From Rev Prof E. Philip Davis.
Sir, In the debate surrounding the likely rise in rates of UK capital gains tax, one aspect that has been little addressed is its likely impact on the housing market. Since higher CGT reduces the attractiveness of housing as an investment asset (in the case of buy-to-let and second homes), it seems likely that house prices will be lower than would otherwise be the case. While most media and public opinion proclaim higher house prices to be a “good thing”, this seems to ignore the plight of non-owner-occupiers, for whom higher house prices entail a larger financial burden for first-time buyers and higher rents for tenants.
These are in effect forms of wealth transfer to owner occupiers, which can be seen as both socially unjust and economically inefficient. Such transfers, which bear particularly on the coming generation, may aggravate likely future intergenerational frictions arising from lower levels of pensions, obligation for repayment of government debt and high levels of student debt that the "baby boom" cohort has effectively imposed on its successors.
Of course, higher rates of CGT will only begin to address the issue of chronically high UK house prices relative to average incomes (where for example in the first quarter of 2010, the Nationwide house price/earnings ratio for first time buyers was still 4.4, well above its long-term average of 3.5).
Further progress would need to “think the unthinkable” for reducing housings’ privileged status, in terms of massive release of land for development, revision of exemption of CGT from primary residence and/or imposition of income tax on the imputed rent from owner occupation (as was the case in the UK under “Schedule A” until 1963).
E. Philip Davis,
Senior Research Fellow,
National Institute of Economic and Social Research,
London SW1, UK
In supporting the government's scheme for road pricing, I contend that John Nugee (FT, 13th June) is too complacent about the serious civil-liberties implications of the currently-proposed scheme, and also ignores broader economic implications that warrant analysis and discussion.
In the UK, which has no written constitution to protect civil liberties, there is already a proliferation of CCTV cameras, whose passive acceptance by UK citizens astonishes many from abroad. There is a proposal for ID cards that would fundamentally change the relationship between citizen and state, entailing address registration and police checks contrary to British tradition. On top of these, the road pricing scheme would introduce a surveillance system which would detect citizens' movements in their cars at all times. The people of the UK seem to be blissfully unaware of the loss of privacy likely to be entailed, and the degree to which future governments will be invested with potential powers of social control, that may well one day be abused.
In respect of economic consequences, one can foresee major redistributions of income across the UK, notably from the congested South East to the outlying, uncongested, areas of the UK. This is because the incidence of tolls will be much less evenly-distributed than that of petrol taxes and road fund licence duties. Transfers of income between regions could be equivalent to several percent of GDP, on top of those already inherent in the existing tax and benefit system. Second, there is likely to be major disruption for businesses that rely on long distance car commuters, e.g. in the home counties. Their employees would either resign on account of impossibly high costs of travel, or demand wage rises hampering cost competitiveness. This could impact on the wider economy. Third, house prices in areas most afflicted by high tolls can be expected to fall sharply while those in areas with low tolls will rise, thus redistributing wealth as well as income in an unforeseen manner.
Incentives on a political level also warrant consideration. For example, could the system be vulnerable to political gerrymandering, whereby local areas might have alleviation of tolls - once they vote for the right party? Would there even be a direct disincentive for public authorities to make investments in roads that could alleviate congestion, as that could reduce government revenue?
In my view, it is not even clear that there will be beneficial effects on the environment, since low petrol costs will encourage use of inefficient large vehicles in uncongested areas. Admittedly, this could be partly offset by lesser pollution from traffic jams, and perhaps less journeys in congested areas not merely due to higher average tolls but underlying uncertainty how much a journey will cost.
I conclude that the scheme as proposed is wholly undesirable.
Professor E Philip Davis
From Prof E. Philip Davis.
Sir, The proposals announced on Monday by Gordon Brown for aiding first-time buyers by having the government share in the housing equity along with the lender, while having obvious political attractions, would seem to be fraught with dangers ("Brown proposes help for first-time buyers", May 23).
Introducing such a scheme when house prices are, by most estimates, up to 30 per cent above their equilibrium levels (based on income, interest rates and, in some cases, demographics and housing supply) would seem likely to perpetuate or even increase the misalignment. The eventual correction when an inevitable "shock" to confidence occurs could hence be yet more painful.
Furthermore, moral hazard can arise from this policy at a number of levels. The most obvious is that belief may grow in the existence of a "Brown put" at a macro level, whereby the government is expected to introduce measures to underpin the housing market, for fear of negative equity, whenever a fall is likely. The history of the "Greenspan put", which extended the equity price bubble in the 1990s and thereby aggravated the correction, is a painful reminder of the related dangers.
Second, there may be moral hazard vis-à-vis the borrowers, who may hold the government responsible for any future negative equity, given its "agreement" in the original price paid for the property. Third, the lenders may feel over-confident as a consequence of the government's involvement and hence fall into excessively lax lending practices; the abuses of the savings and loans crisis in the US spring to mind.
Finally, such schemes, once introduced, are hard to reverse and might be subject to pressure for extension. This raises the question, How much housing equity (which could, in some cases, be negative) is it wise for the government to hold?
While it may sound harsh, first-time buyers would in my view be better served by allowing prices to return to more affordable equilibrium values, as well as reducing the equilibrium itself by allowing supply to expand.
E. Philip Davis, Economics and Finance, Brunel Business School, Brunel University, Uxbridge, Middlesex UB8 3PH
Amid much talk of crisis, Adair Turner, ex-CBI boss and head of the government's Pension Commission, will report on Tuesday on the scale of the nation's retirement savings shortfall. But just how worried should we be? E Philip Davis, professor of economics and finance and Brunel University*, takes a dispassionate look at the issues.
The UK pension system has traditionally been seen as successful.
High take-up of voluntary private pension schemes and a low burden of social-security pensions are rightly seen as major advantages, compared with the generous but unsustainable social security pensions offered in France and Germany.
Britain is also ageing more slowly than much of Europe, which eases the provision of retirement income during the coming demographic transition to an older population.
Not everything is rosy, however. There are widespread deficits in final-salary schemes following the collapse in share prices earlier this decade, and many such schemes have been closed to new entrants. Companies are tending to offer vastly inferior money purchase plans to new staff, to which companies contribute far less.
There is also ongoing adverse publicity from the mis-selling of personal pensions and the more recent failure of Equitable Life.
Ups and downs
Little wonder, then, that there has been a loss of public confidence in long term saving, which is resulting in inadequate provision for retirement. Many people appear to be taking risky bets on house price trends to "assure" their pensions.
There is at least some relief: a recovery in share prices and sufficient topping up by firms will eliminate the current deficits, and memories of current scandals will fade.
But my analysis suggests that there are longer-term weaknesses of the system.
At the root of the problem are two factors: an excessive reliance on voluntary funded schemes, the result of inadequate public pension; and state reliance on means-tested benefits to assist those on low retirement incomes.
Means to an end
It is easy to see how these long term weaknesses are aggravating the current malaise.
Retirement incomes are highly exposed to asset price volatility, as revealed by the current deficits. Furthermore, since funded pensions are so important they have to be price-indexed, the burden of which further encourages firms to abandon the final-salary model.
The many elderly who rely on low state pensions, but who resist means testing, suffer incomes below the poverty line.
Worse, there are major disincentives to save for those likely to be affected by means testing in future, since the better-off will lose state benefits. Means testing even deters financial institutions from selling low-income households pension products, lest they be accused of mis-selling in the future.
Reform to perform
Although there have been some reforms, such as stakeholder pensions, they have been insufficient. More fundamental reform is also necessary. Two alternatives should be widely considered:
A boost in the basic state pension to levels typical of countries such as the Netherlands and the US - roughly 30-40% of average earnings. This would be combined with an elimination of means testing, which would boost voluntary pension saving. Although the overall cost of universal provision would be higher, the income tax system would return much of the benefit from higher income earners to the Exchequer and there would be large reductions in administrative costs. Also, retirement ages could justifiably be linked to longevity, reducing fiscal costs.
Compulsory contributions to private pensions, including compulsory and sizeable employer contributions. Switzerland and Australia are among those that adopt this approach. Compulsion is needed if individuals otherwise fail to be look ahead in their pension saving. Besides mandating saving, compulsion would also avoid the biases in coverage of high-quality private pensions (towards men, high earners and so on) that tend to occur when schemes are voluntary. To be successful, any such reforms would need bipartisan support and stability, which have been absent to date.
Successful reform would require an overall view to be taken of the impact of government policies on pensions, which also appears sadly lacking at present. For example, the high student fees now being introduced may deter individuals making sensible savings decisions at the beginning of their working lives, particularly in money purchase schemes where early contributions are the most remunerative.
* E Philip Davis is professor of economics and finance at Brunel University, West London. He is also a fellow of City University's Pensions Institute, a visiting fellow at the National Institute of Economic and Social Research, an associate member of the Financial Markets Group at the London School of Economics and an associate fellow of the International Economics Programme at the Royal Institute for International Affairs.
It is healthy for democracy to debate crucial issues, and hence I am pleased that my letter of June 18th provoked a copious response. Unfortunately, with respect, I contend that the responses fail to address the key risks to the UK economy from leaving the EU, which I accordingly expand upon here for the benefit of interested readers:
The views expressed are too static - economies evolve. We live in a globalised and dynamic world where countries prosper by attracting investment by multinational enterprises - and retaining at home the footloose investment that is undertaken by large domestic firms. All the evidence (from a UN report of 1993 to myriad economic analyses) shows that EU membership stimulates foreign direct investment (FDI) in a country, given the access it provides to a barrier-free single market, and accordingly, leaving the EU would reduce such investment. Besides the short term macroeconomic impact of a decline in investment (i.e. a recession and related job losses), there would be a long term cost to the UK economy from loss of FDI, because it is a key means whereby the economy benefits from new ideas, working practices and technologies. Hence, besides a temporary rise in unemployment, EU withdrawal would lead to lower UK productivity with a permanent and sustained loss to national output. Pain and Young (Economic Modelling, 2004) calculate that the UK would lose a third of inward manufacturing investment, somewhat less in other sectors. Export performance would also decline, due to loss of FDI. Even allowing for reduced budgetary payments and lower food prices, this would in turn imply a permanent loss in GDP of 2-3% per annum, as well as 75,000-160,000 job losses in the short term.
I contend that this is likely to be an underestimate. Business investment is highly sensitive to uncertainty, as uncertainty gives a value to the option of delaying a project, a delay which with changing circumstances may become a cancellation (see the survey of empirical work by Carruth et al, Journal of Economic Surveys 2000). The prospect of leaving the EU, and even more, its realisation, would generate major uncertainty on the part of both UK and foreign firms, leading to yet lower investment. This will both deepen the initial recession and lead to permanently yet lower levels of fixed capital and productivity in the UK. We have already had a foretaste of this, as foreign direct investment has declined since it became evident that the UK will not join EMU for some time, since firms can now look forward to longer-term risks of exchange rate volatility that can wipe out profits.
In evaluating this argument about investment note, first, that the competitors for investment projects within the EU include the dynamic economies of Eastern Europe and not just Germany and France. Slovakia for example has already prospered as a major producer of cars. Furthermore, although the EU common external tariff has fallen to low levels, blocs such as the US and EU have increased their use of non-tariff barriers such as anti-dumping duties and technical standards in a balancing manner. This is why Japanese firms changed their strategies in the 1980s and 1990s from exporting from Japan to setting up plants in the EU and US. By leaving the EU, the UK would be unattractive as an investment location - and its trade hindered - by enhanced vulnerability to such trade practices, as well as the more general administrative burden associated with renewed border controls etc. even if tariffs remain low. Note that the EU product harmonisation measures that are frequently vilified in the foreign-owned press are generally concerted attempts to overcome non-tariff barriers that EU countries would otherwise erect, and thus the measures help free trade. Without a common standard for lawnmowers (for example), the Germans (for example) would retain their own, which would be only readily met by domestic producers. And it is qualified majority voting, as introduced under Margaret Thatcher, that enables such legislation to be passed.
Meanwhile, the employment effects of a recession likely to accompany withdrawal will in my view be aggravated both by a greater fall in investment owing to uncertainty and also falls in consumption because individuals will revise down their long-term expectations of income growth, in an economy likely to less capital intensive. These could make the recession and its employment effects much worse. Furthermore, a rapid absorption of the resulting jobless requires a fall in real wages.
A further reason why Pain and Young may underestimate costs of withdrawal is potential effects on the City. A global financial centre like the City acts as a "pole of attraction" as the benefits of setting up in the centre increase with the number of firms already there. (see Chapter 3 of HM Treasury paper entitled "The location of financial activity and the euro", 2003). This is because of shared benefits such as the liquidity of markets, increasing number of business contacts feasible, a shared pool of skilled labour etc. On the one hand, this means that the business of the City is fairly robust compared to other sectors that do not benefit from such "economies of agglomeration". But on the other, there will still be a tipping point - and once a financial centre begins to unravel, the agglomeration economies mean it can do so in a cumulative manner. The more firms leave, the less attractive it is for the remainder to stay. Zurich, outside the EU, was once a global financial centre but is now of second rank. It is worth noting that the bulk of the City's business is international business undertaken by foreign firms, who have no particular stake in the UK economy but find London a convenient location - and many of the most important ones are EU and US commercial and investment banks. It is easy to see how loss of some of the benefits of EU membership, notably guaranteed access to the Euro payments mechanism, would make London less attractive in this way, lead to loss of financial activity - and cosmopolitan skilled labour - to other EU countries and lead to decline of a key source of UK prosperity.
As before, seeking to overcome these difficulties by adhering to the European Economic Area will merely lead the UK to be obliged to adopt relevant EU Directives - as does Norway - with no say in their formulation. Switzerland, outside the EEA, took many years to negotiate favourable access to the EU market and again has to swallow relevant Directives without a voice. During the negotiation period, Switzerland suffered a protracted period of slow growth.
What are these risks being taken for? In my view, for a marginal gain of sovereignty that will be illusory if the UK joins the EEA, and major economic losses if it does not. And for loss of the opportunity to influence the future course of Europe.
I note a pervasive nostalgia in the current wave of euro-scepticism, for the days when the UK had its Commonwealth links and relied on industries such as steel, coal, fishing and agriculture. I sympathise - for example I find steam locomotives appealing and enjoy seeing them on preserved railways. But this does not mean it is desirable or feasible to run the London rush hour with steam-hauled trains….
Four detailed responses before I close;
· I was challenged by Mr Samuel-Camps of UKIP to provide details of the benefits of EU membership. I just give four here (the Independent had a comprehensive and largely accurate list on 16th June). Economically, the most crucial in my view is inclusion in a Single Market of 400 million people, within which the UK economy has scope to specialise in its areas of comparative advantage (such as financial services, other services and some types of manufacturing) via attracting investment of UK and foreign firms, as well as developing our own small and medium firms. This is the mirror image of the losses highlighted above. Free movement of labour is another benefit - the UK benefits considerably from inflows of skilled labour from the rest of the EU, our young people can widen their horizons by working abroad and the elderly are free to retire in the sun (all of these are much more administratively difficult in the US or the Old Commonwealth). Another is the negotiating power of the EU, for example in dealing with trading practices of the US and Microsoft. Although my focus is economics, the political aspect of keeping the peace in Europe should not be neglected.
· Mr Samuel-Camps suggests that the City does not favour Euro membership for the UK. Even if true, this is not at all the same as saying they would favour withdrawal.
· In my earlier letter, I was careful to note that the foreign owned press is seeking to whip up xenophobia and not that any party or person has succumbed to its blandishments.
· Allowing for the fact that some trade via Rotterdam or Antwerp has an eventual non-EU destination, as suggested by some correspondents, does not change the dominance of EU as a market for UK exports. Trade with the Netherlands is around 7% of the UK total and Belgium 5%, so even if a half of this trade is re-exported, the EU total remains around 50% (a total which has now grown further given the advent of the new accession countries).
I urge readers to assess these issues cautiously - it is your future prosperity that the UKIP and its supporters, as well as the foreign owned press, would put in jeopardy. And I remain convinced that UK citizens will conclude that the adventure of withdrawal is not worth the risk.
Yours sincerely, Professor E Philip Davis
LETTERS TO THE EDITOR: Fees worsen worker-student relations By Philip Davis Financial Times; Feb 08, 2003
From Prof E. Philip Davis.
Sir, Michael Prowse's article pointing to the shortcomings of the proposed UK system of university fees ("How the 'enabler' state atomises society", Weekend FT February 1-2) is sensible but does not go far enough. I would contend that just as damaging as the "intragenerational" atomisation that he highlights - as "each student must bear the precise cost of their own higher education" - will be an extremely dangerous "intergenerational" atomisation. Each generation now subject to "pay as you went" education is likely to regard itself as solely responsible for its own welfare.
But the damage to relationships between the current working and student generations could go deeper. The baby-boom generation, currently in power, has taken advantage of a system of free university education paid for by taxes on the previous generation. Now government policy implies that the same baby-boomers are refusing to provide a similar benefit for the coming generation. Despite this, the baby-boom generation still assumes that the coming generation will provide for its retirement. This may be directly via pay as you go social security or indirectly by working with the capital the pensioners have accumulated. It also expects the working generation to provide old people's homes, means-tested welfare and so on. Will such expectations be fulfilled? It is clear that the existing political risk to future retirement security is sharply aggravated, now the contract between the generations has been so blatantly breached.
Nor is this the only adverse impact on the pension system. High tax rates will be imposed on young people to finance their "pay as you went" education in the context of the ongoing shift of pension funds to a defined contribution basis, where the most remunerative contributions are those made by individuals in their twenties. They are evidently less likely to make such contributions under such circumstances, given high expenditure needs in young adulthood.
E. Philip Davis, Dept of Economics and Finance, Brunel University, Uxbridge, Middx UB8 3PH
Martin Wolf: The brave should confront the bear By Martin Wolf Published: February 2 2003 19:22 | Last Updated: February 2 2003 19:22
The FTSE All Share index is now below its 1969 level in real terms, a remarkable piece of information I owe to Eric Lonergan of Cazenove. One conclusion is that this is an impressive bear market. Another is that "buy and hold", the stock market nostrum of the 1990s, is remarkably foolish. Yet another is that UK stocks are cheap. As it happens, all three are true.
This bear market now compares in magnitude with that of the early 1970s. Philip Davis of Brunel University notes in the latest National Institute Economic Review, from the London- based National Institute of Economic and Social Research, that the British stock market declined by 77 per cent in real terms in the early 1970s, while the US market fell by 56 per cent and the German market 43 per cent.* On Datastream's total market indices, the real declines this time have been 63 per cent for Germany, 50 per cent for the UK and 49 per cent for the US.
For German stocks, this bear market has been considerably worse than that of the 1970s. For the US market, it has been a little better. For the UK, however, it has still been much less severe, though the run-up in the UK market in the late 1990s was also far smaller than in the US and Germany.
After the last big bear market, it took until June 1985 for the German market to regain its 1972 peak. It took the British market until May 1987 and, still more remarkably, it took until August 1993 for the US to do so. Unless an investor is able - or willing - to be very patient indeed, buying at valuation peaks and selling at troughs is a silly idea. Timing matters. One would expect sophisticated institutional investors to understand this. One would, alas, be disappointed. As Mr Lonergan notes: "Net selling of UK equities by the insurance sector is a useful contrarian indicator and a reason to buy UK equities [today]."
Insurance companies made record purchases of £12.5bn worth of equities in the first quarter of 2000, at the peak of the bull market. Then they made net sales of £7.1bn between the second quarter of 2000 and the third quarter of 2002. Over the past 40 years, insurance companies have been net sellers of equities in only eight quarters. Five of these have been in the present bear market, while two were in the bear market of the 1970s. Their timing has been impeccably wrong.
This recent institutional selling is, in all probability, the main explanation for the UK market's collapse, despite its relatively modest previous rise and apparently attractive valuations. As Prof Davis notes, between 1998 and 2001, holdings of UK equities by life assurance companies and pension funds fell from 35.1 per cent of the total to 27.5 per cent. In contrast with what happened in the 1970s, "long-term institutional investors were no longer prepared to act as contrarian investors and sharply reduced their holdings". The explanations include minimum funding regulations for pension funds, reduced solvency margins for life assurers and worries about future returns. The alternative hypothesis - that UK economic prospects have deteriorated dramatically since 2000 - seems implausible.
As a result of these huge corrections, British stocks look cheap. One simple measure is the ratio of earnings on equities to their price. For the UK, this is now 7.4 per cent. Mr Lonergan suggests that the cyclically adjusted ratio of UK earnings to prices is even higher, at 9 per cent. The British market is also giving a dividend yield of 4 per cent. If dividends grew in line with the economy, at about 2.5 per cent a year, total real returns would be some 6.5 per cent, on this basis.
These are attractive returns by historical standards. Certainly, they are far higher than the 2 per cent now obtainable from index-linked British government securities. Meanwhile, Germany's ratio of earnings to prices, at close to 11 per cent, looks very attractive. But, with a dividend yield of only 3 per cent and a long-term economic growth rate of only 1.5 per cent, the alternative measure of the prospective return is only 4.5 per cent. Meanwhile, a ratio of earnings to price of 5 per cent and a dividend yield of 2 per cent make US equities relatively expensive by their own historic, and today's international, standards. Even if dividends grew at 3.5 per cent a year, total returns on US stocks would be 5.5 per cent, about a percentage point below long-term historic norms.
This does not mean bear markets are over, even in the UK. If Wall Street falls further, as still seems plausible, it is likely to take the others down with it. Equally, markets tend to overshoot in both directions. There may also be bad news ahead, partly because of uncertainties over war and partly because of the markets' falls themselves, which threaten spending by both consumers and companies.
It would take a far braver person than me to call the bottom. But what one can say, with some confidence, is that the collapse in important European markets, particularly the UK, has brought them to attractive levels. It must make far more sense to bet on equities today than three years ago, which, given the perversity of humanity, is why few are doing so.
* Comparing Bear Markets -1973 and 2000, National Institute Economic Review January 2003, www.geocities.com/e_philip_davis
Euro 'would boost UK by
ending volatility' By David Turner,
London still main
European finance centre By Our Economics Staff Published: February 7 2002
20:51 | Last Updated: February 7 2002 20:59
Before the birth of the euro, there were fears in the City that the