The power of discounting

Across the industrialised world house prices appear extremely high. Much of the commentary in the UK, where house prices have become a national obsession over the years, continues to bemoan the elevated level of house prices, arguing that it is unfair on the younger generation of potential buyers who have been shut out of the market. But it is not just a UK problem: The Riksbank in Sweden has been worrying about excessively high house prices for what seems like much of the last decade; the Swiss National Bank has made references to high residential property prices and even in Germany we hear concerns at the extent of valuations.

We can value house prices in one of two main ways, depending on whether you are on owner-occupier or a renter. An owner-occupier is concerned about affordability relative to their income so the price-to-income multiple is an appropriate measure. In the UK, average house prices are worth around 5x the annual income of a first time buyer versus a multiple of 3.5x over the period 1983 to 2007. On the assumption that they are unable (or do not want) to borrow 100% of the purchase price, this implies that prospective home buyers either have to save for longer to build up a deposit, or they put down a lower deposit and borrow more (i.e. they are more highly leveraged). On the basis of the OECD's data, UK house prices relative to incomes are 28% above their long-term average. But valuations are more extreme elsewhere. The data suggest that prices relative to incomes in Sweden are 44% above their long-run average; in Australia this rises to 46% and 56% in Canada (chart 1).

Renters care about their short-term rental costs relative to income, and I have used the OECD’s data on house price-to-income ratios and price-to-rent ratios to construct indices on rental costs relative to incomes. For the most part, rents appear to have grown more slowly than incomes over the last decade. Across the OECD as a whole, they are around 12% down relative to their long-term average versus 4% below in the euro zone (chart 2). But the cost of buying houses relative to the stream of rental income has increased sharply. UK house prices relative to rentals are currently 44% above their long-term average, whilst the corresponding figures for Sweden and Canada are 72% and 97%.

One of the standard arguments used to explain the elevated level of house prices is that the great recession of a decade ago impacted severely on residential construction, chopping out at least a couple of years of construction that would otherwise have been expected to take place to cope with rising populations. In the UK, this has been compounded by the lack of public sector housing, which has collapsed in recent decades. As recently as the 1970s, more than 40% of all housing completions were in the public sector. In the period 2003 to 2010 it collapsed to 0.1%. But as a couple of neat blog posts on the BoE’s Bank Underground website make clear (here and here) a lack of supply is not the whole story.

Like any asset, housing is valued according to the stream of services it yields. If we think of a dividend discount model, in which the price is determined as the future value of housing services discounted by the interest rate, it stands to reason that as interest rates collapse to all-time lows, so the discounted future value of future services (i.e. prices) will rise sharply. Housing services are valued in terms of rental income: If you buy a house and rent it out, you can directly value the income. If you buy a house to live in, the standard statistical approach is to measure the rent that you would otherwise pay to live in that house if you were a renter (imputed rent). But whichever method we use, low interest rates have clearly boosted house prices. This simple fact explains why prices have shot up hugely whilst rental costs have not – it is the power of discounting that has distorted the price-to-rents ratio. The authors of the BoE blog posts use this insight to construct a model which concludes that the rise in UK house prices since 2000 cannot be attributed to physical shortages – it is all about the interest rate.

Since it appears that for the most part, the price-to-rents ratio is further out of line with its historical average than the price-to-income ratio across the OECD, it is not unreasonable to suppose that this has been repeated across the globe. Obviously the extent to which prices diverge in different countries will depend on a variety of local factors. However, as  one respondent to the blog post noted, quoting an economist at the Australian Banking Royal Commission, ”the price of housing is a function of the demand for and supply of credit not the demand for and supply of housing.”

As a result, no amount of housebuilding is going to reduce house prices: Only central bankers can do that. However it does raise a question mark as to what happens if and when interest rates do start to rise. Reducing the discounted value of rents is likely to result in a sharp fall in house prices, and to the extent that housing forms a substantial part of household net wealth, falling house prices could squeeze consumption hard. Indeed, the severity of the 2008 recession in the US is partly attributable to the impact of falling housing wealth. At some point, some of the air will have to be let out of the bubble, even if it is still a long way off in the future. The bottom line is that some central banks will have to think long and hard about the damage that raising rates could cause and even small changes could have bigger effects than we are used to. What goes up must come down, and what goes up a long way must also come down a long way.

Five years and two referendums later

I was reminded today of the fact that it is exactly five years since the Scottish electorate voted by a majority of 55% to 45% in favour of remaining in the United Kingdom. Those were what have now come to be seen as the good old days. The decision came just two years after the 2012 Olympics when it felt like the country was pulling together. Despite concerns about the direction of economic policy, the Scottish referendum outcome reflected a decision to bury differences as the country looked to the future with some optimism.

Looking back at what I wrote at the time, I noted: “This may not be the end of the story. For one thing, given the significant swell of support for the pro-independence campaign it cannot be absolutely ruled out that they will push for a second referendum. This will add further fuel to a nascent English nationalist movement led by UKIP, which will thus set the tone for the May 2015 General Election. Once the election is out of the way, the next big item on the political agenda will be the prospect of a UK referendum on EU membership. The main lesson from the Scottish campaign is that it will cause a lot of bitterness.” I could not have foreseen in 2014 just how right that would prove to be.

It is extraordinary to think that less than two years separated the Scottish independence and EU referendums, such was the change in political sentiment during this period. The long-awaited publication of David Cameron’s memoirs, which have been splashed all over the newspapers in recent days, suggests he is deeply saddened by how the EU debate played out and he is scathing about the behaviour of colleagues such as Michael Gove and Boris Johnson during the campaign. But just as Tony Blair could never admit that the UK’s involvement in the Iraq War was a mistake, so Cameron cannot accept that he made a mistake in calling the EU referendum. He believes that a public vote was “ultimately inevitable.” But he is wrong. In early 2016, only 10% of voters believed relations with the EU were a pressing issue for the UK. It was well documented at the time that Cameron was trying to spike the guns of UKIP and I have consistently expressed the view since early 2013 that his call for a referendum was a gamble with the national interest.

Arguably, Cameron’s success in securing the "right" result on the Scottish referendum emboldened his decision to hold an EU referendum. With the benefit of hindsight maybe if the Scots had voted for independence Cameron might not have been so gung-ho about the EU plebiscite, and although UKIP would have continued to be an irritant, the rest of the country may not have torn itself apart over the EU issue. As it is, we are now in a position where the UK is only 43 days away from crashing out of the EU without a deal.

The release last week of the summary Operation Yellowhammer documents make clear the scale of the economic risks facing the UK if it does crash out without a deal. The document notes that “When the UK ceases to be a member of the EU in October 2019 all rights and reciprocal arrangements with the EU end. No bilateral deals have been concluded with individual member states [and] public and business readiness for a no-deal will remain at a low level, and will decrease to lower levels, because the absence of a clear decision on the form of EU Exit (customs union, no deal etc) does not provide a concrete situation for third parties to prepare for.” These are the outcomes that government told us not too long ago were unthinkable and now we find they are government policy.

Just to highlight the specific nature of some of the Brexit-related risks, “the reliance of medicines and medical products' supply chains on the short straits crossing make them particularly vulnerable to severe extended delays. Any disruption to reduce, delay or stop supply of medicines for UK veterinary use would reduce our ability to prevent and control disease outbreaks, with potential detrimental impacts for animal health and welfare, the environment, and wider food safety/availability and zoonotic diseases which can directly impact human health. Certain types of fresh food supply will decrease.”

In other words, the UK government’s inability or unwillingness to accept the deal negotiated with the EU last November poses potential health risks to the country’s population. These are not the hysterical ramblings of desperate Remainers – this is what the government has been forced to admit might actually happen. To further highlight the collapse in effective governance, far from preparing to meet the challenge, the government has suspended parliament in case it asks too many inconvenient questions and is now fighting a challenge to its actions in the Supreme Court. Nor does the madness stop there. For all the obvious shortcomings of Boris Johnson as Prime Minister, opinion polls suggest the Conservatives are actually extending their lead over Labour. To counter this, the Liberal Democrats have now adopted a repeal of the Article 50 notification as their official policy which is (a) unlikely to happen; (b) not particularly wise and (c) not the threat to democracy that the foaming-at-the mouth brigade would have us believe because all you have to do is not vote Lib Dem.

We live in febrile times and the anger that the Brexit debate has stirred up is not going to dissipate once the UK is out of the EU (or not). To put this into some form of historical context I have combined the post-1998 Baker, Bloom and Davis policy uncertainty index for the UK with their index covering the period 1900 to 2008 (based on a smaller sample so there are some comparability issues). Nonetheless, it shows that policy uncertainty spiked to its highest ever level in the wake of the EU referendum and even now is at levels consistently exceeded only in 1919, 1939 and 1946 (chart above). The UK economy is not merely suffering an economic shock: It is being subject to repeated convulsions which will not easily be healed. I fear it will take a generation to heal current wounds. The apparent civility characterising the Scottish referendum in 2014 seems like a lifetime ago.

A negative view of negative rates

My views on the disadvantages of low interest rates have been set out on this blog over recent years and increasingly there are indications that this view is moving into the mainstream. Indeed, across large parts of Europe the debate is not about low rates but rather negative rates. The theory of negative rates is simple enough: Banks are penalised for holding excess liquidity on deposit at the central bank and therefore have an incentive to lend it out. Whilst this policy may work for a limited period of time, it is now more than five years since the ECB lowered the deposit rate into negative territory. 

Today’s move to reduce it further to -0.5% may well be counterproductive although the ECB has finally recognised that forcing rates lower will simply impact on the bottom line of the banking sector and have introduced a system of tiering to provide some form of relief. Nonetheless, the negative interest rate policy is not having the desired effect and rather than continue with more of the same, it is time to reconsider our monetary options.

It is ironic that on the same day the ECB announced changes to monetary policy, the Swiss Bankers Association issued a strong statement decrying the SNB’s negative interest rate policy, arguing that “the societal, structural and long-term damages will become even greater the longer we find ourselves in this ‘lower forever’ environment.” SBA Chairman Herbert Scheidt argued that “negative interest rates are causing massive structural damage to the Swiss economy and disadvantages for the country’s citizens. They result in bubbles and damage the competitiveness of the Swiss economy long term because they keep unprofitable companies alive artificially. Negative interest rates also put the pensions of Swiss citizens at risk. A further lowering of interest rates would further exacerbate this issue. The longer negative interest rates remain in place and the greater the structural damage for Switzerland, the more urgent it becomes to ask from which point onwards countermeasures must be taken against negative interest rates.”

There are a lot of strong arguments there which deserve to be taken seriously. The idea that zombie companies are kept alive artificially is of short-term benefit to those who would otherwise be put out of work, but in the longer-term it hampers the efficient allocation of resources throughout the economy to areas where returns are higher. I have long argued that pension fund returns will be dampened by excessively low interest rates and a report this week highlighted that annuity rates in the UK have fallen to historic lows. Every £10,000 in the pot yields just £410 – down 12.3% from the start of the year – compared to between £900 and £1100 in the 1990s. In effect, buying an annuity to generate a guaranteed lifetime income will, in the words of pension expert Ros Altmann, “mean poorer pensioners for the rest of their lives.”

The impact of loose monetary policy on boosting financial markets to levels which look way out of line with fundamentals has been well documented. Although conventional P/E measures suggest that equities look extremely expensive in a historical context, the fact that the dividend yield on stocks is significantly higher than bond yields for the first time in almost 60 years means that investors are unlikely to dump equities any time soon (chart). By raising the net present value of housing services, low interest rates have also boosted house prices above fundamentally justified levels (a subject to which I will return). 

 

There is, of course, a risk that if markets have been inflated so much by low interest rates, any attempt to raise them will cause the bubble to deflate quickly. Central banks concerned with maintaining the stability of the financial system will be keen to avoid such an outcome. On this reading of events, the lower rates go and the longer they are maintained, the more difficult it becomes to raise them. The US may provide a counterfactual where markets continued to perform strongly despite the fact that the Fed was raising rates, but this was partially owed to the Trump Administration’s corporate tax cuts so the jury is still out.

We should not overlook the fact that central banks can only impact on the supply of credit and its price, but not demand, and we are increasingly at the point where reducing interest rates is akin to pushing on a string (to use the phrase attributed to Keynes). But I had an interesting discussion with a colleague who suggested there is nothing special about negative rates per se – the main problem is that positive rates have been baked into so much contract law that we struggle to deal with negative rates. He described a case of two identical derivative contracts where one receives a floating rate payment over the period of an EONIA contract whereas the other defines a fixed payment calculated on the reference (EONIA) rate. Both are essentially the same instrument in a world where interest rates are above zero but they are treated differently in a negative rate world because interest payments “cannot be negative” whereas the fixed payment can.

In a similar vein, the Finnish financial regulator is currently trying to assess whether it is legal for banks to pass on negative rates to retail depositors. Different countries have taken a different approach to this problem, with some refusing to levy the charge on retail customers. But this raises a question of whether depositors might simply withdraw their funds from one country and place them in another euro zone country where depositors are protected. To the extent that the period of negative rates has lasted longer than anyone initially anticipated, banks’ business models are going to have to change. Last month Jyske Bank in Denmark announced it would issue 10-year mortgages at a rate of -0.5%, although the bank will not lose money on the product since fees and other charges will be sufficiently high to ensure a profit. This may well be a template for the rest of Europe where fees and charges are likely to rise as banks struggle to make a profit in a world of negative rates.

It appears that ECB Council members were not unanimously in favour of the measures adopted today, with the central bank governors of France, Germany and the Netherlands reportedly opposed to a resumption of bond purchasing. Their views on negative rates are not known but this is an indication that northern European central bankers believe we are very near the limits of what an expansionary monetary policy can achieve. Mario Draghi may thus have delivered a poison pill to Christine Lagarde, who takes over as ECB President at the start of November. With Draghi having maxed out the credit card during his tenure, it will fall to Lagarde to deal with the consequences.

Education: Assessing the costs and benefits

The provision of education services, like health, is one of the things that the state does well. Never mind the fact that both are available in the private sector: The vast majority of us at some point or another rely on the state provision of both. But as is usually the case with such services they have also been used as footballs to satisfy various political ends. Since spending on the NHS is such a large part of government outlays, representing around 16% of total outlays, it is a subject I have covered on previous occasions (here, for example). Education also accounts for a not-insignificant proportion of spending – around 7.5% – and it is thus worth looking at some of the issues surrounding it.

My curiosity in this area was piqued by the announcement last December that the ONS is to apply a new treatment of student loans in the national accounts and public finance statistics which will have some profound effects on the data when the figures are rolled out later this month. The reason for the change is a sensible approach to tackle the fiscal illusions caused by their treatment in the accounts. But first, a bit of explanation is in order.  Student loans were first introduced in 1990 as a means of allowing students to cover their living costs. In 1998, they were extended to include loans to pay tuition fees, but in 2012 universities were permitted to increase the cap on tuition fees from £3,000 per year to £9,000 which raised the amount that students were permitted (required) to borrow. Many students can be expected to graduate with debts of around £50,000. They are expected to repay these loans over the first 30 years of their working lifetime, so long as their annual income exceeds £25,000, with interest charged at a rate of 5.4% (down from 6.3%).

As one who is old enough to have received a public grant to study at university, it strikes me as an egregious example of intergenerational unfairness and is a clear example of the law of unintended consequences. One of the reasons why the cap on tuition fees was bumped up in 2012 was to create a market amongst universities in which they could compete for students on price grounds. However, all universities decided to charge the maximum amount in order that their offerings were not perceived as inferior goods. It thus costs the same to study at Oxford or Cambridge as at Bucks New University.  The model has thus failed. It also does not make sense to me why today’s graduates, who still enjoy a wage premium over their non-university educated peers, should not simply pay higher tax generated by their well-paid jobs to repay the costs of their education as my generation did. I will accept that there may be fewer well-paid jobs about today, but the point still stands. Today’s students are being taxed twice: Once for the direct costs of tuition, where loans are charged at an interest rate 465 points above Bank Rate, and once for the higher wages which a university education (theoretically) generates.

Before coming back to the issue of student loans and public finances, an excellent article in The New Statesman questioned the impact of grade inflation on university education. This is, of course, not to denigrate the hard work that a lot of people put in to obtain their degree. But when 24% of students obtain the highest classification compared to around 7% in the mid-1990s, it is difficult not to be struck by the conclusion that there is some correlation between the need to give the customers what they want (good grades) and the increasingly extortionate amount that they pay (more on this another time). Education has thus become commoditised in a way that was previously unthinkable.

So what does all this have to do with public finances? As it currently stands, student loans are recorded as conventional loans in the national accounts – in other words, they are a public sector asset. But given the amount that students are forced to borrow and the almost usurious interest rate, coupled with the salary threshold, a large proportion of the loans will never be repaid within the 30-year timeframe. The Department of Education reckons that between 60% and 65% of the amount outstanding will have to be written off (other estimates suggest this figure could rise to 80%). Since it was never intended that the full amount of loans be repaid, it is therefore nonsensical to treat them in the public accounts as though they will be.

Accordingly, the statisticians will in future treat part of the amount outstanding as genuine loans whilst the rest will be classified as government expenditure. This will raise annual public borrowing by around £10.5 billion (~0.5% of GDP) and add almost £60 billion, or 4%, to national debt (2.7% of GDP) – see chart. It will therefore be interesting to watch out for comments around 24 September when the new data are released, arguing that the government has somehow been massaging the figures (it hasn't, but the accounting treatment has left something to be desired). However, at a time when the government has recently announced a big increase in public spending, it is clear that forecasts of UK government borrowing will be revised sharply higher in the months ahead. 

Nor is the student debt issue confined only to the UK. A VOX blog post looked at the situation in the US, where the market is far less forgiving, and concluded that high student debt burdens have a major impact on the behaviour of the debtors. Borrowers’ are constrained in their ability to take high-risk/high pay jobs “because they need to pay these loans and prefer more stable income” and find that their mobility is constrained as a result. The research also finds that “borrowers benefiting from debt relief … are also significantly less likely to default on their accounts, above and beyond their student loan accounts.”

The build-up of student debt has major implications for the wider economy and public finances. But to the extent that there are significant social externalities associated with education that have long been recognised but are difficult to measure (better heath, reduced tendency towards crime etc.), there is an argument that the government has an incentive to bear at least part of the costs of provision. In the current system where the cost burden is placed squarely on the consumer of education services, this in effect allows governments a free ride on the positive benefits it generates which is something else today's generation of students have a right to feel aggrieved about.

Brexit and the pound

Economics is the study of how people make choices under varying degrees of certainty. But it is the lack of certainty which concerns us at present as global geopolitical considerations impact on investors’ assessment of asset valuations. Here in the UK, the issue of Brexit further adds to the mix. We hear a lot about how this raises the risks to UK financial assets. However, we have to make a distinction between risk and uncertainty. As the economist Frank Knight put it almost a century ago in one of the earliest and most influential works on investment risk-taking, “there is a fundamental distinction between the reward for taking a known risk and that for assuming a risk whose value itself is not known.”

The valuation of risk underpins the insurance industry where actuaries have some idea of the possible range of outcomes. But there are some risks which we cannot hedge because we have no idea of the possible range of outcomes. Brexit falls into this category. Although there has been much concern about the fall in the pound in recent weeks, as anyone who has recently been on holiday abroad can testify, in truth it has traded in a relatively narrow range over the past three years after the initial post-referendum decline. The Bank of England’s trade weighted index, which is a broad measure of sterling’s value against a basket of currencies, has traded in the range 73 to 80 compared to a wider range of 79 to 94 in the three years prior to the referendum. Admittedly, it has traded at multi-year lows against both the EUR and USD of late but given the magnitude of the risks involved, it still surprises me that the pound has not traded even lower. Ten-year gilt yields have traded at all-time lows in recent weeks, in line with global trends, suggesting that the bond market has no real concerns about the UK government’s creditworthiness.

If we were to infer what was happening in the UK purely from watching market moves, we would not conclude that it was going through the most dramatic political crisis of modern times. One explanation for this apparently paradoxical reaction is that the markets cannot price what form Brexit is likely to take, let alone what happens in the event there is no deal, and are holding fire as a result. In other words, markets are trading an uncertain environment rather than a risky one. But we can gain some idea of currency market concerns by looking at trends in implied FX volatility, which is a measure of how much the market expects the pound to move. Three month implied GBP/USD vol has recently traded above 14% (chart above) – ahead of the 2016 referendum it was at 16% (and reached 18% in the wake of the referendum outcome). Aside from the period following the Lehman’s crash in 2008, when global assets were priced for the worst, we are close to the highest recorded levels of idiosyncratic sterling FX volatility.

Of course, the one thing that volatility measures cannot tell us is in which direction the currency is likely to move. But it is accepted that in the event of a no-deal Brexit, sterling will depreciate sharply. Since it is impossible to give any accurate assessment of how big the move is likely to be, we are reduced to taking the volatility measures as a guideline and applying a significant degree of judgement (or guesswork, if you prefer). Forecasting exchange rates is difficult enough at the best of times and these are not the best of times, so the indicative levels shown here should be treated as no more than that.

In the case of no-deal, my guess is that the GBP/USD rate will stabilise around 1.15 (a decline of around 5% from current levels) although it could initially go sharply lower to somewhere around 1.10 before recovering, if the experience of June 2016 is anything to go by. As has become evident in recent days, there is plenty of scope for upside in the event that a no-deal Brexit can be taken off the table. In the extreme case where the UK revokes the Article 50 notification the pound can be expected to rally strongly. Indeed, a simple model based on expected interest rate differentials suggests that fair value for the GBP/USD rate is around 1.50. The chart above shows that since 2016, the exchange trade has traded outside the model’s one standard error bounds which we can attribute as the risk premium baked into the currency since the referendum. Using this model as a benchmark, I reckon that this risk premium results in sterling being approximately 20% undervalued versus the dollar. 

To the extent that the currency acts as a barometer of the market’s assessment of a country’s economic health, the recent slide in sterling reflects the downbeat assessment of the UK’s prospects. But whatever happens in future, it is unlikely that current market levels reflect a stable equilibrium. Either the situation with regard to a no-deal Brexit gets worse, in which case the pound might be expected to fall further, or it improves in which case sterling’s fortunes will also recover. The events of the past few days, in which the prospect of a no-deal Brexit has at least been temporarily been put on the back-burner, suggests that there is some room for optimism. But a more sustainable recovery is unlikely until a permanent solution to the problem is found.