economonkey

Gordon Brown’s rescue plan for the banking industry seems to have been used as a blueprint for similar bailouts across Europe and even in the US, and for now it seems like the stock markets are responding positively with record gains on most of the major markets. So everything’s peachy and happy days are here […]

Although most people have a rough idea of how the UK economy works (or, if you’re being cynical, doesn’t work), the functions of the various components and their relationships to each other can be quite elusive. We’ve covered some aspects of money on this site in the past (here, for example), but there’s more to the economy than money itself. In fact, arguably more important than money is the way in which that money is moved around the economic system of the UK.

Over the next few articles I’m going to look at each of the main institutions involved in the movement and management of money in the UK. I’ll be looking at the Treasury, the FSA, the City of London as a whole and, to start with, the Bank of England (you may have spotted the one glaring hole in this list, more important than all the rest, which I’ll cover at at a later date).

The Bank of England is not a bank in the traditional sense. You can’t deposit your money there directly, and nor can you borrow from it directly. Banks, however, can. This is the fundamental aspect of one of the Bank’s stated core purposes: to maintain financial stability in the UK economy. By lending to banks that are suffering from cash-flow problems, unusual circumstances or moronic management, the Bank can act as a buffer to prevent problems in one area of the economy spilling over into others. Hopefully.

To quote from the Bank’s own documents: “Financial stability entails detecting and reducing threats to the financial system as a whole. Such threats are detected through the Bank’s surveillance and market intelligence functions. They are reduced by strengthening infrastructure, and by financial and other operations, at home and abroad, including, in exceptional circumstances, by acting as the lender of last resort.”

You may feel a hollow laugh coming on at this point, given the last year’s experience of a crumbled, nationalised bank, a bursting bubble of overpriced housing, rising inflation - especially in food and fuel - and incomes that fail to match expenses. It doesn’t look much like financial stability, does it?

I am writing to enquire whether you have any vacancies on your strategic board for someone of my talents. I realise that it is a little unorthodox to apply ‘on spec’ for such a high-ranking position within your organisation, but I believe I have the necessary skills to further increase the profits and assets of Big Bank Plc. In this letter I will attempt to demonstrate my knowledge of the challenges and opportunities in our marketplace.

1) Who are our customers?

I understand that our most lucrative customers are those with the least awareness of financial matters; indeed, the less numerate they are, the better. Rather like the dear old PM, in fact.

If they don’t know the difference between APR and AER, if they fail to read the small print in their credit contracts - not that it matters, as I’m sure I have the necessary legal skills to make such text impenetrable - and if their limited attention is grabbed by an ‘introductory’ rate, then they are exactly the kind of people we need to target.

I think that if we closely follow that other highly successful model of commerce - drug dealing - we won’t go far wrong in attracting and retaining the right customer base.

2) How do we get people to take on more debt?

Usually on this site I write features about various aspects of the financial system, leaving Lance to concentrate on the current affairs opinion pieces. But it’s becoming increasingly difficult to remain dispassionate.

The financial system is having a bit of a wobble at the moment, rather like that earthquake that hit the UK recently, knocking a few glasses off the shelves and knocking a few minor celebrities off the front pages, at least for a day.

What has been called a ‘credit crunch’, and ignorantly predicted to be ‘over by Christmas’ (though, like the war, nobody states which year), is actually something rather more serious: in all probability it’s a return to normality. Risk is now being priced back into investments, default spreads are widening and, in general, everybody’s paying more for their money.

Which is as it should be. The last five years or so have seen a collective delusion on the part of economists, central bankers (with some exceptions), financial journalists, house buyers and consumers.

Of course interest rates will stay low (never mind inflation). Of course house prices always go up by 10% a year when wages rise by 3% (never mind the impossibility of the maths). Of course it’s different this time (no, it never is). Of course the UK has a miracle economy based on selling financial products and ever more expensive houses to each other, and doesn’t need manufacturing (unlike the Germans, for example).

To use the vernacular for a moment, it was all bollocks.

Put two economists in a room together and you’ll get three different opinions on the state and future direction of the economy. Surely economics, the dismal ’science’, could learn something from one of the true sciences, such as physics?

Certainly there have been efforts to do so, particularly among large investment banks and hedge funds, who have used quantitative analysis tools running on powerful computer systems to try to tease out the signals from the noise of price movements, taking into account thousands of different influences from interest rates to tax variations, asset prices to currency exchange rates and much more, all on the basis that there is some underlying predictability, some ‘law’ that governs price movement.

Which makes it all the more surprising that so many of them got it so spectacularly wrong; to the tune of $188 billion and counting. Why?

When people talk about ‘inflation’, they implicitly mean one of two types: price inflation or wage inflation. In simple terms, price inflation is an increase in the cost of the things people buy, such as food, furniture, fuel and so on. Wage inflation is what happens when salaries go up across the board, regardless of the type of market sector or level of job.

One type of inflation can lead into the other, with higher prices leading to demands for higher wages to compensate, then strikes, capitulation, an increase in prices to cover higher payroll costs, and around again, in what’s termed a wage-price spiral, a type of positive feedback loop.

There are various indices that measure price inflation. The UK government used to target RPI (the Retail Prices Index), aiming to keep it below 2.5%: at the time of writing it’s a whisker over 4%. But in more recent times the target has been CPI (the Consumer Prices Index), also known as the Cheap Plastic Index or Chinese Products Index by cynics, because it excludes housing costs and places quite a high emphasis on consumer electronics. Some people complain that ‘real’ price inflation is anywhere between 5% and 10%, depending on who you are and what you buy: you can check your own at www.statistics.gov.uk/pic/