Paul Lewis Writing Archive

This talk was given 10 July 2008
The text here may not be identical to the spoken text

Some of you may know me from Money Box on Radio 4 and my appearances on BBC Breakfast and BBC News. But I am here today as me not Money Box and, God forbid, not the BBC. I am here as a freelance financial journalist – I do lots of other things apart from the BBC. And you can read about all of them on my website and you can listen to Money Box or download the podcast on the MoneyBox website.

Two years ago I gave a talk to some Atradius customers about pensions. And apparently it went down well. Today they have asked me to talk to you about the credit crunch. What it is. Where it is going. And what we can do to protect ourselves against it.

Now you're probably thinking 'This is high finance. Why on earth have they hired a two-bit journalist to talk to us about it?' And it’s true that if you want someone to tell you that

“A collateralised debt obligation is a security backed by a pool of assets such as credit default swaps which are packaged together as a portfolio and then tranched. It comprises a pool of underlying instruments (collateral) against which notes of debt are issued with varying cash flow priority. Senior notes are paid before mezzanine and lower subordinated notes are paid, with any residual cash flow, to an equity tranche.” http://homes.stat.unipd.it/lisif/pd200106/vecchiato.pdf

“The securitization of receivables consists in the sale of a pool of receivables to a dedicated vehicle that finances this purchase by issuing securities on the market. The assets of the dedicated vehicle consist exclusively in the pool of receivables purchased under the securitization transaction (and the cash flow generated by the assigned receivables) and the liabilities, in the securities issued on the market.” http://www.securitization.net/international/europe/France/Gide/Marc_Kergommeaux051501.asp

then I am not your man. And don’t be fooled by the fact that those authors are not English. The language they speak, sadly, is. And all too typical.

But I take a simple approach. And the simple thought I want to put in your mind at the start is that there are two sorts – and only two sorts – of purely financial transaction. I came to this idea years ago when I was considering the financial life-cycle of humans.

Leaving aside Phase Zero – pocket money and being kept by your parents – there are two Phases in life. There is Phase I – adults – we work and earn money but not enough to buy outright the big things we want and need. So we find ways to turn that income – our earnings – into capital. We take out a mortgage to buy a house. Or a bank loan for a car. Or use the credit card to pay for our summer holiday which we pay off over the next few months. And we pay into a pension to convert that income into a fund – or sometimes a promise – that we will use in later life. So in Phase I of our adult life we want to convert income into capital. We borrow against our stream of income.

When we retire we have a different need. In Phase II we have capital – our pension fund, our house, a savings account – and we want to convert that capital into an income. Nowadays Phase II even has a name – ‘decumulation’. It’s been created as the opposite of ‘accumulation’ and it does have proper Latin roots – cumulus is a heap. I don’t like it but I am sure it will enter the OED at a future revision. Especially if I keep saying it.

So decumulation is the time of life when we stop buying stuff and try to turn the things we bought earlier into an income. So we convert our pension fund into an annuity – a pension for life. Or we take out an equity release plan on our house. Or we have a monthly sale of surplus stuff on eBay to raise some money. All of these are using capital items we have to generate an income. In its purest form we put money we have accumulated into a savings account and we the interest it earns and the capital – an unofficial annuity.

And the more I thought about all the financial deals that are on offer the more I began to conclude that there are only these two deals – turning income into capital. And turning capital into income. Now I might be wrong. I’m not an economist. But I find it a very useful way to look at the world and explain collateralised debt obligations and securitisation of receivables a bit more simply than the explanation I read out earlier.

'Keep it simple' is my motto. Which is perhaps why I am not CFO or a PhD (Econ).

Talking of CFOs it is barely a week since Taylor Wimpey – Britain’s biggest housebuilder – got rid of its Chief Finance Officer Peter Johnson after the company failed to secure an emergency £500 million cash injection. When Taylor Woodrow and Wimpey merged last year they were relatively debt free. Today they owe £1.4 billion. The credit crunch is certainly biting them. And other housebuilders as they lay off staff and reduce their activities.

History
The credit crunch. One of my colleagues hates the phrase. She sees it as meaningless journalistic shorthand. Though why she hates it I’m not quite sure! So I decided to find out where it came from. You will read the phrase more than 75 times every single day in the 24 daily and Sunday newspapers in the UK. And if you extend your search to the world you find it used by print journalists nearly 400 times every day.

This graph shows the use of the phrase in UK newspapers every month back to the start of 2007. And you can see that at the start of 2007 it was hardly used at all – a handful of mentions. But then in August and September last year it took off. That continued into 2008 and in the first six months of this year it was used in UK papers no fewer than 12,304 times. Today it is used more than 2000 times every month.

So my colleague is right. It is a cliché used – probably overused – by journalists. It is in every story. My favourite was a colleague of mine on Radio 4 who opened a story on the World at One on Tuesday this week with the memorable phrase

“How has the credit crunch affected the sale of whistles?”. And The Times reports today that the editor of the News of the World claimed he paid a prostitute who brought him information about Max Mosley's sex session £12,000 rather than the promised £24,000 because the credit crunch had affected his newspaper!

But 'credit crunch' has a long history. Here is its frequency back to 1982. We find short revivals of a few hundred uses in 1998 and 1991. Its nadir was in 1988 when just one mention is found. So it existed then. But if you plot that graph on the same scale as the last two years the numbers disappear completely. Its regular use in the UK can be traced back to 9 mentions in 1982 – but that’s a barrier only because newspaper texts are not generally available online before that.

The Times though is. And a look at the digital Times shows that 'credit crunch' was first used in The Times on 7 June 1967 – and those were the days when The Times counted. It referred to “the great credit crunch of last summer”. (The Times 7 June 1967 p24c) And again in October it referred to “the credit crunch of last year” (The Times 19 October 1967 p21e). They were both referring to the credit crunch of 1966. And it was that year that the phrase was coined by two economists, Sidney Homer and Henry Kaufman, who worked for the New York investment bank Salomon Brothers (now owned by Citigroup) after it collapsed due to some dodgy dealings in the 1990s. (See Owens and Schreft ‘Identifying credit crunches’ Contemporary Economic Policy April 1995).

They wanted to describe the tight credit conditions in the Summer and Autumn of that year

“It was preceded by a prolonged period of strong loan demand and easy credit conditions. From 1962 through 1965, sales of negotiable certificates of deposit (CDs) - a financial innovation of the time - grew rapidly. The sales funded bank lending, which grew at annual rates exceeding 10 percent” (Owens and Schreft ‘Identifying credit crunches’ Contemporary Economic Policy April 1995)

Sounds familiar? Far from being journalistic claptrap ‘credit crunch’ does have a precise meaning among economists. It is a ‘period of sharply increased non-price credit rationing’. (Owens and Schreft ‘Identifying credit crunches’ Working Paper 92-1 March 1992)

In other words credit isn’t just expensive, the rationing is not done by raising the price. Rather, you can’t borrow money at any price. And it starts ‘sharply’ so there’s little time to prepare.

So the first credit crunch – so identified – was in 1966. Others followed in 1974 and 1984.

But we can actually trace such times back much further. Economists identify periods in the US of tight credit – the last third of 1959, autumn 1957 and spring 1953. Then they were called credit squeezes or credit pinches. And Britain was not immune from them. In 1954 The Times reported under the heading “weekend credit squeeze”

“Credit turned short…on Saturday. Several of the bigger banks were calling in funds – one in particular withdrew large amounts…With little fresh money the authorities gave a small amount of indirect assistance…in the form of loans over the weekend…” (The Times 9 August 1954 p10c)

“Coming in conjunction with the big capital issue by Lever Brothers and at a time when the money market is suffering a temporary credit squeeze…caused markets to wear a rather depressed look.”

That’s 84 years ago. Now those two were short-term squeezes, part of the ups and downs of the market. But if we look at the previous big events

– although they may not quite fulfil the economists’ definition of a crunch rather than a squeeze – they have an eerily familiar ring.

In 1984 The Times warned in its editorial “the banks are having to rearrange their loans in order to reduce debt payments buy as much as $40 billion this year and must of that extra interest burden will probably go the same rescheduled way.” (The Times 11 May 1984)

“He is now paying the price of past complacency; a credit crunch and a missed opportunity to cut his deficit at the easiest moment which is when economic growth is strongest. All he can do now is strengthen the political conviction that his cuts package is only the first of many, Changing tack in an election year may be difficult but vacillation has its proven disadvantages” (The Times 11 May 1984)

“With the economy weak and financial markets still hurt by a credit crunch and the collapse of the junk-bond market, this is not a good time for the cold-shower business of repaying, rolling over, or replacing corporate debt.” (Economist 5 October 1991 p103/1)

That’s the Economist 5 October 1991. Apart from junk bonds – or including junk bonds if you call them Collateralised Debt Obligations – that could have been written last week.

What this history tells us though is that the credit crunch is nothing new. But just as today’s splinter is more distressing than the memory of cutting your finger a year ago the current crunch is inevitably the one that is concerning us. Though later I will suggest that there is a new and frightening aspect of the world economy which could make this one much worse.

Origins
So where did the present credit crunch come from? Now in some ways it is a familiar story. Its origins are usually blamed on aggressive sales people in the USA selling mortgages to people with no deposit and no documents to prove their income. They didn’t care if the borrower could afford the loan, once a sale was made they got their commission. So it partly began with the commission driven sales – the very thing that has led to every major financial mis-selling scandal in the UK from pensions to payment protection insurance.

But commission driven sales are only bad if the commission encourages mis-selling. That means the product is bad or at least can be bad for some people. And these loans were bad.

They began with what were called Adjustable Rate Mortgages – ARMs. Now there’s nothing wrong with that in principle. We’ve had them in the UK for years called SVR or standard variable rate mortgages that go up or down with the bank rate.

But in the USA they had a problem. It’s a big country. And there’s lots of space to build new houses. And housebuilders wanted to expand. But with home ownership at a record high of almost 70% there were really too few people to buy more homes. Step forward the banks. At the time US house prices were rising strongly, as they were here, and the lenders came up with a variant of the variable mortgage. The ‘teaser rate’. For the first one or two years the interest charged on the mortgage was 1%. After that it reverted to its full rate. That meant more people could afford a home. So happy sales staff and happy customers.

Now the lenders wanted to keep themselves happy too. They wanted to join the happy party by lending more and more. They needed to recycle the money that was coming in from mortgages to lend it out again. So they securitised the loans. Sorry but we have to look at securitisation. Which I suspect some of you understand better than me. But here’s my simple take on it.

· Company has Asset that generates cash flow – eg loan book eg sales book. Has an INCOME. Needs CAPITAL.

· Company sets up a separate, ermm, well, there isn’t – or wasn’t – a word for it. It’s not a company, it’s not a trust, it’s not a charity. So they call it an entity or a vehicle – though no jokes please about the wheels coming off. And it is there to do one job so it is called a Special Purpose Vehicle (SPV) or Special Purpose Entity. Remember it is set up by the Company but independent of it. The SPV buys the Asset.

· But hang on. The SPV has no money. SPV NEEDS CAPITAL. So it uses the promise of income from the company to issue Bonds (securities) which pay interest.

· Investors who HAVE CAPITAL BUT NEED INCOME buy the bonds. That Converts their capital into income.

· SPV uses the capital from the bonds to buy the Asset from the Company. And it uses to the cash flow generated by the Asset to pay the Interest on the bonds. CONVERTS INCOME TO CAPITAL which it uses to buy the cash flow from the Company.

Now this only works if the bonds pay a lower rate of interest than the original cash flow. So why doesn’t the company which needs capital simply borrow the money and pay the interest?

It is possible that the company has poor credit rating. If profits are low for example. But if it has a strong loan book – and remember these loans are backed by someone’s house – then the credit rating of the loans may be very good. So the company finds it cheaper to borrow the money it needs using this mechanism than borrowing. And in fact so much cheaper that it is worth all this complexity in the middle involving arrangers, depositors, asset managers, maybe guarantors, perhaps trustees, all of whom have to be paid. Now if you’re dealing in billions then a small fractional percentage of the amounts managed can create a very nice income for these middle men and women. That’s why securitisation – like tax dodging – is really only good for the very wealthy. If I tried to securitise the fees from my work at the BBC to buy a house my small cash flow would not leave enough for the middle men.

But hang on a minute, the original loans which generated the cash flow were backed by people’s homes. So they should be low risk and charged at a low rate. But they’re not. They are sub-prime loans – risky loans – so the borrowers are charged premium rates.

But hang on another minute. The investors have to accept a lower return on their money. Which means they think they are buying low risk loans. So why are these loan low risk of they are based on an asset that is paying higher rates? How are these high risk and expensive loans here converted to less expensive and lower risk loans?

That was the trick. The dodgy loans were mixed up with stronger loans. It was called pooling. And then the pools of loans from all sorts of sources were combined into a big lake. And then they sold bucketfuls of the lake through what are called Collateralised Debt Obligations or CDOs. That muddied the waters about which loans were risky. But because they were all ultimately secured on physical property – someone’s house – they must be safe, musn't they? At this point you bring in a professional whose job it is to estimate risk. They look at the muddied pool, see that ultimately the loans are secured on homes. That is a very good physical asset. House prices are rising and if worst came to worst you can always evict the borrower and sell the home. And there’s bound to be enough equity in it to repay the debt. Isn’t there? So they say these loans are AAA rated. So the investors accept the low interest rate paid on their capital.

Now if all this seems complex it is. And I don’t feel too bad about not understanding the inner details of it all. A week ago Moody’s – one of the main agencies whose job it is to assign credit ratings to companies and to these complex debt securities – sacked one of its senior staff and disciplined others for getting the credit ratings wrong on $1 billion of complex debt securities. They were actually Constant Proportion Debt Obligations – don’t even ask – and a computer programme which assigned them a risk factor was wrong. Moody’s discovered it in 2007 but kept quiet until it could quietly downgrade the securities when others were falling in 2008. A bit like hiding a body by throwing it out of the window during an earthquake.

I was amused to see in this Atradius report on p16 the question “does your business have any exposure (direct or indirect) to subprime lending?”. That’s the point! you don’t know!

Moody’s and the other ratings agencies Fitch’s and Standard and Poor’s played their part in allowing this merry go round to keep on turning. They rated CDOs as AAA when in fact they were really quite risky.

And so the credit rating agencies are top of some people’s list for WHO WAS TO BLAME for this perfect storm of the subprime crisis which led to the credit crunch.

Me I prefer to start at the other end with the commission driven sales staff. Then you have lenders – banks in the main – which are busy setting up new ways to lend money to more people to spread home ownership. They realise the risk of course so they protect themselves by securitisation. And that becomes muddied water as those pools are themselves repackaged so no-one knows when they buy a debt what is in it. And all this is really based on the premise that house prices will rise inexorably and that defaults will not exceed the normal rates.

It is financial alchemy. Turning base loans into gold. It had to come unstuck. And it did.

Because guess what? Defaults rose substantially as the teaser rates came to an end and people with low incomes who had not provided proof of income found that the American dream home was not affordable. It wasn’t helped when the federal reserve rate put its own rates up through 2006 and 2007. So what seemed like a revert from 2% to a rate linked to 3.5% suddenly became a revert from 2% to a rate linked to 5.25%.

In 2007 foreclosures in the USA were started on 2.2 million homes, 75% up on 2006 and 150% up on 2005. In May this year a quarter of subprime adjustable rate mortgages were 90 days delinquent or more.

Now that wouldn’t matter if house prices were rising. But they began to fall in the second quarter of 2006 and are now more than 16% down on that figure – most of that fall happened in 2007 and experts believe it will go further. So when the homes are sold – either in a fire sale by the owner or at auction the debt will not be repaid in full.

And no-one knows where these toxic loans, as they are called, have ended up. Like a grim game of pass the parcel it is only when every layer of that parcel is unwrapped do the toxic loans emerge and the last one holding the parcel bears the loss. Many of these parcels are still in circulation. The result is that banks will no longer lend to each other in case the collateral they get is a toxic parcel. Or, if they do, they charge a high price. The result is that borrowing dries up. And what lending there is gets higher regardless of what the Bank of England does to base rates.

Effects
But price rises are just the start. We saw earlier that the essence of a credit crunch is non-price rationing. In mortgages we have seen availability being reduced.

First and biggest change is deposits. A year ago it was fairly easy to buy a home without a deposit. Last summer there were 220 mortgage products which would lend you all the money you needed to buy a home - 100% loans. But a week ago there were just seven. Even 95% mortgages are becoming rarer. A year ago there were 977 mortgages offering a loan of 95% of the price of the home. Now there are 111. To get the best deals you need a 25% deposit.

Second, credit scores. At one time you could get a mortgage if you had an address and a heartbeat. Today it is much harder. You will need a high credit score to be considered at all and with some lenders you will now need a very high score to be offered the best deals. One mortgage broker said to me “Lenders are becoming much less forgiving about small indiscretions for example you’ve been late – not missed, but been late – with a few credit card payments in the past.” One lender C&G will still lend in those circumstances but will charge you a higher rate. It’s what they call the ‘light adverse’ market.

Third, evidence. At one time self-certification was the rage – up to a quarter of loans were made without evidence of income. Lenders didn’t care terribly because they could always repossess if you couldn’t. And with property prices rising….well you heard it all before on the US sub-prime market. Now caution is the word. Self-cert is much rarer except for self-employed people. Which is fair enough as it is always more difficult to prove your self-employed income. But even there you will be lucky to borrow more than 85% of the value of the property.

Fourth, fees. There is huge competition for mortgage business – or at least there was. And that meant using best buy tables and internet comparison sites. And the easy thing to compare is the interest rate. So to keep that down lenders introduced fees up front. These weren’t for anything – though they had various names as if they were – they were just interest in advance. And these fees have risen from £98 in 1992 to £968 on average in 2008. Many are much higher. Leeds Building Society is currently charging 3% of the capital borrowed on a two year fixed deal. So on a £200,000 loan £6000. The rate is very good 5.75%. But if you add the 1.5% of the fee that makes it 7.25% a year and in fact because it is upfront the arithmetic is even worse than that.

Fifth, Buy-to-let. The buy-to-let market was invented by the landlords who wanted to open up the rental market to attract a new sort of investor. Someone who borrowed to buy their property and then let it out. Rent would just about cover expenses and of course rising capital values would produce a nice profit. Lenders took it up with enthusiasm. At first demanding that the rent covered the loan repayments 125%. But over the last few years that relaxed so you could do buy to let at just 100%. Now that is shifting away again. You will once more need 125% cover and that is based on a higher mortgage rate. So many buy-to-let landlords are finding that they cannot remortgage and so stick with the same lender. That pushes up their interest rate by 1.75% to 2% and of course without the promise of capital growth the arithmetic stops working.

So it is no surprise that the number of mortgage products on the market has declined. It peaked in July last year when there were 15,599 separate mortgage deals available. Of those 3648 were buy to let which have declined to 474. And 11,951 were for owner-occupier residential mortgages and that number is now 3282. That is much more sensible. But it is another graphical illustration of the sharpness of the credit crunch when it struck last summer.

Some lenders like Northern Rock and GMAC have all but disappeared from the market. Most of the subprime lenders have gone completely. And sub-prime buy to let – forget it.

That’s why figures from both the Bank of England and the Council of Mortgage Lenders show that mortgage approvals are in sharp decline. The Bank said the 42,000 approved in May was the lowest figure since records began in 1993. Down by a third on their peak in 2003. Similar figures from the British Bankers Association show the number of loans and the amount borrowed are both declining.

The number of loans for house purchases - the purple line - is down. The number of remortgages remains pretty much the same – this peak here due to the number of fixed rate loans coming to an end. But it is the yellow line that I think is particularly worrying.

The orange line shows secured loans not for remortgage or house purchase. In other words secured loans for extensions, kitchens, bathrooms, new cars, holidays, even paying off other debt. Normally I would say that is a good thing – or may be a good thing depending what they are for. But we can see in both numbers and in amount that the use of our home as a money box is going down.

And the chart for the money borrowed shows the same pattern. Down from nearly 1.5bn to just over £800mn.

That is for two reasons. First the banks are making it harder. And again it is not just rationing by price. Barclays announced on Tuesday that it was pulling out of the secured loans business. A year ago there were 18 providers of secured loans. Now there are just seven.

But the other reason is that we don’t look on our home as a money box. Not long ago the value of the average home was rising by more each month than most people earned. It seemed like a magic pot – however much you took out of it there was more left in it. Not any more. And that is depressing the economy.

House prices
For years economists have told us that the rise and rise in house prices couldn’t go on forever. It did. Now it has stopped. But it is worth looking briefly at why it has stopped. And where it is.

I was one of those who used to say prices would not fall. The iron rule of supply and demand would keep them rising. We needed 240,000 new homes a year and we were getting about 180,000. Now it seems we will get just 110,000 this year, 80,000 next. And with the current problems of housebuilders even that may be optimistic. With demand much higher than supply prices should keep on rising.

But although there is still demand it is not realisable because of mortgage availability. 240,000 people may want a home but without the finance they can’t fulfil that demand. So in practical terms demand falls. And prices drift down.

If we take the average of all house prices across five major monthly indices we have now at last seen the first annual fall. The price of the average home in May 2008 is now worth £1741 less than it did a month before in April and about £6000 down on the peak in October. Over the year, house prices are down pretty much where they were, £238 down on May last year. But the fall will steepen as the rise in the last half of last year starts disappearing. And over the year prices could be 6% down at least.

Source: Assetz averages of five house price indices July 2008 FT HPI, Communities and Local Government, Nationwide, Halifax, Rightmove.

Most interesting is this three month moving average which shows the drift downwards from the peak last autumn.

It is very different in America where there is a glut of housing. Too many were built and prices were kept artificially high partly by the loans on offer. Now prices there have fallen 15% and may fall further. That is a genuine crash or adjustment back to a market rate. In the UK it seems to me that prices will drift down but once – or if – credit comes available again they will start to rise.

So drifting down but no crash as yet. But it all adds to the sense that people have that they are not getting richer month by month. The automatic fill on the piggy bank has stopped and money is draining out of a little hole in the bottom. So it destroys confidence.

The recent consumer spending boom – hardly a boom it’s lasted for years – was fuelled by two things. First by the easy availability of consumer credit – credit cards, personal loans, and so on. But second by the fact that while house prices rose and the value of our homes was far more than the money we owed on them we all felt rich. And many people used their home as a money box. If they needed repairs, improvements alternations, or even a car or a holiday they would get a cheap loan secured on the value, knowing that it would still them with a much smaller debt than the property value.

Now that house prices are falling there is a definite sense of being poorer. We are cutting back on using our homes as a piggy bank.

The result is that we are borrowing less. But some borrowing is shifting. Moving to other areas where the credit crunch isn’t biting so hard. There is some evidence that borrowing on credit cards is creeping up again. The latest BoE figures on lending to individuals show credit card debt was falling – down to £53.368bn in August 2007. And then when the credit crunch began it started rising and is now in May £55.365bn which is a rise of 3.7%. Though it is still less than its peak of £56.829bn in January 2006.

The rise in loans from banks and building societies dominates the figures and that is also rising. So the total loans are rising. But the big riser is in non-standard credit. The green line here. And that is worrying because non standard credit is normally expensive.

So borrowing money is getting harder and more expensive. And that will keep us away from the shops. Because even the Government admits – or did a few years ago – that credit is important to keep the economy going.

The Government’s White Paper on consumer credit published in December 2003 began with these words

"Consumer credit is central to the UK economy." (Fair, Clear and Competitive – the Consumer Credit Market in the 21^st Century Cm6040 DTI, December 2003, p 4)

There are those who say we borrowed our way out of a recession. And if we can no longer borrow easily does that make a recession more likely?

Inflation
And there is another factor that is hammering at the confidence of people. Not only do they feel poorer because they don’t see the value of their home rising. Not only is borrowing getting harder and more expensive. But the price of everything is rising.

I have been concerned about inflation for eighteen months, first writing about it in December 2006. And slowly the Governor of the Bank of England has come round to my point of view. Inflation is worrying even him. And it’s his job to control it! Here is his record since he became Governor in July 2003.

Last month’s figures, measured in the way the Government prefers (CPI), is 3.3%. That is the highest it has been since July 1992 when John Major had just won his first full term. But then inflation was falling.

1992 CPI RPI

July 3.6% 3.7%

August 3.2% 3.6%

September 2.9% 3.6%

October 2.8% 3.6%

We have to go back 20 years to April 1988 when Nigel Lawson was Chancellor to find it rising through 3.3%. Two and a half years later it was more than 8%.

1988 CPI RPI

March 3.1% 3.5%

April 3.6% 3.9%

May 3.7% 4.2%

June 4.1% 4.6%

March 1989 4.9% 7.9%

March 1990 5.9% 8.1%

October 1990 8.2% 10.9%

The target for CPI inflation is 2%. And the rule is that when it is more than 1% above that target, i.e. 3.1% or more, the Governor of the Bank of England writes to the Chancellor of the Exchequer explaining why he has missed his target and what he intends to do about it. This month’s letter is four pages long. Here is a précis.

Dear Chancellor
Sorry. But it isn’t my fault. Blame stuff that’s happening abroad like oil and gas and wheat. Not much I can do about that. I don’t expect it to get better for a while. In fact it will soon get worse, topping 4% probably. In some ways it is not as bad as it might be, given everything. And the good news is we will at least keep in touch as I expect to be writing to you a lot over the next year or so.
Yours Mervyn

But this anodyne explanation just won’t do. Yes oil and gas and wheat and copper are rising strongly in price. But when cheap imported goods from China brought down inflation the Bank was happy not only to take credit for it but to cut interest rates. That fuelled an unsustainable boom paid for by cheap credit. And now we are facing the bust.

Then we imported deflation. Now we are importing inflation. And now the Bank is saying ‘sorry not my fault’.

But if in those days of imported deflation interest rates had been kept higher, credit had not been allowed to take off. Then we would be in a stronger position now to deal with it. Here is inflation since Alistair Darling became Chancellor.

We should also remember that inflation for many people is not 3.3% or anything like it. For essentials, the more familiar Retail Prices Index for May is 4.3% pushed by food prices up nearly 8%, energy bills more than 12%, and motoring costs almost 5%.

Resources
I mentioned the role of supply and demand in house prices here and in the States. And the reason for these rises is not just rising wages in China and India. It is also the booming demand from those economies for oil and other rare metals. And as I have been doing the work on this talk I have come to the nasty feeling that this credit crunch is different. Inflation is going to be very hard to control. Because of its origins.

Lack of supply or growing demand can each push prices up. But when supply falters as demand rises that is a double whammy. And if we take oil at the moment supply is faltering. Saudi Arabia is not producing the extra oil it normally does to act as a governor on oil price. That leads people to think maybe it can’t. And the problem is not how much extractable oil is in the ground. It is more about the expertise and the infrastructure needed to move 87 million barrels of oil a day which is the current rate of use. Every barrel doesn’t just have to be pumped up it has to be moved to a refinery, then shipped to its destination. And all this is through pipes and shipping lanes that are approaching their capacity. At the same time analysts say we could be close to peak oil. 2010 could be the year that we cannot produce any more. I am not sure that I believe that at all. But the fear of it is enough to move prices.

In the 1960s we used just over 30 million barrels of oil a day. Now it is nearly three times that and growing. So at the same time as supply is being constrained, demand is rising. The danger is that this teetering structure will get a shock such as a terrorist attack on a pipeline, a shipping lane, or a major refinery in Saudi. We couldn’t cope with for very long. So it is no wonder that analysts are predicting that the price of oil will continue to rise.

In this graph the black line is the consumption and the red line the price of oil at 2008 prices (the white line is the historic price). Already out of date, we get a new record price for a barrel of oil almost every day. $145 was the latest on Monday. And it is interesting that when you look at the figures for oil consumption you find exactly the same figures for oil demand. The terms are used interchangeably. Because in the past consumption rose to meet demand. Not any more. Despite rising demand in developing countries oil consumption only grew by 1% last year. King Abdullah of Saudi Arabia has recently been quoted as saying that if more oil was found in his country he would be inclined to leave it in the ground because "with the grace of God our children might have a better use of it." (Financial Times 10 July 2008 p15)

These are pre-1992 penny and two pence pieces. Ten pence altogether. But each penny is worth more than 1.5p for the metals alone, principally the copper. So this 10p of copper is worth just over 15p. A £1 bag of copper is in fact worth £1.56. Now coppers are made of steel. So you can sort out the valuable ones with a magnet. Around the world lead is being stolen from roofs, railways are coming to a halt as copper signalling cable is being stripped out overnight. In the USA new SUVs (4x4s) are being stolen from sales lots, parked round the corner, stripped of their catalytic converters, and left. Because the most valuable portable item is the platinum that catalyses toxic emissions into harmless gases. In New York people are considering collecting road sweepings to recover the platinum from catalytic converters that is being lost forever on the streets.

These metals are also running out as demand rises and supply is not growing with it. Six years ago a tonne of copper was about $1400. At the end of 2006 it was $6340. Today it is $8564. Two years ago tin was $9000 a tonne. Today it is $23,360.

If every car in the world had a catalytic converter there would be no more platinum in 15 years’ time. In India the Tata car will be sold for $2500. Millions will be made for the Asian market. Every one will have a catalytic converter.

Another metal, Indium, is in every LCD screen. One estimate says there is ten years’ supply. In 2003 it was $60 a kilo. In August 2006 it was $1000. Tantalum is in mobile phones. But may run out in a generation. Even lead will run out in 40 years or so even at present rates of use.

Unlike grain you cannot make more copper or tin or platinum. Unlike oil you cannot substitute other things. An element is just that - an element. When they are gone they’re gone. The finite nature of the Earth's resources is becoming apparent.

Summary
So. We are caught in the jaws of a credit crunch which dries up borrowing – the oil the machinery of modern business needs. Inflation is back mainly due to too many people wanting too good a life. And we are running out of crucial things we are all used to having – like food and oil but more crucially metals that we can’t replace – copper, platinum, lead. And some most of us have never heard of – indium, tantalum, hafnium. We are literally spending the earth.

I don’t want to seem to be copping out here – but I want to discuss this with you rather than talk at you. You see I have a theory. Just as all financial business - corporate or personal - is capital to income or income back to capital. I think the rules of personal finance hold true for corporate finance.

Don’t save and borrow
Use your savings as your capital. It is always cheaper to borrow off yourself.

Don’t borrow over a longer period than the asset will last
If you pay for your holiday with your credit card clear the debt before your next holiday comes round. And pay for Christmas before next December arrives.

Borrowing to pay off a debt is not paying off a debt
It may be taking on a cheaper debt. Or it may not.

Keep it simple
As the Atradius research found bigger firms suffered more from the credit crunch. And bigger firms got involved in complex debt deals such as securitising receivables. Now securitising receivables may seem like a good way to reduce risk. And a better way of borrowing than taking out a loan. In fact it can increase risk. And it can cost more.

Keep it flexible
Respect the Earth. Look at that table. It doesn’t worry me. I shall be quietly recycling myself by the time anything significant runs out. But it should worry you. Because you cannot assume that everything is going to go on as it has. It clearly isn’t.