Britain facing steeper recession than U.S.

Tag : High Shrink Ratio


British observers have in the past year indulged in a considerableamount of schadenfreude about the US subprime crisis, theexcessively expansionary monetary policy of US Federal Reservechairman Ben Bernanke and the substantial recession that appearsimpending.

They should be less eager to gloat; the recession into whichBritain is heading is likely to be considerably more serious thanits US counterpart, and the way out, less certain.

One reason for Britain suffering a deeper recession than the US isthat its house prices got more out of line. Whereas in the UnitedStates, the house price to income ratio peaked at 4.5 times,against a long-term average of about 3.2, in Britain in 2006 thatratio peaked at around 5.5 times.

Housing is more tax-advantaged in the United States, since mortgageinterest payments are tax deductible, unlike in Britain. Hence theequilibrium British house price to income ratio would appear to beabout three times, marginally above the 2.7 times level of 1970,when the British housing market was close to equilibrium. Thatimplies that an average fall in real British house pieces of 45% isneeded to bring the market back into equilibrium, considerablylarger than the 29% drop needed to bring the US market intoequilibrium.

Those figures may seem startlingly high but remember: the averageTokyo house price dropped by no less than 70% between 1990 and2005, as Japan's 1980s stock and real estate bubble deflated. Thusa 45% drop is perfectly within the bounds of possibility. The UShousing market appears well on its way to the necessary 29%correction, with the Case-Shiller house price index already down18% since late 2006. Conversely, the British market has only justbegun to drop in price, with current national average prices downby no more than 5%. Hence the future economic effect of the housingdownturn is likely to be considerably more pronounced in Britainthan in the US.

There are however other reasons for believing that Britain islikely to have a deeper recession than the US, the principal ofwhich is the different structure of the British economy. Not onlyis it more finance-oriented than that of the United States, but itsfinance sector appears considerably more vulnerable, largelybecause of the lack of locally controlled institutions involved init.

One of Shakespeare's better-remembered lines, from Julius Caesaris:

'The evil that men do lives after them,
The good is oft interred with their bones.'

For almost no political leader has this been so true as for formerpremier Margaret Thatcher, thankfully still with us but surelywatching in horror as the positive parts of her legacy disintegratewhile her few mistakes return to haunt us in ever more terribleform.

She cut back the size of the bloated British public sector, buttoday it is larger in terms of gross domestic product than when shecame to power. She brought a new assertiveness to Britain'srelations with the European Union, and today the EU is forcingthrough a treaty that would be rejected by an overwhelming majorityof the British people.

With president Ronald Reagan, Thatcher brought about the fall ofcommunism, but today Vladimir Putin's Russia is as threatening tothe West as any Soviet regime since Josef Stalin died, and we can'teven rely on the inherent contradictions in its economic managementto weaken it.

Thatcher brought a new self-discipline and self-respect to theBritish people, but today the British people are as wayward andfeckless as they have ever been. She more or less inventedprivatization, but today that technique of extracting assets fromthe dead hand of government is little used, and the net British andglobal trend appears to be towards more state control, not less.She defeated the trade unions, an achievement that still stands,but maybe they would have been defeated anyway by the forces ofglobalization and the disintegration of the British manufacturingsector.

As for her mistakes, we have been given a stark reminder this weekof her first major political blunder, the 1979-80 Lancaster Housesettlement of Rhodesia/Zimbabwe. When she came to power, aninternal settlement for that country had been achieved and amajority-population prime minister, the moderate and respectedBishop Abel Muzorewa, had come to power through elections agreed byinternational observers to be free and fair. All she had to do wasratify the process that had produced Muzorewa, regularizeRhodesia-Zimbabwe's independence, and provide a certain amount ofaid and investment, and Zimbabwe would have become a beacon ofrelative prosperity in the continent and a staunch British ally.

Instead, Thatcher succumbed to the politically correct machinationsof her feeble foreign secretary, Peter, Lord Carrington, and theincorrigibly leftist Foreign Office, and forced a settlement thatdeprived the elected incumbent government of office and allowed theMarxist terrorist Robert Mugabe to intimidate his way to power.Mugabe has been there ever since, representing no sort of democracyand driving his terrorized populace into ever greater misery andpenury. Seldom if ever has political feebleness brought suchcatastrophic results, none of which have accrued to the primeminister responsible or the electorate that chose her expectingbetter.

Thatcher's reorganization of the City of London by the FinancialServices Act of 1986 is likely to produce fewer actual fatalitiesbut in the long run may be even more damaging, at leasteconomically. It was designed on a wholly fallacious theory thatLondon's financial 'playing field' should be leveled to produce amore competitive marketplace. It abolished market structures thathad worked well for close on 300 years, replacing them with aninferior copy of the structures prevalent in New York. It wasimplemented shortly after a decade in which the British merchantbanks had been devastated by recession and near-hyperinflation, sothat in real terms they were a quarter the relative size they hadbeen in 1970.

The result of removing the market mechanisms with which localhouses had been familiar and subjecting them to fierce competitionfrom much larger foreign banks (who themselves remained protectedin their domestic markets) was inevitable; within 15 years of theact's passage the London merchant banks were not merelyforeign-owned but non-existent. It was the most suicidal Britisheconomic legislation since the 1846 Repeal of the Corn Laws.

The long-term damage to Britain's economy caused by the 1986 Acthas been a generation in arriving, but appears now to be on us. Atthe 20th anniversary of the act's implementation in November 2006,there was much bien-pensant rejoicing, with declarations that theCity and Britain in general were incomparably more cosmopolitan andbetter off as a result of it.

As we now know, that rejoicing was premature, since the anniversarycoincided almost precisely with the apogee of the financialservices bubble that has since so damagingly begun to implode. Thefancy bonuses achieved by the remaining British bankers, kowtowingvigorously to their masters in Frankfurt, Paris, Zurich or NewYork, are unlikely to be matched again for at least a couple ofdecades, if ever.

It seems most likely that the financial services industry, whichapproximately doubled its share of world value added between 1980and 2006, will shrink back to somewhere close to its original size.Many of its 'innovations', such as securitization, turn out to havehad fatal flaws in their incentives design that produced aberrantand in some cases criminal behavior by participants. Globalovercapacity in the sector is likely to reduce both individualremuneration and the fees charged by financial institutions.

The multi-tiered investment management business, in which manyfunds were distinguished solely by the splendor of their feestructures, is likely to shrink back to a modest economic activitythat competes mostly on price. A return to much tighter monetarypolicy and real interest rates well above zero will greatly reducethe amount of loose money sloshing around the world looking for ahome.

Britain is likely to be more deeply affected than the US by aprolonged implosion in the financial services business for threereasons. First, and most simply, it is a more important part of theBritish economy, and its decline will cause more difficulties inthe London real estate market, up-market retailing and so forththan will the equivalent decline in New York. Second, Britain hasmore or less hollowed out its manufacturing industry. We arealready seeing some of the effect of US resilience this year; asthe financial services business gets into greater difficulty andthe dollar declines, manufacturing companies such as John Deere areable to take advantage of the weaker dollar and high commodityprices to expand their businesses at a rapid rate. Britain has fewsuch opportunities.

Finally, Britain will suffer an additional recessionary effect fromthe 'branch-plant' nature of its remaining financial servicesbusiness. Asian finance is already moving increasingly to Asia,since London is in reality little more convenient than New York tocarry it out. US finance, to the extent it has migrated to London,will migrate back to New York, since skilled staff will beavailable there in profusion as the business shrinks.

Only the slow-growing European Union and maybe some Middle Eastbusiness will remain in London. However, other European financialcenters and Dubai are keen competitors in those areas; to theextent the Middle East remains a viable economic region once oilprices decline, it will probably want to carry out its ownfinancing, and the same will be true of the other major Europeancountries. With few significant domestic institutions, London'sglobal market share is thus headed sharply downwards, reducingemployment opportunities and revenues even beyond the effect of theshrinkage in the financial business generally.

Not only is it easy to see how the British economy could sink intoa recession much deeper than in the US, it is difficult to see howit can emerge from that recession to renewed prosperity. Certainlya revival of London's historic position as a financial servicesentrepot seems highly unlikely.