27 August 2009

All Fall Down

Another of those rogue green shoots is the supposed recovery in the housing market. Are falling house prices now in the past, or is this just a blip on the way down?

One good index of how overvalued house prices are is to compare prices to average earnings. Nationwide provides a useful time series of house prices going all the way back to 1983. They also calculate the ratio of prices paid by first time buyers to average earnings. I have put these figures on the chart below.

The first observation is that the ratio is still higher than at the peak of the 1980s bubble.

A second point is that during the last downswing there were occasions when the ratio ticked up - eg Q2 1991 and Q4 1994.

The average ratio is 3.3. First time buyers pay 3.3 times the average earnings, on average. Currently the ratio is 4.2. If the ratio is to return to its historic level then prices have another 21% to fall relative to earnings. Of course, if wages rise quickly then prices need not fall so far.

Another look at the chart shows that after the last housing bust, the ratio overshot the average and fell to a low of 2.1. In Q4 1995 first time buyers were only shelling out about twice average earnings. To fall back to that level, prices would need to fall by half or wages double.

What does this mean for the economy. Falling house prices have a "wealth effect". People feel poorer and decide to save more, postponing consumption and so reducing demand. At present government spending is lifting demand but the stimulus packages will begin to run down next year. The household spending which will be needed to keep the recovery going may not materialise.

23 August 2009

SproutWatch August

Plenty of green shoots around this month, but are any of these sprouts going to take root?

First lets see how the three part economic crisis looks according to my traffic lights.

Banking Crisis: I measure this crisis using the spread between the policy rate and the LIBOR, which is down to 25pb. Another 5bp and it could go amber. But for now we are still on red.

Debt/Demand Crisis: The Economist poll of polls forecast for 2010 has slipped back to 1% GDP growth. To be fair, this figure came before the Q2 GDP figures were published and so next month could see the forecast rise. For now it is as red as ever.

Trade Crisis: The index is up. Trade is more imbalanced than last month.

For details of the indeces see the small print.

Is the gloom unrelieved? There are some genuine green shoots, just not in the UK. (I don't mean France and Germany which are getting a boost from the fiscal stimulus, but I have urged caution on one quarter's figures.) The real green shoots are in Asia. If Asia's growth is generated without the help of Western consumers then this all round good news. China needs to expand domestic demand both to survive the global downturn and to help balance the trade flows.

20 August 2009

When does a recession end?

The recession is over. At least for France and Germany. One quarter of positive growth and all the press and media agree - the recession is finished. But is it?
How do we know that a recession is over? We know what a recession looks like - unemployment rising , falling orders, short time working, businesses closing down, GDP falling, tax receipts down, etc. How will we spot when it turns the corner?
GDP is an obvious indicator. When GDP is falling there is a recession and when growth returns it is finished. Sadly it is not so simple.
The chart shows quarterly growth for the UK from 1990. The economy shrank for five quarters beginning in the third quarter of 1990. GDP then grew slightly for two quarters before shrinking again. You might have thought that the recession was over by the end of 1991, but you would have been wrong. It didn't end at least until mid 1992. So one quarter (or even two) of GDP growth does not guarantee the end of the slump.
An alternative might be to look at the level of at GDP rather then the change. The UK economy grew to a peak in early 2008, since when is has been contracting. Is the recession over only when GDP again reaches the level it was in Q1 2008? If so then we have a long way to go. GDP has fallen by 5.7%. If growth returned to a normal rate (about 2.5% a year) it will take more than two years to get back to the pre-recession level.
Perhaps that is too strict a test. It might reflect reality if unemployment is our main concern, but then why not just use the unemployment figures.
The alternative which appeals to me for calling the end of the recession is when the annual growth rate turns positive, ie the growth over the last four quarters is positive. In the 1990s it is clear that this condition was not met until Q3 1992. Another criterion could be for quarterly growth to return to (or exceed) the trend rate (about 2.5% annually for the UK, or over 0.6% a quarter). On this condition the earlier recession ended in Q4 1992.
So, it is too early to be sure that either France or Germany has exited from recession. I will wait until one of these two conditions have been met.

18 August 2009

The End is Nigh?

What is wrong with this picture?

This is the Bank of England's projection for economic growth taken from the August Inflation Report published last week. At first sight it would appear to be good news. It shows a strong recovery from recession. Here we have a V shaped and not a U shaped or W shaped or even an L shaped recession. So what is the problem?

The first problem is that in the press conference, Mervyn King , the bank's governor, warned of a fragile recovery, "The pace of recovery over the next few years is highly uncertain." (See the BBC) The fan chart, on the other hand sees growth back to normal levels next year.

The next problem is interpreting the chart. This shows the annual growth rate, or more accurately, the 4 quarter growth rate. So when the central projection crosses the zero, as it does early in 2010, then the growth rate over the last four quarters is zero; ie the economy is the same size as it was in early 2009.

(Another difficulty is that it looks like the ONS data is only available up to the first quarter of 2009, but from the shape it is obvious that the latest data (Q2 2009) is included. See here) Reading off from the chart, annual GDP reaches about 1% at the end of Q1 2010.

This is where it gets interesting. GDP fell by 0.8% in the second quarter of 2009. So to get to 1% in March next year, the economy must grow by over 1.8% over the next three quarters, equivalent to an annual growth rate of 2.4%. So either the economy grows at its trend rate from now on, or it grows faster than its trend rate in the early months of 2010.

I know that the monetary policy committee is stuffed with people who know more about economics than I ever will. But I can't see how this projection is possible.

If there is a choice between an optimistic chart and a pessimistic governor, I'm with the governor.