Contact: Harvey Cole, (01962) 865930

1 Introduction

1.1 The following are the Independent Adviser's thoughts on the economic and financial scene, as at 22 October 2007.

2 Recommendation

That the adviser's comments be used as background to the discussions of the Panel.

3 Preliminary

3.1 On re-reading my comments for the May meeting of the Panel, I find that there is one word which should be changed. In paragraph 2.6 I said:

`That the squall passed without immediate disaster should not be interpreted to mean that there is no more fine weather ahead of us.'

An undetected typographical error substituted `fine' for `foul'.

4 Aftermath

4.1 And so it proved. Much money has flowed under the bridges since May - but the tide has not been all one way. The most extraordinary feature of the upheaval of 2007 has been the fact that the flight to quality that always seems to follow a panic has, on this occasion, been into equities - surprising in itself - but predominantly into the shares quoted on the emerging markets of the world. While the UK, America and Europe have been challenging their earlier highs for the year (London being up around 6 per cent) prices on virtually every Asian and South American exchange have soared. See the Table attached in Appendix 1.

4.2 However there are signs of continuing nervousness and the question is for how long this buoyancy can be sustained. It is reminiscent of the third of the seven stages of life in `As You Like It', with the soldier `seeking the bubble reputation, even in the cannon's mouth'.

4.3 I examine later the prospects of this shift of emphasis proving durable enough to support the world's economy and its financial markets in the face of the universally expected slowdown in the US - with particular emphasis on the role of China - but first I examine the causes and course of the summer's implosion.

5 The Rout

5.1 The orthodox explanation of events attributes virtually all the blame to the reckless selling and buying of so called sub-prime mortgages in the US. These were then `securitised' by being parcelled up together with sounder loans, with the resulting financial instruments being sold on, composed of mortgages of varying degrees of expected risk in different proportions. The theory was that this would spread risks, take the instruments out of the hands of the originating banks and finance houses (thus replenishing their coffers to make further transactions) and at the same time, offer purchasers of the new paper a higher return. The last, miraculous, ingredient was assisted by the key agencies rating the risk of default on these securities on the basis of the standing of the issuer rather than the contents of the package - which were, almost by definition, unknowable.

5.2 That is accurate as far as it goes. But it overlooks two key facts. First, the technique of bundling together debts and obligations of various degrees of risk was not confined to house mortgages. A bewildering variety of new fangled securities, parcelling up all kinds of commercial debt, flooded onto the markets. I list some of them in Appendix 2. By mid-2007 the volume of these alphabetical derivatives had reached $40 trillion - just about equal to the entire world's GDP. Clearly, the great majority of this huge mountain was simply held for yield (although a vigorous market in swapping exposures and maturities did develop) but the lack of trading meant that there was no benchmark against which their current values could be assessed.

5.3 The second problem was even more serious. Even the most sophisticated operators confessed that they were unable to understand more than a small part of this brave new world. A leading American academic commentator on finance has found that the documentation accompanying many of the contracts setting up the new-fangled securities is so complex that it is simply not cost effective to employ the necessary experts to explain just what they mean before signing them.

5.4 As has been well said, `ignorance is not evenly distributed'. So what was bound to happen was that those who understood a little, transferred risk to those who knew less. This game of pass the parcel ended up by concentrating risks rather than dispersing them. (And even where dispersal was achieved, it was apt not to have expected beneficial results because the very process made it virtually impossible to ascertain where those risks finally ended up.)

5.5 Often a risk that had been transferred out of the front door surreptitiously reappeared through the back entrance. The classic example is where a bank offloaded an instrument to a client hedge fund. If a problem arose, the fund would look to the bank for additional finance, thus in effect putting the risk back on the bank's books. Trouble was aggravated if the fund was either unable to sell the now-dubious investment (or unwilling to discover how far it had fallen below the purchase price) and instead sold sounder assets - thus weakening their price.

5.6 The scene was set for something like a repetition of the collapse of Lloyd's in the 'eighties, when many syndicates destroyed themselves by reinsuring each other, thus escalating the risks they were running faster than they could be covered by the premiums.

5.7 As credit markets tightened up because of the growing unwillingness to buy the innovative pigs because they might bring with them a traditional poke, a further new breed of investment agency - the so-called conduits and special investment vehicles emerged blinking into the twilight. These were off-balance sheet entities set up to take part in innovative trades but which turned out, when they got into difficulty, to have assurances of additional funding from their sponsoring bodies. Providing money to them further restricted the flow of finance to others.

5.8 The inevitable result was complete paralysis in the provision of credit to lubricate the financial system, and a threat that this would develop into a seizing up of commerce as well. While that immediate threat seems to have been averted, mainly through the cut in the US Federal funds rate, credit remains effectively scarcer and more expensive. The cry that `it is different this time' goes up at the beginning and end of every financial cycle - and usually turns out to be quite mistaken. But this time it seems that there is a new factor: as long as a large proportion of the credit instruments in circulation remain opaque, business will flow less than smoothly.

6 Collapse of the models

6.1 One of the biggest casualties of recent months has been the sophisticated computer model designed to exploit trading opportunities in the markets - and even, in some cases, to initiate sales and purchases automatically, on their own initiative and without human intervention. Instead of providing solutions, they have created multiple new problems.

6.2 They are primarily designed to exploit, instantaneously, tiny anomalies in the relative prices of assets and to arbitrage them away. The process has been compared to `hoovering up nickels in the path of a slowly advancing steamroller'. This is fine as long as you gauge the pace of steamroller accurately, but a single error can cancel millions of dollars worth of nickels.

6.3 Models are programmed to take account of all available information about the past, but is impossible to tell them about the future or the unexpected. The very proliferation of the new derivatives - which have yet to build up identifiable patterns of behaviour - was itself an accident waiting to happen.

6.4 Computers are notoriously both very bright and extremely stupid. They can beat world champions at chess, but in an unexpected situation, or operating against another computer with a similar programme (or in an unforeseen context) they tend to have the equivalent of a nervous breakdown.

6.5 Of course, the fault is not in themselves but in their programmers. If a model is defective, events will find it out. It is no good blaming the events themselves as an expert at Goldman Sachs did when he complained that what happened in August was `a 25-standard deviation occurring several days in a row that should happen only once every 100,000 years'. There are two fallacies here. First, if something is really to be expected every 100,000 years, it is still equally likely to happen tomorrow as in November 102007. Secondly, and more important, such a divergence from expectations ought to suggest very strongly that the model is defective. It calls to mind the remark made by Admiral Beatty at the battle of Jutland as one British battle-cruiser after another blew up and sank:

`My god, Chatfield, there's something wrong with our bloody ships today.'

In fact, the fault was in the assumptions on which the ships had been built - that armour-plating the decks against shells plunging from a steep angle was unnecessary.

6.6 No doubt, the mathematical wizards are already hard at work on a new generation of computer models avoiding the fallacy that assumes that the frequency of events in the world of finance - with its continual attempts to seek rational explanations for irrational behaviour - can be equated with the so-called Bell curve which predicts a symmetrical distribution of biological or physical variables around the average.

7 Recovery?

7.1 Meanwhile attention turns to picking up the pieces. Despite earlier pretences that the financial crisis would have no impact on the `real economy' knock-on effects are now generally accepted in terms of a slowing down in the growth of the world economy in 2008, and some redistribution of that growth. The IMF has recently signalled a decline in global expansion from 5.2 to 4.75 per cent - with the pace in the US slowing from 2.8 to 1.9 per cent. The main risk here is on the downside, as the repercussions of the collapse in the US housing market could still ramify more widely, and difficulties in accessing credit (in spite of more easing of official interest rates) could produce a further clogging up of trade.

7.2 However even a reduced rate of growth is still expansionary - a fact that is often overlooked. In particular a slowdown will still mean increases in demand for commodities and raw materials, and continuing, if lower, pressure on prices - subject to the extent to which speculative interest is built into current levels.

7.3 The key question is whether shifts in growth rates internationally will lead to a new balance or to a period of instability. As always, there seem to be two sides to every trend. The decline in the US dollar seems set to continue, with interruptions no doubt into 2008. This would help to reduce the large continuing US trade deficit - which is already contracting - but at the twin cost of higher inflationary pressure as import prices rise, and a lower stimulus to international trade to the extent that those imports decline.

7.4 If other countries, mainly in Asia and the Middle East, continue to resist pressure to let their currencies appreciate against the dollar, the burden of adjustment will fall on the Euro, thereby diminishing the scope for European exporters to contribute to the growth of global trade.

7.5 Such a pattern, while reducing the US current deficit, risks a worsening of its capital account as a lower dollar reduces the attraction of financial investment. Countering this, and the outflow of US funds abroad that has already begun, would seem to require either higher interest rates, which are likely to slow economic activity, or a much warmer welcome to foreign direct investment in US companies than has been forthcoming in the recent past. In these circumstances, a good example of being careful what you wish for, the US would seem well-advised not to persist with any arm-twisting of China to let the renminbi float higher. The inevitable further fall in the dollar is the last thing that is needed now.

7.6 At this point a closer look at the role of the emerging countries is needed.

8 Making BRICs or clutching at straws?

8.1 With growth of between 7 and 11 per cent this year, the group of so-called BRIC countries, Brazil, Russia, India and China, led by the latter, account for half the world's increase in GDP - almost in line, for the first time, with its share of global population.

8.2 The key questions are: first, whether this pace can be maintained, enabling them to take over the role of locomotive for the world economy from the US; and secondly, if they can do this, how much of the benefits will be spun off to other countries?

8.3 With European and US markets for their goods likely to flag next year, the BRIC's main opportunities in international trade lie with each other and the rest of the developing world, together of course with the prospects of increases in their own domestic consumption.

8.4 Of these components, the only one that could make a strong contribution is a strong rise in Chinese consumption. At first sight, this appears a very plausible proposition, but closer examination reveals a number of obstacles. Although the Chinese consumer has been spending a lot more - this year shows a growth in real terms of 16 per cent on 2006 - even an acceleration of this rate would not be as favourable as it sounds.

8.5 While purchases of increasingly sophisticated goods, and luxury items, have indeed risen sharply (China is the world's biggest market for Bentley's and has more than four times as many mobile phones as Britain) and household consumption has doubled since 2000, it has still fallen as a proportion of GDP, from 46 to 36 per cent over the same period.

8.6 The Chinese still save well over 20 per cent of their net incomes. And the task of diverting more of this into spending is complicated by the demands of other services on available money. Eight per cent of expenditure goes on education and the lack of state provision for medical services, insurance and pensions means that further slices of private incomes are pre-empted.

8.7 The result is that China's output is growing much faster than domestic demand, and thus is exporting a contraction in demand to the rest of the world. Even a partial reversal of this situation is likely to mean no more than a diversion of production from export markets. Although the accompanying reduction in China's trade surplus, forecast to be 12 per cent of GDP this year, would be welcome, it would continue to act as a deflationary force as far as world demand is concerned.

8.8 A further question-mark is posed by the behaviour of the Shanghai share market. The chart at the end of this report shows its movement this year. Point 1 is the January dip which was ignored by western markets and point 2 the subsequent, smaller, drop in February which triggered short-lived panic. Since then prices have more than doubled after reflecting some of the world-wide summer turbulence.

8.9 This has all the appearance of an eventually bursting bubble. The conventional view is that the Chinese market is now very much more insulated from those in the west, and that a sharp fall in Shanghai would leave London and New York virtually unaffected.

8.10 That may be so. But it overlooks another factor. Fifty million Chinese now have personal share-trading accounts and, according to The Economist, that number is increasing by 2 million a week. That means that a higher proportion of the Chinese are directly involved in the market than in Britain and, if those Americans who simply hold mutual funds are excluded, the same is probably the case in comparison with the US.

8.11 Given a correction of, say 20-25% per cent, this may indeed not create waves elsewhere - although in my view it probably would. But much more important is the blow this would inevitably deal to the buoyancy of private consumption, particularly given the extent to which trading on margin has been allowed to develop.

8.12 In summary, which the BRICs seem capable of replacing some of the momentum likely to be lost by slowing down in Europe and the US, they will not make good all that decline, and they will themselves enjoy the greater part of any benefit that is created.

9 The outlook from here

9.1 Reverting to the domestic scene, I set out some brief comments on a number of aspects.

The economy

9.2 While the economy has continued to expand at a rate of almost 3 per cent (to the surprise of many observers) a slower pace next year must now be expected. Although the previous Chancellor regularly surprised pundits by correctly forecasting faster growth than they proved possible, his luck may well not extend to Mr Darling. Export markets do not look too buoyant and domestic consumption faces a multiple squeeze from a combination of an attempted clampdown on pay rises; rising prices; scarcer credit; higher mortgage rates (even in spite of a potential cut in Bank Rate) and a possible fall in house prices. (See next note).

Housing on the turn

9.3 After many cries of `wolf' in the last three years, a fall in house prices does now seem to be well on the cards. Not merely are mortgage rates headed upwards as fixed-interest deals made two years ago expire, but lenders will be judging applications by more critical standards. Houses are already taking longer to sell, and stories of gazumping are being replaced by examples of houses being sold increasingly below the original asking price.

9.4 Even without becoming a sharp decline, this will affect sentiment and the economy. A serious point is that with inflation running so much lower than in the collapse of the late 'eighties, nominal prices have much less far to fall before owners find themselves sitting on a real loss, thus removing the (false) comfort of the price illusion.

9.5 It should be noted that, over the past 20 years, house prices here have consistently risen faster than those in the US. In real terms they have gone up 125 per cent against just over 80 per cent over there. It is true that risky and sub-prime loans seem to be running at much lower levels in Britain but as against that the fastest growing element in Northern Rock's `solid' portfolio seems to have been no-deposit 125 per cent advances on high income multiples.

Inflation

9.6 Price rises have continued to be on the modest side, but this is likely to change, although with the officially targeted CPI rising more slowly than the RPI, which is much closer to most people's perception of inflation.

9.7 Oil and food prices are the principal threats (although it should be noted that, as oil is priced in dollars, the headline $90 a barrel is some 6 per cent less than in sterling terms a year ago).

9.8 During the last oil-price surge it was widely, and correctly, pointed out that the increase in its cost was tantamount to a tax being levied by the producers. As such, unless higher oil prices were being offset by lower costs elsewhere, the effect was deflationary rather than inflationary. Precisely the same applies this time round - and also to higher prices for grains and other foodstuffs. Yet there is widespread talk of their inflationary effect and a consequent need to raise interest rates to counter this. To do so would be to fall into a delusionary trap. Higher prices will deflate demand: the task of policy is to head off `compensating' income increases which would provide the real fuel for an inflationary spiral.

Markets

9.9 On both sides of the Atlantic profit forecasts for the third quarter of 2007 are highly gloomy. Yet there has been an extraordinary rush into equities. In London the FT All-Share is up 11 per cent from its August low (and 8 per cent higher than a year ago). This is all the more striking in the light of financial stocks (which make up 37 per cent of the index) being down 7 per cent on the year (with banks off 11 per cent).

9.10 The explanation seems to be the belief that all the bad news is being pushed into the third quarter figures and that profits will rebound in the last quarter of the year and into 2008. This seems a potentially dubious proposition, redeemed only by the fact that a rising proportion of profits by London-quoted companies is earned abroad and could benefit from the relative buoyancy of some overseas operations. But it remains to be seen if this will prove enough to support continued exuberance.

9.11 There will also be a continuing shadow cast by the impenetrability of so much difficult to value paper still clogging up the markets. Hopes are being placed on the marvellously named Master Liquidity Enhancement Conduit, set up by three major investment banks with an invitation to others to join in. The aim is to acquire difficult to sell securities, loans and corporate debt from other holders, at a suitable discount to face value and gradually feed them back onto the market (or hold them to redemption) so providing additional liquidity to stimulate new trades.

9.12 The crucial point is how these securities will be valued. Current holders want them off their balance sheets but are unwilling to auction them for fear of finding how little others value them. To resort to the MLEC they must therefore expect that they will get a better price. But that will raise questions in the minds of prospective repurchasers as to how genuine the prices are. In turn doubts as to the real, clearing, price of these assets will simply be transferred to MLEC.

9.13 Trading will continue to be inhibited as long as prospective purchasers are not fully confident of the value of what they are buying and MLEC could find itself perpetuating a new round of moral hazard.

9.14 There are already doubts as to the wisdom of the Fed cutting interest rates by a full half-point in August, which triggered an explosively positive reaction - and expectations that more will follow if problems persist. Perhaps Herbert Spencer was actually wiser when he said:

`The ultimate result of shielding men from their folly is to people the world with fools.'

Section 100 D - Local Government Act 1972 - background documents

The following documents discuss facts or matters on which this report, or an important part of it, is based and have been relied upon to a material extent in the preparation of this report.

NB: The list excludes:

None