4. The rate of inflation
The Monetary Policy Committee that sets interest rates is not tasked with ensuring that the value of a person's savings are maintained when placed in a bank. They are set the task of maintaining a fictitious level of growth based on the Government's data including in particular inflation. This misrepresentation of the real rate of inflation and therefore growth rates is the reason that putting money into a bank or a building society is ill advised. If the inflation figures were legitimate then the rate of return on money that was placed in a bank would have been the same as it would have been if it was invested in the stock market or in property over the last 30 years. It is clear that all Western governments have had a vested interest in maintaining low interest rates as a way of keeping their economies running. Once the rate of inflation is misrepresented the long term consequences are very serious. This falsehood has meant that putting money in a bank, a building society, or even a pension fund has been a waste of time for the last ten years as it has lost value and certainly not appreciated.
No-one other than the British Government could have believed that the rate of inflation has ever been less than 7% over the last decade and today it is clearly a great deal more than 10%. This being the case then interest rates should have remained at or above 10% for the last decade. There is every indication that the 'real' level of inflation will be over 15% by the end of 2008 yet the Government insists that the rate is less than 5%. The 'official' Government inflation rate has supposedly been between 2% and 4.5% over the last decade and the official growth rate has supposedly between 2% to 3% until very recently. What this denial of financial reality means is that the Western economies have not been growing but have in reality been in recession ever since 2000. This is a fact that no government would dare to accept but it would fit very comfortably with the experiences of businessmen throughout the Western World. It means that very few businesses anywhere in the Western World have made a profit in the last decade. They have almost all been making losses that have been hidden by false reference data. The fact that growth rates and inflation rates are so similar between Western nations, despite them having such different economies, shows that the data is routinely massaged by every government. It may be possible to wonder why this fact is not reported and why organisations like the World Bank and the IMF have not made comment. The reason is that everyone in the financial world has a vested interest in encouraging the notion of growth and success. Maintaining confidence in the system is vital. There is also the fear of all professionals of standing out from the crowd which results in the phenomenon of The Emperor's New Clothes.
There were many vested interests who wanted the level of private borrowing to rise over the last 10 years. The Government, the pensions industry, the banks and big business all stood and still stand to gain by ignoring reality. Keeping down interest rates encourages borrowing and so stimulates financial activity. If people can borrow at an official inflation rate that is only half of reality then the process can go on for a very long time. If inflation is officially 3% but in reality is 6% then the Government can claim a 'growth' rate of 3% even if there is no actual increase taking place. If inflation is officially 3% but is in reality 8% then 'growth' can still be officially 3% even though the economy is slipping back by at a rate of 2% per annum. This is the situation that has existed since Labour came into office. The British economy has been in recession ever since 2000. This fact was just disguised by cheap imports and borrowing. Nowhere in the Western World have interest rates come close to matching the true level of inflation since 2000. The idea of uncontrolled borrowing is not strange in the context of the American economy as it has lived with a massive balance of trade deficit for decades. However Britain is not in such a strong position and yet the borrowing in Britain has continued in an almost uncontrolled manner for almost a decade.
When it took office the current Labour Government arranged for interest rates to fall to a record low level to facilitate a high level of borrowing. This kept the economy running but jeopardised the whole future of society. As soon as the money supply was checked there had to be a recession. If interest rates went back to 12%, as they were not so many years ago, then house prices would have to go back to something close to pre 2000 levels with a little extra for construction cost inflation. This is one reason why the British Government can never accept the real level of inflation. If the official inflation rate was acknowledged by the British Government to be say 10% then the interest rate would have to be set at 12%. With interest rates at this sort of level most people who have taken out a mortgage since 2000 would be unable to make their repayments. The banks would then have to repossess large numbers of dwellings and the loss to the UK banks and building societies could be in the order of £700 billion. There is no way that they could sustain this scale of loss or that the British Government could bail them out. In turn this means that the British Government can never acknowledge the real rate of inflation. It also means that interest rates cannot be used to control inflation. The other problem is the unrest that there will be as people are given low wage rises that are out of step with the real rate of inflation.
The data that is used by the Government to determine inflation rates is so carefully chosen that the resulting figures are meaningless. The official inflation rate is incorrect because it omits a number of factors. The official rate of inflation is based on the consumer price index which is artificially depressed because it excludes many of the costs that people have to meet. It also uses the cost of common food stuffs and consumer items which the major retailers deliberately keep low as loss leaders or key value items. The Government's 'official' interest rate since 2000 has been far lower than the 'real' inflation rate. The lack of honesty in these calculations will increasingly become the focus of debate as the British public find that their standard of living is falling. Already the 10% difference between the Government's inflation figure and what people are experiencing in their everyday lives is causing critical comment. The Government's preferred index the Consumer Price Index has shown an inflation rate of 1.2% rising to 2% over the last decade. The old RPI rate that the Bank of England uses gives an inflation figure of slightly more. Even earlier this year the Treasury was claiming that inflation in services was 3.5% but in goods it was supposedly only 0.4%. Even today inflation is supposed to be 4.5%.
It is interesting that the Consumer Price Index (CPI) annual inflation (the Government's target measure) has recently been 3.0% yet the Retail Price Index inflation rate has been over 4.0%. The RPIX inflation rate (all items RPI excluding mortgage interest payments) was supposedly 4.0%. However the output price annual inflation rate for all manufactured products rose to 9% earlier this year while input price annual inflation rose by some 25%. The question then has to be how it is that the rate of inflation for the individual is supposed to be a fraction of that of a business. The only possible reason has to be that the Government's interest rates are totally fictitious. The simple truth was that allowing low cost goods to flood into Britain allowed the Government to claim a low inflation rate. Politicians are not in power for the long term and so their interest in the long term wellbeing of the country is limited. Exactly the same principle applies to welcoming cheap foreign labour. It is a good way to hold down wage increases in Britain. Even though the price of everyday items is soaring the Government is still insisting that the underlying level of inflation is low. This makes it clear that all official data is modified to suit the Government's agenda.
Houses are built from materials that are largely priced at local rates using local labour. Few of the items that are used in the construction of a dwelling can be imported from low cost economies. Small items can be imported but all the bulk materials have to be manufactured reasonably locally. The cost of a house therefore reflects real costs within the economy. Over the last 10 years the price of building a home has increased by about 10% per annum. Cheaper materials and lower standards were employed towards the end of this period which would confirm that the real inflation rate in the UK must have been at least 10% per annum since 2000. The level of local government expenditure has risen by 10% per annum on average over the last decade. The cost of private school fees has risen by 10% per annum. There are many other examples that all show an inflation level of 10% per annum since 2000. However there is nothing that corroborates the Government's 2 to 3% (recently rising to 4%) rate for inflation which proves that these rates have to be false. Quite how the British Government will continue to explain away an 'official' inflation rate of 3% or 4% against a background rate of 10% to 15% has yet to be seen.
The Chinese and others like them will eventually siphon up the bulk of the World's resources and wealth. If they want to earn more money as time passes then they can increase the price of their finished goods. Once the Western domestic producers have been eliminated the Chinese do not have to worry about competition. This is a simple rule of business management that would appear to have been forgotten in the West - once the competition has been driven out of business you are free set your own price. China has already reached the position where it can increase its prices so that its own inflation is passed on to someone else. The West has enjoyed the benefit of the drop in the price of consumer goods made in low cost centres for two decades. From now on prices can only rise right across the board. Already the Chinese manufacturers have started to drop the quality of the products that they are producing to meet the diminishing ability of the general public to pay.
The current Labour Government is proud that it has increased the level of expenditure on the Health Service at a rate of 8% per annum since 2000. This is a useful indicator of the real rate of inflation since Labour came into office because many branches of the Health Service are technically bankrupt. The Government's figures are also disingenuous as they hide the fact that most of the extra finance that they claim has gone into the Health Service is tax money that is being recycled. If say half of each year's 8% increase went on wages then just over 3% of the 'additional' money never left the Treasury. It was given to the Health Service in theory and taken back in theory. So a headline increase in expenditure of 8% was really only 5%. As we discuss elsewhere 3% of that was claimed back in other forms of taxation. In reality the Treasury was really only looking to take another 2% from elsewhere in the economy. The question then is where did this additional money come from? The additional money that has been spent on the Health Service since the Labour Government came to power had to come from increased borrowing by the general public. In reality the Health Service needed a minimum increase in expenditure of 10% per annum over the last decade just to match the real level of inflation. The increase in the 'hidden' Health Service debts perfectly matches this 2% shortfall.
In the late 1990s there was a large amount of money in the banking system that needed to find a home. A good way to find a use for this money was to lend it and the most obvious thing to do with it was to encourage people to buy consumer goods and property. Borrowing large amounts of money to buy houses made sense to a lot of people as long as the price of property increased at a rate that was significantly greater than the supposed rate of inflation. If the real rate of inflation had been the starting point then such borrowing would not have made any sense. Again the British Government had a vested interest in encouraging borrowing and was prepared to accept property price inflation as it kept the economy running. It was only three years ago that many leading economists were urging the Euro Zone countries to encourage their population to borrow in the same way as the population of the USA and the UK so as to get the Euro Zone moving.
France, Germany, Spain and Italy have been recording low but steady levels of growth and low inflation since 2000 but these official levels are not recognised by business managers in these countries. The reason is that the governments in these countries are also using false inflation and growth rates when they describe their economies. Every country in the Euro Zone has to fall within prescribed norms established by the European Central Bank and specified in various treaties. Having norms for the Euro Zone has encouraged all these governments to adjust their data to stay within these strictly prescribed limits. Once a block of data has been falsified going back to reality is very difficult. Correcting data that has been massaged for a decade would create such inconsistencies that it would be impossible to handle.
People have always regarded property as a good item for speculation. It has happened for relatively short periods in the past but then the increase in property prices were in balance with the real rate of inflation. For the last 10 years the notion that property prices should increase at a rate that dramatically exceeds the declared rate of inflation has not been regarded as unusual. After all there was nowhere else that money was safe. That is the reason why 70% of all the new properties in London finished in the last three years were bought for investment and not owner occupation. Interestingly this use of property for investment was true in many other countries where the rate of increase in the value of dwellings have been remarkably similar.
Investing in businesses listed on the stock exchange has not been particularly attractive since 2000 and has only improved recently largely because there are few other places to invest money. All listed companies need to be able to claim year on year 'growth' above the rate of inflation but then if the rate of inflation is false then many of the claims of corporate growth over the last decade have also been false. The 'growth' in the profits of most companies since 2000 has really been due to understated inflation figures. If the companies in the Footsie Top 100 had expressed their profits against a background inflation rate of 7 to 10% over the last decade, most would have been reporting losses after inflation. Once again this is what business managers have been feeling over the last decade although the major listed companies would never admit it.
The current outcry about the price of oil is largely an inevitable response to the fall in the value of the dollar. The Unites States only produces a small part of the oil that is consumed in the world. However oil is priced in dollars. The countries that produce oil still expect to receive the same monetary value for their oil so that they can meet their own commitments. If the value of the dollar drops then the price of the oil should logically rise by a proportionate amount. The same logic will apply to a number of other commodities that are also, in a large part, traded in dollars. For example the USA is the World's largest producer of maize. It is only logical that if the value of the dollar falls that the price of maize on the open market should rise. When calls are made to find money to help reduce the cost of basic food stuffs for poorer countries all that will happen is that the extra money will offset, in part, the fall in the dollar.
Everyone uses electricity and are well aware that prices have risen by an average of 19 per cent over the last year. Grocery bills have risen by an average of 23 per cent over the past year but individual items have risen much more. This is partly due to speculation but also to the restricted inflation working its way out of the supply chain. Prices were held down because a status quo had been established. The sudden drop in the value of the dollar and the rise in the price of fuel caused a shake out in the supply chain. A lot of currencies are tied to the value of the dollar. When the value of the World's premier currency plunged a lot of 'wealth' was lost. Many companies in the supply chain needed to make good at least some of this loss and this has been done by increasing the price of their products. The fact that say peas or wheat are produced in Western Europe for consumption by Europeans does not matter because they are valued at the World price. There may be a speculation spree, be it in oil or wheat, but it is because there is nowhere else for the money to go. Gambling on a rise in property prices no longer works so gambling on other commodities is another outlet for the money.
The current spate of commodity price increases is often attributed to the principles of supply and demand. However these principles were always very general and are not applicable to a world where it was possible for markets to respond instantly to just the perception of a change. In Britain in the last forty years there have been shortages of fuel, sugar, bread and toilet paper brought about largely because the general public decided to hoard these basic essentials. This sort of behaviour is not supposed to happen but when it does the principles of supply and demand go out the window.
Even today the British Government would appear to be confused about how supply and demand applies in the modern World. A good example of this was a report published a couple of years ago entitled The Barker Review of Housing. The financial analysis of the housing market would have done justice to a thirteen year old. No mention was made about the fact that the price of a dwelling has more to do with the willingness and ability of the banks and building societies to lend money than anything to do with the operation of a free market. It made no mention about the fact that interest rates had been manipulated to encourage borrowing and as a result 'growth'. It certainly made no reference to the effect that an increase in interest rates would have on the construction industry or the financial institutions that were imprudently lending money at that time. The misery that had to eventually befall millions of people when the market finally corrected itself received not a mention although the behaviour of the market was easy to predict.
The basic principle of supply and demand only works in theory and in the modern market only a tiny change in supply has a huge impact upon price as there are computers programmed to look for the slightest fluctuations even if they are not real. If there is any indication that there could be a shortfall in the supply of any commodity and prices rise out of all proportion to the reality of the situation. The gentle adjustments that the principle of supply and demand says should happen do not happen in the modern world. A few decades ago the principle of supply and demand might have applied in a very general way but then there were always buffers in the supply chain. In the case of say leather shoes the man who killed the animals had some slack in his business. The man who cleaned and prepared the hides had slack. The wholesaler who collected the hides together had slack and there was always the need to move the consignment around the world. Then the domestic wholesaler had slack, the manufactures of the shoes had slack, and the retail mechanism had slack. Communication between the beginning and the end of the supply chain was very restricted. With agricultural produce like wheat there was always slack with the silos only being emptied just in time to prepare for the new harvest. Grain was being transported and there was always some being held over to the following year in case of a poor crop. The ultimate buffer was the millions of farmers who kept some grain on their farms to take advantage of the peak prices that were always available towards the end of winter. Today there is no real buffer and the price of grain can change instantly in response to the World price all thanks to computers.
Fifty years ago Western governments used to ensure that there were strategic reserves to protect their people against extreme fluctuations in supply and in case of wars. The current increases in the price of fuel would have been far more extreme if it was not for the fact that at least some governments have strategic reserves that might be released and so damage the speculator. However, with only a few exceptions like fuel, there are no longer reserves in place. Maintaining such reserves was expensive and all that governments have been interested in over the last thirty years has been to make every saving possible to keep down the cost of living for their electorate.
There will be violent movements in the price of food stuffs in the coming years because there are no buffers in place. The Egyptian and Roman Empires understood the importance of ensuring that the granaries were full at the end of summer. There are always peaks and troughs in the food production system but with buffers in place and with a world that worked in distinct zones matters balanced themselves out without too much pain. Today the World has less than 3 months worth of food reserves. A volcanic eruption followed by a cold summer and these reserves would not be replenished. A particularly bad El Nino and the reserves could be exhausted before the next major harvest. In 2007 the summer was very dry across parts of Eastern Europe and the maize and sunflower crop were a disaster. In 2008 parts of Western Europe were very wet and the wheat and barley crop was very poor. Such vagaries will cause ever more difficulties in the future with systems that are stretched too tight.
As far as the consumer is concerned there is also the ratchet principle at work. Once prices have risen there is a great reluctance on the part of anyone in the supply chain to acknowledge that the prices have fallen back. If the commodity is very 'perishable', strawberries would be a good example, the product has to be sold very quickly otherwise it has little or no value. However oil and grain can be kept for some time provided that there is the capacity to do so. Some of the speculators that have registered a loss when prices fall back will wait hoping to recover their position. There are special exceptions e.g. if the price of wheat falls so the price of bread might fall if a major large supermarket chain uses bread as a loss leader. However in most cases the supermarkets are reluctant to pass on savings in the supply chain. The supermarkets just put the gains into their bottom line which has been a continuing complaint of farmers over the last two decades. The result is that retail prices continue to rise as the ratchet works. Only if all the major governments of the world were to reinstate massive strategic reserves would these problems be solved and no Western government has the money or power to order this. The only exceptions might be India and China, plus a few other countries that are prepared to stop exports to protect their people. This sort of action causes even more extreme commodity swings in the free market as Western Nations are not able to play this game.
Published: August 2008