Essex Economics

Definition:

Essex economics is an approach to economics which relates all economic topics or news to the impact on house prices. It is widely followed in early 21st century England.

Example:

Newsnight sent a team to Essex to investigate the impact of low interest rates on people living on fixed incomes including savings. They returned with a report on home ownership in one Essex town and buy-to-let in another.
 

Key concepts:

In Essex economics the only investment considered is purchasing a house; commercial investment means purchasing a buy-to-let property. Interest rates are a major topic as it affects the cost of mortgages. Economic crises are synonymous with falling property values. The most watched indices for Essex economics are known as the Nationwide and the Halifax.

 

The related political economy requires politicians to promise to ensure ever increasing values for residential property. (See eg Help to Buy)

Forever Blowing Bubbles

From time to time it is good to look at the Nationwide's index of house prices to see how overvalued housing still is. I tend to follow the ratio of prices to earnings for first time buyers. This time I have put the long run average on the chart. The long run average for house prices is 3.4 times average earnings for first time buyers.

Source: Nationwide

I'm not sure that the long run average is the right measure of where a sustainable ratio should be. About 18 months ago when I looked at these figures the long run average was 3.3 times. The longer prices remain high the higher the long run average becomes. I once used a trend line from 1983 to 2003 and projected it forward. This gave a flat trend close to 2.9 times.

I previously pointed out the irresponsibility of a government boosting house prices in these conditions. It is pleasing to see that this view is widely shared, at least outside the government's supporters.

I worry more about the consequences of the next fall in prices. The best we can hope for is that house prices stagnate while earnings catch up. Unfortunately at present the opposite seems to be happening.

Update: small correction to improve clarity.

Some Last Thoughts on Saving

I have a few final thoughts on the subject of saving, before I get back to my promised posts on the three equations to explain the crisis.

Firstly, here is the World Bank series on real interest rates, posted for no other reasons than it is interesting to see, and because someone asked about the more recent data.

Source: World Bank

My other thought is what do we mean by saving. A lot of comments concern incentives to save. One idea of saving is someone putting money away for a later date. I think that is what Frances Coppola had in mind when she talked about savers complaining about low interest rates.

The savings data I have used is aggregate saving and so includes negative saving as well as positive. Positive saving happens when people consume less than their income and put the difference in the bank. Negative saving occurs when someone consumes more than their income and fills the gap by borrowing or running down their capital.

So when we think of incentives it is important to see both sides. There is perhaps here a difference of perspective. Looked at from the point of view of banks what incentivises their customers to save or to borrow is an important question. Indeed saving and borrowing are seen as very different activities. To an economist who thinks in aggregates, they are two aspects of the same thing.

The difference between banking and economic perspectives is a big topic and one I would like to explore, when work and family life allow.

One point I haven't touched on is investment, by which I mean the purchase of real capital assets. (The purchase of financial assets is a type of saving.) I tend to look at these things from a simple Keynesian perspective where income is split between consumption and saving; and saving is used to finance investment.

Savings and Real Interest Rates

Following up on yesterday's post, do higher interest rates incentivise saving? Do lower interest rates encourage people to save more to meet a savings target? Or is saving unaffected; people save what is left over after paying for everything else?

It is an empirical question, and so I have tried to find data to provide an answer. I was not happy with my first go because the data I had was for nominal interest rates. To strip out any effects of inflation I have found data on real interest rates from the world bank. Combining this with the ONS data on savings rates (via the BoE) for 1967-2009, I have produced this scatter chart.



Source: World Bank, ONS via BoE

Is there a correlation? I have put a trend line on the data, but don't take it seriously. The R squared is less than 0.01, which means that the savings rate is independent of the interest rate.

On a loanable funds model this implies a vertical supply curve, just like my old textbook said.

The same caveats as yesterday apply. This is one country over one period and done in a rush. Other empirical analyses are welcome.

Savings and Interest Rates

Frances Coppola has been writing about what determines the interest that savers earn on their accounts. On Twitter she asked what do we mean by savers, people who save out of current income or people who hold savings accumulated over time. During the discussion we got into how interest rates affect decisions to save.

To me that is an empirical question. Do higher interest rates incentivise saving?  Do lower interest rates encourage people to save more to meet a savings target? Or is saving unaffected; people save what is left over after paying for everything else?

When I studied macro we had a diagram which showed the loanable funds theory of interest rates. (The interest rate is the price that matches the number of borrowers to the number of savers.) In this diagram the supply curve was vertical, meaning that the level of saving was independent of the interest rate. I always wondered if that really was the case. As I say it is an empirical question.

Using some data I have to hand (The BoE's useful three centuries of data series). I have done a scatter chart.

Source:BoE and others

I have used long run government bond yields as an index of interest rates and the savings rate in the UK from 1948 to 2009. This data is not ideal, but it gives a quick and dirty answer. Other countries and time periods might give a different result.

The answer is that the savings rate is higher when interest rates are higher. The R squared is 0.59 suggesting that interest rates explain 60% of the increase in savings. In the loanable funds model the supply curve would be upward sloping.

The one issue I am aware of is that I have not controlled for inflation. It would be better to use real interest rates, which I will do when I can look for another data series.

Say It Again, Sam

I tweeted, early this morning, a piece by Samuel Brittan in today's FT. I quoted:

No so-called banking union will suffice while these imbalances remain

 Which chimes with my own scepticism that banking union is neither necessary nor sufficient to deal with the Eurozone's problems. Now I am fully awake I have second thoughts. Did I fall into a rhetorical trap? Here is what he meant by "these imbalances":

Since the euro was inaugurated in 1999, German unit labour costs have risen by less than a cumulative 13 per cent. During this time, Greek, Spanish and Portuguese labour costs have risen by 20 to 30 per cent, and Italian ones by even more.

Of course, banking union is not meant to deal with the problem of competitiveness diverging between Eurozone countries. You see the trap. It reminds me of a recent article by Ken Rogoff where he argued that Keynesian stimulus to demand would not work in the Eurozone; what was needed was to fix the banks. So fixing the banks will not resolve the competitiveness problem and boosting demand will not fix the banks and, I suppose, sorting competitiveness will not boost demand.

There are in fact three problems in the Eurozone:

• a financial crisis, in which many banks' solvency is questionable;
• a recession caused by a lack of demand; and
• imbalances in competitiveness (by which I mean misaligned real exchange rates).

A solution for one is not the solution to all. Banking union is intended to deal with the financial crisis, not the competitiveness crisis, and boosting demand is meant to deal with the recession. Where Sir Samuel and Mr Rogoff are correct is that solving only one problem is not sufficient as the three issues interact. So we need to stimulate demand and fix the banks and somehow deal with the effects of different rates of inflation in the Eurozone.

In the heading of this blog, I say that Equals, as in equations, will not fear algebra. I actually have in mind an equation to explain each of the problems. When I find the time I will blog on each.