Why the economy is nothing like a brick

It's one of the many analogies pundits are using to persuade the Bank of England not to be too hasty in hiking rates. But whatever way you look at it, a soft landing is beginning to seem like wishful thinking.

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Now that most people are starting to realise that the Bank of England is going to keep raising interest rates for much longer than everyone had been expecting, we've been seeing some hoary old analogies being trotted out in the papers.

One that's proved particular popular is the idea that the economy is a brick at the edge of a table, and the interest rate is a piece of elastic tied to the brick. If you don't tighten enough, the brick doesn't move. If you tighten too much, it flies back and thwacks you in the face. This is supposed to partly illustrate the delayed impact of rising rates, and the pundits who use it are usually warning the Bank not to be too hasty in hiking rates.

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This is a weak analogy for several reasons, which we'll come to later. But the main thing we dislike about it, is that it still offers the slim hope that somehow, there's a level of rates that will bring the brick sliding gently across the table and give you the soft landing you crave.

The reality is that there is no perfect interest rate. The brick is always going to twang back and hit you in the face.

The only question is - how hard?

When it comes to the economy, what the old analogy of the brick and the elastic band doesn't take into account is this - the brick doesn't want to move.

When an economy gets going, it doesn't want to slow down. Businesses want to grow, consumers want to spend, people want to get rich, improve their standard of living, live the high life - who wants to give all that up?

This brick in fact, has hands, and is clinging onto the edge of the table for dear life. That's why there are only two possible outcomes - either the Bank stops raising rates too early, the brick stays where it is, and the economic imbalances continue to worsen; or the Bank tightens enough that the brick is forced to let go - and then it flies back and whacks everyone in the face, hard.

A good illustration of this is the buy-to-let market. There were a lot of pieces in the weekend press asking if the sums still add up for amateur landlords. By and large, the conclusion was no. Various pundits - usually buy-to-let mortgage specialists - warned that the game now was about "long-term capital gains" rather than income. There were suggestions that subsidising your tenant's rent was OK, as long as you were looking to the "long term".

As almost anyone who has ever bought any shares knows, a long-term investment is just a short-term one gone wrong.

The idea of holding onto anything for long-term capital gains rather than income is silly. You buy things for two reasons - to use them, or to make money from them; to consume or to invest. Most people don't buy a car to make money - you buy it because it's useful (or because you like cars). On the other hand, you don't buy a share in a company because of the great pleasure or utility it gives you - you buy it because you think that it's going to go up.

Now, when it comes to shares, why do they become more valuable? Well, they go up for lots of reasons, but the fundamental reason for buying a company is that you think it's going to keep making money, or make more money in the future, and you want to share in that.

Fundamentally, the price of a share is dictated by the future income it will generate for the holder. There are lots of different ways to work this out, and lots of different opinions - which is what makes a market, of course. But ultimately, that's the question you ask yourself - how much money will this company generate in the future, and, given that, is the current share price good value or not?

A property is the same. The reason you buy property as an investment, rather than a home, is because you think it will make you money. Again, the current value is dictated by the income that you expect the home to generate now and in the future. And that usually means how much rent you can expect to fetch for it.

But if the rental yield is actually negative just now, then that suggests the property is already over-valued. That means there's no reason for the capital value to rise in the future - in fact, it should probably fall before it goes any higher.

But people still keep clinging on to their buy-to-lets. Some are unable to sell because they haven't yet covered their costs. In fact, some city-centre flat buyers could conceivably be in negative equity - one landlord with an extensive portfolio interviewed in The Sunday Times said that one of his flats in Leeds is valued at less than when he bought it, a full four years ago.

These people will just keep holding on, throwing good money after bad, in the hope that the Bank will stop raising or even cut rates - as it mistakenly did in August 2005 - before they are yanked back into reality and forced to sell up before they go bankrupt.

There will be no soft landing. It's nature's way. It's one of the most basic laws of physics - for every action, an equal and opposite reaction.

If you have a boom, you get a bust. Once property was the path to untold wealth - today's investors won't forget that until they've lived through a time when it becomes the route to untold poverty.

Turning to the stock markets

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In London, the market was closed for yesterday's bank holiday. However, a late rally saw the FTSE 100 end Friday 5 points higher, at 6,570. ITV was the day's biggest riser with gains of over 4% sparked by rumours that BSkyB is to sell its stake in the broadcaster. For a full market report, see: London market close.

Elsewhere in Europe, the Paris CAC-40 closed 6 points higher yesterday - at 6,071 - on a day of light trading. In Germany, the market was closed.

On Wall Street, stocks closed higher on Friday ahead of the holiday. The Dow Jones added 66 points to end the day at 13,507. The tech-heavy Nasdaq was up 19 points at 2,557. And the S&P 500 was 8 points higher at 1,515.

In Asia, investors in Japan were cheered by strong jobs and household spending data, helping send the Nikkei to a close of 17,672 today - an 84-point gain.

Crude oil had fallen nearly 1% today and was last trading at $64.56 a barrel. In London, Brent spot had climbed to $70.88.

Spot gold was little changed from Friday at $655.30 this morning. Silver, meanwhile, had edged up to $12.93.

In the foreign exchange markets, the pound had risen to 1.9864 against the dollar this morning and was at 1.4763 against the euro. The dollar was down to 121.24 against the yen and was at 0.7249 against the euro.

And in London this morning, a group consisting of the Royal Bank of Scotland, Spanish Bank Santander and Fortis made an offer worth e71.1bn for Dutch bank ABN Amro. The proposed bid is 10% higher than that of a rival offer by Barclays, based on the most recent closing share price. Royal Bank of Scotland shares had fallen by 0.9% this morning

And our two recommended articles for today...

What will happen when the China bubble bursts?

- We may bemoan the UK housing bubble, but it's nothing compared to the vast bubble in Chinese equities. Private investors are ignoring public warnings on the dangers of speculation. And if and when the bubble does pop, it won't just be Chinese widows and orphans who are in trouble. To find out what the implications for other markets will be, read: What will happen when the China bubble bursts

How the US government creates jobs

- Elected officials and Wall Street executives all have a vested interest in keeping the perception of a robust economy alive. So although the job market looks sound, can we really trust the data? For Richard Benson's insights into the reality behind the numbers, click here: How the US government creates jobs

John Stepek

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.