Monday, 22 October 2007

Black clouds loom on horizon after years of plenty

From The Times
October 22, 2007

Anatole Kaletsky: Economic view

For the first time in 15 years, I am seriously worried about the outlook for the British economy, the housing market and sterling. For almost the whole of the period since 1992, when British economic policy was liberated on Black Wednesday, I have been at the optimistic extreme of economic opinion in Britain. Today, however, I find myself at the opposite end. Most economists are predicting nothing worse than a modest slowdown for the British economy next year and are laughing off the IMF’s suggestion that house prices here could fall more steeply than they have in America. But to me it appears that all the risks in the year ahead - to economic activity, employment, house prices and sterling – are now clearly on the downside. To explain why I have turned so bearish, let me borrow the technique of Donald Rumsfeld: I will start with the obvious risks, move on to the “known unknowns” and finally to the “unknown unknowns”.

Starting with the known problems, there are essentially three, corresponding with the three main driving forces of British economic growth in the past decade. These have been financial activity, public sector spending and housing. The first two forces clearly will be much weaker in the year ahead than they have been for most of the past decade. Public sector employment has already stopped growing and will be squeezed much more tightly in the next few years. Wholesale finance and business services, which are more important to Britain than to any other major economy, are bound to experience a serious setback after the recent credit crisis.

With public sector employment and financial incomes stagnating and the wholesale mortgage markets semi-paralysed, the property boom of the past two years must – surely – be over. The only question is whether the next phase of the housing cycle will be a long period of stable prices, which is what most British economists are still predicting, or whether the boom will be followed by a bust, like the one in America, as suggested in an IMF report published in Washington last week. The IMF report did not predict a crash in British housing, but merely pointed out a simple statistical fact often mentioned on this page: house prices in Britain, along with many other European countries, have risen much faster in the past decade than US house prices and the difference in house price inflation cannot be explained by relative movements in incomes, population or interest rates.

The fact that house prices in Britain and in several other European countries (see chart) have risen 40 per cent more than the IMF can explain on the basis of such fundamental factors does not mean that they are likely to fall by this amount. But the IMF figures do show that Britain (along with Ireland, Spain, France, Denmark and many other European countries) is potentially even more vulnerable than America to a property shakeout if the forces stimulating housing demand ever run out of steam. And that is what is happening now, as the simultaneous slowdown in financial and public sector employment combines with the sudden loss of liquidity in the mortgage markets and the vertiginous levels already reached by house prices and mortgage borrowing.

Until recently I would, nevertheless, have joined the moderate majority of commentators in suggesting that the British housing market could enjoy a relatively soft landing, because of the strong underlying demand for housing, especially in London. That demand was, in turn, due mainly to London’s position as the world’s financial capital. In the past few months, however, this calculation has abruptly changed and this is where we come to Rumsfeld’s “known unknowns”.

Nobody knows how much the process of global financial liberalisation will suffer as a result of the summer credit crunch, but there is certain to be less growth in wholesale financial services than there was in the past two years. It is even harder to say whether the mismanagement of the Northern Rock crisis will damage London’s standing relative to other financial centres, but it is not going to help. Most unpredictable of all is the impact of Gordon Brown’s unexpected tax changes on London’s position as the unchallenged centre of global finance.

The post-Budget controversy over inheritance tax and capital gains tax reform, has overlooked the even more radical changes in the tax treatment of foreigners living in Britain. Anecdotally, there is already evidence of hedge funds, banks and international businesses moving some of their highly paid international staff out of London to Geneva, Monte Carlo and the Channel Islands. Of course, these tax havens will never replace London as the financial centre of Europe, but at the margin they are now likely to divert more of the international incomes and employment that would otherwise have come to Britain.

As a result, the London economy is likely to suffer much more than the rest of the British economy in the impending slowdown – and this will be particularly true of the top end of the London housing market, whereI foreigners have accounted for more than 50 per cent of the buyers in the past few years.

Indeed, the evidence of a sharp turnaround in the London property market has already started to appear in unofficial figures, such as the monthly surveys published by, the high-end property website, which has reported two consecutive months of falling prices in London and an increase of 32 per cent in the number of properties for sale. To make matters worse, the preBudget change in capital gains tax could well encourage buy-to-let landlords to put their properties on the market from next April onwards to take advantage of the big tax reductions that many expect to be reversed in future budgets. This will put further downward pressure on property prices next year – another “known unknown”, suddenly introduced by an abrupt change in economic policy that nobody could have predicted even a few weeks ago.

Which brings me finally to the “unknown unknowns”, which have suddenly made the economic outlook for Britain even more uncertain, but also more alarming. All of the policy U-turns of the past few weeks, the random and uncoordinated tax reforms, the loss of confidence in the Bank of England resulting from the Northern Rock crisis and the signs of panic in the Government in response to Tory gains in the opinion polls raise serious questions about the sustainability of the economic framework that has kept Britain so prosperous and stable since 1997.

Suppose a panic-stricken Prime Minister appoints a political crony as governor of the Bank of England. Suppose that public sector unions, sensing the Government’s weakness, refuse to accept the cutbacks in public spending that the Treasury has planned. Suppose the recent tax reforms blow up in the Government’s face and end up yielding less revenue than expected.

After the events of the past few weeks, it is easy to imagine such “unknown unknowns” – and all of them spell bad news.

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