The UK‘s choice – Perseverance or Printing

The UK economy grew by 1.0% in the third quarter, the fastest quarterly growth rate for five years.  After several quarters of negative data and a slump into double-dip recession, this would appear, at first sight, to be very good news.  Though the news is welcome, it cannot yet be described as good. First there are two, significant one-off items that should be stripped out; the Diamond Jubilee holiday last June is estimated to have reduced the economy by 0.5% in the second quarter.  Absent anything else happening, there would have been a statistical rebound in growth of that amount in the third quarter.  Additionally, in August the sales of Olympic tickets were estimated to have contributed 0.2% to economic growth.  This leaves 0.3% as the underlying figure for economic growth once these have been taken into account.  Rather surprisingly, in an age of government austerity, the increase in output of government services accounted for 0.36% in the third quarter, which leaves the non-government sector still in decline!

A clearer view would appear from looking at the data over the last twelve months as a whole.  Over this period, growth in the economy has been essentially zero, as it has been since the third quarter of 2008 when Lehman Brothers collapsed.  Four years of zero growth is a far better description of what has occurred than the sequence of recessions and recoveries that media headlines would imply.

The number of people employed in the UK recently reached an all-time high, beating the previous record set in 2007. However, the UK economy is actually 3% smaller than at the time of that peak in employment – this implies that productivity (the amount of output produced for each worker) in the economy has actually been falling, which is very unusual, and has been causing much head-scratching amongst economists.  The explanation comes from two sectors.  First, North Sea oil production has peaked and is becoming progressively more difficult and expensive to produce, so productivity is in decline.  The second area is financial services;  over the last five years there has been a 16% fall in measured output from banks and insurance companies with no significant decline in employment.

In a recent speech in Cardiff, Mervyn King, the Governor of the Bank of England, made it very clear that he believes that this period of zero or very low growth is likely to continue for some years.  He stated that Western banking systems had still not recognised the full extent of bad assets remaining on the books of the banks. Until the banks do this and recapitalise themselves, monetary policy alone (including QE) was not going to be able to solve the economies’ problems.  The effectiveness of QE is really limited to offsetting some of the weakness in demand that this consolidation of the banking sector would generate, rather than generating economic recovery.

Lord King’s perspective is that the policy choice for the UK (and indeed the other indebted Western countries) is between Perseverance and Printing.  As befits a Central Banker, he believes that Perseverance is the best path back towards economic growth.  This requires enduring more (un-quantified) years of near zero growth (as the banking system corrects itself and consumers and governments cut back their spending so that they can reduce their debts), while the Central Bank supports the economy through QE.  The alternative of Printing, which he would not endorse, but has been hinted at by Lord Turner, a potential successor to Lord King next year, is one of “helicopter money”, in which newly created money is handed out to the public.  This is clearly the inflationary solution to the debt problems facing Western economies.  However, it is not a solution that is yet being promoted, but the concern must be that the longer the period of low or zero growth, the more that politicians will seize on such ideas as a means of creating employment and growth, and hence votes.

It is for this reason that gold should have a key part of everyone’s portfolios, as the insurance policy that Printing overcomes Perseverance through a long period without growth.

A three dimensional view of UK financial services – regulation, price and trust

Prior to the Thatcher government’s move to deregulate the industry, UK financial services were characterised by heavy regulation, high prices and confined to a relatively small group of people who were considered specialists. Thus, you could only get a mortgage from an institution that you had been saving with for some time and where you passed an interview with the manager – then you paid the rate of interest that they said. Those wishing to save had two choices; either buy an insurance bond of some description from a salesman where the commissions and investment performance were not visible, or go to a stockbroker who would make investments for you in shares by trading with his friend on the floor of the Stock Exchange called a jobber, and then charge you a fixed, and large, commission. In summary there was a high level of regulation, prices were high but there was also a high degree of trust from the consumers of financial services towards the providers, some of which could be attributed to consumer ignorance, but bank managers and stockbrokers had a high social standing then.

The deregulation of the financial markets began in earnest in the 1980s, most famously with the “Big Bang” of 1986, blowing open the restrictive practices of the UK securities markets and allowing the banks to own and operate securities companies. A boom in house prices and the sale of council houses saw greater demand for mortgages and many more entrants into the mortgage market, which became a low-margin product used to sell a much higher-margin endowment or savings scheme to repay the capital at the end of the term. The unit trust market expanded on the back of this new demand, a bull market was well underway and suddenly everyone wanted product to supply this new demand for long term savings. As the bull market of the 1980s led into the bull market of the 1990s, more and more investment products came out and business models evolved from providing good advice to clients towards delivering sales targets. As the level of regulation declined, competition increased and pricing fell – the performance of the products was good but there was a decline in the level of trust between financial advisers and their clients, as a “product-push” mentality developed.

The post-bubble bear market from 2000 to 2003, saw US interest rates cut to 1% and a new bull market in housing. Financial innovation in securitised and derivative markets dominated by the major banks and a massive increase in financial sector gearing meant that profits from advising clients well became puny compared with the profits that could be generated by the banks from their trading books in these areas. Regulation came to be seen as inimical to innovation and capitalism itself. The bursting of this bubble that has been witnessed over the last 5 years has produced terrible returns for investors and demonstrated that very low levels of regulation, even though combined with relatively low pricing, has come at the cost of a total breakdown in trust between financial institutions and their clients.

What is needed in the next phase of history for the UK financial services sector, is a combination of 1) heavier regulation, particularly over institutions in the investment banking markets and the inherent conflicts of interest they contain; 2) the costs of this regulation  not  falling upon the ultimate purchaser of financial services and 3) new business models that are able to rebuild the trust that needs to exist in the financial services sector between an advisor and his client.

The financial services industry has to get back to a situation where the client is assured that the only interest of his adviser is to give him the best personal, financial advice. To work at its best this means advice needs to be on a fixed fee basis rather than remuneration tied to the purchase of particular products or other services. This may be revolutionary but its time has come.