Saturday, 23 March 2013

I D Lowe " A great Read"

Economic Prospects
In 1932, eighty years ago, the western world was in the midst of the Great Depression, the circumstances, causes, consequences and cure of which are relevant to the "second Great Contraction" as termed by Reinhart and Rogoff in "This Time is Different". Three years earlier, on 29 October 1929, in the Wall Street Crash stocks had lost approximately 10% of their value, an event marking the onset of the Depression. In 1930, the first bank panic occurred resulting in a wave of bankruptcies and a major contraction in the money supply, and GNP fell 9.4% and unemployment rose from 3.2% to 8.7%. In 1931 the second major banking crisis occurred and GNP fell another 8.5% and unemployment rose to 15.9%. In 1932 there was a record fall of 13.4% in GNP accompanied by a rise in unemployment to 23.6%, a fall of industrial stocks to 20% of their 1929 values, and a failure of 40% of the banks existing in 1929. Since 1929 GNP and the money supply had both fallen 31%, and industrial production 45%. Worse was to come. In December 1932 the third, and largest, wave of banking panics occurred, and economic activity declined even further, reaching its minimum in March 1933. The "new era" of the "Roaring Twenties" had appropriately enough gone out with a bang!

During the Great Depression two broad macro-economic theories were advanced to interpret it. Say's Law (Jean-Baptiste Say 1767-1832), ambiguously interpreted by Keynes "supply created its own demand", but also explained as "a glut can take place only when there are too many means of production applied to one kind of  product and not enough to another". Thus a depression was a period of adjustment of the "too many means of production". The second macro-economic theory, the loosely-termed "Austrian school of thought", mimicked Say's law insofar as the Great Depression was interpreted as resulting from too much productive capacity from earlier overinvestment. The theories argued strongly against Government intervention as this would delay the necessary adjustments to supply. In essence the conditions were caused by oversupply not underdemand.

Such theories formed an arguable intellectual basis for the "Liquidationists" in the Hoover administration and on the Federal Reserve Board, including Treasury Secretary Andrew Mellon, who advised Hoover to "liquidate Labour, liquidate Stocks, liquidate the Farmers, liquidate Real Estate ... … … it will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people". In his memoirs published in 1952, twenty years after his election defeat (8 November 1932), Herbert Hoover continued to maintain that, if Roosevelt and the "New Dealers" had stuck to the policies his administration had put in place, the economy would have made a full recovery: if they had had the resolve to "stay the course" and "take our medicine" then a recovery would have been effected within eighteen months. Modern explanations of the Great Depression imply that it is almost impossible to imagine worse policy prescriptions in the 1929-1933 period.

Subsequent theories of the causes of the "Great Depression" differ from those of the  Liquidationists. Some contended that specific events were the principal or, at least, a principal cause: the 1929 Stock Market Crash, both the immediate wealth effect and as a predictor of future economic activity; the collapse of consumer durable spending; the collapse of the housing market structure;  and the Smoot-Hawley Tariff of 1930, which imposed a 40% tax on over 20,000 imports. These and similar theories, collectively termed non-monetary/non-financial, may account for the trigger for the first year of the Great Depression, but they do not provide a good explanation for its length, depth and durability. The US economy had previously suffered many recessions, most recently in 1919/1921, but output then had only fallen 3% before recovering quickly, but the Great Depression was different. 

"This Time is Different" is the title of Reinhart and Rogoff's analysis which distinguishes the greatest five depressions within which the Great Depression is further categorised as the "First Great Contraction" and the current depression as the "Second Great Contraction". Before the onset of these depressions all five shared the "confidence" of "This Time is Different", which had unusually high debt levels, and inflated asset prices and all five subsequently suffered prolonged financial and banking crises.

An advertisement placed on 14 September 1929 graphically illustrates. "This Time is Different":

when all Europe guessed wrongly
The date - October 3rd, 1719. The scene - Hotel de Nevers, Paris. A wild mob - fighting to be heard. "Fifty Shares!" "I'll take two hundred!" "Five hundred!" "A thousand here!" "Ten thousand". Speculators all - exchanging their gold and jewels or a lifetime's meagre savings for magic shares in John Law's Mississippi Company.

History sometimes repeats itself - but not invariably. In 1719 there was practically no way of finding out the facts about the Mississippi venture. How different the position of the investor in 1929!
Today, it is inexcusable to buy a "bubble"- inexcusable because unnecessary. For now every investor has at his disposal facilities for obtaining the facts. Facts which - as far as humanly possible, eliminate the hazards of speculation … … "

An advertisement placed in the late 2000s before the Second Great Contraction might well have read:

FAMOUS WRONG SPECULATIONS IN HISTORY: The Great Depression or when the Western World bankrupted.
History rarely repeats itself. In 1929 investment was not regulated and lacked today's sophisticated computer controls and risk sharing across the world. How different the investor of today.
Today you need not speculate. In 1929 there was limited technology, no insurance, little regulation, no control of inflation, rigid exchange rates and no sophisticated computer modelling.

Today you do not buy a bubble, there is no inflation, boom and bust is banished, globalisation and advanced technology guarantee exponential growth and the downside is protected by regulation and profound understanding of monetary policy and the risk spread by securitisation

Both advertisements imply changed times, new understandings and technology and new certainty, symptomised by Reinhart and Rogoff's title "This Time is Different". Unfortunately the consequences have broad similarities including the depression's depth, its protracted length, its widespread propagation and the concentration on the financial sector. A third of the US banks closed in the First Great Contraction in the US; over a third of the UK banks would have closed in the Second Great Contraction, including the RBS, had not the UK government intervened about twenty-four hours before it ran out of cash.

The most persuasive explanation of the First Great Contraction is provided by the "Monetary Hypothesis" of Friedman and Schwartz and is based on the inter-relationship among money stocks, prices and output. Friedman observed that money stock, output and prices went down together from

1929 to 1933 and then up again in subsequent years. The money supply dropped 35%, prices 33% and GNP 43%. Unfortunately, such simultaneous changes do not prove causality: what was causing what? Are changes in the money stock causing changes in prices and output, or is the money stock passively reflecting changes in the economy or, indeed, is there an unmeasured other factor that is affecting all these variables? In order to determine causality Friedman identified four periods where changes in the money stock or in monetary policy had occurred for reasons unrelated to contemporary changes of output and prices. A sudden outside, or exogenous, monetary change and a later response in the economy might reasonably be interpreted as cause and effect, provided a similar pattern could be seen over and over again.

Friedman's tests indicated a direct causality between money supply and output and he asserted the Federal Reserve Board's policies had been the major cause of the progression of the recession into the Great Depression. The money supply was affected very severely by the failure of about half the nation's banks and the loss of the deposits, an effect "geared" up by the bank multiplier and which he claimed the Fed failed to offset by expanding the money supply. Separately he indicted the Fed for not lending aggressively to solvent but illiquid banks. For instance Friedman said "At all times throughout the 1929-1933 contraction, alternative policies were available to the System by which it could have kept the stock of money from falling, and indeed could have increased it at almost any desired rate". These policies did not involve radical innovations. They involved measures of a kind the System had taken in earlier years, or of a kind explicitly contemplated by the founders of the System to meet precisely the kind of banking crisis that developed … … …"

Ben Bernanke, the present chairman of the Fed paid a gracious tribute to Friedman in a speech given in honour of his 90th birthday:- "I would like to say to Milton and Anna:  regarding the Great Depression, you're right, we did it. We're very sorry. But thanks to you, we won't do it again."

Notwithstanding this fulsome praise, Bernanke has been a leading critic of the Monetary Hypothesis which he contends both qualitatively "and quantitatively" is not comprehensive, although he supports the main findings.  One shortcoming of the Monetary Hypothesis is that economic theory holds that change in the stock of money changes nominal variables such as prices, wages and exchange rates, but not real variables such as output, real GDP and real consumption i.e. money is neutral, whereas by implication Friedman maintains that it is "non-neutral" over a protracted period. Quantitatively Bernanke contends that the reductions in the money supply were insufficient to account fully for the falls in output.

To counter these deficiencies Bernanke proposes further explanations for the extent and length of the Great Depression, including particularly the increased cost of credit intermediation (CCI) and the cost and availability of credit. Bernanke's CCI covered a wide range of additional costs in obtaining credit and he notes banks' preferences for more liquid investments even when higher credit risk clients, or more likely, clients whose credit risk was difficult to determine, because of lack of information or uncertainty, were likely to produce higher returns. If £χ is a "big" number the certainty of £1.0χ is more "valued" than say a 55% chance of £2χ, even if the expected value of the latter is £1.1χ.

Bernanke measured the extra cost of CCI as the increased cost of BAA corporate bonds, the best proxy he could find for borrowers whose liabilities are not traded, over US Government bonds. In the twelve months before October 1930 the average premium was 3.06 percentage points, but in the next twenty-four months it was 4.76 percentage points, or 1.70 percentage points higher, and reached 8.00 percentage points in mid-1932. In contrast, in the 1920-22 recession the differential never exceeded 3.5 percentage points. The effect of the shrinkage of credit due to "risk aversion" was also very significant. For the twelve months to October 1930 loans outstanding represented 80% to 86% of banks' demand and time deposits, but during the twenty-four months from October 1930 loans shrank almost steadily to 64% falling later to less than 60%. In the same two periods net loan extensions divided by net monthly income fell from -1% to 12.8% with a record fall to 31% in October 1931, the worst month for bank failures.

Bernanke reinforces his theoretical analysis of the role of credit in The Great Depression with contemporary empirical evidence, citing a 1932 National Industrial Conference Board survey: "During

1930, the shrinkage of commercial loans no more than reflected business recession. During 1931 and the first half of 1932, it unquestionably represented pressure by banks on customers for repayment of loans and refusal by banks to grant new loans". "Refusal" implies the operation of a policy, not a risk-assessed non-acceptance practice of determining loans by rationing. Bernanke cites D M Fredrickson, writing in the October 1931 Harvard Business Review who illustrates the position:- "We see money accumulating at the centers, with difficulty of finding safe investment for it; interest rates dropping down lower than ever before; money available in great plenty for things that are obviously safe, but not available at all for things that are in fact safe, and which under normal conditions would be entirely safe (and there are a great many such), but which  are now viewed with suspicion by lenders". Fredrickson suggested that low interest rates per se do not indicate "easy money"; money may be easy for a very few safe borrowers, but difficult for everyone else.

It appears a stark anomaly that a low price can persist with a high demand! In different circumstances it occurred in 1932 when the Fed suspended its brief open-market purchasing operation because it considered that the then low interest rate indicated more than adequate supplies of money. Unfortunately, the withdrawal of open-market purchases, and the policy signal so implied, was followed by a further dramatic relapse in the economy. Low interest rates do not imply adequate money or sufficient credit, a confusion that persists.

Bernanke provided an explanation for this paradox as an addition to Friedman's Monetary Policy through an elaboration of Irving Foster's 1933 "credit" hypothesis of The Great Depression. Foster emphasised the effect of deflation in reallocating wealth from debtor to creditor, and causing asset prices to fall below the security value in banks' accounts. A huge fall in asset value without deflation creates the same result. Such falls impair banks' solvency, and, as solvency is more important, if only in regulatory terms, than profitability, assets are reallocated from loans to safer, probably government, securities and loans become "unavailable". Policy before the New Deal did not include shoring up, rescuing or recapitalising banks, so exacerbating the role of credit as one of the causes of the depth, the extent and the spread of propagation of the Great Depression.  The policies that contributed to the recovery from the Great Depression are, prima facie, likely to be effective now as indeed is the reversal of any policies that contributed to it.

The most striking policy measures contributing to the recovery were those associated with Franklin D Roosevelt's "New Deal" following his inauguration in 1933. Famously he closed all the banks for an extended "holiday" and in one day, 9 March 1933,during that closure the Emergency Banking Act was passed and signed into law. This Act provided for deposit insurance and federal loans to those banks assessed as solvent. Confidence in the banks was regained, deposits surged and the banking system was stabilised, bank failures falling from more than 500/yr prior to the depression (4004 closed in 1933) to less than ten/year. Within a month billions of dollars in hoarded currency and gold flowed back, thus stabilising the banking system and expanding the money supply.

Greater expansion of the money supply resulted from two other policy decisions taken later in March and in April 1933. The US abandoned the gold standard and allowed the dollar to float on the foreign exchange markets with a nominal gold price which the administration set progressively higher until it reached $35 per ounce ($20.67 before) at which point the dollar had depreciated 41%. The exchange rate against the German Reichsmark fell from 4.21 to 2.48 with similar falls against other fixed exchange rate currencies. The devaluation of the dollar, the rise in the dollar value of gold "created" extra dollars which were used to purchase securities (QE) so increasing the money supply and reducing interest rates and the devaluation increased domestic demand. Those policies were very expansionary.

The New Deal fiscal policy was originally contractionary, but this policy became subordinated to other conflicting policies. In order to balance the "regular" (non-emergency) Federal budget the Economy Act of 14 March 1933 was introduced which, inter alia, cut civil servants' pensions, and veterans' pensions by 15%. However, the non-federal budget savings were soon vastly exceeded by the spending on the various public and social "aid" programmes introduced such as the Works Programme that employed 3.8m men on public infrastructure, the Tennessee Valley Scheme, the Reconstruction Finance Corporation that loaned money to various beneficiaries, including indebted firms or firms

seeking investment funds and the Agricultural Adjustment Act, a subsidy scheme for farmers. Thus there was a substantial, if notionally unintended, fiscal expansion.

A portion of this fiscal expansion was directed to the housing sector. The Home Owners' Loan Corporation refinanced mortgages on longer terms of up to fifteen years, the Federal Home Loan Bank Board guaranteed the savers' deposits in Savings and Loans ("thrifts") and the Federal Housing Administration provided insurance for mortgage lenders for up to 80% LTV twenty year low interest loans. These measures boosted the rapidly-sinking housing market. Also at the same time 15% of the Public Works Administration budget was spent on low-cost housing and slum clearance.

In 1934 growth returned to the US economy - a notable 8.9% - and, also of great importance, prices rose 3.1%. The return of inflation in 1934 followed a deflation of 24.0% since 1929 which had dealt a crushing blow to the economy by increasing the real value of debt by 31.6%, and by reducing the value of debtors' security and the assets and reserves of the banks.

The "involuntary" Fiscal expansion was probably a political reaction to the growing social unrest in the Great Depression but it was a key element in the recovery from it. Thus the US was following a Keynesian approach to taxation and spending, which served it well. Truly, by accident of design, the New Deal mobilised a formidable armoury of policies that facilitated the recovery from the Great Depression. Unfortunately, such was the depth of the Great Depression, that real output did not reach the pre-recession level (of 1929) until 1940, over ten years later.

The Second Great Contraction was undiscriminating in its extent and in its severity in the developed world and all major western economies declined 3% to 5% or more in 2009.  In 2010 most economies recovered by 2% or more but performed much less well subsequently. The US economy is likely to be the best performing in 2012 growing 2.1% following 1.7% in 2011 and a forecast continued growth in 2013 of 2.1% and of 2.8% in 2014.  The Eurozone is likely to contract by 0.3% in 2012 and have nil growth in 2013 followed by only 1.1% in 2014. Within the Eurozone there are very wide variations among the constituent countries. The two best performing economies, Germany and France, have average forecast growth rates over the three years to 2014 of 1.1% and 0.6% respectively, according to the OECD, but the next two largest economies, Italy and Spain, are forecast to have contracted by 0.87% and 0.73% respectively by 2013, although meagre growth of 0.6% and 0.5% respectively returns in 2014. Greece continues to be the worst-performing economy of the Eurozone and is forecast to have an average contraction of 4.0% pa until 2014 by which time the economy will have contracted 23.6% since growth ceased in 2007. The UK economy is likely to contract 0.1% in 2012 but grow 0.9% in 2013 and 1.6% in 2014, but growth then to fall to about 1.1% in both of the subsequent years.

The US economy appears to be recovering well. US housing prices have risen for six consecutive months and the S& P/Case-Shiller house price index by a seasonally adjusted 0.3% in September and is now up 3% over the last year. Even in some of the cities hit hardest by the housing crash, such as Las Vegas, Phoenix and Detroit, housing prices have risen about 1% and house building statistics have risen 15% to their highest level since Lehman Brothers failed. The turnaround in the housing market has several important direct and indirect consequences. The construction industry, normally 4% of GDP, is currently 2% and indicates the extent of a possible recovery. Increased prices increase consumers' wealth which, historically, after a lag, results in a 4% increase in consumer expenditure per $1 extra wealth. Current housing wealth is about $19tr and a modest 5% growth would add an extra $40bn in consumption or say 0.3 percentage points to GDP.

Rising house prices have coincided with a continuing fall in consumer debt from 100% of GNP to 87% which is already close to the long-term trend and, with a rise in consumer confidence, as evidenced by a rise of 30% in the Michigan index of consumer sentiment since last year, consumers become both more able and more inclined to borrow. The rising housing market will increase consumers' equity in their houses putting some out of negative equity and allowing others, with 20% or more of equity, to refinance an existing mortgage or take out another one on a new house at lower interest rates, also boosting consumption.

The change in the labour market indicates the improving economy and in turn supports that improvement. At present the ratio of open jobs to total employment is 2.7%, the pre-recession level, compared with less than 2.0% in 2009. Thus there is the possibility of a virtuous cycle: rising employment creates demand for houses boosting the housing sector which in turn creates more jobs. Fortunately such a virtuous cycle can be facilitated by bank lending which has been rising steadily since mid-2011 as the US banks, as opposed to most European banks, have largely been properly recapitalised.  The major potential threat to the US economy is the January 2013 "fiscal cliff", the expiration of fiscal loosening initiated by President George W Bush, amounting to almost 4% of GNP. The extent of the renewal of the fiscal stimulus will be a major determinant of US economic growth. The resolution will be a "cliff hanger".

The prognosis is that the US will have had a "good" recession, a Second Great Contraction that fortunately has been merely a side show compared with the Great Depression. If this prognosis proves correct, it will be largely because many of the factors responsible for the Great Depression are no longer operating, either by circumstance or by policy decisions.

The US economy entered the Second Great Contraction with a floating exchange rate. The $/€ rate in mid 2007 was 0.7451 and by mid 2011 it had fallen to 0.6952 and is down 6.4% on a trade-weighted basis from its high this year so providing a stimulus to the economy as evidenced by the almost doubled exports over five years.The current floating exchange rate, as opposed to a fixed rate or the gold standard, did not preclude the beneficial effect on demand of a devaluation.

The Fed reacted to the onset of the crisis very quickly and has pursued a very expansionary monetary policy ever since. In December 2007 the Fed rate was 4.25% but by December 2008 it had been reduced to 0.00%-0.25% where it has been maintained since. In December 2008 the Fed announced the first of what were to be three large-scale programmes of purchasing Bank and mortgage-backed securities. The first of these, QE1, in December 2008, purchased mortgage-backed securities and was expanded in May 2009 to include $300bn Treasury Bonds. By October 2009 the QE1 programme had purchased $1.25tr MBS as well as the $300bn bonds. In November 2010 QE2 was announced with the aim of buying $600bn of Treasuries by July 2011, a target completed timeously.

In September 2011 the Fed announced "Operation Twist", the purchase of $400bn of six to thirty year bonds and the sale of $400bn of three year bonds thereby lengthening the maturity of the Fed's portfolio and reducing longer-term interest rates. Operation Twist was extended by a further $267bn in June 2012 and later the Fed announced its commitment to keeping rates low until late 2014. The latest announcement in September is the most far reaching as the Fed announced QE3, or QE infinity as it is being termed, a programme to keep buying unlimited bonds, including mortgage-backed securities, "for a considerable time after the economic recovery strengthens" and it has promised to keep rates at virtually zero until 2015. QE1 and QE2 were announced soon after the US inflation expectations, as derived from the bond market, indicated that deflation possibly threatened, which would result in an increase in the real value of debt and so imperil any recovery. QE infinity has been announced when inflation expectations are a "safe" 2% and there is no obvious deflation threat. Unsurprisingly the derived inflation level has risen to almost 2.5%. The Fed is able to conduct monetary policy without being tied to an inflation target, unlike the Bank of England, as it has a dual mandate both to limit inflation and to safeguard full employment.   At times more employment is more important than less inflation. This powerful stimulus has unsurprisingly boosted asset prices: thirty year mortgage-backed Fannie Mae bonds yield 2.2%, the S&P index has recovered from a low of 600 to over 1400; and all high-yielding bonds, stocks, corporate debt loans and structured assets have risen sharply.  The high yields available on buy-to-let houses have attracted investors who accounted for 20% of all house sales in October. Blackstone has invested $1bn in 6,500 houses in 2012. It would be most surprising if this benign monetary policy did not continue to have a beneficial effect on the economy. Mr Bernanke suggests that QE has already increased output by 3% and employment by more than 2m, but with interest rates already so low QE3 is likely to be less effective than previous stimuli.

The current huge monetary stimulus stands in direct contrast to the initial response to the "Great Depression", but compared with spectacular recovery then the recovery rate now appears slow. However, the success of the current stimulus should be measured by the comparative shallowness of

the contraction resulting from early action. The extent of the possible recovery is indicated by the 14% gap between current output and output at the trend level. This gap indicates a demand shortage and limits the extent of any resulting inflation - the stimulus is more likely to achieve too little demand than excessive demand leading to inflation.

In the New Deal the fiscal stimulus was an indirect result of social and public expenditure programmes. The fiscal cliff, the programmed elimination of $500bn tax cuts and the introduction of $1,000bn government spending cuts, is a Damoclean sword hanging over the economy sufficient to result in a 3.8% contraction in GNP if there was a sudden withdrawal of these fiscal stimuli. The extent of the extension of these stimuli is uncertain. However, having followed the precedent of the New Deal, a relapse to liquidationist policy that characterised the Hoover policies at the beginning of the Great Depression would counter all the very successful policy initiatives that have enabled the US economy successfully to temper the damage of the Second Great Contraction.

The Eurozone's economic analysis lacks cohesion as comparisons between the Eurozone and the US or the UK usually vary much less than the variation among its individual constituent countries. The Eurozone and most of the constituent economies, including notably Greece, had growth rates usually at or above those of the US and the UK before entering the Second Great Contraction. In the recession in 2009 all western economic areas contracted significantly, the US by 3.5% and the UK and the Eurozone by about 4.4% but in the three years since then the US has recovered more than the Eurozone and the UK, both of which are expected to contract in 2012 and over the next three years the Eurozone has the lowest expected growth. Within the Eurozone several economies, including Italy and Spain, the third and fourth largest, are contracting in 2012 and face continuing contractions in 2013.

In the Eurozone only limited aspects of economic policy are common to all the Eurozone countries, primarily the use of the Euro and the monetary and other controls of the ECB. The Euro is not part of a fixed exchange rate system, unlike the US tie to the Gold Standard before the New Deal, and since the start of 2007 the trade-weighted index has declined by over 10% providing a stimulus to demand.

The ECB is a central bank, without full powers, but with a wide responsibility, primarily for price stability, but also "supporting economic growth and preserving financial stability, provided price stability is achieved". In response to the current crisis the US Fed reduced interest rates very quickly and supplied a huge and continuing monetary boost to the economy. In contrast the ECB started cutting rates from a peak of 4.25% in July 2008, reducing them slowly to 1.25% in April 2011, before increasing them briefly to 1.50% in July 2011, and then resuming a reduction to 0.75%, the current level, in July 2012. The ECB's mandate is that its official policy stance reflects the changing economic conditions of the Euro area as a whole, and therefore does not reflect the diversity among the national economies. One size has to fit all.

The ECB is hampered by more serious constraints. It has no power or overt political mandate to undertake a vast expansion of the money supply or to operate as a lender of last resort. These constraints are reinforced by the German Bundesbank tradition, in whose image it was formed, of rigid inflation targeting as per its mandate and on independence from government, both of which developed as a result of Germany's experience of the hyperinflation of the 1920s. Rescues of delinquent debtors by means involving the creation of money with the inherent risk of inflation were therefore contrary to its inflation mandate, its political restrictions and its cultural inheritance. In such a context, Jens Weidmann, President of the Bundesbank, quotes a warning from Goethe's Mephistopheles: "Such paper in the place of gold is practical: we know just what we hold … …  But wise men will, when they have studied it, place infinite trust in what is infinite".

The contrast between the ECB position and that of the US Fed in the New Deal and in the midst of the Second Great Contraction could hardly be greater. The turning point of the Great Depression was arguably the recognition that, instead of letting more banks fail, as about 10,000 had in total by the time of the New Deal, the Fed would guarantee them and issue the necessary recovery funds. Similarly, in the 2008 US financial crisis the signal event that marked the turning point may have been the recognition that the Fed was wholly committed to increasing the money supply to meet all the requirements of essential financial institutions. This may have occurred in a television interview with

Ben Bernanke, in which he declared that the Fed was the world's lender of last resort. When asked if he had been "printing money" he replied "Well, effectively … … ... and we need to do so, because our economy is very weak and inflation is very low".

Things change, even for the ECB. The ECB appears to have moved from implacable opposition to limited acceptance of the need to support the Eurozone financial system, as evidenced by the multitude of various ad hoc measures undertaken, including a declaration by the Chairman of "unlimited" support.242 Unfortunately, in spite of such declarations, market opinion and political reality are at variance with the Chairman's aspirations. Even a few weeks after the declaration the probability, based on bets lodged, of a country leaving the Euro before 2014 was still over 55%. A distressing feature of the ECB's various supportive schemes is that the "half life" appears to shorten progressively. For instance the most recent proposals have been subject to different interpretations by different nations and so render the proposal at best uncertain, but certainly not "unlimited". It appears that whenever the ECB advances the political process slows down, a continuing pattern that is the true tragedy of the Eurozone's crisis management, one wholly inherent to its structure. The restatement of the policy returns the Eurozone to the position before the Chairman's announcement - the existing policies are still inconsistent with the survival of the integrity of the Eurozone. Without doubt the Eurozone appears to be moving towards a position where the financial crisis might be controlled by means other than greater fiscal austerity, with its echoes of the pre-New Deal "Liquidationists", but the question is whether the political will and democratic endorsements of that will achieve the necessary solution and consent timeously and so avoid the crisis before the crisis arrives. A patent oversimplification but a coruscating insight to the political reality of this "enigma" machine is given in my Spanish phrase book: "Esta Sonora (Merkel)  pagara por todo … … "

Just as the Eurozone's structure precludes certain New Deal policies for the whole, it precludes other polices for the constituent members as is singularly relevant and demonstrated in the Greek economy. Like that of the Eurozone, the Greek economy grew strongly in the years before the recession, but contracted 3.3% in 2009, similar to the Eurozone's contraction of 4.3%.  But since then Greece's economy has continued to contract by 3.5% in 2010 and by over 6.0% p.a. in the two following years. Further contractions of 4.5% and 2.5% are forecast for 2013 and 2014 respectively by which time the economy will have contracted each year for six years, longer than the period of contraction in the US during the Great Depression. Tragically the Greek economy demonstrates that certain features of the Eurozone were the major contributing factors to the dramatic contraction in output and that other features of the Eurozone are the major contributing factors to the difficulty in recovering from that contraction.

For several years before the recession Greece benefited from growth rates of up to 6.0%, but incurred substantial Government deficits from which it accumulated debt equivalent to 120% GDP. This was facilitated by the then implied "guarantee" that all sovereign debt was "Eurodebt" and the availability of such funds to finance deficits at Euro-interest rates, rates whose level was related to repo rate set by the ECB's to whom by treaty monetary policy is wholly ceded and which sets interest rates and whose Executive Board "gives the necessary instructions to the National Central Banks." Central monetary control, but no fiscal control, allowed fiscal latitude, at least in the short term.  Such central control constricts the monetary policies available to independent nations and because the Euro is a common currency Greece cannot devalue as a means of stimulating demand, unlike the US when it left the Gold Standard.

The New Deal introduced many Government aid and investment agencies, which caused federal deficits and supplied demand to the failing US economy. The Greek economy is characterised by persistent current Government deficits which were 6% of GNP even in pre-recessionary 2006 but rose to a peak deficit of 16% in 2009, and the total debt has now spiralled to its present level of 170% of GNP. The fiscal stimulus appears already to be very large! Prima facie it appears none of the New Deal options is available to Greece. Worse, the Greek economy is a debt trap. If both Government debt and GNP are 100 (ratio 1:1) and if growth is less than the interest rate, then the ratio gets progressively worse:  for instance if growth is 3% and the average coupon rate on the debt is 4% then, unless repayments are made, after one year the debt has grown to 104 but GNP only to 103 and the ratio becomes 1:01. The current Greek ratio is 1.6, and, if growth as forecast is -7%, and the coupon is say

5%, then after a year its ratio becomes 1.8. The Greek budget published on 31 October 2012 forecast debt to rise to 1.9 times GNP. Needless to say as the ratio - and of course other economic indicators - deteriorate, the higher the coupon becomes on new debt raised either to meet the deficit or to replace debt being rolled over: a bad situation gets worse.

Sovereign debts are either repaid, monetised - redeemed in devalued money - or defaulted, probably for Greece in some combination as a default has already occurred. The prospects of full repayment are remote. If the integrity of the Euro is to be maintained there can be no devaluation or rampant inflation, so default is inevitable if Greece is to remain within the Eurozone. However, maintaining the integrity of the Euro
does not cure the underlying problem that resulted in Greece threatening its integrity or the inherent uncompetitiveness of the Greek economy.

Competetiveness might be restored if "strong" Euro countries like Germany inflate, increasing costs, or Greece deflates, reducing costs. The former seems unlikely given German culture and the latter will cause considerable further contraction of the economy, giving more serious unemployment and possibly severe social and political unrest. The non-economic difficulties could be alleviated by continuing fiscal transfers to Greece, subsidising the economy but not curing it. Greece would become to the Euro area as the Highlands and Islands are to the UK (or may become to the rest of Scotland!). Such transfers will require both fiscal and cultural changes in the rest of the Euro area which at present seem unattainable, unless there is a Neuen Vertrag. The bitter irony of the tussle between creditor and debtor countries is that it resembles the inverse of the tussle that arose after the treaty of Versailles in 1919 when the French adopted a positive and moralistic stance against the Germans, but it may be functional to consider the possible social, political and economic repercussions of such a fine moral stance. 

HM the Queen, touring the LSE at the beginning of the Second Great Contraction, remarked to the Director of the London School of Economics, Professor Luis Garciano: "If these things were so large, how come everyone missed them?" If the same question is asked of the ECB in relation to the inherent instability of the Eurozone then the statement made by Herman Van Rompuy, now President of the European Council, in 2010 provides some insight. "The Euro … … was like some kind of sleeping pill, some kind of drug. We weren't aware of the underlying conditions."

The ECB diagnosed the disease but misidentified the victim - their Emperor had (healthy) clothes as their reports in August 2009 indicated. Commenting on global imbalances in current account surpluses and deficits, the ECB said: "The issue is important as a potentially disorderly unwinding could pose a risk for the global economy and the stability of the international financial system". The article focused on the rise of the US current account deficit "to unprecedented levels" and the surpluses of China, Russia, Saudi Arabia and Japan, contrasting these imbalances with the current account of the whole EMU countries which were "broadly balanced". Unfortunately within the Eurozone lay the largest imbalances as Greece, Portugal and Spain had deficits of 11%, 10% and 9% respectively while Germany and the Netherlands had surpluses of 6.5% and 9%. These were all larger than the then US current account deficit of 6%!

The long-term survival of the Eurozone requires a different New Deal, a political New Deal that will transform the structure of the organisation. When the reunification of Germany took place the writer, Thomas Mann, termed it "Not a German Europe but a European Germany" but what may emerge is a European Germany in German Europe.251 However, rather than by a Gestaltic jump, the process may proceed slowly and erratically prodded by the fear of collapse, restrained by the power of inertia and, as envisaged originally by Jean Monnet, a founding father of European integration, crystallised by the process of step-by-step technical integration, and coalesced through crises - "crises are a great unifier" he said. But they may also prove a great fragmenter.

The UK is not shackled by the economic inflexibility of the Eurozone or by the greater restrictions faced by individual Eurozone members. The UK controls both monetary and fiscal policy and sterling floats. The UK debt is rated AAA and on current policies the public sector net debt is estimated by the

OBR to peak at 80% of GNP in 2015-16. Inflation, while at 2.4% in Q3 2012, is forecast to reach the target 2% within Q4 2014 and having fallen over 2 percentage points in a year.

Notwithstanding the flexibility of policy measures and the comparatively stable conditions of the UK economy, growth has been low. The recovery from the last recession took place in 1991 (Lord Lamont's "Green Shoots" - unfortunately the earliest ones were rather frosted!) and lasted more than sixteen years; - sixty-six successive quarters - before falling in five consecutive quarters in 2008-2009 by 6.3% and recording the largest annual fall since the Second World War. Growth resumed in 2010 but fell to 0.8% in 2011 and during 2012 returned to recession when it is expected to have contracted slightly. The current depression has already lasted fifty-seven months, longer than any of the five major recessions since 1920, as even the Great Depression lasted forty-nine months, and at this stage of the cycle output was already above the pre-recession level, while in the current depression it remains at 4% below the pre-recession level. If output continued to grow at the pre-recession level of, say, 2.5%, then it would have been 17.3% higher than the current level.

Forecasts for the UK economy are conditional on developments worldwide, but in particular the Euro area. The Bank puts it elegantly: "A key source of risk is if policy makers in the Euro area are unable to ensure that the required adjustments to the levels of both debt and competitiveness in some countries take place in an orderly manner. The degree of requisite rebalancing and adjustment is so pronounced that there remains a risk of serious dislocation ... … there is no way to calibrate the size and likelihood of such outcomes". The Bank's "central" projection is that growth in 2013 will be 1.25% to 1.75%, but it noted that the average of independent forecasters showed a 44% chance of 2013 growth being less than 1%. In 2014 the "central" forecast is for 1.75% - 2.25% growth.

Other forecasts, normally conditioned by the Euro crisis, are similar for 2013 and 2014: the OBR expects 1.2% and 2%; NIESR 1.1% and 1.7%; and HMT (Independent Forecasts) 1.1% and 1.7%. Forecasts of only 0.5% for 2013 are given by EIU and Capital Economics. The prospective growth is low compared with pre-recessionary growth and much lower than that expected from an economy recovering from a recession.

The US authorities engaged a wide range of resources under the New Deal which led to the recovery from the Great Depression. The UK authorities are less comprehensive and more tentative than the admittedly very aggressive - maybe "gung-ho"- measures taken in the mid-1930s. The conditions now bear little relation to the very dire conditions obtaining in the Great Depression, but the policies used then can be considered in the contemporary context.

An over-riding part of the New Deal was that the measures were extreme and far-reaching. Possibly a view was formed that something "so big" was bound to be effective, the "bazooka" effect so sought by the ECB - and so badly misfired - that confidence increased, giving an immediate boost to the economy.

The width and the aggregate effect of UK measures fall far short of those of the New Deal although in one very important area no policy change was or is required as, unlike the US tie to the Gold Standard, Sterling's value floats freely as it has done since the withdrawal from the Exchange Rate Mechanism on 16 September 1992. The floating £ permits the UK economy to benefit from the increased demand resulting from lower exchange rates, which depreciated from the real effective exchange rate of 97.7 at the beginning of the recession to 77.4 in early 2009 since when it has risen as the Euro crisis intensified in mid-2011 to about 91.0 The overall devaluation is about 8% and 12% against the Euro, giving only a modest boost to demand.

The New Deal provided a significant monetary boost, and in the current crisis the Fed has used a wide variety of policies and massive resources to ease monetary policy. The Bank has also undertaken extensive monetary easing and expansion, but it has been more circumspect.  The Bank, having surprisingly raised Bank Rate in 2007 to 5.75% just before the storm struck, has, unlike the Fed, cut the rate slowly to an all-time low of 0.5% in March 2009 where it remains. Bank Rate (implied by formal market interest rates) is not expected to rise above 0.5% until Q1 2015, six years after it was reduced to the current all-time low. Interestingly, market rates imply a further fall in Bank Rates next

year. The Bank has also completed a massive £375bn asset purchase programme which last year the Bank estimated had raised GNP by 1½% to 2%. The Bank considers that the transmission mechanism occurs as sellers of gilts buy other assets, reducing yields on corporate debt and equity and so encouraging investment, and the boost in asset prices may encourage consumer spending. Finally, lower yields may lower the exchange rate and boost net trade. The implication is that these are desirable ends and if so, there seems considerable merit in the Fed's policy of bypassing gilt purchase and purchasing other classes directly, especially, as in the US, mortgage-backed securities.

QE is an indirect policy and critics such as the EIU remain "sceptical about the benefits of QE for the real economy" and suggest it "does not improve credit flows to smaller companies". The New Deal provided a measure of direct support for smaller companies, in an economy where the "Great Contraction" was very real. The Fed's restrictive monetary policy before the New Deal caused around 10,000 bank failures whose greater effect was not the loss to depositors or shareholders but the effect on the money supply and the volume of credit the overall effect of which, between 1929 and 1933, was that while the public, through liquidation of assets and savings, increased their cash holdings by $1.2bn, the cost of the extra liquidity was a decline in bank deposits of £15.6bn and a decline in loans of $19.6bn, equivalent to 19% of GDP in 1929. The conditions before the New Deal are in many significant ways totally different from those applying now, but the commercial banks operate on the fractional system which, with a much-reduced reserve , say 5%, of total deposits can multiply the money supply twenty times. Unfortunately, the reverse applies equally, and as the commercial banks as a whole are responsible for the vast majority of money creation, when the banks' criteria change, for whatever reason, they determine the change in credit and liquidity available to a greater extent than the central bank.

The effect of credit, or rather the lack of it, on the economy is widely recognised. The Bank acknowledges that QE does not directly improve credit flows to small companies while the OBR state "growth is not forecast to return to firmly above trend rates until 2015 as credit conditionsbegin to normalise". The Bank's November Inflation Report states "Bank loans to private non-financial corporations continued to decline in Q3" as indeed they have done since 2009 by 19.1% as indicated by the resolution in broad money. Surveys on credit for SMEs consistently report that credit is not available for credit-worthy schemes and such views are supported by anecdotal evidence. David Miles, a member of the MPC, quoted D M Frederiksen (see above):- "we see money accumulating … … … but not available at all for things that are in fact safe .. … .. " David Miles said "he (Frederiksen) might have been describing how things looked at the end of 2008".

The unavailability, the rationing of credit, for schemes within the normal range of credit risk, and the importance of such credit has been acknowledged by the introduction of Project Merlin, which failed dismally to meet its objectives, and recently by the Funding for Lending Scheme ("FLS"). The Bank's Inflation report says: "Tight bank credit conditions may also have constrained some companies' investment .. .. .. in particular SMEs .. .. .. as they tend to rely more heavily on bank credit .. .. .. to the extent that FLS improves corporate credit conditions, that should support investment."

Both Project Merlin and the FLS rely on banks' participation, incentivised by lower lending and moral persuasion, which in Merlin's case clearly were insufficient, probably because reducing lending was a greater priority than the marginally-enhanced profit potential. The incentives on FLS are greater but as the Bank says the extent of "pass-through is uncertain. For example some banks .. .. .. will take the opportunity to boost profits and capital .. .. .. " The FLS's introduction may be based on a long overdue official recognition of the deterioration in credit conditions. The Inflation Report in August says "UK bank lending was more likely to decline than increase over the coming eighteen months, in part reflecting the fact that some banks had announced plans to shrink new lending over the next few years". One wonders why the Governor has taken so long to invite Mr Hester to tea .. .. ..  The November report continues: "Lending is likely to remain weak given the need for some banks to contract their balance sheets".   The Governor put the position more starkly: "I am not sure the advanced economies in general will find it easy to get out of the current predicament without creditors acknowledging further likely losses .. .. ..  a significant writing down of asset values and recapitalisation [of the financial systems]". Some banks' necessity to contract their balance sheets is reflected in their valuation. Andrew Haldane, executive director of the Bank of England, writing in the

FT, observes that, while prior to 2007 each £1 of bank equity was valued at £2 to £3, now "most global banks are valued at a discount - many at a small fraction of their equity book value".

The FLS may mitigate the difficulty in supplying credit but will not solve it. The banks have not been lending because their losses, prospective losses and impairments have eroded and will continue to erode their equity. Equity will also be eroded by the restitutions required for PPI mis-selling of £4.6bn to £10bn, according to the Bank, money laundering, Libor fines and other scandals. In addition, higher capital ratios and risk weighting of assets will require more capital, to maintain existing loan volumes without contemplation of expansion. Alternatively a partial solution is available by shrinking the loan book, a strategy currently restricting credit and previously precluding the successful implementation of Project Merlin. Delay is a vital strategy as it assists debtors, and asset values may rise rather than fall, and the passage of time allows access to the huge stable underlying profits available to the oligarchy of the UK retail banks - a high-energy drip feed.

The domestic profitability compares starkly with the UK Banks' international operation which was responsible for three-quarters of UK Banks' losses in the early years of the crisis. The MPC observed that these losses overseas resulted in a domestic requirement to stock their balance sheets:  some of the UK's credit shrinkage was imported.

The huge balances allowed the banks to gear up their equity and, while it lasted, their profits. In the 1880s total bank assets were 5% of GNP but by 2007 this had risen to 500% of the very much larger GNP and the three largest banks' assets had grown from 7% of GNP to 20%. The equity leverage changed from three to four times to thirty times but the return on these huge assets was only 0.5%, the same as over 100 years earlier. Only a very slight fall in value of profitability in a vast portfolio was required to bring down the whole edifice. In the US, they have a saying: "Gathering dimes in front of a steamroller".

Amusingly, the near failure of some banks has been interpreted as a triumph for Karl Marx, for communism at the heart of capitalism. In the near failure the capital holders got nothing, they were raped by the staff who paid themselves extravagant sums out of illusory profits. The shareholders had been destroyed by the workers, having duped them into paying vast wages to retain "talent". These workers had enjoyed what Professor John Kay describes as a call option; bonuses and remuneration plans based on shareholders' 5% equity holding, effectively another call option. For some this provided too great a temptation to gear up wildly, especially if the downside was a comfortable retirement marred only by lectures on moral hazard - possibly too difficult a concept for practical men!

Some commentators are more direct. Martin Wolf says: the UK's banking system remains too feeble, not least because of the damage of further write-downs … .. brutal reassessment is necessary to recognise losses, restructure and recapitalise. Without the necessary recapitalisation UK economic growth will continue to be hampered, and although this requirement is at least recognised no proposals are evident. This handicap does not apply in the US where, with measures supported by the Fed, the US banks were properly recapitalised. The US recapitalisation is consistent with economic theory and with the view of the Fed. However, what is striking is that recapitalisation was one of the important earliest policies in the New Deal, significantly part of the extended "Bank Holiday".

In contrast to the UK, the New Deal was also characterised by fiscal expansion, although I have shown earlier that this was largely inadvertent. The US is currently following such an expansionary policy, albeit one that may be attributed to the so-called "fiscal cliff" of tax rises and spending cuts. Fortunately market sentiment indicates that a "deal" shortly will substantially reduce the cliff.

The UK policy has been to jump off a "cliff" by embracing tax rises and spending cuts. In 2010 the incoming Coalition government moved sharply to an austerity budget: "We are going to ensure, like every solvent household, that we buy what we can afford; that the bills we incur, we have the income to meet; and that we do not saddle our children with the interest on the interest (sic!) of the debts we were not ourselves prepared to pay". So far the Chancellor is achieving precisely what he sought to avoid. The Chancellor evokes echoes of Thatcherism and the classic allusions of Micawber and

Polonius, but economic management is neither morality nor an abhorrence of fecklessness but an assessment of net balance. Colourfully put, Samuel Brittan observes: "the Deficit should be a policy variable rather than targeted to meet a dim accountant's idea of balance". This policy variable was well used in the past: currently debt is forecast to be 79.7% of GDP in 2015-16OBR-6 but the average over the last 324 years is 112% with long periods over 100%.

A policy of sharp fiscal consolidation, the current policy, is likely to be counter-productive. Herbert Hoover, writing at the time of the New Deal, advocated "stay the course" and "take our medicine".  Parker in his overview of the Great Depression comments: "In hindsight, it challenges the imagination to think up worse policy prescriptions for the events of 1929-33". The cumulative output loss so far exceeds that of the 1930s and is at least 10% below what would have been forecast from previous trends as fiscal contraction leads to economic contraction. Lawrence Summers, a former US Treasury Secretary, puts it succinctly "the [UK] doctrine of expansionary fiscal contraction is an oxymoron in the current context". Instead he recommends increasing demand in the short run as a means of jump starting economic growth and setting of a virtuous circle in which income, growth, job creation and financial strengthening are mutually reinforcing.

A recent study by the NIESR concludes that austerity at the current level has a pernicious effect and is self-defeating and considers that UK GDP could be 4.3% and 5.0% lower in 2012 and 2013 than it would be without the government's fiscal consolidation programmes. Moreover, had the growth occurred, the debt-GNP ratio would also have been lower.

The IMF has attempted to quantify the relationship between the marginal effect of a £1 reduction in government spending and the change in the output of the economy, considered by the OBR to be 50p, or 0.5 of the marginal change. However, the IMF considers that 0.5 is too low by 0.4 to 1.7, especially in an environment where interest rates are already low and trading partners also experience low growth. Their estimate for the periphery of the Eurozone is nearer the high end of the adjustment and, if it were 1.5 for the UK, then a fiscal adjustment of 3% would imply a GDP drop of 4.5%. Particularly worrying is the possibility that losses in output are permanent, the hysteresis effect occurring when factors of production are permanently lost - scrapped, retired etc - and cannot be recovered.

I conclude that immediate prospects for the UK economy are not good. Even excluding the possibility of major external upsets, the economy will at best grow slowly, continuing to be hindered by severe economic discord in the Eurozone. The UK's prospects would be greatly improved by major changes in monetary policy, by reform in banking, including regulation and increased competition, by bank recapitalisation, and by the subsequent increased provision of credit, and by a less restrictive fiscal stance. Many economic difficulties, including those experienced in the Eurozone, have been caused by insufficient understanding of the consequences of particular actions, by over-riding political concerns or by indifference to the likely outcomes. The current monetary policy is focused on inflation targeting and is implemented narrowly and restrictively and those factors limit the contribution that monetary policy makes to economic recovery. A change in policy would be beneficial: perhaps the appointment of a new Governor will facilitate it.

Property Prospects
In the previous property investment cycle the CBRE All Property Yield Index peaked at 7.4% in November 2001 and fell steadily to a trough of 4.8% in May 2007 before rising in this cycle to a peak of 7.8% in February 2009,201 a yield surpassed only twice since 1970,201 on brief occasions when Bank Rate was over 10%. Yields fell rapidly from the 7.8% peak to a low of 6.1% in 2011 from which they have risen by 0.27 percentage points to 6.3% over the last year. The yields of components of the Index, Retail, Office and Industrial all increased similarly except shopping centres which remained steady at 5.9%. However yields fell 0.1 percentage points in Central London shops, Out of Town Shopping Centres and London Docklands and Fringe office areas.

The peak yield of 7.8% in February 2009 was 4.6 percentage points higher than the 10 year Gilt Yield, then the highest "yield gap" since the series began in 1972 and 1.4 percentage points higher than the previous record in February 1999. The correct yield of 6.3% is however 4.8 percentage points higher

than the exceptionally low 10 year Gilt Yield of 1.5% creating a new record. The present record "yield gap" occurs primarily because of the low gilt yield, while the 2009 "gap" occurred primarily because of high property yields.

From the 1970s until the late 1990s, except for one year, the 1993/94 downturn, the position was reversed - "the Reverse Yield Gap" - and the Gilt yield exceeded the property yield, the current "Yield Gap" was re-established in 1997 and has persisted since then, except very briefly at the 2007 property peak when property yields fell to 4.8%. The "Yield Gap" of 4.8 percentage points is much higher than the average over twenty years partly because 10 year Gilts yielded only 1.5% at the comparison date.

The All Property Rent Index, which, apart from a brief fall in 2003, had risen consistently since 1994, fell 0.1% in the quarter to August 2008 and then fell substantially for four consecutive quarters by 12.3% altogether. From August 2009 rents rose for four consecutive quarters, due wholly to a rise of 6.9% in office rents, and the index rose by 0.9% in the year to August 2010 and by 0.5% in each of the years to August 2011 and 2012.

Office rents have continued to rise over the last two years, by 2.8% in August 2011 and a further 0.7% to August 2012, mostly due to increases in London. Other sectors are little changed except out-of-town retail where rents have fallen by 2% to 3% altogether over the two years to August 2012.

Property Investment, as measured by the IPD All Property Index, returned 3.1% in the year to 31 October 2012, of which the income return of 6.8% was offset by a fall in capital values of about 3.6%. In the year to 31 October 2011 the return was 8.7% of which 6.9% was income and 1.7% capital. In the year to 31 October 2010 the return was 20.4% compared with minus 14.0% in the year to 31 October 2009 and minus 22.5% in the year ended 31 December 2008, a month that produced a record fall of 5.3%. As the 2008 IPD total return figures include about (plus) 7 percentage points of return from Income, the negative total return figures disguise an even greater capital loss than indicated by the return. The Bank notes that Commercial Property prices had fallen about 44% by late 2008 but had recovered by 2010 to be about 35% below the 2007 peak, and with the small capital growth of 1.7% recorded last year more than offset by this years fall of 3.6% will now be about 36% below the peak. The total return of 3.1% as measured by the IPD index for the year to 30 September 2012 was far lower than the return to equities of 9.8%, to bonds of 7.6%, and to property equities of 15.5%.

Total Property returns in 2012 are forecast to be about 2.3% and the mean return based on derivatives 1.6%. This time last year returns in 2012 were forecast between 4.5% (IPF) and 8.2% (Colliers), but the return implied by derivatives of 1.2% appears almost certain to be least inaccurate. The forecasts made in 2010 for 2012 of between 8.6% and 12% were unsurprisingly even more inaccurate, but the derivatives at that time indicated only 4.0%. Future returns implied by derivatives are poor, rising from only 1.75% in 2013, to 3.0% in 2014 and 3.25% in 2015 and 2016. Surveyors forecast total returns at around 5.0% in 2013 rising to 8.0% in 2014 and the IPF forecasts are similar. Poor prospective returns occur because in 2013 almost all forecasters expect capital values to continue to fall and rental increases, if any, to be small. Subsequent years are forecast to have small increases in capital values and in rents. All these forecasts were made before the OBR December report and the Chancellor's autumn statement, both of which downgraded previous forecasts of economic growth. Low economic growth, which may relapse back into a third recession, will reduce demand for occupational property and so reduce rents and increase vacancies, both of which will reduce investment values.

Present and prospective economic conditions have already reduced the quality of tenants' covenants which has had a dramatic effect on tertiary property values. Since the peak the difference in yield between primary and tertiary property has widened from lows in 2007 of between 1.8 percentage points and 2.8 percentage points, depending on the category of property, to between 3.5 percentage points and 7.5 percentage points. For retail property the difference was increased from 2.1 percentage

points to 5 percentage points. The difference between prime and secondary has also increased, as prime yields, have risen 0.17% points during 2012, but secondary yields have risen 1.67 percentage points. These differentials are expected to continue to widen.

Retail has been particularly badly affected in the depression. Between 2007 and 2012 thirty seven large retailing companies averaging over one hundred stores each have gone into administration each year and this year so far another fifty-two companies have failed affecting 3907 stores. Vast numbers of other retailers have also gone out of business giving vacancy levels of up to 30% in some high streets, and much lower rents and greatly reduced investment values. All categories of retail investment property are affected to some degree except prime London shops and prime retail centres.

I see no recovery in the investment property market until there is a prospect of "normal" economic growth. However the overall investment property market will continue a secular erosion caused by technical obsolescence, loss of locational primacy and competition from new formats, particularly for retailing. Last year I reported the sale of a New town office for £650,000 that we sold for £970,000 in 1989. In real terms this represents a fall in value of about 65%.

Investment values are also being depressed by the significant change in the credit market which seems likely to continue to depress demand even after economic conditions improve. Credit is severely restricted by rationing and, even when available, the conditions are now much more onerous. Typically, compared with pre-2007, margins moved from c1% to c3.5%, LTVs from 80-85% to 50-60% and repayment terms, fees and covenants are much more onerous. At the present time the strategy of the traditional non-specialist investment company has been undermined. Unfortunately rising yields, increased vacancies and tighter credit conditions have caused many property-based loans to be delinquent or non-refinanceable, estimated at c£100bn. Many loans are being "managed" by the lenders, but if conditions require these properties to be refinanced at short notice, a large supply of mostly secondary property will erode investment values further. For specialist investors such sales will present many opportunities and this niche together with certain other niche markets will be amongst the few rewarding investments over the next few years.

This time last year predictions of change in house prices in 2012 ranged from several pessimistic forecasts, including Capital Economics of -5.0%, to a solitary optimist of +5%. The specialist house price surveys were generally pessimistic - Nationwide expected prices on the "downside", Hometrack expected an "acceleration of price falls", and LSL said "the outlook for transactions in 2012 is that they might weaken slightly in the light of reduced confidence, tighter household budgets and restricted lending". Similarly the Bank commented that "forward looking indicators of housing market activity have remained weak",

The outturn to November 2012 varies amongst the index providers between - 1.7% Halifax to +2.3% LSL Academetrics. The widely used Nationwide records -0.9%. Of the indices, the Land Registry (+1.1%) is the only one that tracks solely properties previously sold and uses geometric means so reducing the influence of "outlying" prices. In contrast all the major Scottish house price indices show falls to September 2012: -2.9% LSL/Acadametrics; -3.9% Nationwide; a colossal -6.6% Halifax; and -1.4% Registers of Scotland. LSL/Acadametrics adjust their figures for seasonal variations and for "mix" variations e.g. standardise the number of small flats and mansion-houses, but Registers of Scotland use the actual data unadjusted. The two mortgage providers use prices at mortgage offer.

There have been significant differences in price changes among the regions and among house types. In England and Wales, in the twelve months to September, prices have risen in Greater London by 8.3%, but falls of 1.5% have occurred in the North West and of 1.3% in Wales. Anomalously, the average price of flats has increased by 8% in the three months to October 2012, due probably to high prices in London, but detached houses are unchanged. In London houses in the two most expensive boroughs, Kensington and Chelsea, and City of Westminster increased by over 20% in twelve months, but the lowest price borough, Barking and Dagenham, had no change. The only fall, 0.5%, occurred in Tower Hamlets, a borough in the mid-price range.

LSL report that Scottish prices have fallen 2.9% in the twelve months to September 2012, the monthly prices oscillating around a downward trend line from £148k to £144k. Current prices are below trend and an upward oscillation is a high possibility.  Of the thirty-two local authority areas, prices rose in ten, the highest being Inverclyde by 5.5% and fell in 22, notably 5.5% in Glasgow. Edinburgh prices were almost unchanged. In Scotland the peak price in the Halifax index was £199,600 in August 2007, and, as inflation to 2012 has been 17.8%, the average price adjusted for inflation would be £235,129. The Halifax House Price of £159,467 in September 2012 implies a fall of 32.2% in real terms.

Forecasts of house prices in 2013 vary widely. The average December forecast in HMT, Forecast for the UK Economy, is 0.4%, interestingly the same as in February, but the City forecasters within the sample, notably Capital Economics and Merrill Lynch at -5% and -4% respectively, are less optimistic and their average is -0.4%. The average rise of all the medium-term forecasts is about 2% in 2014, 3% in 2015 and 4% in 2016. The OBR forecast prices to rise by 0.7% in 2013 with steady rises to 4% in 2016.  LSL expects little change in 2013 and say there is "little likelihood of sustained growth until 2014 at the earliest" for both the UK and for Scotland, and Halifax and Nationwide expect little change. Cluttons, Jones Lang Lasalle and Knight Frank expect prices to fall in 2013 with growth of 2% or more for the following four years. Savills expect the UK prices to increase 0.5% with growth rising over the next three years to 3.5% pa . The Economist argues that UK prices may not yet have reached a "floor" and, even if they have, they may go lower by undershooting "fair value", as occurred by 33% in the mid-1990s. The Economist compares long-term average house prices against rents and disposable income.  Current UK prices are still 23% higher against "rents" and 17% higher against "disposable income". By comparison France is +49% and +38%; Germany is -18% and -21%; and USA -15% and -24% respectively.

House prices depend on the balance between supply and demand. The long-term supply of houses is relatively inelastic and slow to respond to changes in demand largely due to the long production cycle time which includes negotiating land purchases, securing planning consents, so often subject to years of delay, and construction. The long-term demand for houses, according to the currently used econometric models, is likely to continue to grow at a rate which may have been reduced, but is unlikely to have been appreciably altered, even by a depression of such continuing length as at present and a cumulative supply shortage by 2022 of 1.4m houses in England and 400,000 in Scotland is forecast by Savills. Demand also increases as time, convenience, amenity and quality of location all become more valued as affluence increases. Because of this persistent  fundamental imbalance between the supply and demand prices will be higher in the long term.

The short-term market is supplied by recycling existing houses and by new houses increasingly built for established demand. Existing house supply is derived from owners exercising their discretion to move house - larger, smaller, smarter, relocation - who buy other such houses so effectively recycling them. Another supply source, but a "non-discretionary" one, is from estates, from household "break-ups" and from repossessions. The volume from the first two should be relatively steady, but supply from repossessions varies with economic conditions particularly unemployment. In spite of the continuing depression unemployment levels remain surprisingly low, two to four percentage points below those of the previous recessions and house repossessions are currently at a four year low of 8,200 per quarter compared with 9,600 last year. Fortunately low prospective interest rates - the Bank rate implied until 2016 by forward market rates is less than 1% - and continuing forbearance by lenders is limiting the supply of repossessions.

Short-term demand will be determined primarily by mortgage cost and by credit availability. Fortunately mortgage costs are likely to remain low although SVRs have increased about 0.2% but credit for house purchase seems likely to continue to be restricted and subject to rationing, so restricting demand, when supply is at best steady. Thus the short-term outlook for the housing market is not favourable and I expect some price falls in 2013. The Bank expect FLS to ease mortgage credit from 2013 but only moderately initially, but, if credit did ease significantly, demand would increase and prices would rise.

The housing market is a paradox: demand rationed by credit is the major influence on short-term prices and supply rationed by institutional factors is the major influence on long-term prices. In the short term credit rationing, together with deteriorating economic conditions, is likely to depress prices. Credit rationing is a major contributory factor to the current house price falls and, when it eases, probably coincidental with stronger economic growth, then supply will again become limiting. Thus the key determinant of the long-term housing market will be a shortage of supply resulting in higher prices.

Future Progress
The Group has completed three major objectives. Our investment portfolio has been realised apart from two high-yielding multi-let retail parades, which will be retained. Sales have taken place primarily when development or special opportunities occurred or when the investments matured. Bank loans have been repaid and the Group has no bank debt. Our development portfolio contains a very high proportion of sites with excellent planning consents, many of these gained in the last few years. Our several strategic land sites have been extensively promoted for inclusion in Local Plans and we have secured bridgeheads there. The investment in these long planning processes has been considerable and will be further reduced next year.

Our emphasis has shifted to the completion and realisation of development opportunities which can be marketed shortly. Within our development portfolio there are sufficient opportunities to allow several years of such minor sales. As these sales take place other development opportunities will be brought forward to provide replacements for the realisations. This, together with the income from our investment portfolio, will provide stability during the continuing prolonged depression.

We will not commission any major development until market conditions stabilise, or at least until the probability of another downward lurch in the economy is significantly reduced. We do not depend on a recovery in prices for the successful development of our sites as most of these sites were purchased unconditionally, i.e. without planning permission, for prices not far above their existing use value, and before the 2007 house price peak. The main component of the possible development value lies in the grant of planning permission, and in its extent, and is relatively independent of changes in house values. For development or trading properties no change is made to the Group's balance sheet even when improved development values have been obtained. Naturally, however, the balance sheet will reflect such enhanced value when the properties are developed or sold.

The Group has completed its withdrawal from the investment market, a policy introduced in the mid-2000s. As long ago as 2005 I said "Investment property seems fully priced .. .."; in 2006 "a further disadvantage of investment property is that recent price rises are arguably due to a short-term speculative serial correlation - a momentum effect - which ultimately will be susceptible to a long-term reversal"; and in 2007. "Returns have been very high; a relatively specialised asset class has been opened up to retail investors who have invested heavily; funds have aggressively promoted commercial property investment; bank investment has increased; more and more complex geared investment vehicles have been created; and reasonable expectation of returns has diminished progressively and depended more and more on increasing capital values". The crash of 2008, the Second Great Contraction and the long continuing period of depression has proved that policy prescient.

We will deploy the same care in determining future decisions and the policy of the Group will continue to be considered and conservative, but responsive to market conditions and opportunistic. The mid market share price on 20 December 2012 was 70p a discount to the NAV of 75.6p. The Board does not recommend a final dividend, but will restore dividends when profitability and consideration for other opportunities and obligations permit.

The UK and other Western economies are in the midst of the longest depression for over a hundred years. Policy interventions by Governments' have alleviated the worst possible outcomes, especially for unemployment and social conditions as the measures in the New Deal did for the US in the 1930s. The consequences of that instability included social unrest and upheaval which facilitated the establishment of extreme centralist regimes in certain countries. Policy interventions and inherent fiscal and social stabilisers now ameliorate such conditions, but the innate contradictions within the Eurozone lead to largely inflexible economic conditions which may become very destabilising in some countries. The resolution of this instability within the Eurozones is hindered both by political differences relating to fiscal transfers and by economic policies still largely based on contractionary deflationary prejudices.  The US, subject to avoiding a sudden fiscal contraction, has successfully deployed a wide range of policies now facilitating economic growth. The UK is muddling through without the maximum benefit from either monetary or fiscal policy, but facilitating both of these seems likely to change. The autumn statement released some amelioration of fiscal conditions.  The appointment of a replacement for the Governor is likely to give the opportunity to embrace a wider monetary stimulus, as adumbrated by FLS, as well as a more appropriate, and more flexible mandate for the MPC - a single target has never been functional. These improvements will gradually take hold over the next few years when economic growth will return, but these growth rates are likely to be lower than those prior to the boom, because of the destruction of economic capacity and the absence of the previous artificial credit stimulus. Fortunately I do not foresee a Japanese-style stasis.

The Group continues to negotiate the worst economic crisis for a century. The implementation of considered strategies should permit us to operate on a cash-neutral basis over the remainder of the depression while still affording us the possibility of realising major opportunities even while it persists.

I D Lowe
21 December 2012

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