices tripling between 1997 and 2007. As in the US, consumers borrowed freely against the rising value of their homes and this helped spawn a rapid increase in jobs related to the housing sector. There was a host of reasons for this explosion in home values: there was the easy availability of credit, financial deregulation, property speculation, property tax breaks, and importantly, Britain’s trade deficit with the rest of the world. Earnings had long been under downward pressure and consumer borrowing had taken up the slack, borrowing fueled by rising house prices. The economy depended on large extent on consumer spending, which in turn depended on consumer borrowing. That borrowing was underpinned by high house prices, which allowed homeowners to raise money against equity.
Larry Elliot and Dan Atkison have an apt metaphor for the circularity of household debt:
“The circularity of the whole business was rather like the fabled perpetual motion machine of yesteryear. Rising asset prices supported increased borrowings, which supported economic growth and rising asset prices. These rising asset prices supported yet more borrowing, which supported more economic growth and even higher house prices. Everything ran smoothly as long as consumers kept borrowing ever more money against ever more expensive houses while spending some part of the notional real estate profits on goods and services. Before long the average property would cost dizzying multiples of the average wage, so to keep people buying at ever higher pries required even lower interest rates.” (Gods that Failed, 230-231).
Many mainstream economists and policymakers encouraged the British to look at both sides of the balance sheet rather than just liabilities, and rising house prices meant that the private sector’s balance sheet was strong. But of course, when the bubble burst, the value of the asset collapsed but the value of the debt did not. Mortgages currently account for about 1.25 trillion of personal debt, and because of the forecast decline in the value of household price (already down 20% from the peak and continuing to fall), net worth of UK households is forecast to decline as a percentage of income.
According to the OBR, UK personal debt will grow by nearly 50% between 2011 and 2015, forecasting to reach 2.12 trillion pounds. This is insane. There is no increase in the take-home pay to offset this massive expansion of household debt. Instead the reverse.
OBS explains: “We forecast that income growth will be constrained by a relatively weak wage response to higher-than-expected inflation. But we expect households to seek to protect their standard of living…this requires households to borrow throughout the forecast period [2011-2015]”. Borrowing to support desirable but unaffordable lifestyles was the reason for the mess in the first place. The OBR forecast means that the UK is propelled toward a more dangerous, unsustainable phase.
Everything that is being done by policy makers around the world is attempt to restart private borrowing. A better analogy is therefore not a tsunami but a drug overdose—and our “neoclassical” economic doctors are attempting to bring the patient back to health by administering more of the same drug.
The crisis was caused by debt and it is being exacerbated and prolonged by debt.
If you think that the UK household financial debt is bad, you have to have a look at the scary level of UK Financial Sector Debt. It is off the charts. While the largest component of US debt is household borrowing and the largest share of Japanese debt is government debt, the financial sector accounts for the largest share of UK debt (219%), a ratio that is 5 times greater than the US.
The USA and UK both began 1987 with roughly comparable levels of finance sector debt — roughly 50% for the UK and 40% for the USA, but two decades later, the UK Finance sector debt peaked at 219% of GDP, more than twice that of the US. The UK is the Private Debt Capital of the G20 world.
Deprived of its traditional sources of wealth, the center of gravity has moved to the speculative activities of the City of London, the money extracted from an overheated housing market to finance consumer spending and public spending. Household debt was generated from the financial system and hoisted on public led to think that home prices could rise forever.
From 2000 to 2008, the financial markets took advantage of the liberalisation of consumer credit and adopted aggressive marketing techniques aimed at encouraging people to take on more borrowing. The financial institutions saw the British public as fresh meat, and they aimed to fatten them up with easy credit. House prices almost tripled as many institutions such as Northern Rock imprudently issued mortgage deals to allow customers to borrow 125% of their home’s value plus up to six times their annual income.
How does the financial sector pile up debts? There is no breakdown in the financial sector debt, unfortunately. Here is my speculations:
- There is a reasonably large proportion that is corporate and household savings and investments (deposit accounts, ISAs, other forms of long-term savings).
- The financial sector holds a lot of government debt, much of which it is required to hold under regulatory rules designed to reduce the risk to smaller investors.
- There is much interbank borrowings, which is money that the banks owe to each other.
- The UK financial sector has significant deposits (debts) from overseas investors.
- The UK financial sector has significant sized derivatives (debts) tied to its speculative gambling plays around the world.
- Most relevant: Under Fractional Reserve Banking, bank lending creates deposits, and these “created” deposits are included in figures for financial sector debt. However, the loans become a problem when the asset securing the debt is in doubt. That’s the current problem. Home prices, as well as real capital land values in the UK are still in bubble mode and have some way to fall. The UK financial sector so hugely indebted to housing will become bankrupt under any significant fall in home prices.
their books, making their assets equal their liabilities. They can create all the money they can find borrowers for, but if the money isn’t paid back, the banks have to record a loss; and when they cancel or write off debt, their total assets fall. To balance their books by making their assets equal their liabilities, they have to take the money either from profits, or from funds invested by the bank’s owners, or from money borrowed from the government or Central Bank; and if the loss is more than the bank or its owners or the government/central bank, can profitably sustain, the bank will have to close its doors.
Remember: the massive UK debt bubble, just like the US debt bubble, had been popped by the housing bubble, and its gigantic weight is falling down in slow motion, only temporarily held in check by the frantic efforts of UK government (in absorbing some of the debt load of the banks), and BOE’s quantitative easing (printing trillions of pounds to buy the toxic mortgage backed securities and government bonds). However, if home prices continue to fall, as they probably will, no amount of bank debt absorption by the government, or money printing and lending by the central bank, can stop the fall.
UK Government Debt
It is interesting to note that public sector debt stayed fairly low and consistent from 1987 to 2007, rising from 48% to 53%. Then, after the crisis hit in 2008, net public debt (excluding financial interventions) rose dramatically from 53% to 81% (30%+ gain), while real debt (including financial interventions) rose from 53% to 150% (100%+ gain).
Let us look at these two types of public debt in turn.
The UK Net Public Debt (excluding financial interventions): 30%+ Growth Since Global Financial Crisis
It is not so much the current size of the debt that is a problem, as there are other G20 countries more in debt, but the acceleration of it. As of end of 2011, the UK debt to GDP ratio stood at 85%, 5.6% higher than the year before (end 2010: 79.4%), which was 11.6% higher than the year before that (end 2009: 67.8%). Consider that at the end of 2007, before the crisis hit, the national debt was a paltry 44.5% of GDP. Now, 4 years into the crisis, the debt stands at 85%. That is near double debt growth in 4 years.
The accelerating factor of Debt Growth is the UK’s Government Budget, which has always been in yearly deficits, but recently, after 2008, these deficits have been growing bigger: -11.5% (2009), -10.2% (2010), -7.8% (2011), -8% (est: 2012), with anything under 5% deficit a striking speed. At the start of the sovereign debt crisis, the UK was one of the worst offenders for being in budget deficit. These deep budget deficits have been happening despite the current government’s commitment to austerity or reduced spending.
Consider the ‘ring of fire’ chart published in 2010 by bond fund giant PIMCO the captures the acceleration path of UK debt. Ideally, a country would want to be in the top left corner; being too far to the right is too much in debt, and being too low down is too much annual borrowing (debts growing too fast):
You can see that because of the overlarge UK yearly budget deficits, the UK is swinging at an accelerating speed towards the overlarge debts of USA, Greece, and Japan. Some economists regard a debt-to-GDP ratio of more than 90%, which UK is very close to now, as the point of no return on the route to eventual default and national bankruptcy.
Reason for Increased Budget Deficit and National Debt:
No doubt in mind that that the main cause of the debt acceleration is that tax revenue has fallen less than expected because the country had entered into a recession. Meanwhile, despite all the talk of austerity, government spending has continued to climb. The coalition aimed to reduce the government deficit substantially (the extra amount borrowed each year), but it is failing. Because of the recession, revenues are declining, but spending is increasing by its own momentum.
According to the website www.ukpublicspending.co.uk, public spending as steadily increased from 12% of GDP in 1900 to 47% today, and according to the breakdown, the biggest share of spending coming from Public Pensions (£138 billion), National Health Care (£126 billion), State Education (£97 billion), Defence (£46 billion), and Social Security (£117 billion). Few politicians dare touch these entitlements. Yet, without any foreseeable structural change, Britain’s public debt as a percentage of GDP is forecast to be around 90% in 2014/15. At that level, international studies show that servicing debt becomes so all-consuming that governments can often no longer pay their way.Any further deterioration could undermine faith in the financial system completely. The UK risks passing a tipping point, beyond which is possible default or unspeakable inflation.
Who is paying for UK debt?
It used to be as of 2005 that 65% of UK public debt was held by the Finance Sector (Insurance Companies and Pension funds, and other Financial Institutions), households held 11%, and overseas investors held 25%. Now, moving into the crisis (2010), because the debt has become dramatically bigger, the composition has changed: the finance sector now holds 40% (15% less than before), while the household sector holds a tiny 1% (10% less than before). So who is taking up the slack (the missing 25%)? It is not the overseas investors (e.g. German banks or US investment trusts) who increased their holdings of UK debt to 302 bn or 31% of total debt (only up 5% from before). The size of the current account deficit forecasts a maximum capacity in which foreign investors can choose to invest in UK debt. Instead, the Bank of England’s is printing money to buy the debt through its purchase facility fund, or QE program, buying 206 billion, or 21% of the debt. They were not direct purchases of debt before the crisis. Now they will be growing fixture. The BOE will be forced to buy more share of the debt moving forward as the debt becomes exponentially bigger and the other parties (finance, household, foreign) cannot increase their debt purchases at the same rate of growth.
Real UK Public Debt (including financial interventions): +100% Growth Since Global Financial Crisis
When bank bailouts and other ‘financial interventions’ are factored back into the debt, the debt to GDP jumps to 150%:
How this worked out in the case of Northern Rock? The UK government borrowed 1.4 billion and then gave this to Northern Rock, yet the 1.4 billion was never included on the national debt. And Northern Rock is tiny compared to Lloyds TSB and RBS. The fact is: part of the 219% financial sector debt has been assumed by the UK government, transferring the risk from the finance sector to public sector. I would argue that the 85% net UK public debt is bogus, and what one should be looking at is the 150% real public debt to GDP that includes those financial interventions, aka, bailouts. The real risk here is, if the housing bubble continues to fall, as I think it will, the financial debt assumed by the UK government will become an unbearable liability, and the UK government debt might be forced into default, or else, the BOE will be forced to rev up its printing press to the point of hyperinflation.
Note: Real-Real Debt is even Bigger still when you include state and public pension liabilities of over £5 trillion, an additional 200% of GDP.
Interest Rates, Inflation Rates, Asset Bubbles
|Source: guardian.uk||Source: tradingeconomics.com||Source: economist.com|
The BOE set record low interest rates in the 2000s, helping to fuel the housing bubble. From Jan 2000 to Jan 2007, the BOE kept its base rate average of 4.5%, while UK inflation was an average of 2.5%. What is this now in terms of real interest rate (herein defined: base rate – inflation rate)? The real interest rate was 2% for the 2000s, fanning the property bubble that had begun in 1996. These rates were never so low in decades and naturally, everyone decided to borrow and speculate on housing prices.
One might ask, why didn’t the record growth levels of private debt (growing at 15% per year) throughout this period (2000 to 2008) produce extraordinary high rates of inflation? Actually, it did. There are three kinds of inflation: asset price inflation, commodity price inflation, and consumer price inflation excluding food and energy. Asset price inflation in the UK was extraordinary: by looking at the economist’s interactive historical home price chart, you can see that home prices increased 130% from 2000 to 2007 (100% in real terms, or 80% above average income), and 250% from 1996 to 2007 (or 200% in real terms, or 120% above average income). As of 2012 (Q2), UK home prices remain at lofty levels, having fallen only 20% from the bubble peak, and thus they still have some way to fall to get back to a reasonable level, such as the average rate of inflation or the average income. Commodity price inflation also took place during this period, with most commodities hitting record highs by 2007. However, extreme labor price deflation (globalization resulted in the 95% drop in the marginal cost of labor by bringing people from the developing world into the global industrial workplace) prevented surging commodity prices from spilling over into higher rates of consumer prices. If globalization had not occurred during this time, the rapid credit (debt) growth would have produced crippling rates of inflation (stagflation or hyperinflation) for the UK throughout the last three decades.
BOE should have acted to prick (with higher interest rates) the expanding bubble back in 2002 (then already 100% higher from 1996); instead it lowered interest rates in 2002 to inflate the bubble a further 100%. That alone should have warned everyone that the BOE works towards a model of growth at all costs, even the cost of borrowing, and even the cost of asset and commodity inflation. It tells us it only sees inflation from the CPI, the consumer price index, which shows the much smaller effect of inflation, given the extreme labor price deflation of globalization and cheap Chinese goods purchased at Walmart. To make matters worse, it myopically sees only core inflation, which is the price of a basket of goods excluding food and energy (these two items go up when there is commodity inflation).
What happened when the CPI finally shot up to near 5% in late 2008? Did the BOE rush to raise interest rates then? Just the opposite. The BOE imitated the actions of the US FED in lowering rates to record low of 0.5%, a level not seen since the Bank of England was founded in 1694. The theory is that, despite the economy saturated with debt, lower interest rates will encourage borrowing and thus lead to greater spending, more house purchases and new business investment. It is classic Keynes, who said:
“The remedy for the boom is not a higher rate of interest but a lower rate of interest! For that may enable the so-called boom to last. The right remedy for the trade cycle is not to be found in abolishing booms and thus keep us permanently in a semi-slump; but in abolishing slumps and keeping us permanently in a quasi-boom”
Keynes himself was dealing in quasi-reality, or fantasy. The more the central bank inflates, the worse the reckoning will be. Every new wave of additional artificial credit deforms the economy further, making the inevitable bust all the more severe, because more capital will have been squandered and more resources misallocated.
But the low interest rates failed to boost the borrow-spend economy as expected. People were maxed out and could borrow no more. Houesolds and corporations realized that the fall in home prices left them with big debts, and both sectors sought to pay down debts instead of taking out additional loans at near zero interest rate. In the last four years, the UK corporate sector payed down 14% of its debt, and the household sector had paid down 5% of its debt. At least two sectors were doing the right thing.
But two other sectors, government and finance, took up the borrowing slack; in the last four years, the goverment has borrowed an additional 28%, the finance sector an additional 11%, at these record low rates to continue (mis)spending as before. One reason interest rates are so low is that, through QE, the government (as the Bank of England), could buy 30% of its own debt (as issued by the Treasury) with those low rates. Next we will see how BOE acted to print money to rescue the overly indebted public and financial sectors.
Central Bank Intervention
Asset inflation (the housing bubble) was the leading cause of the financial crisis in 2007, and yet oddly enough, inflation was viewed as the medicine for the cold. BOE cranked up the electronic printing presses a further 500 billion pounds through a process of quanatitive easing (QE), a program in which the central bank buys UK government bonds (gilts) from commerical banks in exchange for cash. They indugled in a sort of money creation policy normally associated with German in the 1923, Latin American banana republics in 1970s and more recently, Robert Mugabe’s Zimbabwe. Most of this money has gone to pay for government debt, as mentioned, and as the government budget deficit is now 8% GDP, with household and finance sectors unable to borrow up and invest in debt as before, the central bank will take an indefinate and increasing role in money printing to buy government debt. Another big part of QE has gone to fund banks with cheap loans in order that they increase their mortgage and small business lending. The banks, in turn, have hung on to most of the funds generated through QE, using the money to restock their tattered balance sheets. Since the housing bubble will continue to fall, and the heavily indebted financial sector will find themselves near bankrupsy again, they will be forced to borrow more and more from the central bank moving forward.
What effects have low interest rates and QE had?
In a free market economy, prices find their own level. Nobody expects the government to set the price of bread or beer or cars. Yet the Bank of England determines the price of money. Those who have mortgages linked to its base rate may be delighted that it remains low, but low interest rates are not automatically good for the economy. One of the less favourable consequences of low interest rates is the persistence of stubbornly high inflation. The Bank of England’s primary statutory role is to keep inflation at the government’s target of 2% for the Consumer Prices Index (CPI) yet it has been above that for most of the past six years. The target means that the government’s aim is to devalue its people’s money by 2% a year and yet it has exceeded this mark month since December 2009. Though the ostensible mission of most central banks today is to provide price stability, most have utterly failed in their mission as their currencies have steadily depreciated over the last 100 years. The truth is that the Fed (and most central banks that mirror its example) exist for the sole purpose of providing the inflation (via money expansion) necessary to allow governments to spend more than it can collect in taxes.
With wages rising less quickly than prices, everybody is feeling poorer. Taking inflation into account – up 17% since the crisis began – household incomes are back to their 2005 level. While the people are saving more than before because they have become more debt adverse, they are seeing their savings go down the tube at -2.5% real interest rate (base rate of 0.5% – inflation rate of 3%). The central bank impoverishes savers by pegging the bank rate well below the level of inflation
Low rates crush the local currency. Foreign investors do not want to invest in a currency with a negative real interest rate. They loved the pound when it had a high interest rate relative to the Yen before 2007, and so the GBPJPY was a favorite carry trade earning nice yearly interest on leveraged positions. But when the Pound has a real rate of -2.5% and the Yen has a positive rate, the GBPJPY becomes more attractive as a short play. The negative rate strips the Pound of its former appeal, revealing for little underneath that it makes it attractive. The 25 percent depreciation in the value of the pound has made imports dearer and caused higher inflation.
Money printing also causes inflation and devalues the Pound. The first rounds of money printing have pushed up inflation by about 1.5%, and the currency has depreciated considerably, even though the banks only lent out a small part. When the lending taps are turned on full again, inflation will gush out and the Pound will continue to deteriorate. The saving grace for inflation is the buffer of cheep chinese products and the saving grace for the Pound relative to other currencies is the fact that other G7 governments have cut their base rates down to near zero and are printing money at the same rate of speed. The big question then becomes: who is printing money faster and winning the race to the bottom?
The latest crisis has been brought about by artificially low interest rates which have caused malinvestments (particularly in housing prices), and pushing down these rates only serve to prolong the crisis until it becomes stagflation. Trying to prevent the recession’s effects, as current policies do, may limit some short-term pain but only at the expense of sound long-term growth. When interest rates rise, as they eventually must, the effect upon everyone currently in debt, from households to companies to banks to governments, will be all the more painful.