I KEEP WATCHING the news in the United Kingdom. The reason is simple. We seem to be following in the same economic footsteps, delayed by about a year or so. U.K. home prices stalled and reversed a little just about a year ago. There are serious signs the U.S. housing peaked last summer.

Retail sales in the United Kingdom initially held up for a couple of months after housing stalled, and then weakened considerably. Worse yet, for the retailers, there are not only falling prices, but rising costs, especially for energy. That is putting a huge squeeze on profits. There are some signs the United States will follow. Christmas sales this year will sure be interesting.

Chancellor of the Exchequer Gordon Brown’s growth forecasts have been too optimistic too long. He has been forced twice to ratchet down his optimism. His “golden rule” will be in jeopardy if he has to do it a third time. The golden rule dictates that the government must not borrow to fund its current spending averaged over the economic cycle.

On Oct. 21, The Independent reported, “Chancellor Is Closer to Hitting His “Golden Rule”:

“A strong rise in tax receipts last month put Gordon Brown closer to hitting his ‘golden rule’ to balance the public finances, but did little to assuage concerns he will need to raise taxes to fill a ‘black hole’ in his coffers…

“Overall public sector net borrowing, which includes investment, hit £5.2 billion, the largest shortfall for a September since modern records began in 1991.”

UK Economic Weakness: Bad News for the Chancellor

On Sunday, Oct. 23, Hamish McRae, writing for The Independent, reported, “Falling Retail Sales Are Bad News for the Economy, and for the Chancellor’s Face”:

“Over the past 12 months, the economy has grown at 1.6%, and the outcome for this calendar year will be somewhere around that too. That compares with a budget forecast of 3-3.5%, recently revised down to 2-2.5%.

“The high street is feeling the slowdown most severely. Retail sales grew in volume terms at 0.7% in the year to September, but prices are falling by 0.9% a year, so the actual cash taken by retailers is down.

“Tax receipts have not been too bad — or rather, they have not been as bad as one might have expected given the fact that the economy is growing at only half the pace expected by the Treasury in the budget. But they have not been too good.

“So far this financial year, the public sector has borrowed just under £25 billion — that is its net cash requirement. For the year as a whole — that is to next April — it is supposed to borrow only (only!) £35 billion.

“My own reading of this is that the worry is not so much this year but rather the next, and the years beyond that. The chancellor will be embarrassed, insofar as that is in his nature, by missing his pre-election growth forecast by such a big margin. But he can just about maintain that he is still within his own golden rule of borrowing only for investment over the economic cycle. The problem, in any case, is not what happens in any one particular year but, rather, what happens over a longer period. The truth is that the country is stuck with a deficit of a little over 3% of GDP and the chancellor can do little about it.

“Virtually all the professionals think that tax rates will have to rise and they expect this irrespective of any unexpected shortfall in income tax. But tax rises next year would hit an economy that is already slowing.

“Maybe the chancellor can push troubles forward for yet another year. That is what France, Germany, and Italy have done, sticking with their deficits above or close to 3% of GDP. (Though Germany has just postponed a cut in corporation tax by one year because of the need for revenues.) But sooner or later, either revenues have to rise or public spending has to be cut.”

Meanwhile, the BBC is reporting a “Bumpy Road for U.K. Company Profits”:

“The number of firms in the United Kingdom warning that their performance would fall short of forecasts has shot up, research by auditors Ernst & Young (E&Y) says.

“According to the firm, 103 firms listed on the London Stock Exchange issued profit warnings in the three months to Sept. 30.

“The figure is a 39% jump from the same period in 2004…

“Among the firms issuing a warning, the most prominent sectors were construction, media and entertainment, electronic goods, software and computer services, and business support services.

“Most of these, E&Y said, were suffering from lower consumer confidence and a slower economy — causing wafer-thin margins and a slide in discretionary spending.”

UK Economic Weakness: Weakness in the US

I would expect weakness in the same sectors in the United States going forward:

1. Construction — as U.S. housing slows, evidenced now by falling homebuilder share prices.

2. Media and entertainment — as there is less consumer discretionary spending.

3. Electronic goods — same reason, less consumer discretionary spending.

4. Software and computer services — same reason, less consumer discretionary spending.

5. Business support services — anything associated with mortgage lending is suspect.

I find the talk of tax hikes by Hamish McRae in the first article rather interesting.
Something has to give. As I see it, Brown has two options: toss out the “golden rule” or raise taxes. Raising taxes into a slowing economy will not be easy. Think what it might do to consumer spending and housing in the United Kingdom.

Strikingly enough, the United States is in a similar situation. We keep throwing money we do not have down the sinkhole known as Iraq.

Meanwhile, Katrina, Rita, and now Wilma are all going to increase in federal funding requirements. Where is the money coming from?

Hmmmm.

Is there any wonder there is now talk that “Tax Reformers Eye Breaks for Housing”:

“Mortgage deductions and other benefits are costing more than forecast. With a rising federal budget deficit, they may be scaled back.

“Just as the nation’s housing boom appears to be slowing, debate is starting among policymakers about reining in one of the most sacred cows of American public policy: the mortgage-interest deduction and other generous tax benefits granted to homeowners.

“A presidential commission on tax reform will take up the subject for the first time Tuesday. ‘”Everything’s on the table,’ said Charles Rossotti, a panel member who was commissioner of internal revenue from 1997-2002.

“The mortgage-interest deduction saved homeowners $61.5 billion last year. No one expects the commission to recommend its elimination.

“Instead, the panel may consider scaling back the deduction for mortgage interest on second homes or home-equity loans, and changing the deduction for property taxes, among other things…

“Eight years ago, capital-gains taxes were eliminated for home sellers who had profit of as much as $250,000 (for individuals) or $500,000 (for couples). That has created a vast amount of wealth and helped power a housing boom that has seen prices double or triple in Southern California and other hot markets.

“Some policymakers and analysts are beginning to wonder whether such breaks are providing the wrong incentives, giving hefty deductions to millionaires buying Beverly Hills estates as well as to speculators snapping up Las Vegas ranch houses, hoping to turn a quick profit.

“U.S. Comptroller General David M. Walker said provisions such as the capital-gains exemption were costing the government much more money than anyone forecast when they were first proposed. In a new study, the Government Accountability Office calculated that the exemption drained $29.7 billion from federal coffers last year.

“‘We need to review the reasonableness, appropriateness, and effectiveness’ of such provisions, Walker said in an interview…

“The stakes in such a discussion are huge.

“Changing the tax benefits for homeowners, even if done slowly, could cause short-term convulsions in the market as buyers recalculate what they can afford. The tumult could be most pronounced for homeowners in states with the highest home prices, such as California. In the long term, housing could become more affordable as some of the stimulus that has sent prices soaring is removed.

“Any proposed shift would encounter strong and possibly overwhelming resistance. But with a rising federal budget deficit, the prospects for change are much greater than they’ve ever been, say those involved in the debate.”

When Republicans are even so much as hinting that mortgage tax breaks might be reduced, you know there is more trouble than meets the eye.

Will anything be done? Many say no. “The mother of all tax subsidies…shall remain untouched,” wrote economist and tax expert Martin A. Sullivan in State Tax Notes.

It is likely (for now) that Sullivan is correct. This Congress is unlikely to have the guts to upset one of the largest voting blocks in the country: homeowners. Deficits be damned.

That said, something has to be done about budget deficits and reckless spending. Pressure to leave the Iraq sinkhole behind is likely to increase. That at least will be a good thing.

UK Economic Weakness: GDP Forecasts Lower

Watch those U.S. GDP forecasts start to be lowered just as they were in the United Kingdom. It will no doubt be blamed on the hurricanes. Of course, by then, everyone will have long forgotten that the U.S. cheerleaders were predicting strong rebuilding activity on account of those very same hurricanes. The “broken window fallacy” will be proven once again.

Bankers in the United Kingdom and the United States are worried about the wrong things now. Both seem fearful of rising oil prices and the supposed inflation thereof. I doubt that lasts long. I look for another rate cut from the BOE in December or early next year as the economic situation in the United Kingdom degrades, with housing leading the way.

Check out this recent headline: “U.K. Average House Price Has Fallen 7,000 Stg Over the Last Year”:

“The average house in the United Kingdom has shed 7,000 stg of its value over the last year but a recovery is likely in 2006, a property Web site revealed today.

“In its monthly survey of the sector, Hometrack found house prices fell another 0.1% in October — the 16th consecutive month of house price falls.

“The national average house price now stands at 160,700 stg, down from a peak of 167,700 stg in June 2004 and down over 3.5% in the past 12 months.

“In September, Hometrack found house prices fell 0.2%.

“One bright spot Hometrack identified was another increase in the number of potential buyers.

“It said the number of buyers registering with estate agents has increased by 2.1% in October this month, bringing the total increase in buyers this year to over 22%…

“‘The key ‘feature of the market this month is a significant increase in house sales activity, helped by more buyers returning to the market,’ said John Wriglesworth, Hometrack’s housing economist.

“‘However, the number of houses for sale has also increased and as a result, excess supply continues to plague the market. House price falls continue unabated,’ he added.”

Prices have fallen for 16 consecutive months, huh? Once prices get into a sustained downtrend here, expect to see similar results, and then some. As for that “bright spot,” note that increased sales were easily met by increased “for sale” signs, with increased inventory causing prices to drop. A recovery is “likely” says Hometrack. Hmmm. Did Hometrack forecast this 16-month downtrend? How much credence does an association of realtors or a property Web site have when it comes to rosy forecasts?

Look for an end to U.S. rate hikes just as they ended in the United Kingdom. Will it help? No more than it helped retail sales and home sales in the United Kingdom. In a single word, no. Once the housing super-tanker turns, it will be all over. It ended the boom in the United Kingdom, and it will end the boom in the United States.

Various sectors in the United States are following step by step on a 6-12 month lag of events that already took place in the United Kingdom. If you want to know where the United States is likely headed, keep one eye on the United Kingdom. As for right now, I see no reason to change the forecast of “U.K. Headed for Recession,” and I see every reason for the United States to follow with a lag.

Mike Shedlock / Mish
November 1, 2005

UK Economic Weakness: Keep One Eye on the UK was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.