Us "Gloomsters"

There's something almost cute about the optimism Simon Wolfson, chief exec of Next PLC, writing in today's Times, has for the UK economy.

"Moderation in print is harder than it looks. So an article suggesting that things are not as bad as the gloomsters would have us believe, without saying the recession is over, is a real challenge. But that is my view. The recession will still take a while to end but the worst is probably over."

This is more or less the view of the government, too. It's also the view of one of my best friends, who has bet against me £300 that in the next five years, the UK will not officially enter into a depression. Ker-ching!

Let me say right now that I would like nothing more than for these optimistic outlooks to become reality. I'm not a "gloomster" because I want to be, or because I'm particularly keen on being gloomy and depressing the crap out of everyone in any given room should the conversation turn to matters economic. It's because the "gloomsters" are right. It's because they predicted the crisis again and again. And I believe we're facing a global inflationary depression and a downturn that will last at least ten years. Sorry.

Mr Wolfson's central thesis is centred around the idea that although, yes, things may be bad, there are two economic indicators showing that it's nowhere near as bad as we are led to believe and that "the worst is probably over." I'll bite back the usual retort of where - have - we - heard - that - before? - (well actually, that's a lie, I won't bite it back; it's a very valid point that I like to continually make) but I will try to address the key points behind Mr Wolfson's unbounded optimism, and break his naive little heart, turning his optimistic smile into a gloomy frown. Sorry, Simon.

Firstly:

"Unemployment is indeed rising but crucially employment is not falling nearly as fast. Since its peak in May employment has fallen by 162,000; in that same period unemployment has risen by 401,000. So while more people are claiming benefits - and this is a headache for Government - the larger labour market means that the impact on national earnings will not be as extreme as expected."

So in the last year, unemployment has risen faster than employment has fallen. So what? Both rates are dire. Let's put this in perspective.

At the end of 2007, the Chartered Institute of Personnel and Development (CIPD) predicted that 2008 would provide "easily the worst" jobs market since 1997, forecasting growth in the labour market of only 0.25%. Now, employment is actually decreasing, that is to say, it is not growing at all but contracting. This, now, is of course not news - but placed in perspective with the last decade, it is an indicator of just how bad a state the economy is in.

As for unemployment, the fact that from February to March this year, it rose at the "fastest pace since records began", kind of says it all.

Moreover, despite pointing out the disparity between rates of employment and unemployment, Wolfson fails to draw any distinction between private and public sector employment. Before the economy crashed, our government use to like talking about the steady continuous job growth they'd overseen in the last decade - of course, all this really meant was that whenever there was a shortfall in private sector growth, the government simply enlarged the public sector to balance out the figures. The government likes "creating jobs" this way because when the public hears there are more jobs, they see it as A Good Thing. More jobs mean higher productivity, which means more stability and prosperity. Wolfson takes this view as well. Sadly, more jobs is only A Good Thing when these jobs reside in the private sector.

Jobs in the private sector are there to provide a necessary service. Companies employ people when they think they need them to succeed in the market, and they pay them according to what they think their labour is worth, coupled with how much they can afford to pay out. If they overvalue or undervalue their labour, if they have too few employees, or not enough, one way or another they will suffer competitively in the market. Thus they are incentivised to provide the best service they can, as cheaply as they can - and those who do this best are the most productive.

The public sector, on the other hand, competes with no one. It shows: for every quid we pay the State, only 50p of it reaches frontline services - the rest is swallowed by pointless bureaucracy. This would be a surefire road to failure in the private sector. And who recalls former trade minister, Lord Digby Jones, coming out against our bloated public sector? He said:

"I was amazed by how many people frankly deserved the sack - and yet that was the one threat they never worked under, because it doesn't exist as long as they have not been criminal."

And he called for half of the civil service to be culled. The government could function just as well - in fact, more efficicently - without a sizeable portion of its ever-increasing stream of penpushers and middle managers. As opposed to being employed because there are necessary roles for them to fulfil, they are employed for reasons of political expediency - and as opposed to being brought in to do specific necessary work, they are found work to do. This is not productive labour, but unproductive. More than that, it is counterproductive to the economy as a whole, because it is taking human capital (i.e labour) from the private sector, as well as just capital (i.e more money in taxes - or borrowing, for which we will eventually be taxed), to fund unproductive activities. Taking from the productive to give to the unproductive is counterproductive.

And of course, as private sector jobs slump in this crisis, the public sector is insulated from it. In fact, the public sector payroll is having names added to it. As we lose our jobs, they get more, and we're footing the bill.

Onto Wolfson's second key point, on mortgage-backed securities:

"Alongside more encouraging employment statistics it appears that the problem of bad debts is not quite the catastrophe the markets were expecting. A key indicator of this is that defaults on mortgages are nothing like as high as the depressed prices of mortgage-backed securities would suggest.

Mortgage-backed securities are large pools of mortgages lumped together by banks and sold on to investors so that the banks can raise funds. In a given pool the best 93 per cent might be classed as triple AAA. Investors who buy these securities will only lose their money if more than 7 per cent of the total loan is not paid back. A 7 per cent loss would require many more than 7 per cent of borrowers to default, because the value of repossessed properties is likely to cover a significant portion of any unpaid loan.

Let's say the mortgage loans represent a not untypical 70 per cent of the value of the underlying property, even if the properties fall in value by half the bank will recover 71 per cent of the value of its loan. So, in this example, for the AAA bonds to incur any losses an astonishing 23 per cent would have to default - that's more than one in five. That is simply not happening; repossession rates are still well below 1 per cent.
...

The conclusion must be that mortgage-backed securities are now trading at way below reasonable value. In time, the smart money will take advantage of this and banks will see the market value of their assets increase. This will free up the banks to lend more money and, slowly but surely, the banking sector will come back to life."

Mr Wolfson's stats here are dubious. To be fair, he doesn't outright say it, but the implication from his article is that your average mortgage-backed securities have a loan-to-value ratio of 70%. This is disingenuous: it's much closer to 90%. Meaning that the values of repossessed properties are going to take a fair amount less of a chunk out of an unpaid loan than Mr Wolfson supposes. Plus the sheer expense of foreclosure decreases that chunk further.

Also, most of the securities were heavily leveraged - in which case, instead of a more than 7% loss being the point at which investors lose their money, you're looking at closer to 1 or 2%.

Wolfson's conclusion that "mortgage-backed securities are now trading at way below reasonable value" is off base - the reality is everyone is playing a massive game of make-believe, and no one really knows the value of mortgage-backed securities. Previously, under the "mark to market" valuation accounting methods, the securities were valued relatively to similar assets on the open market. Those rules have since been relaxed and allowed banks to pretty much value them at whatever they fancy, irrespective of the risk of default or rate of return (very low, with interest rates as they are). Thus, the insolvent may pretend to be solvent. It's a mad state of affairs.

My hunch is that the securities are as "toxic" as the gloomsters say. But that said, liquidity could return were they to be priced reasonably - i.e. at market prices, i.e. cheap. The problem is that then we would finally see which banks were insolvent - a prospect the banks (and their new overlords, the government) can't tolerate.

On one more Mr Wolfson's rather fleeting points:

"At the beginning of this year... we also pointed out that the financial pressures on many of those still in jobs would be reduced because of lower mortgage payments and fuel and energy costs."

Does Mr Wolfson honestly believe, what with interest rates as they are and quantitative easing underway, that rapid price inflation is not on its way? It's starting tentatively at the moment - shop prices are up, and oil is back up over $50 a barrel. It's coming, slowly, but it's coming nonetheless, and sooner or later it will take off. Stagflation is on its way - rising prices but a continuing slump. Just you wait.

Mr Wolfson is not an idiot by any stretch of the imagination, and in his article he says some very wise things about the state of our public finances - but as a commenter put it on his article:

"Unfortunately this analysis has the fundamental flaw of believing that this recession is an anomaly, believing that the economic situation of the last decade was sustainable."

Of course, Wolfson is the CEO of Next. I don't say this in an accusatory manner, but it's fair to say he has a personal stake in propagating and believing himself the myth that the consumer "boom" of the past decade and a half represented anything more than the collective gorging of most of the western world on a sweet, bloated pie of easy credit, borrowed money and fake prosperity. We were off our tits on it, and now it's time for a brutal hangover.

And I certainly didn't hear any high street retailers predicting any of what has happened.

This is just beginning. See you on the other side.