The PIIGS and one-sided equations

The good Dr North has been pointing out for some time that things in Europe are not all sweetness and light (for recent examples, see here and here). He observes that mass demonstrations are taking place with a degree of regularity in Spain and Greece as the little people give vent to their frustration at the economic mismanagement of their political masters. None of us knows what the outcome will be, nor whether it will be the same in both countries or, indeed, in any of the other countries teetering on the brink of government bankruptcy.

What troubles me is not that people are finally waking up and complaining, it is that they are complaining about completely the wrong thing. Their target is undoubtedly correct, politicians have left the PIIGS (Portugal, Ireland, Italy, Greece and Spain) deep in the mire through reckless economic mismanagement. Their complaint, however, appears not to be that their governments borrowed and wasted too much but that they do not want their governments to stop borrowing and wasting now that existing debts cannot be repaid. We see exactly the same delusionary behaviour in this country whenever the trades unions wheel out their usual rent-a-mob to bemoan a tiny bit of trimming from departmental budgets to find cash to pay the interest charges incurred by Gordon Brown's feckless stewardship of the Treasury.

I am not in the least bit surprised. Governments all over Europe have been winning elections for years by presenting one-sided equations that sound nice but do not stand up to even the gentlest scrutiny. These one-sided equations are the tool of every headline-grabbing initiative and are not restricted to the field of economic policy, we see them all the time in the field of health policy.

Smoking / drinking / one food / another food / too much exercise / lack of exercise / salt / lack of salt, or whatever is the scare of the day, is calculated to cost the NHS so-many hundreds of millions of pounds and must therefore be banned. The figures are always wrong, always grossly exagerrated, but that is beside the point; even if they were correct they only look at one side of the equation. Treating medical conditions which might not have arisen had the patient not been a smoker can be seen as a cost caused by smoking, there is nothing unreasonable in that as a general proposition. The problem is that the NHS does not exist in a vacuum and it is not funded in a vacuum, it is funded out of taxes and smokers pay taxes that others do not pay; shops and wholesalers make profits on which taxes are paid, workers in those businesses and in every stage of the cigarette production and distribution network pay taxes on their wages. The taxes gathered from the ciggy network grossly exceed even the most dishonestly overstated costs attributed to adverse consequences of smoking.

The same is seen in the moronic argument that "green" production of electricity will be economically beneficial because it will create new jobs. Of course it will create new jobs because no one has been so stupid before to pay people to do anything so utterly pointless, but even so the benefit of these new jobs is only one side of the equation. On the other side lies the fact that employing more people to generate the same amount of electricity means it is more expensive and that cost must be passed on through higher prices. Higher prices for electricity means higher costs for businesses and individuals. Those businesses can be tipped into insolvency causing their employees to lose their jobs and individuals who must spend an extra £100 on electricity have £100 less to spend on other things thereby depriving Mr Patel's Merrymart and Madame Fifi's Sauna and Hanky-Panky Parlour of income, resulting in shed staff and less tax being paid. No one should be surprised that studies in both France and Scotland reveal each "green" job to cause the loss of more than two other jobs.

So it is also with the bubble of economic activity arising from an unsustainable expansion of credit. Of course it means people have more money and buy more stuff which means shops and manufacturers employ more staff, make more profit and pay more tax. The government takes credit for the miracle of an ever-expanding economy. Apparent riches for all means votes for incumbents. The other side of the equation in this situation contains what groovy hep cats might term a "double-whammy".

Credit cannot go on expanding for ever, eventually you reach a point where you cannot borrow any more because even the most foolhardy lender is not prepared to advance you another penny. At that point the economic expansion arising from credit necessarily stops and in due course it must be reversed as people realise they must repay their borrowings. It doesn't necessarily happen all of a sudden although it did two years ago because banks simply stopped lending. In addition to the reduction in economic activity resulting from the wind-down of credit-based spending we have the second whammy, namely a reduction in tax receipts for the government. The additional sums received in the boom years were used to strengthen their electoral position. Were we cruel people we could suggest they used tax receipts to bribe voters, but we aren't cruel so we will instead describe the spending of this windfall of unsustainable taxes as the result of nothing more sinister than stupidity. Unfortunately the stupidity knew few bounds so the PIIGS, the UK and many other countries find themselves with government spending commitments far in excess of tax receipts.

A sober and sensible approach to the problem would recognise that governments handed out treats that could not really be afforded even when times appeared good, so now that they are far from good those treats cannot be given any more. The governments of Spain and Greece are trying to cut back a fraction of the unaffordable treats and it is this that causes discontent on the streets. The people are complaining that something they should never have had in the first place (because it could not be afforded) should be maintained despite government income being substantially lower than it was in 2009, it is utter madness. A particular difficulty arises with government spending compared to individual spending, namely that the consequences of reducing it are highly visible. A million people each spending £50 less is equivalent to government spending £50million less - the former is just a normal incident of life whereas the latter is a headline in every newspaper.

I cannot help thinking that pushing one-sided equations at their people and arguing tooth and nail that the equations in question have only one side is the root of current public disquiet in Spain and Greece. There is every sign that the people demonstrating against plans to trim government spending really believe there is only one side to the equation. In a way this should not be surprising, both countries had long periods of socialist government in which the allure of the magic money tree was all pervading - no need to worry, the government will pay for it, the government has a bottomless pit of money because it just plucks some more from the magic money tree. We should be more worried about this reason for mass demonstration than we would have to be were demonstrators complaining about overspending in the past.

Breaking news - HBOS doesn't lose £500 million

It was announced yesterday (see here) that Lloyds Bank, the lucky owner of HBOS (Halifax Bank of Scotland), will have to pay around £500million to HBOS customers who took out a particular type of loan. The long and short of it is that customers were told they would be given notice if HBOS changed its policy from charging a maximum of 2% above base rate to charging 3% above base rate. The policy was changed, as they were probably entitled to do, but notice was not given to all customers who were told they would be given notice. Nonetheless, 3% above base rate was charged. Lloyds has agreed to compensate those who paid the additional 1% but were not given notice.

On the face of it the position is very straightforward. Whether or not customers would have sought a replacement loan on being informed of the change, they would have had the opportunity to do so. As it is they were deprived of that opportunity. Had they been given notice it seems fair to presume that some would have found another lender and ended up paying less than the amount they paid Lloyds, some would have found another lender and ended up paying more than to Lloyds, some would have switched to a different type of loan with Lloyds and some would have just left the original loan in place and paid the extra interest. There is no way of knowing how many would have fallen into each category although it is probably not unrealistic to suggest that most would have left things as they were and just paid the higher interest charge. After all, base rate had fallen substantially and 3% above base was less than many had been paying a year before when the mark-up was 2%.

If this were looked at as a claim for breach of contract the assessment of compensation would be fiendishly difficult. Leaving aside the question whether there was any breach of contract, compensation would have to be calculated by trying to value the loss of opportunity to switch mortgage from Lloyds to another lender or from one Lloyds mortgage product to another. The position would be different for different borrowers, depending on their own financial circumstances and the degree to which they would have been likely to seek out an alternative loan. Few would have been entitled to repayment of the whole of the additional 1% they paid although it is theoretically possible that a very small number would have been able to prove a case for a larger sum (if they were able to satisfy the court they would have switched to a loan charging less than 2% over base).

Reports say up to 300,000 HBOS customers were affected. It would make no sense (except to the bank managers of the lawyers involved) to have 300,000 separate claims. Were this dealt with by way of claims for breach of contract there would be only one claim in which all customers who showed interest would be involved. "Class actions", as these cases are known, are relatively new beasts to the English judicial process, we see them most often when a large number of people suffer personal injuries due to the same cause - perhaps a drug that proves to have bad side effects or a work practice that causes many employees to suffer illness or injury. Although the accuracy of the compensation in each individual case is somewhat rough and ready the process is generally quicker, certainly much cheaper and has the added advantage of everyone knowing their case has been considered in the same way as everyone else's.

The intervention of regulators of businesses such as banking means that legal claims do not always need to be made, the regulator can step in and require redress to be paid for an apparent wrongdoing. This, of course, is what happened in the present case. We will probably never know how much pressure was applied by the regulator and how much the decision to offer compensation was motivated by either a genuine sense of the need to do the right thing or exasperation at Lloyds with the shabby practices of HBOS and it does not really matter. A problem was identified, a solution worked out and litigation avoided.

At the heart of the solution is the implicit assumption that HBOS/Lloyds should not have charged an extra 1% interest without giving notice to their customers. Whether they were entitled to do so in law is not the point, they said they would give notice and they did not; of itself that is bad practice and, some would say, fundamentally unfair. The amount they received from customers by increasing their margin seems to have been around £500million. They simply should not have received that sum in the first place. Had they followed good practice they would have received the money and would not now be liable to repay it, as it is they should not have received it and now must repay it.

In making the repayments Lloyds will not be losing anything they will simply be handing back money they should not have received. It is quite wrong to think of this as a loss. Any loss is purely hypothetical and results from not giving the promised notice - had it been given they would have received £500million, by not giving it they have lost £500million, except they haven't. By not giving notice they lost the chance of receiving up to £500million but they did not lose any money. By not investing one pound on the numbers 6, 16, 26, 32, 33, 34 and 46 for last Saturday's lottery you lost £4million - that is not a loss it is a failure to make a profit that would have ensued from doing something other than what you actually did.

A classic case of Northern Crock

Someone I know has to sort out the estate of a friend of his who died last week, the poor fellow had cancer and was only 35. He has been making enquiries into his friend's assets and liabilities. Apart from a few hundred in the bank and normal household effects the only major asset is an ex-council flat originally bought some years ago under the right-to-buy legislation, the deceased bought it four years ago for £170,000 with the assistance of a loan from Northern Rock. It is a classic example of why Northern Rock is known as Northern Crock.

The deceased was a hairdresser earning around £30,000 a year gross in 2007. He had been renting all his adult life and wanted to buy his own home but had very limited savings, so he searched for a 100% mortgage. Northern Rock advanced not only the £170,000 needed to buy the flat but also a £10,000 unsecured loan. The mortgage was repayable over 20 years but no mechanism was put in place to repay any of the capital and the borrower was not required to take out any life assurance to provide Northern Rock with a lump-sum in the event of his death. All that is pretty sloppy, they lent £10,000 more than the property was worth, a sum equivalent to about six-time the borrower's gross income, to someone who would have no obvious means of repaying the capital at the end of the loan period. Their only security was the property itself, and that is where the whole thing becomes a true crock.

Because the flat had originally been bought from the council some years before, the lease had only 57 years to run. These days leaseholders have certain rights to extend the period of their lease but it costs money and only happens if the leaseholder gets round to asking for it. In the meantime the property is worth only what it can be sold for in the open market. Flats with less than 60 years left on the lease are not accepted as security by most mortgage lenders (Northern Rock was one of the few foolish enough to lend against such a property), although an extension can be obtained it must be paid for and when the lease is running short it can cost many tens of thousands of pounds plus conveyancing costs and valuation costs if the freeholder does not agree the figure - all these costs must be borne by the leaseholder. In the case I am discussing the lease now has only 53 years to run and I would estimate the cost of gaining an extension to be between £20,000 and £30,000 (I claim no expertise, but that is my best estimate). This affects the current value of the property enormously because it excludes the vast majority of the potential market from being able to buy the flat. Only cash buyers are in the market and they are unlikely to buy an ex-council flat for their own occupation; the real market is professional landlords looking to extend their portfolio. They will only buy through an estate agent if they can get a real bargain, otherwise their money will go further by buying at auction. The reality in such a situation is that the open market value is the forced-sale auction value. In this particular case the open market value of the property on a long lease of 90 years or more is around £190,000-£200,000. As it is, anything in excess of £120,000 would be a good price for the vendor, it wouldn't be at all surprising to find the flat sells for no more than £100,000.

His executor will sell his household possessions for a few hundred pounds to off-set funeral expenses and, if he is sensible, will simply surrender the flat to Northern Rock - there is no point him engaging estate agents to sell because he would have to pay their fees himself. Northern Rock will recover a flat worth at most £120,000 to cover a secured loan of £170,000 and an unsecured loan of £10,000. Their loss is likely to be at least £60,000 - no less than one third of the total amount they advanced.

One might think they could have protected themselves through insurance. I do not know whether any part of the loan was insured against default but the life of the borrower was not. Had they insured part of the loan itself (using what is usually called mortgage indemnity insurance) they might be able to recover 10 or 15% of the secured loan but their loss will still exceed £30,000.

Although this is just one example, it illustrates the folly of the sort of high loan-to-value mortgage loans for which Northern Rock was famed. No one knows how many similar bits of trash sit on their books.

Economic structure is more important than detail

Now that some tentative first steps have been taken on the long path to reducing government spending to affordable levels it is worth asking whether the forecasts included in the Budget papers are as important as the shift of emphasis away from big government. I don't mean the "structural deficit" because that is just a way of describing part of the shortfall between spending and income. I mean the general ethos of reducing the influence of government in people's lives and, therefore, reducing the cost of government.

What is it that those who bail-out bankrupt governments require? One thing first - reduced government spending. Other conditions apply in most cases, but that is and always will be the first requirement. No individual, company, council, state or nation can stay solvent if it spends more than it can afford to repay. Our Keynesian friends babble on about the knock-on effects of reduced spending and argue that cuts now result in the loss of later gains that their spending choices would deliver.

How can the International Monetary Fund and the European Central Bank require spending to be cut hard and quickly if the effect of doing so is to make the borrower country less able to repay the loan? Yet they do impose that requirement whenever they lend to a western government. It is sheer madness according to the ex-Chancellor Mr Darling and now according to the current US President, Mr Obama, who has encouraged European governments to continue trying to stoke-up consumer demand. Both sides cannot be right. It cannot even sensibly be said that they are addressing different issues because the lenders need to be repaid over time and any step taken now that limits the chance of being repaid next year is not one they would be wise to encourage.

I wonder whether the key to understanding the apparent conflict lies not in economics but in politics. It is good politics to be able to boast of economic growth. We saw that first-hand in the UK as the housing price bubble delivered votes for the Labour government because it made people feel wealthier and allowed them to borrow and spend against their new-found wealth. For very obvious reasons the government claimed credit for that feel-good factor and, when the level of unaffordable debt was exposed, distanced itself from the other side of the bubble coin. So far the new government has not taken any steps to deflate the house price bubble because they know it could lose votes.

Interestingly, under John Major's government house prices fell hugely between 1989 and about 1991 and then flat-lined for a few years. During that period came the general election of 1992 and little evidence appeared that deflation of the house price bubble cost the government any substantial number of votes. I didn't hear anyone blaming the government for the nominal value of their house falling by more than half because they knew it had jumped artificially and very quickly in the previous few years. As an example, some friends of mine had their house valued at £375,000 in 1989 and at £150,000 in 1992, they had bought for about £120,000 in 1986. In a six-year period it had risen in value by 25%, an average of more than 4% a year which wasn't all that far away from general inflation. The huge spike was not real and people knew it was not real. The recent huge spike is not real and people know it is not real but the game has changed somewhat because far more people have borrowed against the bubble equity. Now bursting that bubble would raise fears that didn't arise to the same extent eighteen or so years ago.

Not only do people feel wealthier if they are told the "value" of their home has increased, they also feel the country is wealthier if GDP rises. There is no counterbalancing factor of the type evidenced by perceptions of the false spike of house prices in the late 1980s, yet the situation is the same. Why did GDP rise constantly through the 2000s? Of course numerous factors applied but one was the increased economic activity caused by borrowing money we could not afford to repay. Every time quarterly figures appear and inform us that GDP has risen by 2.7% is seems to be treated as setting a new lower benchmark for the acceptable level of economic activity in the country. We have achieved a level of activity and will suffer if that level of activity falls, or so goes the theory. It is as artificial as my friends' house going up in "value" from £120,000 to £375,000 because it has foundations of sand.

To Mr Obama and Mr Darling the maintenance of a falsely inflated GDP figure is an end in itself, presumably because of the possible political consequences of the figure falling. They cannot want to maintain that false and unaffordable level of GDP for reasons of economics because the price of continuing to spend more than you can afford is serious long-term penury. The lenders and the governments of European countries seem to take the view that it is time to stop pretending that unaffordable consumer debt should be replaced by unaffordable government debt simply to maintain a level of economic activity that is necessarily dependent on unaffordable debt.

It really doesn't matter if this approach leads to a fall-back into recession because the substance of the matter will be that the economy shrinks to the size we can afford rather than being kept at a size we cannot afford. At the moment the structure is wrong. Getting the structure right is the only way of ensuring both stability and affordability in the future. To my mind it is far more important than the technical detail of whether GDP is going up, down, in, out or shaking it all about. If our current government had the courage to include deflation of the housing bubble in its plan we could get there much quicker. It doesn't matter whether their predictions are accurate, what matters is that the balance of the economy - the structure - is sustainable. They could be billions out in their predictions of borrowing and spending levels a couple of years down the line, but that will not concern those on whom they rely to fund our broken economy while the costs of Gordon Brown's decade of incompetence are wrung out bit by bit.

While throwing these words together I noticed that the good Mr Economicus has written on the same subject in far more erudite terms, he is always worth a read (his marvelous piece on the illusion of GDP should be branded into the wallpaper at the Treasury).

Never mind the quantitative, feel the ...

So, the merry-go-round has been started up in the great funfair of the vanities that is current economic policy. The government is printing £75billion of monopoly money now with up to another £75billion when this lot fails to achieve anything, so we can make that next month then. This is hailed by the BBC as "Bank to pump £75billion into economy". Doesn't that sound nice? We all need more money in these difficult times, how very lovely of the Bank of England to give us all so much to play with. Super.

It reminded me of a divorce case I dealt with twenty-odd years ago in which the the wife was giving evidence about how much money she needed. After describing her need for a house, a car, two televisions, long finger nails and a small poodle was was being cross-examined about how her husband could be expected to find so much money out of his small shop business. Her reply was "he's hasn't just got the shop he's got a company". Indeed he had, the shop operated through a company with £100 of share capital (ironically owned equally by husband and wife). She honestly thought that a company could just make money appear as if by magic regardless of how much went through the till. "Bank to pump £75billion into economy" has the same ring to it. It gives the impression that this massive pot of cash is going to appear out of thin air and be unleashed for the greater benefit.

Of course the company of the divorcing husband might have been able to raise a loan and, in turn, lend that sum to the husband to pay for the wife's poodle, but there would be nothing magical about it. The company would have to repay the loan with interest and the husband would have to repay the company. No magic new money, just borrowed money that will be a net drain on resources unless it can be put to a profitable use. Such borrowed money is new money for the people who borrow it but the crucial point is that it does not increase their net wealth. It puts, say, £100,000 in the credit column but puts £100,000 in the debit column. As interest accrues further debit entries appear and their net wealth diminishes unless there are corresponding increases in the credit column. That is the whole point about credit and wealth. If you borrow money and make it work for you so that you make a greater gain than the amount of interest you have to pay, then you genuinely create new wealth from that money. But if you just spend it on things that get consumed you diminish your wealth by borrowing. Our pitiful government has defined its own profligate spending as "investment" for the last decade, but that doesn't mean it was investment any more than I might go to the supermarket and say I have invested in a pound of cheese.

The contrast between the divorcing couple and the Bank of England is that the latter can just magic new money out of thin air. There is no need to print a single extra £10 note to do this, all they have to do is press some buttons on a computer and "kerching" they have an extra £75 billion appearing on a computer screen and credited to them. So, if Dodgy Mortgages PLC needs £10billion to lend to individuals and businesses the Bank of England can say "We'll give you £10billion for the mortgages loans you made in 2006 and which are now defaulting." A piece of paper is signed, the Bank of England is now the proud owner of the right to receive payments of interest and capital on loans that aren't worth the paper they are printed on and Dodgy Mortgages PLC is free of those bad debts and has a clean £10billion ready to advance to the waiting hordes. In reality all that has happened is that the bad debts are still in existence but an extra £10billion of cash is now floating around.

The problem with doing this is that there has been no increase in real wealth, just an increase in the money supply. The concept of wealth is at the heart of understanding what money is. Money is just a means of measuring wealth. If I own a house, a car, furniture, books, paintings, sculptures and a set of golf clubs, it is those things which represent my wealth. Whether you value them at £100,000 or £2million, my wealth is exactly the same, all that has changed is the nominal value attributed to each pound. And how do we know the current nominal value of a pound? We take the total wealth in the country and divide it by the number of pounds in circulation (OK, there's rather more to it than that, but it's a good rough guide). Increase the number of pounds in circulation without increasing the assets they represent and each pound represents a smaller proportion of real value, in other words you need more pounds to buy each thing. Prices go up. You have inflation.

One problem with inflation is that it makes ordinary everyday things unaffordable for the least well-off. A great many people spend all their income on the basics - housing, water, food, clothing and fuel. Increase the number of pounds they have to pay without also increasing their income and they have to forgo basics. Not nice. A situation to be avoided if possible.

Throw lots more money into circulation and you risk creating huge inflation of the type seen currently in Zimbabwe. So why, one might ask, is the government following that path now? It seems to me there are two reasons.

The first is to create inflation so that current debts (measured in pounds) represent a lower proportion of national wealth. If you owe £100,000, you owe £100,000. If today £100,000 represents the price of a Rolls Royce and tomorrow it represents the price of a Scoda, your debt falls in real value despite being the same number of pounds. This helps you as a borrower and shafts the person to whom you owe money, which in many instances is ultimately an overseas bank or investor. As always, if something looks too good to be true, it is. Domestic inflation hurts the poorest first last and all the time. That is a high risk for any government to take merely to reduce the real value of debts measured in pounds, and it does nothing at all to debts measured in other currencies.

The second is to provide a stimulus to the economy, primarily by making more money available for the banks to lend. At the moment it is asserted that credit has dried up causing housing sales and high street sales to stagnate, and causing businesses to be short of both working overdrafts and loans to fund investment in expansion. If this stimulus works, real wealth could increase thereby negating the inflationary effect of there being most pounds sloshing about. After all, an increase of 5% in the number of pounds in circulation doesn't matter if wealth increases by 5%, the two balance themselves out. So, if you increase money supply by 5% first and this causes a 5% increase in wealth you will reach a balance even if there is a time lag between the two.

To my mind a number of factors point towards inflation being a greater likelihood than a stimulation of economic growth.

First, there is already an inflationary element in the economy because assets have been overvalued for years, especially housing. Our real wealth has been worth far fewer pounds than it purported to be. While the money supply seemed to be balanced with asset values at their over-stated level, as that level becomes more realistic we will have a surfeit of pounds. To throw more pounds into the national pot increases the prospect of inflation in areas other than housing.

Secondly, there are excessive levels of personal debt on credit cards and through second mortgages which will be repaid through cutting back on discretionary spending. Much of the boom economy was built on spending funded by unaffordable credit, that will end. In addition, those burdened with hefty liabilities on credit cards or other loans will repay those debts by not spending at restaurants, clothing shops, electrical good suppliers and all the rest (or they will go into insolvency). The scope for boosting personal spending by boosting credit is severely limited. Shops selling the optional extras of life are likely to be facing a tough time no matter how much extra cash is in circulation.

Thirdly, the stock market falls over the last year have wiped a third or more off the value of many investment funds. The pressure to save more will be strong. Although historically low rates of interest provide a disincentive to save because the value of what you have saved actually falls when you receive 1% interest and general inflation is above 1%, the fact that existing savings have been decimated requires many to do what they can to build up the funds they will need later in life. This, again, acts to restrict the amount people feel able to spend.

Fourthly, borrowing to buy a house or flat will only be done by those who really need to. The housing market is, it seems to me, still grossly inflated and has a long way to fall to get to realistic levels. Even if it only another 5% (highly wishful thinking, in my view) that is still a £10,000 loss on a £200,000 property; no sensible person will take that on unless they have no other option.

Fifthly, the banks have to be more stringent in their lending criteria than they have been for many years otherwise they will just build up another massive portfolio of bad debt. This affects not just lending for house purchase but for everything else as well. Since they must lend less and with greater profit margins, the scope for a consumer-led recovery is reduced further.

Sixthly, lending to businesses is bound to be tighter as consumer spending falls because potential business borrowers will have to explain how they will be exempt from the downturn in spending. At the moment we hear government ministers complaining that businesses can't get the credit they need to keep going, but this assumes they will be able to keep going even if they get the credit they seek. That is quite unrealistic. Many businesses that were a good risk to the banks a few years ago are now a busted flush.

Seventhly, higher taxes will have to bite within the next year or two because the government has borrowed so much money to throw at the problem. As and when the recession bottoms-out, the higher taxes will have to kick-in, thereby lengthening the time before consumer spending can return to anything like the levels of a couple of years ago.

All these points, and there are probably many more, suggest that it is unrealistic to hope we will spend our way out of this hole. Yet again the government has not had the courage to speak the one unassailable truth in all this horrid mess (and, to be fair, the Conservatives also don't have the guts to say it). For years and years we have been living beyond our means and pretending that we have real wealth and substantial spending power when the reality is that we are nothing like as wealthy as we thought.

We have been living a lie and any attempt to resuscitate that lie by trying to stimulate both borrowing and spending is extremely dangerous. Either it will not work at all, in which case the result is massive wasted expenditure; or it will work in the short term, in which case the problem just becomes greater sometime in the future.

And the greatest error is to think there is a solution other than allowing the problem to work its way out in its own good time. If ever "do nothing" was the right approach, it is now.

Mr Darling hits Rock bottom

Yesterday the government decided to abandon all sense and enter the home mortgage market through its puppet bank, Northern Rock. As you will probably know, Northern Rock got itself into difficulties through a pincer movement of spectacular irresponsibility. It made huge numbers of advances without making proper enquiries into the borrowers' ability to service the loans and advanced a very high proportion of the perceived value of the properties given as security; in many instances it advanced far more than the perceived value of the property. That was the first line - bad loans. In order to fund these loans it had to get its hands on money, much of which it borrowed from other financial institutions over short periods of time. When wholesale credit became harder to find, it still had to repay existing borrowing despite not being able to lay its hands on replacement funds at an affordable price. That was the second line - over-reliance on temperamental sources of funds. The difficulty in securing new funds was made worse by the fact that its mortgage book was stuffed full of dodgy loans, thereby giving rise to doubt whether it would be able to repay any new funding. We covered all of that a few months ago.

Northern Rock borrowed £27billion from the Treasury in 2007. That's an awful lot of money. After being nationalised the bank effectively stopped making new loans and concentrated on turning existing loans into cash to repay the £27billion. To its credit, so far it has repaid around £18billion. This money has come from two main sources. Existing borrowers have continued to make repayments (albeit with high levels of default), giving a cash flow that has not been re-lent; and many have been encouraged to remorgage with other banks so that their borrowings from Northern Rock were repaid. In effect, it was losing the chance of future profits but securing repayment of the capital sums advanced. It has also taken quite an aggressive position with accounts that have gone into arrears and have repossessed and sold properties quickly to prevent losses on those accounts getting even worse. All fairly standard stuff when you are winding-down a business.

I'm no genius, but I reckon repayment of £18billion out of £27billion leaves £9billion plus interest still to be paid back to the Treasury. Some might think the government's first priority would be to get this money so as to make a small dent in its own unaffordable debt. But no, now Mr Darling thinks Northern Rock should start lending money again and is suspending further repayments to allow the bank to make new loans. We wait to see the lending criteria applied, but the indication is that they will be more generous to borrowers than most other banks.

The other banks have reverted to the historically stable formula of limiting loans to 75% or 80% of the perceived value of the property offered as security and advancing only limited multiples of the borrower's income. They have done so for three reasons. The first is that they need to know they are writing sound business because these new loans will be a substantial part of their income stream from which to cover losses which are still waiting in the system but have not yet attached their mandibles to the pin-striped posterior. The second is because they don't have as much cash to lend as they used to, so they can be more selective and advance it on only the soundest deals. The third is that there is no longer a race to the bottom in which they all think they must lend hither-and-yon because their competitors will do so and make profits if they don't. There simply aren't the borrowers out there willing to buy in a falling market.

What is happening now is an interesting example of the extent to which house prices were previously inflated not by genuine demand but by the availability of unsustainable loans. Classic supply-and-demand theory states that where supply is greater than demand prices fall because the buyer is in the driving seat, he knows he can buy elsewhere if one seller doesn't give him the right price; and where demand is greater than supply prices rise because the supplier dictates the price, either the buyer pays it or he misses out because another buyer will pay it. Of course it is far more complex than that because there are numerous factors at play other than a simple numerical comparison between the number of things available and the number of people wanting to buy them. For example, people might be willing to pay more in a local shop than they would at the supermarket three miles away because it is more convenient, and some wouldn't be seen dead in Tesco so they shop at Waitrose instead even though it is more expensive.

One of the major factors affecting house prices is the amount of money potential purchasers have available. Even where numerical demand far exceeds supply, buyers can only pay what they can pay. That five people might each offer £200,000 for a particular property does not necessarily mean the seller can get another £5,000 out of any of them, if they only have £200,000 then £200,000 is the ceiling. It goes without saying that the ceiling will rise if potential buyers can borrow more. Say you have Mr Ordinary on a salary of £30,000. When lending is limited to three times his salary the most he can borrow is £90,000. Applying a laxer standard and allowing him to borrow five times salary means he can lay his hands on £150,000. Not surprisingly, the more he can borrow the more he can afford to offer but that does not mean he can afford a larger property because every potential purchaser is in the same position. Those looking for a one-bedroomed flat can afford more, as can those seeking a two-up-two-down, as can the three-bed semi crowd and those desirous of a five-bed detached with low-level suite in duck-egg blue. Prices all along the chain get pushed-up a few notches simply because banks are prepared to lend more.

Over the last year or so relatively few new house purchase loans were made while the banks reassessed their lending criteria. No doubt part of the slow rate of business was caused by many purchasers deciding to wait and see what will happen to prices over the next year or more, but a part was, nonetheless, due to the banks being extremely cautious. That caution has now translated into the new standard of lending criteria, requiring substantial deposits and applying not just limits to the multiple applied to income but also more stringent assessments of the security of the borrower's income. Now that a new standard has been applied the banks are lending more than they did in 2008. In exactly the same way that their lending was suicidally lax over the preceding few years, leading to far too many unserviceable loans being made, so it was tighter than long-term interests required in 2008 while they reassessed their options.

I can see some sense of Northern Rock re-entering the mortgage market and applying the same strict but sustainable lending criteria applied by the other banks. This would produce valuable assets which could be used to service the outstanding government loans, but only if enough sound new business is done to provide sufficient income to service those loans. What I find difficult is that Mr Darling has already announced that mortgages up to 90% of valuation will be made available. The other banks aren't doing this because they perceive it to be unduly risky in these turbulent times. If Northern Rock is to trade its way out of trouble, one would think the last thing it should do is take risks other banks are not prepared to take. Nor does it seem to make much sense to try to trade your way out of trouble when you have already disposed of much of your existing sound business in order to repay two-thirds of an enormous government loan unless what remains is viable as a business in its own right. It seems highly unlikely that it is viable because it has not been able to shift the bad loans which are defaulting at a very high rate.

In order to re-enter the mortgage market Northern Rock needs money. Having repaid £18billion to the government by cashing-in its existing good business, it is now going to borrow up to another £14billion in order to make loans on less sound terms than most of those they have disposed of. On the face of it the whole thing is bananas. It's bananas for Northern Rock which will then be in hock to the government for up to £23billion with no obvious means of repaying this sum other than selling-off every sound loan it still holds and all the loans it is about to make. And it's bananas for the Treasury which needs to find ways to reduce its own borrowings rather than terminating repayments from a debtor and lending that very debtor yet more.

There is only one possible reason for this move. It is to maintain the existing part of the house-price bubble (if not to re-inflate it to former levels) by challenging the other banks to match Northern Rock's new lax lending criteria. If those other banks are foolish enough to do so the result will be substantial additional funds being made available to potential purchasers with the inevitable result of prices being kept higher than they would otherwise be. It overlooks the need for house-purchase to be affordable and, therefore, sustainable and, therefore, a stable force in the economy. Lend too much and prices are pushed up. Lend too much and the level of default will be high. This risks lenders suffering capital losses which will have to be passed onto their customers which will make the cost of credit high, which will risk yet further defaults.

The idea of lending more to "stimulate" the housing market so as to aid recovery from recession is fundamentally flawed. It will not aid the way out of recession because it will not create new wealth, it will just create new pretend wealth (as to which see my offering of yesterday). There will also be marginal benefits in an increase in trade in carpets, corkscrews and Swedish flat-pack furniture, but that will be dwarfed by the longer term stifling effect of the house price bubble being extended. And, at the same time, it will increase government debt yet further thereby prolonging the post-recession period in which real growth is reduced or nullified by the additional taxes needed to repay that debt.

Mr Darling does not seem to realise that this country's systemic economic problem cannot be cured by the creation of more pretend money.

A special lie from poor Gordon

The Labour Party has started a new website using taxpayers' money, it claims to be a site giving unbiased information and so is dressed as a government site and paid for by the little people. In fact it is just Labour Party propaganda. This is such an abuse of office that I do not intend to compound the insult by linking to it or mentioning its name. But I do want to look at something poor Gordon has written on it.

There is a section about the current recession/depression in which the man pretending to be Prime Minister explains what caused it and how it should be solved. He says this:
"In America people were encouraged to buy homes with cheap credit and low starter interest rates, but salespeople made no proper assessment of what level of lending they could afford to repay.
As US house prices fell and the US economy slowed the number of people defaulting on their mortgage started to rise, and once other lenders realised that was happening, the system started to panic, as everyone was trying to work out how many other risky assets the other banks held."

This is so blatantly simplistic and inaccurate that some might be surprised to find it being put forward by anyone who claims to know what they are talking about. How can he possibly think it a fair and accurate summary of the position? How can he seek to explain the situation in the UK by exclusive reference to what happened in America? The man is clearly now so deluded that all hope of hearing sense from him has passed.

The case he seeks to put forward is that there is no problem anywhere other than America and all losses being suffered by banks are the result of defaults by US housebuyers. The man is absolutely barking. It is certainly true that American banks lent money left-right-and-centre to people who couldn't afford the loans, they had to because of a bizarre legal requirement imposed first by Jimmy Carter and then strengthened by Bill Clinton required them to do so as a condition of being granted a banking licence. But what about here in the UK? The same thing was done by many of our banks voluntarily, in pursuit of a quick profit, with the agreement and encouragement of the government. Our houses did not become grossly overpriced because of anything going on in America, our economy is not saddled with countless billions of unaffordable credit card debt because of anything going on in America, our businesses are not burdened by expensive red tape because of anything going on in America; only someone with prawn cocktail for brains could think otherwise.

I've said it before and, being a boring sort of chap, I'll say it again, levels of perceived wealth over the last few years comprised both real wealth and pretend money, money which did not really exist. That pretend money is now being squeezed out of the system. That's what recessions do, they bring us back to reality when we have been living beyond our means on pretend money. Sadly, lancing the boil of fictitious wealth can destroy real wealth in the process, collateral damage cannot be avoided.

I know poor Gordon is an avid reader of my musings, and I now know he has prawn cocktail for brains, so I will illustrate things in terms even he might understand. Take Mr Ordinary on a post-tax income of £12,000. That means, Gordon, that he has £1,000 to spend each month. Rent costs him £500 a month, gas, electricity, food, travel and clothing cost him £450 a month. He has £50 a month spare. Mr Ordinary wants a car, it will cost £6,000 but he doesn't have the cash so he takes out a loan. It costs £75 a month. Woops, he has a problem. He is now a man with a car, ostensibly a wealthier man than he was last month because then he was a man without a car. He maintains his spending as before and soon finds himself overdrawn at the bank. How can this be? He is now wealthier than he was before, how can he also be poorer? The answer, of course, is that his apparent additional wealth is an illusion. Eventually the time will come when he has to cut back on his spending to balance the books. But, and here is the vital point, it will not be enough just to reduce spending by £25 a month because that will only restore him to a break-even position for the future. He also has to repay the overdraft. In order to negate the loss caused by taking out an unaffordable loan he will have to reduce his normal expenditure to below £1,000 a month until the overdraft is cleared. During that period of hardship his real wealth falls, he started out with £1,000 to spend on himself but for a time he has to spend less than that and suffer a real reduction in the quality of life.

That's what recession is all about, not just reducing your current expenditure to match your income but reducing it to below your established comfort level in order to remove the accumulated cost of having lived beyond your means. It applies to a country just as it applies to Mr Ordinary in this example because a national economy is made up of the individual economies of the people and businesses operating within it.

In one respect the problem of American banks being obliged to lend to the indigent has made things worse in that those British banks that invested in securitised US homeloans face losses that also need to to be addressed. The problem, however, is not that the US banks made bad loans and offered British banks the opportunity to buy an interest in those loans, it is that the British banks accepted the offer. Canadian banks did not, because their regulator did not allow it; accordingly Canadian banks are now sitting pretty. Pointing the finger at America is no answer. When someone offers me a pie and my decision to eat the pie follows encouragement from a dietician, the resultant clogging of my arteries cannot sensibly be laid at the door of the person offering me lard and dripping wrapped in a crisp suet crust. It was my choice to eat it and that choice was subject to the ultimate quality control of the dietician. In real life such a dietician would require good insurance. In the fantasy world of Labour politics they make him Prime Minister.

Here are your conclusions, now go and investigate

Well well, what a surprise. The government is going to launch an "independent" investigation into how banks are managed, so the BBC tells us. There seem to be no plans to look into how haulage companies are managed, or estate agents, or clothing manufacturers, or fish and chip shops or saunas & hanky-panky parlours. Just banks. Why? And why now?

Investigating how certain businesses are run is a perfectly legitimate role of government. There have been many such investigations over the years and for many different reasons. Perhaps there is a suspicion that a cartel is operating and keeping prices artificially high to the detriment of the consumer, or that company law regulations are being breached or taxes being evaded; all sorts of potential wrongdoing can justify an investigation. The common theme always is a concept known as "the public interest".

That term is used in various different contexts to mean different things. In relation to business it covers three things: law-breaking, unfair trading and business practices which cause structural problems to the economy.

Although it is not widely known, the Companies Court has the power to order the winding-up of a business for acting against the public interest. It is a power used to protect the public from cheats and spivs who appear to be running legitimate businesses but are in fact misleading or manipulating people in a dishonest or otherwise unfair way. I recall it being used a few years ago to wind up a company that appeared to be offering a roadside recovery service but had no trucks or contracts to use trucks and, on close examination, the contract gave the company an absolute discretion whether to send out a recovery vehicle at all. It wasn't a fraud because the contract was clear (at least to a lawyer), but it was misleading and the whole operation appeared more geared to refusing assistance than giving it, so the court wound it up to protect the public.

Applications to the court in such cases are made by the Department of Trade (or Business, Enterprise and Regulatory Reform as it is now so absurdly named) in its capacity as a regulator of good business practices. To my mind that is an important function which, perhaps, could be carried out by a non-governmental body, but I have no objection to it being done by a government department provided they keep politics out of it. The reason they must keep politics out of it is that investigatory powers and powers to take action against those who appear to be misbehaving are powers of law enforcement not law-making. Enforcing the law, in a fair society, should be impartial and aplotical. For decades they have had no difficulty keeping politics out of it because governments of both parties have accepted this basic point.

One aspect of aplotical impartiality is that investigations launched by government departments into particular businesses have been concerned primarily with seeing whether existing laws have been complied with. Government has no legitimate function in assessing the efficiency of individual private businesses, that is for the directors and shareholders to consider. So what is this new investigation going to look at?

The report suggests one area is "the extent to which financial incentives encourage bankers to take risks". Call me simple if you will, but I fail to see how any useful conclusion can be reached about the effect of financial incentives (ie bonuses) generally by looking only at one type of business. Nor can you discover anything by looking at specific transactions that you cannot already infer by applying a bit of common sense. You don't need to investigate anything to be able to infer that bonuses payable on the current paper value of business you write will cause people to try to maximise the amount of business they do unless there are countermeasures operating against that incentive.

Any individual banker faced with a decision whether to lend or not lend will be influenced by the desires of his employer. These are contained in formal documents outlining lending criteria: "thou shalt not lend more than 75% of the value of the property offered as security, thou shalt not accept a valuation except from a surveyor holding the qualification of Membership or Fellowship of the Royal Institution of Chartered Surveyors, though shalt not accept proof of the income of a self-employed applicant other than ..." and so on. If these criteria are sound then the total value of business written doesn't matter and no incentive by way of bonus can do anything other than result in increased good business. On the other hand, if the criteria are too lax and leave the bank open to risk, bad business will be done and incentives to increase the amount will also result in an increased amount of bad business.

There. That's the investigation done for them. My invoice is in the post.

Bonuses do not and cannot define the quality of business done although they can influence the quantity. If a bank does not have sound lending criteria it will make bad loans. The relevant question is not what effect bonus structures have, it is what role the regulator should play in circumscribing lending criteria. There is a public interest here, namely the benefit to the whole economy from having a stable financial system. It is, therefore, legitimate for government to investigate causes of instability. What is not legitimate is to hone-in on one of the two forces governing the amount of lending undertaken while leaving the other out of account. In other words, an investigation into the management of banks is so far wide of the mark it will be a waste of time and vast sums of taxpayers' finest.

It has already been made clear what conclusion the government expects the "independent" investigators to reach. It is set out in terms by Mr Darling in his remarks quoted in the BBC article. He is reported as having said "people feel angry about excesses of bank bonuses". There we have it, the conclusion has already been reached, banks have been paying excessive bonuses. Game set and match, thank you and good evening. That is not to say I do not believe bonuses to have been excessive. My belief is that they have been obscene because they have resulted from doing bad business rather than good business and, as far as I am aware, they are not liable to be recouped when risky loans turn sour. That is absurd and, I suspect, is in part the result of bankers believing the government's constant assurances for the best part of a decade that the economy was on a path of irreversible real growth and nothing would turn sour again. More fool them.

If there is to be a formal investigation into what went wrong it must cover all relevant factors. The way banks were managed is only a small part of the picture but it is the one from which the government thinks it can gain the most political capital. Why has it not been announced that there is to be an investigation into false claims that boom and bust have been abolished, or into the failure of regulation of lending criteria, or into Credit Default Swaps and the other ways in which risk was passed back-and-forth and multiplied? It's obvious, because there is no possible chance of gaining votes from the result of the investigation.

What has been announced has nothing to do with the public interest. It is pure party politics and, as such, is an abuse of power.

Sustainable debt, the only practical course

Far more regularly than we might like to admit, we all face problems we have not encountered before. The first illness of the first child, the first time something arrives on our desk at work and we look at it thinking "oh dear, I don't know where to start", the first dripping tap or rotting window sill encountered as a homeowner with no landlord to call on for free help, the first time we exit Madam Fifi's Sauna and Hanky Panky Parlour to see our dearly beloved looking in the window of the shop next door. We have to decide what to do. We can try to tackle it ourselves (usually more in hope than expectation that we will find the right solution) or we can call for help from those who know more about the subject than us (or, in the last example, we can go back inside Madam Fifi's establishment until the risk has passed). What would have us committed to the local asylum, if such a thing still existed, would be denouncing other people's suggestions and then announcing publicly that we haven't got a clue what to do.

Welcome to the world of Gordon Brown. He has now admitted that he is stumbling around in the dark and simply guessing at how to deal with the current banking crisis.

Now let's go back about a year. At that time it had become clear that big banks in the UK and America had been making a lot of very bad loans and off-loading the risk to others, then buying the risk taken by other big banks. It was plainly a complete dog's breakfast. No one knew how much each bank was likely to lose by the time all the bad loans clucked home to roost, so each bank at risk manned the barricades and sought to limit their new business to very safe and secure transactions. While all this was going on, a few big banks had not engaged in the risky stuff and a lot of small banks, with shareholders who keep them on their toes, carried on as they had for decades lending only to good risks and keeping a perpetually beady eye on how each loan was performing. These prudent lenders have carried on much as before and are in just as sound a position today as they were before Mr and Mrs Ordinary first heard the term "Credit Default Swap".

The real problem with the international banker's beano in Davos is that it was an international bankers' beano. They are big wigs, grand fromages, doyens and doyennes with medals of all colours and nationalities to confirm their position as the banking creme de la creme. The politicians are scared of them because they have real power whether or not they deserve it. They can make or break their customers and they can make or break national economies. That necessarily means they can make or break political careers. It would take a true statesman to stand up to them and say "you made a right balls-up of this and now you must pay". Yet the only real power they have over politicians is the power of blackmail and that is diluted by the banks' current parlous states.

I have been hoping to hear a leading politician call their bluff and say to the banking aristocracy: "we are prepared to help you out to a limited degree but we require every penny of that help repaid with interest and you must cut your suit to match your cloth". You see, these banks are not doing us any favours by staying in business. They are not doing so because they think it is in the long term interests of Mr and Mrs Ordinary in Stoke Poges. They are staying in business because they think they will make a stonking great profit a few years down the line. If they thought they were irredeemably bust they would not stay in business, they would fold and let the losses lie where they fall regardless of how that affected any particular country's economy. In fact they know that a well run bank is a steady source of decent profits and a speculatively run bank can deliver massive short-term profits but only at the risk of long-term losses. That is the position they are in now. They speculated and appeared to win for a while but in doing so they build up a catalogue of debt which has proved to be corrosive. It is no surprise that it is corrosive, that has been proved time and again in the past and that is precisely why prudent bankers have never chased speculative short-term profits.

The reason they are fighting to stay in business is the very reason why taxpayers should not take on any of the risk that currently lies on their books. Either the banks will make profits from the business they are doing now or they will not. The business they did in the past has been done and cannot be reversed. It is tolerably clear that there are substantial losses in the system from that business, some of it has already surfaced and a lot more is waiting in the wings. Those losses have to fall somewhere they will not just disappear. There are only four possibilities. First, the losses are kept on the banks' books and are made good out of future profits. Second, the losses prove too heavy for the banks to bear and they fold, in which case investors in those banks lose the value of their investment (be it as shareholder or depositor, but subject to the £50,000 taxpayer-funded guarantee or personal deposits). Third, the banks are relieved of the debts by the government taking them on, in which case they still do not disappear they have to be made good from future taxes. Fourth, the government takes on the losses subject to a right of reimbursement from the banks' future profits.

None of these options is attractive, but that is unavoidable because vast losses are unattractive. The only difference between the first and second options is the future profitability of the banks concerned. Either they make it through the mess they have made or they don't, if they do the first option applies if not the second comes into play. I am attracted to these options because it will mean the gamblers have to take the risk inherent in their gambling. But there is a problem in piling all the loss on just one link in the chain of responsibility. The banks are not the only party to blame in this awful situation. Their activities were subject to supervision by the Financial Services Authority acting on the instructions laid down by poor Gordon when he was Chancellor of the Exchequer. Those of us with a bee in our bonnet about banks lending money to people who cannot afford to repay it get rather miffed to hear the government condemning irresponsible lending. The government was responsible for supervising the banks and, one might think, part of responsible supervision is to prevent irresponsible lending. So, why should the loss all fall on the banks and their investors when government is also to blame?

If we are to be fair about these things we have to accept not only that government was partly to blame but also that we, the electorate, put the government in place. I certainly didn't do so but I am bound by the decision of a general election, and long may that be the case whether or not I agree with the particular outcome. So, if we are to be fair, part of the loss should be borne by the great British public because the incompetent shower they placed in office are also to blame.

How much, then, should the taxpayer have to bear? This is not a matter for an arithmetical formula, it is a matter for looking at the thing in the round any trying to reach a balanced view. Already the taxpayer has taken out massive debts to help the banks restore their capital position and now we are in a recession hitting the little man hardest. It will be a long time before graphs start to turn north and by that time the taxpayer will have been landed with previously unimaginable amounts of debt. That seems a pretty fair price to me. From now on let the banks sink or swim. The level of business they do will determine not only their ability to make good losses on bad loans but also the extent of borrowing the people of this country can sustain.

Forget credit-funded stimulation of the economy, concentrate on what can actually be afforded. There is no point pretending we can live on credit to the level we did in 2005, 6 or 7 and seeking to boost lending back to those levels. If we can't afford it, we can't afford it. If we can afford it, that amount of credit will be advanced. That is not a decision for government it is a decision for individuals, businesses and prudent bankers. If the banks need a further kick-start by some of their losses being guaranteed with an obligation on the banks to repay anything the taxpayer has to fork out, then it can be considered as and when that position is reached. As I said above, they are not in business because they think they will continue to make losses, they know that they can make good profits if only they make good loans rather than bad loans; so any further financial assistance should come with protection for the taxpayer.

How much are houses really worth?

If you want to know the value of something there is, in theory, a simple way to find out. Put it up for sale, advertise it as widely as you can and see what offers you get. If you do this with a television set or an ordinary piece of furniture you can be sure the offers will give a pretty fair reflection of the item's true value because there are no distorting factors to encourage anyone to offer more. Of course it is somewhat artificial to talk of any piece of property having a single true value because you can never expose it to sale to everyone who might want to bid or who might find some flaw in it that others have missed. Nonetheless, giving it fair exposure to a reasonable range of potential buyers will give you a very good idea of what it is worth in the real world.

An interesting twist of the recent credit boom is that it did not fuel price inflation in any field other than housing. In part this was due to increased consumer credit in the UK coinciding with increased availability of the very types of goods people wanted to buy on credit - flat screen tellies, computers, clever music machines and other electronic gadgetry. No scarcity of supply meant there was always another seller who would undercut anyone charging over the odds. Another popular purchase made with borrowed money was foreign holidays. The holiday companies knew an increase of demand was most profitably met by making more available rather than keeping supply static and trying to charge extra. In each of these fields low prices and readily available credit were only part of the story, keeping up with the Joneses also had an effect. Wayne had a flat screen telly, so Darren wanted one, Darren's mate Ryan couldn't be left behind, and so it went on. When it was only a few pounds extra a month on a credit card it seemed easily affordable.

In relation to housing, supply and demand operate rather differently. Obviously you can't turn on a tap in China and create loads of new houses and flats, equally obviously the decision to buy a house or flat involves many factors not relevant when deciding whether to upgrade your fridge. Once prices start spiralling upwards the whole thing becomes a self-fulfilling prophesy. You feel you must buy now because this time next year you won't be able to afford to, equally you see a potential profit over that same period and if you don't make that profit someone else will. Spending £5,000 of your £25,000 salary on interest seems less painful if you think you'll make a capital gain of a greater sum than you spend. We all know now that lending people four or five times their gross salary does nobody any favours in the medium to long term. Some of us have known it for many years because we saw the effect when it was done in the mid to late 1980s. Exactly the same happened then as now - lenders faced huge losses when borrowers defaulted and thousands lost their homes because they could not afford to keep paying such a huge proportion of their income in interest.

Every house and flat must have a true value, be it a precise figure or a bracket of a few thousand pounds. If that were not so there would be no talk of a house price bubble, but how can we know what the true value is and how much is artificial? It seems to me that the true value must reflect affordability. There are always ups and downs. Someone gets hit with a bit of bad luck and can't afford the mortgage any more. Banks take the occasional hit through a customer being unable to repay a debt. These are unfortunate incidents but are not signs of a troubled economy or of the country paying too much for houses. When the level of defaults increases to such a level that banks lose money hand-over-fist you know too much has been borrowed against too little security - the prices paid for houses and flats were not affordable and, therefore, those prices did not reflect true value.

One can analyse affordability in various ways, it seems to me there are essentially two elements to it. First, one has to ask what proportion of income can be spent on a mortgage loan without stretching the household budget so far that default is a widespread risk. Historically the banks restricted mortgage loans to two-and-a-half times the gross income of the main earner plus the gross income of any second borrower involved in the transaction and they required a minimum fifteen percent cash deposit. There is nothing very scientific about these figures, they just proved to be a good guide to what people could afford without stretching themselves too far. This just gives you a figure for how much people can afford to borrow, in other words it tells you what they can afford to spend. It does not tell you what they can buy with that money. The second stage is to look at what one might reasonably expect different people to be able to buy. There are starter homes - small flats and one-bedroomed houses in which one might normally expect to find young single people or young couples. From there you can look to modest two or three-bedroomed houses to which you might expect those young couples to move some years later when they earn more and need more space for children. Then there are larger properties with good sized gardens usually bought by those earning substantial incomes. However many categories of houses and flats you compile, the true value of each is what can be afforded by those buying that level of property for the first time.

For example, take a young couple earning £25,000 and £20,000 respectively. The amount they can afford to borrow is about £82,500 and they must put down at least fifteen percent of the price of their first property. That means they can afford a property costing about £97,000, call it £100,000. As a very general rule of thumb, in areas where those salaries are decent rates of pay for people of their age, £100,000 should be the true value of a modest starter flat. We don't have to go back further than about twelve years to find just that figure being the average price of reasonably sized nice one-bedroomed flats in the area of Islington in which I live. The same flats averaged over £250,000 in the Spring of 2007.

Then take a single doctor aged 30 who has just been made a partner in a GP practice and earns £50,000. He can borrow up to £125,000 which, with the required fifteen percent deposit, puts his purchase price at about £150,000. That is the benchmark for the type of property one would expect someone in his position to buy, perhaps a two-bedroomed flat in a decent road. I haven't designed these examples to relate to the environs of FatBigot Towers, it just so happens that £150,000 would have bought a very nice two-bedroomed flat in a quiet road this area as recently as about ten years ago. A good £350,000 would have been demanded in Spring 2007.

All sorts of other factors affect house prices. I am, however, sure that the strongest factor is the amount of money potential buyers have available to them. Something is only worth what someone is prepared to pay for it, and what anyone is prepared to pay is limited by the amount of money they have at their disposal. If, as I hope will be the case, banks and other mortgage lenders impose tried and trusted limits on the amount they are prepared to lend we should return to much lower house prices and, indeed, prices which reflect true value. They will be a long way below what they are today.

Balancing blame for the recession

When something goes wrong it is often easy to try to identify a single culprit. If what has happened has caused people pain or expense, having someone to blame somehow makes things better, especially if they are subjected to punishment. All those victims of crime who complain about their assailant receiving a light sentence would complain so much more had no one been apprehended and convicted at all because the fact that the guilty party has been identified and suffered some adverse consequences gives solace even where their punishment does not match the suffering they inflicted on others.

In some fields it is simply unrealistic to suggest that one person or organisation is to blame. The current recession is an example of this. Was it all the fault of the banks for lending to people who could not repay the loans? Of course not. Nor was it all the fault of the borrowers who should have known better, or the government who encouraged the illusion of borrowed wealth in order to further their own ambition for power, or the government appointed regulatory authority. All of these groups are to blame in different measures because each made very serious errors of judgment and the consequences for everyone are bad now and look set to get a lot worse before there can be a real recovery. (Although I say "banks", much of the worst lending was carried out by finance companies unconnected to banks, but I will use "banks" to describe all lenders for present purposes.)

One group which has escaped serious censure to date is the banks' shareholders. This is a curious omission because they were in a better position than government to see what was happening and take steps to prevent disaster. The most common structure of a company is pretty much the same the world over and is based on a system devised in this country over a hundred and fifty years ago. The company has directors who are responsible for the day to day management of its operation and shareholders who put up the capital with which it operates and hope to make a profit from the company's activities. Shareholders have great power, if only they choose to exercise it. They appoint directors and can pass resolutions requiring the directors to do (or refrain from doing) certain things. Where the business practices followed by the directors are patently risky (like 125% mortgages or failing to investigate the means of the borrower) that risks falls on the shareholders not the directors themselves (obviously directors might also be shareholders, but that does not alter the substance of my point).

So what should you do as a shareholder in such a situation? Essentially you have two options: licking your lips and grabbing the profits while they are being made (then, if you have any sense, selling your shares before the excrement hits the fan) or taking steps to bring the directors' activities under control with an eye on the long term. Take the first option, as banks' shareholders did, and you are as much to blame as the directors themselves.

In saying this I don't pretend it is easy for shareholders to secure the majority required to pass a resolution forcing directors to change tack. Many shareholders are only interested in immediate profits not in the future, still less do they feel compelled to consider the effect on the wider economy of the business that is reaping them a nice reward. Even those who are sure a big mistake is being made know the easier option is to sell their shares rather than try to change the way a massive business is being operated. In all this there is a type of shareholder who really should have known better, the institutional shareholders with a duty to look to the future, in particular pension companies. A great many pension companies hold shares in banks because they have been a safe historic investment producing a steady return.

Pension companies are themselves huge businesses, administering vast sums of money on behalf of those who will call on them for income when they retire. There are some people who invest a lot in pension funds and build up a pot of a million pounds or more, in some cases many millions. A far greater number put a little aside every month, maybe a hundred pounds or so, to give a modest boost to their basic state pension when they finish work. It goes without saying that 1,000 people investing £100 a month is the same as one person investing £100,000 a month, it's an awful lot of money however it arrives in the pot and it has to be invested sensibly to give the best return over a lengthy period. Pension fund managers know they have to spread the risk they are prepared to take, so they invest some in rock-solid investments with relatively low returns (such as government bonds), much less in fairly risky ventures which might make a packet or might fold tomorrow and most in solid long-term performers like banks. The precise balance they choose to strike between risk and return differs from fund to fund, but shares in banks loom large in almost all.

Shares held by pension companies represent a large proportion of the total number of shares issued by many banks, which means that the pension funds have the muscle to influence the way the banks do business. A pension fund owning, say, five percent of the shares in a bank has great power, far greater power than a five percent shareholding might suggest. If they are worried about the way the bank is doing business and start selling shares they can cause the price of shares to plummet. Some selling is part of the natural way of things and rings no alarm bells, the sudden sale of a lot more than average suggests the bank might be in trouble and causes others to sell just in case there is a problem. Such an event causes a problem in itself and the banks know it. Large shareholders can have a huge influence over how a bank does business if they express concern about lending practices. They won't do it publicly unless they have to and they won't do it at all if they fail to appreciate the need for concern.

One might think pension funds and other very large shareholders would have found a way to get the banks to avoid taking undue risks, after all there were plenty of warnings in financial circles about the difficulties that could result from loose lending. All to often, though, the pension funds fell into the same trap as the banks themselves, they looked only to what they can make this year without consideration for the damage their own business could sustain a little way down the line. No doubt one factor in this was the whopping bonuses payable to pension fund managers if they made a big profit this year, bonuses which would not be recouped if a loss is made next year. That cannot, it seems to me, have been the only factor. There was also the simple fact that the banks were making a lot of profit and to make a move which would result in that profit being lowered would be harmful in the short term to the pension funds those managers had to administer. Even those who saw difficult times ahead could, perhaps, be forgiven for thinking that difficult times would affect other potential investments more than bank shares.

Despite all this, institutional shareholders must look to the long term in order to protect the funds they are running because pensions are a long-term business. Most of their customers will rely on them for more than fifteen years of investment returns before they retire, so jam today is only part of the equation the question must always be asked whether tomorrow's menu will feature jam or humble pie.

The failure of institutional shareholders to exert influence on banks was not just bad for the banks it was bad for the funds those shareholders administer. Their duty to their customers was to protect the funds and if that meant getting heavy with the banks they should have done exactly that. I know it is easy to say this with hindsight but I do not speak with hindsight, I speak with foresight because the problems caused by lending too much against too little security was exposed, painfully, in the early 1990s. During the latter part of the 1980s we saw 100% mortgages and borrowers only having to say they earn £40,000 a year for a bank to accept it and make a loan. It was exposed as appallingly bad practice not just by the housing crash from 1990-1992 but also in a long series of cases in the courts in which banks sought to recover their losses from solicitors and valuers who were alleged to have been negligent in their work during the course of a house purchase. Time after time the damages recovered by the bank were reduced substantially because they contributed to their losses through negligent lending practices. Many an eminent judge accepted the evidence of experienced expert witnesses and concluded that lending without proper assessment of the borrower's ability to pay was a recipe for default.

Those cases were publicised throughout the banking and pension industries, yet within ten years the same thing was happening again. The banks should have known better and so should the pension funds. I think it's time they took their share of the blame.

Queen's Speech 2008 Part II - mortgage default

It was inevitable that the recession and banking crisis would lead to something being included in the Queen's Speech about the economy. The measures outlined in the speech itself were, as always, a potted guide to what the government has in mind and the details will emerge over the next few days. It didn't take long for poor Gordon to raise a populist idea during the debate on the Speech. He proposed a grace period of two years in which those unable to pay their mortgages would be entitled to roll-over the arrears and add them to the principal of the loan. As I understand it only mortgages of up to £400,000 are covered and you get no help if you have savings above £16,000.

Like so many of poor Gordon's ideas it is designed to win votes with little regard being paid to how it will work, how much it will cost and whether it will have adverse consequences which outweigh the benefits. Let's look at the benefits first. This proposal rightly recognises that having your home repossessed is a potentially devastating thing. Not only do you have to move out but a repossessed property will almost always sell for less than average market price and both that loss and all the costs associated with repossession and sale will fall on the dispossessed borrower. More than that, the peace of mind and sense of self-worth which so many derive from owning their own home will be lost; and that cannot be quantified in terms of mere money. Having said that, it would be foolish to ignore the monetary effects of the government's proposal because they will have consequences for everyone. So I ask myself what the consequences are likely to be. Ancient O-level physics tells me that for every action there is an equal and opposite reaction. Let me give an illustration of how I would expect the proposal to operate.

Say Mr Bloggins bought a house for £150,000 in 2003 with a 100% mortgage and it's current market value (after losing 15-20% in the last year) is £200,000. Interest on his mortgage loan is 6%pa (£750 a month) and he loses his job which results in arrears building up over three months of £2,250. The bank repossesses and takes two months to sell, at auction the house realises £160,000. The agents handling the sale charge 2% (£3,200) and there are legal and other costs of £1,500. At the date of repossession Mr Bloggins owed £152,250 and had an asset with a nominal value of £200,000, he was in profit to the tune of £47,750. At the date of sale he owed £153,750 and the asset realised a net price of £155,300. He receives a cheque for £1,550. On the face of it repossession has cost Mr Bloggins a huge amount of money, a sum far in excess of the arrears he built up by the time his home was repossessed. I have left out of account the value of any scheme he had in place to repay the capital of the loan, not least because many of them have been blown to the winds by recent stock market falls.

Then assume he is allowed to roll-up interest over two years and gets another job which allows him to resume repaying the bank. Over that two year period interest of £18,000 will accrue (assuming a steady interest rate of 6% and no compounding), making his debt to the bank £168,000 rather than £150,000, but he keeps his house. His monthly interest payments will then be £840 rather than £750. But what effect will it have on his net worth? Of course we can't tell because we don't know what will happen to the housing market in the next two years. A fall of just 10% from current values will leave Mr Bloggins with a house worth £180,000, and a debt of £168,000; a loan-to-value ratio of 93.3%. A fall of 16% from current values and he would owe £168,000 whilst owning a property worth exactly the same amount. 16% is at the low end of current estimates of the likely further fall in property values.

In one sense Mr Bloggins won't mind. He will still have a roof over his head and will hope the market will pick up in the future. But what about the bank? Let's cast our minds back a few months. The banking world was in even greater turmoil than it is at present. Inter-bank lending had dried up, Lehmann Brothers had gone to the wall, the value of security held by banks (and other lenders) had plummetted, numerous lending companies most of us had never heard of closed their doors because they couldn't borrow and, therefore, couldn't lend. All because many lending institutions had systematically advanced too much money against too little security. Instead of insisting on a substantial deposit and lending a maximum of 75%-80% of the market value of a property loans were made of up to 125% of current value. Instead of realising that their most important line of repayment was the borrower's income, they made advances against the anticipated future value of the property and allowed people to borrow five times their income or more, if they enquired about income at all.

To regain stability in their businesses banks and others who advance money for house purchases have had to go back to the old ways by limiting the loan-to-value ratio and lending a smaller multiple of the borrower's income. Giving Mr Bloggins a two-year breathing space by rolling-up arrears of interest and adding them to the principal of the loan rocks the boat in two respects. First it increases the loan-to-value ratio above what it was when he first went into arrears. It might still be below what it was when he first borrowed to buy his house, but that loan was way above currently acceptable limits. Secondly, by increasing his monthly interest bill once the period of grace has ended the lender is more reliant on the security of his employment and income than it would consider prudent for a new borrower. There is a third possible problem in that Mr Bloggins might well not be able to secure a job commanding as high a salary as he enjoyed before. In that case the proportion of his income required to pay the mortgage would increase, thereby increasing the risk of future default.

Where does this leave the lenders? At a time when they need to increase the security they hold to make up for past bad lending practices they will be faced with having to carry defaulting borrowers and the diminution of the value of security that their defaults cause. The very problem they have to remove from their books will be inked-in with a thick red pen. It is no answer to say that the lenders cannot lose because the government is guaranteeing the two-years' arrears with taxpayers' money (estimated at a maximum of £1billion - yet another billion being added because, as I said the other day, the figures are now so huge that an extra billion doesn't seem to matter to this government). The government might well guarantee the £18,000 extra that Mr Bloggins adds to his mortgage loan account with the Nearly Bankrupt Bank but it will not guarantee anything else. It will not step in when the additional repayments required of Mr Bloggins cannot be met out of his reduced new salary and new arrears accrue under a loan of £168,000 rather than £150,000. It will not step in when the housing market falls further and repossession leads to an even lower auction price than it would today.

I must not overstate my reservations about this proposal. There are a great many borrowers who are a good risk in the long term and for whom the availability of a two-year cushion will be beneficial both to them and to the company that has lent them money. But there are also many who default now because they should never have been lent so much money in the first place and for whom a two-year deferment of interest will result in an unaffordable position becoming even more unaffordable. No doubt the government is hoping that the housing market will stabilise over the next two years. I am sure it will, but not at current market values. The bubble element of house prices has not yet deflated, not by a long way. A further substantial fall is inevitable and to lock lenders into unrepayable loans secured against sinking assets will deepen the difficulties those lenders face.

Some good will result from this measure, it a matter of guesswork whether that will be outweighed by the detriment.

Free markets and lefty morons

One of the most depressing features of the current recession is the way in which both the cause and the cure have been hijacked by the extreme left with hardly a whimper of dissent from the Conservative party. It seems to be open season for nutty Marxist theories which have been proved over and again to fail. I will pontificate on their suggested cure another time, today I want to look at what they have said about the cause.

The cause of the recession is easy to identify. Too many people borrowed too much money or, if you prefer, the banks lent too much money to people who could not afford to repay it. Eventually chickens came home to roost and the excess credit now has to be squeezed from the economy. Since the excess credit has been buying goods and services for years it is inevitable that reducing that credit bubble will cause fewer purchases and a downturn in the economy. Very simple. But why did banks lend too much to too many?

Anguished cries of "free markets don't work" have filled the airwaves from the mouths of naive bearded lefties. To an extent they make a fair point because a market with no constraints can lead to exploitation of the weak by the strong. A very obvious example of this is the black market in booze and cigarettes that grew up during World War II when "official" supplies were rationed. Demand was still there and a supply was available through nefarious sources, so the spivs stepped in and fleeced as much as they could. Where they are hopelessly wrong, moronically wrong, is in using the term "free markets" at all.

There are two definitions of a "free market". One is a market which operates purely as an interaction of supply and demand for a given product without any factors outside the control of seller and buyer affecting the strength of either the supply or the demand. Illegal drugs are probably the only products falling into that category today. The other definition is a market without tariffs. This is a very different concept and relates only to trade between nations, it is nothing to do with the current recession (except very obliquely in relation to trade between the UK and non-EU countries.)

The constraints which prevent markets being free markets within the first definition come from various places. Companies have directors responsible for setting their trading policies and are answerable to their shareholders at least once a year. A director who has concerns can raise them at board meetings and shareholders who wish to protect their investment can force changes where the company's business is being conducted badly. Where the company's business involves the supply of goods or services the general law steps in to ensure that customers who buy shoddy or dangerous goods or are given a shoddy service have a remedy. Where the company's business is reliant on external factors, such as the national "standard" interest rate, the acts of the bodies responsible for those external factors affect the company's options. Where the company's activities might be harmful to others, such as the disposal of certain industrial waste, the law steps in to try to keep the risk to an acceptable level. Where the company's business might have a significant effect on the working of the national economy as a whole, it is for government to decide what sorts of controls or restraints are appropriate to keep a sensible balance between the ability of the company to trade and the wider interest of economic stability. Countless other factors apply to affect the strength of either supply or demand for goods and services. The market for goods and services is the interaction between supplier and customer as defined and circumscribed by all those external factors.

It is ridiculous to suggest, as the loudest lefties seem to do, that the market for loans has been a free market over the last eleven years. I say eleven years not only because the current government has been in power for eleven years (why people keep saying ten years is beyond my understanding) but also because there were no problems with bank lending when they came to power nor for several years before that. What failed, what caused banks to lend too much to too many people, was not the essential system of supply-and-demand that is at the heart of any market mechanism, it was the constraints imposed on both supply and demand.

Where too much is being lent for the longer term stability of the economy, an increase in the "national" interest rate can be used to stem supply. Where too much unsecured lending is taking place for the longer term stability of the bank doing the lending, its directors and shareholders can step in. If they do not do so and there is a risk to the longer term stability of the economy, measures can be imposed to rein-in the risk (of which requiring banks to limit unsecured lending to only a certain proportion or multiple of their capital is the most obvious and most easily enforced). None of these steps has anything to do with a free market because there is no free market in loans. And none of them means that markets do no work, what they do mean is that the constraints which define a market sometimes need to be altered. There is no difference in substance between imposing additional regulation on banks where current practices give rise to a longer-term problem for the economy as a whole and imposing additional regulation on food manufacturers when it is found that a particular ingredient used in food is potentially harmful.

In America, which is being blamed by poor Gordon with even greater mendacity than that thoroughly dishonest man usually shows, the constraint on the market which failed was not one of regulation to prevent banks doing what they wanted to do to maximise profits. It was the exact opposite. Legislation was passed in 1977 (under President Carter) and widened in 1992 (under President Clinton) to force banks to lend to those who could not repay on pain of losing their licence to operate if they did not do so. Their credit bubble was caused almost entirely by bad loans the government forced the banks to make. No failure of the underlying market mechanism there, just the usual consequence of simple-minded, lefty, meddling, do-gooding legislation.

Over here the problem was growing through lack of scrutiny of banks' activities by their shareholders combined with lack of governmental action to head the problem off at the pass. One might ask why the government did not act. The answer is simple, it was beneficial to them in the short term to pretend that the country was getting richer and richer. Votes were at stake, their hand on the levers of power was at stake and, to a government for which nothing is more important than having power for power's sake, slowing or reversing the illusion of wealth was unthinkable. The IMF warned of the problem, the three previous Chancellors of the Exchequer warned of the problem, even the Liberal Democrats warned of the problem, but poor Gordon had told a really big lie - a really big one even by his standards. He said boom and bust was over. He said it was now all boom. Regardless of the facts, it was then politically impossible for him to apply the brakes.

There is no excuse for directors of the banks allowing excessive lending which put their businesses' survival at risk. But they did, so it was for the shareholders to knock some sense into them. There is no excuse for institutional shareholders failing to do so. But they did, so the ball was then in the government's court. Not only did the government do nothing to alleviate the problem, the exacerbated it by taxing and spending at such an enormous rate that they needed the bubble to inflate further and further to feed their addiction.

We can blame greedy bankers. We can blame complacent and short-termist shareholders. We can also blame the very thing the lefties look to as the cure to all ills, government. What cannot be blamed is free markets because there is no such thing in banking.