Monday, 11 April 2011

Mervyn King says the rise in inflation is temporary.

Do you worry about the increasing expectations of inflation? Well, worry not, the Bank of England governor, Mervyn King, asserts it is nothing to worry about:

April 18, 2007
The Governor said that inflation had become more volatile, in line with the Bank’s forecast, and he repeated its view that inflation was likely to fall back “within a matter of months”.
21 June 2007
Our central view remains that inflation will fall back this year as the rises in domestic gas and electricity prices last year drop out of the annual comparison, and the recent cuts in prices feed through to household bills. But it is important to look through those temporary effects to the outlook further ahead.
Oct 12, 2007
The inflation report describes a benign central view of steady growth with inflation remaining close to the target,” said governor Mervyn King.
However, he anticipated that the rise in inflation would be temporary and would be due to increases in imported energy and food prices that were unlikely to recur.

12:30PM BST 17 Jun 2008
The Bank Governor indicates that the recent rise in inflation is both largely beyond his control, having been generated by international factors, and will be temporary.
16 September 2008
"Inflation has risen sharply this year, from 2.1% in December, to 4.7% in August. Inflation is ultimately determined by the pressure of money spending on capacity, which is controlled by monetary policy. But, other factors both here and in the rest of the world can have temporary implications for inflation.
16 Dec 2008
The MPC considers the direct price level effects associated with the changes in VAT to be an example of such a temporary disturbance.
British consumer price inflation rose unexpectedly to 3.2 percent in February, data showed on Tuesday, and Bank of England Governor Mervyn King said it was probably a temporary move due to sterling weakness.
it is likely that overall CPI inflation will return to target in the first half of 2009 and then move materially below it later in the year.
13 Oct 2009
"In August, Governor King forecast inflation falling 'quickly' with the chances of it dropping below 1pc as 'more likely than not," said Philip Shaw, an economist at Investec.
December 16, 2009
As the Monetary Policy Committee [MPC] learnt last year, a temporary rise in inflation, by itself, is not a good reason to raise interest rates.
6:00AM GMT 17 Feb 2010

In the letter, the Governor said the Bank's Monetary Policy Committee (MPC) expected the rise to be "a temporary deviation of inflation from the target" because of short-term factors including VAT, the volatility of oil prices, and the fall in sterling in 2007 and 2008 which is still feeding through.

May 19, 2010 - 02:19 AM
The MPC judges that together these factors more than account for the deviation of CPI inflation from target and that the temporary effects of these factors are masking the downward pressure on inflation from the substantial margin of spare capacity in the economy.

10:54PM BST 14 Aug 2010
However, Mr King has repeatedly argued that high inflation will be the temporary result of one-off shocks – including higher fuel prices and, from January 2011, the rise in VAT to 20pc from 17.5pc – while a sustained UK economic recovery is not yet guaranteed
15 November 2010
As I described in my August letter, the MPC's assessment is that the current elevated rate of inflation largely reflects a number of temporary influences
6:00AM GMT 16 Feb 2011
Mr King believes inflation should ease as "temporary" factors such as the VAT rise, the low value of the pound and rising energy prices fall away.

So, worry not. The current inflationary trend is "temporary", and will - as has been repeatedly assured for months, even years now - fall back to within its 2.0% target any day now.

Tuesday, 5 April 2011

John Law lives.

Fed's Dudley says NY Fed, money managers and banks will create swap plan

Well, excuse me for being a cynic, but I think this will work like this:

1. QE2 will be shut down, as the inflation expectations it bring with it are spiralling out of control.
2.The primary dealers will keep buying treasuries, but will repo these back to the Fed in exchange for cash.

One of the drivers of John Law's Mississippi Company bubble, was the French National Bank allowing MC equity being accepted as collateral for new debt - which would then be promptly reinvested in MC equity (repeat ad infinitum).

But, this time, instead of Mississippi Company equity eventually crashing, it will be US Treasuries.

But, of course, that's just my opinion as a cynic.

On peak oil, UK imports, and the economics behind it all.

UK oil production peaked in 1999, at a time where the oil price ran in the $10-20/barrel range. At that time, total production of 3m barrels per day (bpd) meant 1m were destined for export. At a $15 average price point, for the UK this meant total income of:

1mbpd * $15/barrel * 365 days = $5.5bn in income contribution to the British economy.

However, this doesn't factor in production cost, which is generally said to be running in the $9/barrel, when you factor in exploration, extraction, and general production costs (for the record, these have in the meantime increased to around $22/barrel for North Sea oil):

1mbpd * $(15-9)/barrel * 365 days = $2.2bn in post-production cost income contribution to the British economy. The bottom line is that the British economy via the public and private sector have overall had income emanating from the oil sector.

However, as the UK is now well past peak, imports will necessarily rise, and just at a time when oil price is spiking due to a rising demand/supply imbalance.

Last summer, BP released the current status on localized demand and supply, and it shows the demand of the United Kingdom to be gradually reduced 3-5% on an annual basis, no doubt the direct result of higher prices, which puts a limit on marginal demand. However, this fails to keep up with the decline of supply, which runs in the 6-10% bracket (General North Sea decline is around 9% annually, with some estimates all the way up to 17%!).

In 2009, the demand and supply figures for the UK were 1.611mbpd and 1.448mbpd respectively, which essentially means the need for imports is the differential (1.611-1.448=) 163kbpd. In monetary terms, this means with a current Brent price of $120/barrel, the amount of money leaving the British economy on an annual basis amounts to:

163,000 * 365 * $120 = $7.1bn.

This is not an issue at present time, but if we consider demand/supply decline rates of 4 and 8% respectively, this is the equation to consider (The equations are admittedly simplified, but the errors introduced will not be statistically significant):

fnc(year,avg_price) = ((1.611*((1-0.04)^year)) - (1.448*((1-0.08)^year))) * avg_price * 365

Assuming the price stays static at $120/barrel (which is highly unlikely), these are the figures we get (annual, and cumulative):

2010 - $9.3bn, $16.5bn
2012 - $13.0bn, $40.9bn
2014 - $15.7bn, $71.2bn
2016 - $17.6bn, $105.6bn
2018 - $18.9bn, $142.8bn

However, with a 10% annual oil price growth, this is the equation to consider:

fnc(year,avg_price,avg_price_growth) = ((1.611*((1-0.04)^year)) - (1.448*((1-0.08)^year))) * (avg_price*((1+avg_price_growth)^year)) * 365

And here are the net results:

2010 - $10.3bn, $17.5bn
2012 - $17.4bn, $48.6bn
2014 - $25.3bn, $95.1bn
2016 - $34.4bn, $
2018 - $44.6bn, $243.2bn

The bottom line is that what used to amount to a gentle financial aid to the British economy, is rapidly turning into a huge drain, which will leave the British economy struggling, increase the pressure on the welfare state and hence increase the deficit. And this is not considering gas imports, which are rapidly growing as well.

Saturday, 2 April 2011

On financing the UK budget deficit.

No-one questions a small elite sit on a disproportionate amount of the wealth in the UK:

Top 1%£688,22821% of total UK wealth
But in this post, I intend to focus on income taxation, not wealth confiscation, regardless of which arguments may exist to further this issue, if for no other reason it's a complicated topic as wealth confiscation ultimately lead to capital flight, and hence a gradually reduced gain. Introduced capital flight regulation of course would be possible, but this would with almost certainty guarantee plummeting foreign investment in the UK, and furthermore a London finance sector on board the next available flight to Zurich.

An assumption with regards to my calculations is that higher taxation will not lead to reduced motivation and brain drain, both of which lead a high income taxpayer reduction, and hence less income gained for the inland revenue, and thereby a rising deficit once again. It also assumes small business owners will not simply decide to just shut down, which would lead to a higher number of individuals on transfer incomes, yet again which would result in a rising deficit.

I finally also ignore potential effects with regards to inflation, currency valuation, and interest rates, as these would increase the length of this post significantly.

Some of the numbers are not in complete sync in terms of year - the budget is from 2011/2012, and the household figures are 2008/2009. However, since the start of the financial crisis, income figures have been largely stagnant, so the introduced error should not be significant.

A final note, as I most certainly will be accused of "protecting the bankers" and other such nonsense - no, I don't. I am simply going through the numbers as they stand, and in this regard it is important to note the the current deficit is not the result of support for the banking sector other than through added gilt interest, which amounts to no more than the statistical inaccuracies attributable to the expected 2011/2012 deficit of £122bn (keep in mind that bond interest rates are practically at all-time lows, and have been for the past few years, so any gilts sold over this period would have a low coupon rate, and also a significant amount of bonds have been bought by the Bank of England, which transfers interest paid back to the treasury).

Anyway, disclaimer out of the way - although I won't be using these as basis for my calculations, I add them here to put a perspective on numbers - here are the numbers of high income earners in the UK:
£50,000 to £70,000859,000
£70,000 to £100,000410,000
£100,000 to £200,000300,000
£200,000 to £500,00089,000
£500,000 to £1 million16,000
Over £1 million6,000

I found the following stats on households, rather than individuals, which would seem more appropriate, as often the rights of children in poverty is brought up as a main argument for a more equal wealth distribution:

The number of households in England is projected to grow to 27.5 million in 2033, an increase of 5.8 million (27 per cent) over 2008, or 232,000 households per year.
So, for 2008, the number of households in the UK is (27.5-5.8=) 21.7 million.

In 2008/09, income before taxes and benefits of the top fifth of households in the UK was £73,800 per year on average compared with £5,000 for the bottom fifth, a ratio of 15 to one. After taking account of taxes and benefits, the gap between the top and the bottom fifth was reduced with average income of £53,900 per year and £13,600, respectively, a ratio of four to one
Average income for the top 20% percentile is £73,800, or £53,900 after income taxes.

This means the top 20% of the population gains approximately:
(0.2*21.7m) * (73,800) = 4.34m * £73,800 = £320.292bn.

But this is a pre-tax figure; post-tax figure is given by:
4.34m * £53,900 = £233.926bn of potentially taxable income.

The 2011/2012 current budget deficit runs at (an optimistic estimate of) £122bn:

So for the deficit to be covered by the top 20%, 122/233 = 52% of currently post-tax incomes must be taken by the Inland Revenue. For the average top 20% household, this results in total income taxes of:

(73,800-53,900) + (53,900*0.52) = £47,928 annual tax bill
(73,800-47,928) = £25,872 total post-tax pay

Yielding an effective tax rate of (47,928/73,800) = 65%.
The current effective tax rate is (73,800-53,900) / 73,800 = 27%.

So, the actual numbers say that for the current budget deficit to be entirely solved by "taxing the rich", the effective tax rate for the top 20% income bracket must more than double, and for this to even work, it is assumed that no-one from this bracket will become unmotivated or take their business elsewhere, which is frankly a little more than a stretch.

It also completely ignores what would happen to the housing market, in the event post-tax income were to collapse for the top 20% as calculated. And if the housing market were to collapse as such, it would not only inevitably take down a lot of home owners, but also lead to lower income taxes received through stamp duties, ie a yet again rising deficit.

In other words, believing this budget crisis can exclusively be solved through "taxing the rich", with absolutely no cuts in public sector spending, is nothing short of fantasy.