Did you see “The Full Monty?”

The film starts with a scene from a promotional film from the sixties, extolling the virtues of a booming Sheffield. At that time, the city was a prosperous industrial cluster based on one high-tech industry – steel. The scene then cuts to twenty years later, showing a derelict and deserted former steelworks. Could the same thing happen again – but with different industry in a different town? In this opinion piece, Martin Duckworth has some thoughts on the asset price cycle.

In the 1960’s, 70’s and 80’s, the UK economy was characterised by a series of stop-go business cycles. Lower interest rates stimulated demand and growth. In episodes now known by names such as the “Barber Boom” and the “Lawson Boom”, politicians could not resist letting the good times roll, until rising inflation forced chancellors to stamp on the brakes with swingeing interest rate rises.

In the 1990’s, this regime was changed. Governments introduced inflation targeting – setting interest rates to maintain constant consumer-price inflation. At first, this was done within government, and then Gordon Brown,in 1997, assigned responsibility for interest rates to an independent Bank of England. The specified target for retail price inflation was 2.5%, plus or minus 0.5%. Since then, the economy has been remarkably smooth, with no recessions and steady economic growth.

So have we seen the end of the economic cycle?

Perhaps not. We must remember that the inflationary booms and busts are a relatively recent invention, as governments learned to print money to inflate their way out of economic downturns. Before Keynesian economics, the gold standard constrained the general level of prices, much as the Bank of England constrains them today. These eras were characterised by much longer economic cycles with booms that would last longer (“the roaring twenties”, the “Second Industrial Revolution”) and busts that would also last longer (e.g. the “Great Depression” in the 1930’s, and the “Long Depression”, which lasted from 1873 to 1896!).

Are we then in an era of longer economic cycles?

Perhaps we are. Over the last twenty years, we have seen muted consumer price and earnings inflation, but rampant asset price inflation: stock markets are at or near all-time highs, land prices are high, and average house prices are at unheard of multiples of average earnings. This situation can persist for a long time, as it is self reinforcing, through several mechanisms:

• Rising house prices make people feel better off, and they can extract cash from their homes to fund current spending.

• Businesses report the growth in the value of their assets (particularly land and buildings, and intellectual property) as profits, which underpin the dividend payouts that support high share prices.

• People don’t feel the need to save because they believe that their pension assets (whether houses or shares) are sufficient to buy the services (nurses, plumbers, bus drivers, etc,) that they will need in twenty years time.

• Open economies attract immigration, like in the UK and Ireland, which pushes up the demand for housing and keeps the spiral going.

But in the very long term, asset price inflation must keep roughly in step with current price inflation: asset prices cannot keep on growing to ever higher multiples of earnings, as eventually nobody would be able to afford to buy them. As the late Herb Stein said: “If something cannot go on forever, it will stop.” Sooner or later we must expect an era when current prices rise faster than asset prices – or where asset prices fall.

We are now seeing indications that we may be reaching the limits of asset price inflation. House prices are now falling in the USA. The appetite for debt is very much reduced, after the recent inter-bank credit crunch.

At the same time, current price inflation is returning. Oil prices are at record highs. Pressures for wage inflation are kicking in, especially for public sector workers like tube drivers and doctors. The time when Chinese manufactured goods drive down prices in the West is largely over, as Chinese workers start to command higher wages. Countering these will drive up interest rates and undermine asset values.

But what has this got to do with Sheffield?

Not a lot. But we don’t have to look far for a City that is prospering on the back of a single industry. Apart from activity associated with central government, London is absolutely dependent on the Financial Services industry. This has been fed by the asset price boom. Stock markets are rising, and private equity houses have made fabulous profits by buying companies, gearing them up with debt, and selling them on.

But this whole process depends on a background of rising asset prices.

It is now very easy to construct a scenario where interest rates rise to keep the lid on consumer price inflation; asset prices start to fall; banking profits dry up; fewer City bonuses fail to support London house prices; immigration pressure eases; people start to look elsewhere for work; and houses become unsaleable. Our prediction that current prices will rise faster than asset prices comes about through restricted current prices and falling asset values.

Will this happen?

Who knows? But we can predict this or one other scenario. Either the scenario outlined above will play out for the whole country, or inflation will be allowed to let rip.

It is politically very easy for the Bank of England to keep consumer price inflation in check, when the interest rates needed to do so are lower than those needed to rein in asset prices. The political difficulty will come when the situation reverses.

Will future chancellors maintain the Bank of England’s explicit inflation targets if so doing drives the economy into a prolonged recession, and makes inevitable a collapse of house prices and stock markets? Probably not. The much trumpeted independence of the Bank of England is at risk in these circumstances. To support asset prices, interest rates will be lowered, in a classic Keynesian move, and the prediction that “current prices must rise faster than asset prices” means just that. And if Gordon Brown doesn’t do it, the electorate will choose another government that will.

What are the implications for SAMI clients?

Nobody can predict the future (despite what we say above), but the art of scenario planning is a tool to allow businesses and government to deal with the uncertainty. Our message is that recent events in the City should act as a wake-up call to scenario planners. Are your latest strategic plans based on cosy unvoiced assumptions about continued economic growth and the conquest of inflation? And do you need help in extending your portfolio of scenarios to encompass other possible, but less palatable, futures?

Martin Duckworth

September 2007