Britain: Less Dead Than Advertised

The moral: A lot can be going right in an economy, but you won't notice it whilst zombies stalk the financial system.

The week after the Budget is not a bad time to take another look at the British economy. Were on to judge from newspaper headlines or the ex-cathedra pronouncements that the BBC mistakes for journalism you'd conclude there's little hope.

In fact, that's wrong: there's a surprising amount to like about the British economy right now: from my analysis, I think:

• Asset turns are about the highest they've ever been.
• Labour productivity has grown consistently mid-2009 and is now 2.6 Standard deviations above the 1998-2008 trendline.
• As a result of that, employment is growing – the latest data shows employment up 2.1% - and there's nothing mysterious about that strength.
• When you measure domestic demand momentum by looking at retail sales, vehicle sales and employment, you'll find the underlying 12m momentum is rising the fastest this century.

But there's one thing seriously wrong: zombie banks stalk the land plunging monetary velocity ever-lower. The unwillingness or inability to deal with the zombies immediately after the crisis of 2008/09 is by a very considerable Britain's biggest economic problem. It is truly disabling that Britain's politicians do not see this. Unwillingness to encourage and foster the development of a new and clean set of financial institutions – universally-distributed money market mutuals are the obvious vehicles – are the single major stumbling block to recovery.

Does the bullet-point list of good news seem implausible? Here's how I reach the conclusions.  

Asset Turns & ROC Directional Indicator 

First, I generate the asset-turns /ROC directional indicator in the same way as I do for any other country, by looking at nominal GDP as a flow of income produced from a stock of fixed capital, and then estimating that stock (and its changes) by depreciating all gross fixed capital formation over a period of 10 years. On these calculations, Britain's stock of capital shrank by 0.7% in 2012, whilst nominal GDP rose 1.5%, so asset turns continue to rise. In the face of rising ROC, gross fixed capital formation rose 1.4% in 2012, after shrinking 2.9% in 2011. In the absence of a major investment cycle, ROC will continue to rise during 2013.

Of course, in the face of bank deleveraging, the vigour of the investment cycle will be constrained by the limits to which investment spending can be financed by cashflow. Nonetheless, one should certainly expect investment spending to continue to rise.  

Rising Labour Productivity

Labour productivity is one of those concepts who's simplicity disappears as soon as you try to grasp it: if you are willing to overlook that, you will find current British labour market conditions baffling, with GDP basically flatlining, how can employment be expanding so vigorously? The key is this: merely looking at GDP per worker takes no account of changes in capital inputs. If workers' productivity rises are merely the result of a rising capital/worker ratio, ideas about 'effort' and the contribution of 'skill/experience' are lost. That seems wrong. So I measure GDP per worker, but deflate the number by changes in capital stock per worker. This calculation tells us that output per worker, minus changes in capital stock per worker, rose by 0.8% in 2012, having risen 1.4% in 2011 and 2% in 2010.

Now, some labour productivity gains are always experienced coming out of a recession purely as a result of operational leverage. The key point to realise is that the gains in productivity have passed that point: in fact labour productivity had regained the long-term trendline by mid-2011. By end-2012 labour productivity was 2.6SDs above that line. Breaches of that size suggest a secular change in trend – for the better - is now being discovered.

Such a change would help explain the rise in employment which otherwise might seem baffling: the number of people in jobs began to rise first in early 2010 (the initial response to rising productivity), took a breather throughout most of 2011 before rising again sharply in 2012 (as productivity broke through the trendline and kept on growing). In the three months to January 2013, employment was up 2.1% yoy, and in the 12m it was up 1.3%.

And there is another aspect to this: if investment in capital equipment is constrained by the lack of bank lending and expansion has largely to be financed through cashflow, and if capital and labour are to some extent fungible, then it may make sense for companies to take on more workers rather than buy new machinery. Ironic perhaps, but if credit constraints go hand in hand with positive cashflow, a substitution of labour for capital would allow rising employment to coexist with falling capital stock and flat GDP.

Domestic Demand: 12 Momentum Strength

Even if you have followed me so far, the next step will probably prove a step too far: domestic demand is no longer 'flat on its back' but rather has developed considerable underlying positive momentum. I freely grant that this is not obvious from recent monthly data: but this is partly because it is difficult to see through its unusual volatility. Looking at the 6ma deviation from seasonal trends, positive momentum had been maintained since May 2012 – the longest positive uninterrupted run since 2006-2007. More, this run has taken the 12m momentum to the most positive point in recent British economic history.

Such a positive reading is difficult to accept, as it runs absolutely counter to the popular economic narratives heard in the UK. Still, on a 12m basis:

• retail sales values are rising by 2.7% yoy, which is approximately the annual average achieved since 2008;
• car registrations are rising 6.4% yoy, vs a post-2008 average of minus 1.4%
• employment is up 1.3%, which compares with a post-2008 average of 0.2%.

The underlying improvement in the economic data is unrecognized both in popular economic narratives, but also in consumer confidence indicators, which show no sign of uptick at all.

The Problem: Zombie Banks

One reason is that Britain's fundamental problem remains unaddressed: its banks are still effectively zombies. This really is all over the data: in January M4 was down 0.2% yoy, the 24^th successive monthly of yoy contraction; outstanding sterling bank loans have fallen 7.8% over the last three years, and shows no sign at all of recovery; the British Bankers Assn today reported Feb mortgage loan approvals down 7.1% yoy in value.

This is no longer a matter of the net credit-worthiness of the private sector: currently the private sector holds £51bn of net deposits in Britain's banks, a reversal from the immediate pre-crisis peak net indebtedness of £293bn of October 2007. Nor is a lack of loan-demand responsible: Bank of England credit condition surveys for 4Q12 found the highest demand for both secured and unsecured lending since the immediate onset of the crisis.

Rather, the problem is that the banks are either unwilling or simply unable to lend. Having spent time in Japan, the problem is very familiar: they are simply zombies. One result is obvious: with zombies stalking the financial system, monetary velocity is unable to rise, and nominal GDP is constrained.

(Footnote about Volatility: One can, of course, set against that weak industrial data (exports, industrial production), but there's a serious caveat hanging over these data series in 2012, with the seasonal adjustment process generating a volatility quite unprecedented in both series' previous history. Faced with such an outbreak of volatility, one would naturally assume 2012's data 'comes from a different population.' Having written to the ONS about this, I can assure you that they are as puzzled/worried about it as I am. For the time being, I think you can't base an argument on this data.)