Economic review of September 2007

Following on from last month’s discussion of the credit squeeze, it still came as something of a surprise when Northern Rock fell prey to a “run” – the first on a UK bank for over a century. This was only resolved when the government stepped in and guaranteed the savings of all those holding deposits at the time. It is not so much that commentators felt the bank was particularly well run, or that it was not known to be heavily into the more risky parts of the mortgage market – and was growing more rapidly than other banks.

It is more a matter that most of us probably recognised that a real collapse of a UK bank was unlikely and that customers were really facing nothing more than a cash flow problem within the bank. In the end the Bank of England stepped in as lender of last resort and the problem evaporated (even if it did leave Northern Rock’s share value at a quarter of its August level, by the end of September).

While the International Monetary Fund has apparently suggested our mortgage market is in just as poor shape as that in the US, it is interesting to note that not a single bank took advantage of the Bank of England’s offer of up to £10 billion in loans, during the month. Perhaps this demonstrates, once again, the importance of sentiment in finance.

We should not, however, ignore the fact that turmoil in capital markets can severely affect the economy generally. Some economists are warning that there is a broader threat to markets that could impact not just on share prices – which would hit everyone with a pension plan - but also on employment, should businesses find it more difficult (or simply more expensive) to borrow money in order to finance capital and current spending plans.

However, laudable it may have been that the government acted quickly to protect the interests of savers, this gives a clear signal to bankers; take all the risks you like (in order to maximise you personal bonuses) we will underwrite any losses. How can that be good for confidence in the banking system?

An over-reliance on the city?

We have previously commented on the increasing level to which the economy relies on financial markets, especially in terms of Gross Domestic Product and the Balance of Payments (or current account).

The result of this imbalance is that our manufacturing base is becoming relatively weaker and the financial services sector more important to all aspects of our lives. So if there is a problem there, as we have just seen, we do not have a sufficiently strong manufacturing base easily to ride out the storm. This time, we may have survived, but confusion over who actually regulates the banks – this is a tripartite arrangement between the Bank of England, the Treasury and the Financial Services Authority – is not the only issue.

Increasing regulation of business – the latest issue of Tolley’s Yellow Tax Handbook is the equivalent of 10,500 pages, compared with fewer than 6,00 pages in 2001 – is making it more difficult for businesses, particularly SMES, to compete on the world stage.

Interest rates

The Monetary Policy Committee (MPC) had already voted 9-0 to hold interest rates in the UK before the full extent of the Northern Rock “situation” was clear; and there are probably good reasons for their having done so. However, with the Federal Reserve subsequently slashing a full half percentage point off the US lending rate, our interest rate is now 1% higher then theirs, making sterling more attractive to investors. This may be good for UK holiday makers in America, but does not help exporters or, in the long term, the UK economy, which could become even more dependent on services, as manufacturing finds it more difficult to compete on world markets.

Some commentators are now advising the MPC to cut UK interest rates, in order to head off a recession. This could well be the right time to do so, even if it does give a fillip to any plans Gordon Brown may have for an early election.

Inflation

The spectre of inflation receded slightly during August (the latest figures currently available) according to the government’s favoured Consumer Prices Index falling back to an annual rate of 1.8% from 1.9% in July and 2.4% in June. However the more realistic RPI, which includes mortgage repayments, was up from 3.8% in July to 4.1% for August, reflecting the higher cost of personal borrowing.

According to Alan Greenspan, former Chairman of the US Federal Reserve, the days of low inflation are over. While we may hope he is wrong, there is nothing to suggest that his vast experience is no longer relevant.

Comprehensive Spending Review

Much will depend on what comes out of October’s Pre Budget Report and three-year Comprehensive Spending Review.

The key problem is that economic growth forecasts are generally expected to be in the region of 2% a year for the foreseeable future, compared with much stronger historic figures. If this is correct, the government faces a stark choice between breaking existing spending plans in Education, health and defence; leaving other departments with virtually no growth at all; borrowing more or increasing taxes. All these options threaten to take money out of the “real” economy and this will further reduce growth.

Profligate growth in government spending during recent years has not helped. There has been a 600,000 increase in the number of public sector jobs since 1997; accompanied by a spectacular increase in pension liabilities. Actuaries, Watson Wyatt calculated last year that the sum required to cover future public sector pension liabilities alone is almost £1,000 billion and wil be £1,200 billion in three years; twice the entire government budget for this year.

Markets (Data compiled by the Insurance Marketing Department Ltd.)

Most markets recovered during September, with the FTSE100 regaining 2.5% of its value and AIM, 0.8%. However, the mid-cap FTSE250 lost a further 2.4%, leaving it 1.26% down on the year-to-date. The FTSE100 is still 3.95% up on the year-to-date.

In the US, the Dow Jones and Nasdaq100 both grew by just over 4% while elsewhere the Eurostoxx50 added just over 2% and the Nikkei225, 1.31%

Sterling added more than 1% against dollar, reaching $2.24, but eased 3.22% against the Euro to settle at €1.43. Brent Crude oil 1-month futures, which had eased during August, bounced back up to end September at $79.17 a barrel, its highest month end figure for a long time. Gold hit $735 an ounce during the month.

Private Equity

There appears to be some confusion over whether venture capitalists are to become the latest scapegoats (or do we mean election fodder?) as comments by Prime Minister Brown that they were to lose tax breaks were quickly back tracked on by Chancellor Darling who, no doubt briefed by the Treasury, accepted that this would be difficult to achieve as it could easily affect ordinary investors (which would not be popular once it was fully understood) and could lead to a mass exodus of wealth creators to other territories.

Perhaps the government should pay far greater attention to the massive profits made by banks at the expense of individuals and small businesses, which could probably generate far more revenue if taxed “properly”.

We all love to hate …

Microsoft has recently lost a European Court case against the European Union over competition issues. The case revolved around allegations that Microsoft had abused its market position to disadvantage competitors and had been fined almost half a billion euros by the Commission. Subject to a possible appeal to the EU’s highest court, the European Court of Justice, Microsoft will now have to open up some of its systems to allow competitors to interface more easily with Windows.

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