The Prospector had an in-depth chat with leading economist and author George Magnus on a wide range of domestic and global economic issues. He also shared his thoughts on the UK's financial future. This is the first of four parts of the interview which will be published here in the coming days.
Jay Elwes: So the first question was about interest rates—do they need to rise?
George Magnus: Well I think there are obviously people with either kind of broad political interest or narrow interest, for example, those people who are concerned about people who have suffered from low interest rates – pensions for example, who would probably welcome the opportunity for interest rates to go back up again. They look at economic numbers, the labour market statistics particularly in the United Kingdom, certainly for the beginning of 2014, look on the face of it pretty strong. So I can understand why people want interest rates to go up and there is kind of important economic argument, that the cost of capital—what it costs people to borrow money, what it costs to invest—should bear some resemblance to something other than zero.
Having said that, the one—perhaps it is the single most important weakness in all of the kind of economic statistics—is that real incomes are still declining, as they have done since 2008. So we have not yet got a sustainable recovery, in the sense that you cannot have a sustainable recovery when real incomes are falling, otherwise whatever is driving the economy will eventually run out of steam. So I think it would be premature for the bank to raise interest rates. It doesn’t have a social welfare function, that’s someone else’s responsibility (the government), and I think it would be very, very dangerous if the bank started raising interest rates in the way that people are urging them to do.
What would the consequences be now if rates were to rise?
Well supposing the unemployment rate dropped below 7 per cent which is the bank of England’s current threshold over the next three or four months, and the bank started to raise interest rates first by 25 basis points and another 25 points and so on in its traditional way. The small incremental changes in short-term interest rates probably wouldn’t have an immediate effect on the economy, although adjustable mortgage rates clearly would go up immediately. But the expectation of rising interest rates would then have, quite a dramatic effect on level of gilt yields. So in nerdy economic parlance the yield curve, which measures the difference between short term and long-term interest rates, would then change and it’s the increase in long-term interest rates which would probably then do damage to all borrowers and to those with weak balance sheets—companies that have debts and people who have debts. And that probably would have quite a significant effect on bringing this economic expansion to a halt.
So eventually of course, we want interest rates to go up and they should go up. When people’s real incomes—when wages and salaries—are rising at an acceptable rate, but they’re not rising at all. They are falling in real terms and that’s still a big, big drag on the economy.
So could there come a moment where the governor of the bank of England, Mark Carney has to ignore his own forward guidance threshold?
[NB This interview took place the day before Mark Carney, the Governor of the Bank of England said in a BBC interview that the Bank had decided to “evolve” its view of Forward Guidance on interest rates, a comment widely viewed as breaking with the previously stated intention of raising interest rates when unemployment had declined below 7 per cent. Favourable growth and unemployment figures had made this threshold untenable.]
Yes I think he is pretty close to being at that point right now because the unemployment rate is only precariously poised above the threshold. Of course the bank has already said that there are circumstances when they would not necessarily act immediately to raise interest rates if the unemployment threshold was reached or breached. But there’s a lot of pressure—probably when the bank’s inflation report comes out next, in February—a lot of pressure really on the bank to redefine what I call “Forward Misguidance”, or to say that there are a range of indicators that the bank is looking at, which would determine interest rates to go up, and I think that real incomes should be one of those indicators because I think it would be erroneous for the bank to change its interest rate policy, unless there is a real change in real income formation.
Having said that, there are some people who the bank ought to give some sort of signalling intention, for example by raising the policy rate, the minimum lending rate for banks, maybe by five basis points, by 10 basis points, quite unusual really—the bank’s never operated in that way before. But at this extremely low level of interest rates, some people do argue that this signalling is potentially quite important. But again, we don’t really know where that would lead if it causes long term interest rates, again to rise disproportionately because of expectations that this is beginning of a trend, it could be quite damaging.
But in Westminster, there’s no such ambiguity—the PM is very happy at Prime Minister’s Questions to tell Labour on the economy: “You broke it, we fixed it.” He’s got growth and it looks quite good and the IMF has uprated us to 2.4 per cent growth for the year which is a good thing. Does this prove that Osborne was right? Is austerity vindicated?
Well it sort of depends on your point of view. If you could take the argument, and say by definition, because the economy is now growing again, and by most standards if you look at the rest of the industrial world, Britain will probably have the second highest growth rate of major countries this year after the United States. You could therefore say: “Case proven. If we had not been through the austerity we would not have this growth.”
You could make that point. You could also say that we could have been in a much better economic position if we had not gone through the austerity that we’ve already been through. The level of output in the UK is still 2-2.5 percentage points lower than it was five years ago, and the level of employment is quite high. And there is quite a lot the government would like to crow about. We haven’t really seen much real change in the level of real income growth. Investment spending: people are hopeful that it might pick up but there are no real statistics out there to demonstrate that that’s happened yet.
And the recovery we do have, really it would be churlish not to welcome it, of course it’s good news. But actually it is the wrong kind of recovery. It’s the same-old, same-old recovery, based on housing, financial services and a huge balance of payments deficit which is only going to get worse. The current account imbalance is starting now at about 5 per cent of GDP. So heaven knows what that will be in six or 12 months time.
So the worry that I think a lot of economists have—not all, but many economists have—is that it’s an unbalanced recovery, it’s kind of the same old structural recovery that we had before the financial crisis. And policy is quite unbalanced as well, everything is coming down to what monetary policies should or should not be doing and not what the government itself should or should not be doing with its own budgetary policy—infrastructure spending and other things that could happen to make the economic recovery more durable and foundations more robust. So as I said, one doesn’t want to be a naysayer about a turn in the economic fortunes of the country. But I think we need to be very careful that we don’t pitch too much expectation on it.
Do you think there is a housing bubble?
Well I think in the south east of England particularly and particularly in Greater London I think unquestionably there is a housing bubble. I think house price valuations just seem to be out of proportion to anything that we think is reasonable in relation to income or most of the denominators that we would look at, like income for example, and other measures of affordability are just ridiculously high. So I don’t think anyone would say that this is also true in the Midlands or the north west, north east of England or the south west. But obviously there is a danger, the longer this goes on, it will lead to unsound lending practices and loan to value ratios which are too high and the excessive growth in mortgage lending relative to where the income affordability capacity for most borrowers is.
So I think it’s wrong again to say that the housing recovery is good news—I mean obviously for home-owners it’s great news if the prices of their homes are going up. But we know where this kind of thing can lead and it’s not pretty. So my concern really is that, not that the government shouldn’t be doing Funding for Lending or a Help to Buy program, but that actually it’s too generic, it applies to all kinds of properties in all parts of the country, which is not necessary and perhaps undesirable and I think the Financial Policy Committee at the Bank of England, which is charged with what people call “macro prudential regulation,” should be taking a look at this. I know they said that they would at the end of the year but I really don’t see why we should wait. I think for example the Swiss have just raised or put barriers on the amounts of new mortgage loans they will prepare to offer to borrowers, to try to stem excesses in their own housing market. I think the Bank of England ought to look at that too, sooner rather than later.
Does the housing bubble pose a systemic risk?
Not yet. Most of what the banks do in this country, in terms of lending, is for mortgages, so if there is possibly a systemic problem in the banking system in Britain, that’s essentially where it’s going to be. So my view about this is, I don’t think that’s an imminent risk, the banks do have more capital, they are more liquid, they certainly are more closely regulated and supervised than they were before. And yet, the banks are pretty much unreformed when its come to behaviour, size, structure of operations and so on. And so, even though I’m not concerned about there being an imminent, systemic problem in the banking industry so soon—five years is a long time but it is quite soon after the last crisis—but it just worries me that if we are complacent about this and just let it run then in two to three years time then we could certainly have another problem.
Part two of this interview is coming soon
Jay Elwes: So the first question was about interest rates—do they need to rise?
George Magnus: Well I think there are obviously people with either kind of broad political interest or narrow interest, for example, those people who are concerned about people who have suffered from low interest rates – pensions for example, who would probably welcome the opportunity for interest rates to go back up again. They look at economic numbers, the labour market statistics particularly in the United Kingdom, certainly for the beginning of 2014, look on the face of it pretty strong. So I can understand why people want interest rates to go up and there is kind of important economic argument, that the cost of capital—what it costs people to borrow money, what it costs to invest—should bear some resemblance to something other than zero.
Having said that, the one—perhaps it is the single most important weakness in all of the kind of economic statistics—is that real incomes are still declining, as they have done since 2008. So we have not yet got a sustainable recovery, in the sense that you cannot have a sustainable recovery when real incomes are falling, otherwise whatever is driving the economy will eventually run out of steam. So I think it would be premature for the bank to raise interest rates. It doesn’t have a social welfare function, that’s someone else’s responsibility (the government), and I think it would be very, very dangerous if the bank started raising interest rates in the way that people are urging them to do.
What would the consequences be now if rates were to rise?
Well supposing the unemployment rate dropped below 7 per cent which is the bank of England’s current threshold over the next three or four months, and the bank started to raise interest rates first by 25 basis points and another 25 points and so on in its traditional way. The small incremental changes in short-term interest rates probably wouldn’t have an immediate effect on the economy, although adjustable mortgage rates clearly would go up immediately. But the expectation of rising interest rates would then have, quite a dramatic effect on level of gilt yields. So in nerdy economic parlance the yield curve, which measures the difference between short term and long-term interest rates, would then change and it’s the increase in long-term interest rates which would probably then do damage to all borrowers and to those with weak balance sheets—companies that have debts and people who have debts. And that probably would have quite a significant effect on bringing this economic expansion to a halt.
So eventually of course, we want interest rates to go up and they should go up. When people’s real incomes—when wages and salaries—are rising at an acceptable rate, but they’re not rising at all. They are falling in real terms and that’s still a big, big drag on the economy.
So could there come a moment where the governor of the bank of England, Mark Carney has to ignore his own forward guidance threshold?
[NB This interview took place the day before Mark Carney, the Governor of the Bank of England said in a BBC interview that the Bank had decided to “evolve” its view of Forward Guidance on interest rates, a comment widely viewed as breaking with the previously stated intention of raising interest rates when unemployment had declined below 7 per cent. Favourable growth and unemployment figures had made this threshold untenable.]
Yes I think he is pretty close to being at that point right now because the unemployment rate is only precariously poised above the threshold. Of course the bank has already said that there are circumstances when they would not necessarily act immediately to raise interest rates if the unemployment threshold was reached or breached. But there’s a lot of pressure—probably when the bank’s inflation report comes out next, in February—a lot of pressure really on the bank to redefine what I call “Forward Misguidance”, or to say that there are a range of indicators that the bank is looking at, which would determine interest rates to go up, and I think that real incomes should be one of those indicators because I think it would be erroneous for the bank to change its interest rate policy, unless there is a real change in real income formation.
Having said that, there are some people who the bank ought to give some sort of signalling intention, for example by raising the policy rate, the minimum lending rate for banks, maybe by five basis points, by 10 basis points, quite unusual really—the bank’s never operated in that way before. But at this extremely low level of interest rates, some people do argue that this signalling is potentially quite important. But again, we don’t really know where that would lead if it causes long term interest rates, again to rise disproportionately because of expectations that this is beginning of a trend, it could be quite damaging.
But in Westminster, there’s no such ambiguity—the PM is very happy at Prime Minister’s Questions to tell Labour on the economy: “You broke it, we fixed it.” He’s got growth and it looks quite good and the IMF has uprated us to 2.4 per cent growth for the year which is a good thing. Does this prove that Osborne was right? Is austerity vindicated?
Well it sort of depends on your point of view. If you could take the argument, and say by definition, because the economy is now growing again, and by most standards if you look at the rest of the industrial world, Britain will probably have the second highest growth rate of major countries this year after the United States. You could therefore say: “Case proven. If we had not been through the austerity we would not have this growth.”
You could make that point. You could also say that we could have been in a much better economic position if we had not gone through the austerity that we’ve already been through. The level of output in the UK is still 2-2.5 percentage points lower than it was five years ago, and the level of employment is quite high. And there is quite a lot the government would like to crow about. We haven’t really seen much real change in the level of real income growth. Investment spending: people are hopeful that it might pick up but there are no real statistics out there to demonstrate that that’s happened yet.
And the recovery we do have, really it would be churlish not to welcome it, of course it’s good news. But actually it is the wrong kind of recovery. It’s the same-old, same-old recovery, based on housing, financial services and a huge balance of payments deficit which is only going to get worse. The current account imbalance is starting now at about 5 per cent of GDP. So heaven knows what that will be in six or 12 months time.
So the worry that I think a lot of economists have—not all, but many economists have—is that it’s an unbalanced recovery, it’s kind of the same old structural recovery that we had before the financial crisis. And policy is quite unbalanced as well, everything is coming down to what monetary policies should or should not be doing and not what the government itself should or should not be doing with its own budgetary policy—infrastructure spending and other things that could happen to make the economic recovery more durable and foundations more robust. So as I said, one doesn’t want to be a naysayer about a turn in the economic fortunes of the country. But I think we need to be very careful that we don’t pitch too much expectation on it.
Do you think there is a housing bubble?
Well I think in the south east of England particularly and particularly in Greater London I think unquestionably there is a housing bubble. I think house price valuations just seem to be out of proportion to anything that we think is reasonable in relation to income or most of the denominators that we would look at, like income for example, and other measures of affordability are just ridiculously high. So I don’t think anyone would say that this is also true in the Midlands or the north west, north east of England or the south west. But obviously there is a danger, the longer this goes on, it will lead to unsound lending practices and loan to value ratios which are too high and the excessive growth in mortgage lending relative to where the income affordability capacity for most borrowers is.
So I think it’s wrong again to say that the housing recovery is good news—I mean obviously for home-owners it’s great news if the prices of their homes are going up. But we know where this kind of thing can lead and it’s not pretty. So my concern really is that, not that the government shouldn’t be doing Funding for Lending or a Help to Buy program, but that actually it’s too generic, it applies to all kinds of properties in all parts of the country, which is not necessary and perhaps undesirable and I think the Financial Policy Committee at the Bank of England, which is charged with what people call “macro prudential regulation,” should be taking a look at this. I know they said that they would at the end of the year but I really don’t see why we should wait. I think for example the Swiss have just raised or put barriers on the amounts of new mortgage loans they will prepare to offer to borrowers, to try to stem excesses in their own housing market. I think the Bank of England ought to look at that too, sooner rather than later.
Does the housing bubble pose a systemic risk?
Not yet. Most of what the banks do in this country, in terms of lending, is for mortgages, so if there is possibly a systemic problem in the banking system in Britain, that’s essentially where it’s going to be. So my view about this is, I don’t think that’s an imminent risk, the banks do have more capital, they are more liquid, they certainly are more closely regulated and supervised than they were before. And yet, the banks are pretty much unreformed when its come to behaviour, size, structure of operations and so on. And so, even though I’m not concerned about there being an imminent, systemic problem in the banking industry so soon—five years is a long time but it is quite soon after the last crisis—but it just worries me that if we are complacent about this and just let it run then in two to three years time then we could certainly have another problem.
Part two of this interview is coming soon
