Monday, 22 November 2010

How do we avoid another housing crash and fallout?

Last week all eyes were focussed on the financial crisis in Ireland and the probability of an IMF bailout. The reality is that property market collapses (and in particular the domestic housing market) have led to such catastrophic financial situations in several countries. In Ireland is said that the collapse of the housing market, following a major property boom, led to huge losses for Irish banks. House prices have collapsed by up to 60% with major social dislocations. The collapse of the property market in Spain after huge construction boom has led to an unemployment rate of 20% in the Spanish economy. The worldwide credit crunch had as its genesis the losses incurred by US and UK banks in US sub-prime mortgage market with the consequent and uncertain exposure to risks and losses of financial institutions worldwide. We all know the consequences of that.

Why is it that housing seems to be the only purchase item where, if the price goes down people say “oh dear” or “how terrible” whereas if the price of food, energy, transport, wine, foreign holidays, consumer goods etc etc goes down people usually say “great”? In the UK we have had many property booms and busts most recently in the early 1990s and the later part of this decade. After a frenzy of buying and escalating house prices a property market collapse usually ensues. Over the previous years of the cycle many people will have made large financial gains from buying and selling houses but many who bought at the peak of the market suffered major financial losses and end up in negative equity and possibly bankruptcy, homelessness or both.

For the last twenty years or so I have always argued strongly that treating housing as an investment asset instead of being a purchase item essential for civilised life was a major disease of the UK and other Western countries. In choosing a house, many people would look at the financial gain they were likely to make, if they sold the house in a few years, and not its suitability as a place to live and raise a family. I also remember cautioning people who had decided not to have a pension scheme (where the financial risks are spread by fund managers) but to put all their savings into property on the basis that it was “bound to make a good return”. I wonder where they are now. Of course, economic history shows us endless example of people believing that asset prices could only go up and not come down (e.g. South Sea bubble, 1929 crash etc)

If financial losses on housing were just an individual matter then we might not need to give it too much attention since it is up to people how they invest their money and what risks they wish to take. However it is not as simple as that and these booms and busts in housing have a number of major economic and social consequences some of which include:-

• Many people and families have their properties re-possessed and are made homeless
• In some parts of the country (e.g. London) even though there can be a shortage of appropriate housing while some property stock is kept vacant since landlords are happy making capital gains without the bother of having tenants
• The rapid escalation in house prices in an area makes housing unaffordable to many people especially first time buyers.
• Borrowers, encouraged by irresponsible financial institutions, take on completely unaffordable mortgages, in order to get on the housing ladder, and ending up in calamitous financial situations
• Investment funds applied to property purchases are diverted away from more productive forms of investment
• Perhaps most importantly the financial crises that have occurred in many countries have led directly to: collapsing economies, unemployment and major reductions in public services and infrastructure.

A couple of years ago, somebody said that the seeds of the next financial crisis are already being sown in the backrooms of banks and other financial institutions by people thinking up the next dodgy product range which can be sold to naïve people at a profit.. This may or may not be the case but the question I would ask is whether now is the time to think about how we might avoid yet another housing market boom and bust with its dreadful consequences. One approach might be by trying to apply restrictions as to how much banks etc can loan to potential house buyers. Somehow I suspect ways will be found around these bureaucratic constraints by a combination of people desperate to get their own house and financial institutions desperate to lend them money. Instead I would like to suggest that the Government considers applying capital gains tax to all domestic property transactions including their first properties. Firstly, this would give a signal that housing should not be seen as an investment asset but a human right. Secondly the tax would also reduce the attraction of housing as an investment by reducing the possible gains and thirdly raise additional funds for HM Treasury. In the past such a policy would have been seen as political suicide but maybe it might be now politically possible in the current economic and political climate. Clearly the details would have to be worked out in terms of rates of tax, exemption limits etc but it is not a policy I would expect the current coalition government to be interested in. However, it is a policy which might resonate with the Labour opposition keen to create a platform for the next election whenever that might be.

Tuesday, 16 November 2010

How stupid or Machiavellian can you get?

The last set of GDP figures for the UK were trumpeted as positive news in many quarters showing as they did a 0.8% increase in GDP for the quarter. While we certainly need some good news it would be hugely naïve to just swallow these figures without some consideration of other factors such as:-

• The fact that the figures are preliminary and may change
• VAT will increase by 2.5% in January 2011 with a consequent impact on economic activity
• Much of the recent economic growth is probably due to re-stocking after recession and it is difficult to see signs of much investment led growth
• The world financial system is still in a mess and is very unstable
• Countries are already (and may continue) to adopt protectionist policies.

However, a big issue for the future of the UK economy is job uncertainty among public sector workers. We all know that the impact of the CSR could be the loss of 500,000 jobs over the next four years. However there are some six million public sector workers in the UK and we are now in a situation where, because of the way the cuts in spending are being handled, a large proportion of them (and their families) are facing considerable uncertainty over their future employment prospects and may continue to face this uncertainty for many years.

Back in September, the deputy governor of the Bank of England, Charles Bean, encouraged Britons to go and spend more to invigorate the economy. With a large proportion of public sector employees, and their families, I would suggest there is a fat chance of that happening. I would expect them to be more likely to:

• Reduce spending at Christmas
• Defer booking next year’s holiday
• Forget about buying a new car
• Cancel subscriptions to leisure clubs
• Reduce spending on a whole range of goods and services etc

While the loss of 500,000 public sector jobs might only have had a relatively small impact on UK economic activity the impact of several millions of public sector workers and their families reining in their discretionary spending could be huge especially when you also take account of the VAT increase. Furthermore, the impact on the local economies in those areas very reliant on public sector employment (e.g. Wales, the North East) could be even worse.

Why did the government choose an approach to cutting public spending which will take so long to implement and leave millions in considerable uncertainty for a long period? Probably because they wanted to try and avoid the blame for decisions about specific cuts in public services and so passed the buck to local authorities and other local agencies. Somebody once said that governments centralise in a time of growth but delegate in a time of cutbacks. How right they were.

Monday, 15 November 2010

How good is the private finance initiative (PFI)

The Private Finance Initiative (PFI) has been one of the most significant broad based public policy developments of the last fifteen years and affects substantially the delivery of public services in most parts of the public sector in the UK. PFI aimed to bring the private sector more directly into the provision of public services, with the public sector as an enabler and, where appropriate, guarding the interest of the users and customers of public services. It is not simply about the financing of capital investment in services, but about exploiting the full range of private sector management, commercial and creative skills and the delivery of certain support services. The PFI policy has been enthusiastically adopted by governments of both major political parties, and over £50bn of capital formation has taken place in the public sector through the PFI.

However, PFI has also generated a huge amount of criticism and controversy. PFI projects are supposed to demonstrate good value for money in the use of public resources compared to the publicly funded equivalent. Also some transfer of project risk to the private sector is supposed to be achieved. Some will argue that it is impossible for the private sector to do this and make a profit while others will say it is achievable through grater innovation in service design and greater efficiency in delivery

Thus a key question is how effective has the PFI policy been in achieving these (and other) objectives. Because of political sensitivities any such evaluation of PFI is a difficult task because of the lack of evidence in the public domain or a lack of reliability in using what evidence is available. Using publicly available information the author undertook a research project aimed at identifying and assessing the effectiveness of the PFI compared to traditional financing routes. The key conclusions were:-

• There is some indication that the PFI model has resulted in additional capital spending in public services over and above what might have been achieved through a publicly financed route. In other words there is some additionality achieved through PFI.
• It is often claimed that PFI is better at curtailing capital cost over-runs. The evidence suggests that capital cost over-runs might have been reduced through PFI, although the reasons for this are not clear.
• Caution must be expressed about the results of many individual PFI project evaluations because of the difficulties of accurately forecasting the costs, and the possible incentive for public sector managers to understate the projected costs of the PFI route in order to get the go ahead for a project.
• Many if not most PFI projects lack any rigorous evaluation of the impacts on service quality.
• The various “external” evaluations of PFI projects that have been undertaken have not reached a unanimous conclusion. In these circumstances, one has to wonder whether there is some bias at play, and whether the methodologies used by each evaluator are comparable.
• Health PFI projects do not seem to have done as well as PFI projects in other areas. This is possibly due the exclusion of large volumes of service activity from health PFI projects, or to the fact that health PFI projects are generally smaller in size than the average PFI project.
• PFI has succeeded in shifting large amounts of liabilities off public sector balance sheets but high levels of risk now exist,

Overall it seems that the jury is still out on the merits of PFI. Unfortunately, the jury will probably never reach a verdict because certain key information about PFI was just not collected, was manipulated for political purposes or has been lost. Hence, all we can do is ensure that for future PFI projects the data required to make an assessment of the projects is collected and is available.

Copies of the research paper referred to above are available, on request, from the author.

Are student fees the coalition’s poll tax

The vigour of this weeks protests about the planned increase in university fees seemed to come came as a surprise in many quarters. I am amazed at this surprise and it does seem to suggest a complete lack of understanding at the top of government about the impact, out there in the real world, of what is being proposed. Having heaped much of the burden of public expenditure reduction on the poor through benefits cuts the coalition government is now likely to alienate both the poor and the middle classes at the same time through student fees.

Firstly the poor. I was part of that generation who came from a working class background but gained entry to university through free student tuition, something I would not otherwise have been able to do. Remember the famous speech by Neil Kinnock some years ago “Why am I the first in a generation to go to university”. One has to come from that background to understand the psychological barriers that students from poor families face when taking on student loans at any level let alone £9000 per annum. It is no good economists harping on about the financial return to be gained by graduates from their studies (even if there is still such a return) since such students, because of their impoverished backgrounds, will worry about leaving university with a £5,000 loan let alone £50,000.

Secondly the middle classes. Many such parents were probably resigned to a bit of financial austerity to deal with the fiscal crisis. However, they never realised it might impact on their children in such a devastating way. They will now either be panicking about saving enough to put their children through university at much higher fee rates or be resigned to and upset by the fact that the children will have substantial 30 year debts to deal with on top of mortgages and sub-standard pensions.

Colin Talbot quite correctly pointed out in an earlier blog this week that it is naïve to think that increases in fees of this magnitude can take place without any impact on demand. If that was the case then university education in the UK must be one of the most price inelastic commodities ever know to humanity. Furthermore, there is another issue about whether all universities will raise their fees to the same level (i.e. the level of the cap) or whether competition will drive down fees. Earlier experience suggests all universities will adopt the same level of fees and this is, in part, another issue of market failure. The level of fees a university charges is often seen by teachers, students, parents and universities themselves as a surrogate for quality. Lower fees mean lower quality not a bargain. Why cut your own throat?

The irony of all this is that there was a perfectly acceptable and workable funding policy (originally supported by Vince Cable) which had a broad consensus of support. This was the graduate tax. Look at it this way – the state invests (at some risk) in your higher education by providing you with free up front education. The state subsequently takes a return on that investment linked to how well you do in the job market. The better you do the more you get and the more the state gets. Forget all the waffle about students who disappear abroad and don’t pay the tax – this is a side issue. The real opposition to graduate tax came from the right wing of the Tory Party who wouldn’t support any form of additional taxation even one which is effectively hypothecated to universities.

I return to my title – is this the coalition’s poll tax. The poll tax was an example of a political shot in the foot which didn’t need to happen and which caused the demise of Mrs Thatcher. The student fee issue affects so many people that I suspect opposition to it will grow as more and more people understand its impact on them and their children and the fact that there was a fairer and workable alternative available. I really wouldn’t like to be a Lib-Dem campaigner on the streets of Oldham East and Saddleworth trying to justify this one to the people of that constituency. Moreover it could now become the conduit for much wider public protests against other coalition policies which are seen as distinctly partisan and unfair. Let’s keep a close eye on the opinion polls?