February 5, 2008 | posted by Michael Baxter in UK economy |

The Centre for Policy Studies is not a fan of the Labour Government. If you browse its web site, you will find a plethora of articles with headlines such as “Tories’ economic legacy has been squandered” and “The EU’s costs are outweighing the benefits.” It seems that many of the articles on the site seem to reflect the views held by members sitting on a certain wing of the Tory Party.

There is nothing wrong with that, we live in a democracy and many would argue these are legitimate views, but in the interests of balance, it often seems to damage the credibility of an argument when it is presented with too much of a political stance.

Even so, it is difficult to argue with the latest report from the Centre. Entitled “Why do we feel so broke?” and penned by Charlie Elphicke, who by the way was selected last year to represent the Conservative Party in Dover.  It makes damming reading.

The average household’s disposable income after deducting housing costs is lower today than it was in 2002.

The report showed that for an average family, gross income rose by 19 per cent over the five years between 2002 and 2007. But then, when you take off tax, and add on child tax credit, earnings after tax rose by around 18 per cent.

But then, if you take into account council tax, mortgage interest payments, water, gas and electricity and household repair costs, then the level of disposable income after these items actually fell 5 per cent.

Now this analysis isn’t perfect. After all, mortgage repayments, utility bills, and council tax have seen above-average inflation increases. By focusing on household costs, Mr Elphicke was in effect focusing on data that would by default throw up a particularly bad result. After all, it ignores areas where inflation has actually been negative.

If, instead, we compare the data with official inflation figures, the result isn’t quite so bad. The RPI index (that’s the older measure used for calculating inflation, which includes mortgage repayments and council tax) increased by 17 per cent over that period. So disposable income just about kept ahead of inflation.

Even so, the report tells a story which often seems to get forgotten.

Latest data from the Office for National Statistics revealed that average earnings with bonuses rose by 4 per cent in the 12-month period to December. This was exactly the same as the increase in the Retail Price Index over that period.

There’s lies, damned lies and statistics. These days, when targeting inflation, the Bank of England is supposed to keep the Consumer Price Index within 1 percentage point of 2 per cent. But people fall into the trap of comparing our earnings with this index – and it’s a misleading guide. The RPI index, on the other hand, is a far more accurate gauge of how inflation is affecting us.

So, just bear all this in mind next time an economist, or a property market bull, paints a rosy picture, saying as earnings start to rise interest payments will become more affordable.

But there is something else that neither the report from the Centre for Policy Studies, or indeed the official RPI data, take into account.

Sure, mortgage interest payments have shot up, but what about the cost of repaying the initial sum borrowed.

We all know that between 2002 and 2007 house prices rose much, much faster than inflation. And with that increase, the size of mortgages rose dramatically too. And yet, the area of biggest cost increases is the one area which just about all reports systematically ignore.

Now, you might say, the cost of repaying a mortgage doesn’t matter. Well, you could to an extent have got away with that argument in the 1970s, when runaway inflation made the size of a mortgage relative to earnings reduce very rapidly. But in today’s era of low inflation, surely the repayment of the initial amount borrowed is more important than ever.

An economist answering to the name of Minsky, once talked about three stages in the development of a credit bubble. Stage 1, borrowing is affordable. Stage 2, borrowers can’t afford to repay the loan, but they can afford to pay interest. Stage 3, they can’t even afford interest, and may borrow from elsewhere to repay existing loans.

Then, all of a sudden credit dries up – backlash against the untenable borrowing occurs – this is called the Minsky moment.

For some time now, much of the lending on houses was only repayable if the houses went up in value – it seems Minsky’s moment might be upon us.