Financial Times chief economics commentator calls for investment as the way out of the crisis – by Michael Burke

In recent articles in the Financial Times, that paper's chief economics commentator Martin Wolf has increasingly acknowledged that investment will be decisive in engineering an economic recovery, especially for highly-indebted countries, such as Britain. [1] He also argues that conventional wisdom about the prospects for economic recovery, and the policy adjustments that will be necessary, is wrong. 'The conventional wisdom is that it will also be possible to manage a smooth exit. Nothing seems less likely.'

The reason for his sober assessment is the trend in private sector financial balances; that is, the growing surpluses of private sector incomes over private sector expenditures. For the OECD as a whole this surplus of private sector savings is projected to reach 7.4% of GDP this year. Britain is one of six countries that will run such financial surpluses of more than 10% of GDP.

This situation, as Wolf points out, has been dubbed 'the paradox of debt' by Paul Krugman, following the Keynesian notion of the 'paradox of thrift'. The argument is that, while for each highly-indebted company or individual it makes sense to save, or in the current climate pay down debt, for the economy as a whole it is potentially disastrous. The aggregate saving reduces final demand, both for business investment and household consumption, and thereby deepens the recession. So incomes for individuals and companies falls further, and they respond by cutting expenditures further, and so on.

There are many criticisms of this notion from what has become orthodoxy over the past several years. The only serious one is that, if the private sector saves in this way but continues to consume and invest in the same proportions all that will then happen is that prices will fall, and goods and services will be cheaper at the new, lower level of spending. However, this ignores two trends that tend to occur in crises and are happening currently, most especially in Britain.

The first is that in a recession investment falls much faster than consumption. Private investment is controlled in the first place by profitability and not by the objective need for production of society. Furthermore, both individuals and companies cut back on investment in order to maintain vital consumption.

Of a total decline in Britain's GDP of £80bn, personal consumption has fallen by £29.5bn and fixed investment has fallen by £45.9bn. In fact, the fall in investment accounts for a little under 60% of the aggregate decline in GDP. This is shown in Figure 1.

Figure 1

The same pattern, whereby investment is the main driver of the recession, is replicated across the OECD. It is simply not the case that consumption and investment fall in equal proportions. Household consumption has fallen by 3.6%, compared to a fall in fixed investment of 19.3%. Investment is still falling, whereas all the other key components of GDP experienced small rises in the last quarter of 2009.

The second reason why this orthodox criticism is invalid is the level of debt. If prices fall, as orthodoxy expects, the real level of the debt only increases - as has happened in Japan since the beginning of the 1990s deflation in that country. In Britain there was a real danger of deflation, that is persistent price falls, at the end of 2008 and beginning of 2009, which has been averted by lower interest rates and a weaker pound. But a return to falling prices would mean increases in the debt-servicing burden for all income earners in Britain, including individuals, corporates and the government.

Martin Wolf argues that, while extremely loose monetary policy has been necessary, simply by itself it stores up two alternative problems, both of which lead ultimately to potential disaster. One possibility is that cheap money reignites a boom in consumption, which itself merely postpones an even bigger future financial crisis. The other possibility is that there is no recovery in consumption and the fiscal position deteriorates further, to the point of widespread government defaults.

His solution, set out more fully in the second article 'How unruly economists can agree', is that investment is the solution to both the economic slump and the crisis in government finances. 'What governments should do, instead, is ensure that deficits are credibly temporary, and growth-promoting. By all means, plan to cut the structural deficit faster than the government now intends. But do not believe that that would be the end of the matter. The actual deficit might need to be larger than that, for a long time. Try investment, instead'.

Who will invest?

This focus on investment is the correct one. But Martin Wolf's reliance on the private sector, and cutting the government deficit, is misplaced.

As we have already seen, it is the huge investment fall which is driving the recession. Only a very large increase in investment can therefore restore both prior levels of activity and government finances. Martin Wolf correctly chides many private sector economists and policymakers for wishing the world would return to the way it was before the crisis. He dismisses that hope as both misguided and forlorn. Yet his own hopes for a return to private sector investment themselves are seriously inadequate.

Many private sector economists expressed shock at the very recent data showing that the collapse in UK business investment continues unabated They shouldn't be surprised. Business fixed investment fell by 5.8% in the final quarter of 2009, down 27% from its peak in early 2008. The annualised fall is £40bn, over half the fall in GDP. Manufacturing investment is down 37.5% from its peak, construction down 54.3%, engineering and vehicles down 37.8%, transport down 29.8%.

This litany of an investment collapse, a literal investment strike, highlights a key problem for the idea that encouraging the private sector to invest will provide a sufficient answer to the crisis. Martin Wolf's proposals are private investment incentives - which may or may not work. They have a patchy record, often being taken up by businesses that would have invested in any event, and providing insufficient encouragement to create genuinely new investment. At the same time, he appears to accept the idea of cutting government spending.

While government spending has been rising modestly, and provided a very small cushion against the recession, the private sector is either too cash-strapped to invest, or will not do so because it cannot be confident of profits. The idea, then, that government should forego investment spending, and the economic support it brings the wider economy, is a reckless one. It is premised on the false notion that government investment in a situation such as the present 'crowds out' private investment, as if the economy were a fight in a phone booth. As we have already seen from the investment data, the private sector is in no hurry to invest, the investment strike continues. And taxpayers now own a swathe of the banking sector, so that government could force banks to lend to support any rebound in private sector investment that does occur. Government investment can replace lost private sector investment, especially in areas of extreme falls such as transport, construction, engineering and vehicles. The state may need to increase its direct control over those sectors to achieve that.

But, while it is possible to disagree with Martin Wolf on the likely source of investment over the next period - end entirely disagree with him on the need to cut government spending - it is welcome that influential mainstream economics commentators are now coming to the view that investment holds the key to economic recovery. In his words, 'Let us not repeat past errors. Let us not hope that a credit-fuelled consumption binge will save us. Let us invest in the future, instead.'

Source

[1]Martin Wolf 'The world economy has no easy way out of the mire' and 'How unruly economists can agree'

Memo to Martin Wolf - India and China show that to maintain support for globalisation reliance on 'trickle down' needs abandoning

In his blog from Davos Martin Wolf, chief economics commentator of the Financial Times, notes: 'I am listening to Lawrence Summers as I write. He has emphasised that we cannot maintain global integration if it is seen as a source of domestic disintegration. This tension - that between the global economy and domestic politics - is a central challenge of our time. It affects everything we try to do.'

Martin Wolf is a very strong supporter of global economic integration for reasons he set out in Why Globalisation Works and numerous other writings. The danger he warns against is that popular backlashes in favour of protectionism will undermine the process of global economic integration. In the US and a number of European countries popular sentiment in favour of protectionism has increased - although its effect on those who make economic policy, as regards the most important issues, is as yet far more limited.

For slightly different reasons to Martin Wolf this blog is also strongly in favour of the process of global economic integration and against protectionism. The reason for this is that division of labour, followed by investment, is the most powerful force in economic growth and in the modern era participation in increasing division of labour is necessarily international in scope. Preventing popular, indeed any, backlashes in favour of protectionism is therefore an important question.

In dealing with this issue Martin Wolf could reflect on the difference in sentiment between India and China on the one hand and the US and Europe on the other. In India a government pledged to take the country down the strategic path of integration in the international economy was re-elected with a convincing mandate. In China, as anyone who visits the country knows, popular support for the 'opening up process' (official terminology for the country's orientation towards globalisation) remains high. The contrast in popular mood between India and China on the one hand and the US and Europe on the other is therefore striking.

Part of this difference is, of course, the much more rapid growth of India's and China's economies compared to Europe and the US. However, simply rapid growth is not sufficient to maintain popular support for international economic integration - and while the US and European economies have been expanding less rapidly than India and China they were, prior to the current recession, still growing.

The former BJP government in India achieved rapid economic growth but was tossed out of office by the electorate. Entirely rationally the population will not support globalisation if this merely yields higher GDP figures recorded in statistical works,. They will support globalisation only if it delivers better living standards for them. The majority of India's population considered the BJP's rapid economic growth had not delivered for them and therefore voted against the government.

The strategic concept of the new Congress government under Manmohan Singh was, and remains, 'inclusive growth'. It aimed at rapid growth, using global economic integration as a key means to achieve this, but did not rely on 'trickle down' to make sure the mass of the population shared in its benefits. Conscious programmes of redistribution of resources to rural areas, and less well off sections of the population, were part of the bedrock of 'inclusive growth'.

It is also notable in China that Hu Jintao's 'harmonious society' has included direct measures to redistribute the benefits of growth to those who were not previously perceived as having gained sufficiently. In China's stimulus package to confront the international financial crises, price reductions on consumer durables were targeted on rural areas, the government has reintroduced free education, a major expansion of the health care system is taking place, large scale investment is taking place in the less well off inland provinces etc.

In short, both India and China have abandoned 'trickle down' as the method of ensuring all share in the growth produced by international economic integration.

In the US and Europe, on the contrary, the movement has been towards greater reliance on unfettered free markets. The evidence shows, however, that unfettered operation of the market increases inequality sharply. The most notable result of this is that median wages in the US have relatively stagnated for two decades at the same time as relatively sustained economic growth occurred - it is necessary to look no further than this to understand populist backlashes in the US. In the US the gap in income and wealth between the bottom and top of society has widened greatly, as it has in Britain. The US and Britain by relying on 'trickle down', by the operation of the free market, have therefore sharply increased inequality - and, in the case of the US, deterioration of the economic situation for significant layers of the population has occurred.

India and China, in short, have abandoned 'tickle down' while the US and Europe have embraced it. In India and China support for strategic global economic integration remains high. In the US and Europe a backlash against it has developed.

Martin Wolf, in his entirely justified argument against the US and Europe embarking on protectionism, can therefore consider the contrast in the popular mood in India and China. It may indicate why, to maintain popular support for globalisation, the US and Europe also need to abandon reliance on 'trickle down'.

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This article originally appeared on the blog Key Trends in Globalisation.

The convulsion in world trade

This blog has analysed on several occasions that the current decline in financial markets, including share prices, has continued for 17 months to match in rapidity that after 1929 – i.e. the most severe recorded.

As may be seen from Figure 1 the rise in share prices on Wall Street in the trading week 9-13 March week did not break out of this declining trend. The shift so far has simply moved the rate of descent closer to the declining trendline that has been operating since October 2007 following several weeks of more precipitate than average falls.

Figure 1

As may be seen from the comparison in Figure 2 the rate of descent of the Dow Jones Industrial Average since October 2007 continues to be as rapid as in 1929 - i.e. it greatly exceeds in speed any other major share decline, apart from 1929, seen since the beginning of the 20th century.

Figure 2

Considering the relation between the financial decline and the productive economy, an article on this blog earlier this month also noted that, for the major industrialised economies, the annualised rate of decline in exports in the last three months has actually been more rapid than in 1929.

The latest statistical data released by the Organisation for Economic Co-operation and Development (OECD) for world trade up to December 2008, with data for more recent months in a few cases, allows the calculation of a picture for a wider range of countries that confirms this trend in striking fashion.

Due to the extremely rapid shift in the situation three indicators have been calculated for exports – the actual year on year decline to December 2008, the actual decline in exports since the peak month for each country or area last year, and the change during the three months to December 2008 on an annualised basis.

In order to give a historical scale of comparison the decline of US exports, in current prices, was 22.5% in 1929-30, 32.7% in 1930-31, 32.4% in 1931-32 and 4.0% in 1932-33 after which partial export recovery commenced - i.e. the most rapid annual rate of decline of US exports in the Great Depression, and the most rapid on record to date, was 32.7% in 1930-31. By 1933 US exports had fallen 66.2% below their 1929 level.

Considering first the OECD area as a whole, and the situation in the European region, the data is set out in Table 1. As can be seen for the OECD region as a whole exports have already declined by over 30% since their peak in April 2008 - essentially equaling the rates of decline of the worst year of the 1930s. The annualised rate of decline in three months up to December 2008 was an astonishing 64%.

For the major G7 economies the decline was only slightly less severe - with a decline of 26.9% since the peak in July and an annualised rate of decline of 57.8% in the three months to December 2008.

Within the Euro area the annualised rate of decline for the three months to December 2008 was 50.4% and for the OECD European region, which includes some East European states, the annualised rate of decline was 67.0%.

It may therefore be clearly said that in the field of trade, as in that of financial markets, the current decline is full comparable in speed of descent to the onset of the Great Depression. The difference, so far, is not in the speed of fall but in its duration. The decline in exports after 1929 continued for four years whereas so far the current decline has been occurring for a year.

Table 1

Turning to individual countries, Table 2 shows the figures for the largest OECD economies - the G7. As may be seen all have seen declines in exports of over 25% since their peak levels last year and in the three months to December 2008 all witnessed annualised rates of decline of more than 50%.

In short, the precipitate decline in world trade, at 1930s rates of descent, is not confined to smaller economies but fully affects the largest ones.

Table 2

Table 3 shows the rates of decline of exports for the non-G7 European OECD states. As may be seen with the exception of two small economies, Luxemburg and Ireland, which have done better than others, all OECD European countries have seen actual export declines of at least 25% and annualised rates of decline of 50% or more.

It is possible that the rate of decline for Spain, an incredible 99.7% annualised rate in the three months to December 2008, is a statistical freak or error but the annualised rates of decline for Sweden, Poland, and Norway are almost as severe - respectively, 79.1%, 82,8%, and 83.1%. Such rates may rightly be characterised not as decline but of collapse of exports in at least the short term.

Table 3

Turning to non-European economies, the data is set out in Table 4. Again, with the exception of the small economies of Iceland and New Zealand, the highly publicised decline of Chinese exports by 22.3% since their peak last year, and at an annualised rate of 53.0% in the three months to December, are themselves actually significantly smaller than for other countries. Mexico and South Korea have already seen actual declines of exports of over 30% and South Africa and Turkey have seen falls of over 40%. The annualised rates of decline of exports for South Korea, Brazil, Indonesia, South Africa, and Turkey - at 70.7%, 72.4%, 78.2%, 82.1%, and 90.1% respectively - are clearly catastrophic.

Table 4

Countries for which OECD data is available for January confirm continuation of the same trend – as shown in Table 5. The chief difference is that with the extra month the actual declines in exports, as opposed to only the annualised rates of fall, have become more serious.

The actual falls recorded from the maximum levels of exports are 29.8% for Switzerland, 41.1% for South Africa, 41.4% for Sweden, 46.3% for Norway and 47.5% for Turkey. There is nothing in this pattern which indicates results for other countries are likely to show an improved tendency.

Table 5

Summarising the above data, of the 34 countries studied 14 had annualised rates of decline of exports of more than 70% and 20 had rates of decline of more than 60%. The widely publicised reports of declines of exports in the last three months of last year such as the annualised 51.9% for Japan, 53.0% for China, or 54.0% for the US, which attracted much publicity, are actually modest compared to the falls in most countries.

While the annualised rates of decline show the extremely striking implosion of world trade during the last three months of 2008 an annualised rate, naturally, indicates an, in this case extremely severe, tendency. What is equally disturbing is the factual falls in exports recorded from the maximum levels last year. Seven countries registered actual falls in exports of more than 40% and 19 of more than 30%.

It should be noted that trade today plays a more significant role in the world economy than at the onset of the 1929 crisis. Exports in an economy with relatively low exposure to trade such as the US now account for 12% of US GDP compared to 7% in 1929 - the figures for most countries are of course much higher. The result of any continuation of such rapid rates of decline of trade therefore, all other things being equal, would be more severe than in 1929.

The transmission mechanisms of the financial crisis into the productive economy are also made clear by such trends. As has been noted previously, initially in the present crisis there was a disjunction between the decline in financial markets, which was of 1929 magnitude, and the situation of the productive economy - which was of a severe but not equivalent decline. As such a disjunction is highly unlikely to continue either financial markets would recover, having overshot on the downside, or the trends and statistics in the productive economy would be shown to have been a lagging indicator and they would adjust downwards to the tendencies indicated in financial markets.

The extraordinarily powerful falls in world exports shown in the latest figures for all major economies indicate that the decline in trade is operating as a key mechanism by which the crisis revealed in financial markets is beginning to affect the productive economy. It may now be said that in two areas of the world economy, financial markets and trade, rates of decline are fully comparable to 1929 scale. How powerful the transmission mechanisms from the international sector are into domestic economies must clearly be carefully studied. The duration of the crisis is also critical - the so far unique severity of 1929 was not only due to the rapidity of the fall but by its duration. The decline in US trade and GDP in the 1930s continued for four years whereas the current decline in financial markets has lasted 17 months, the decline in trade slightly under one year, and the fall in GDP approximately six months.

Nevertheless quite sufficient data are now in to say with certainty that in the last three months of 2008 a convulsion in world trade occurred. The extreme rapidity of the fall in world trade, as with the situation in financial markets, confirms that the benchmark for present analyses must be not only post-World War II recessions but also 1929 itself.

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This article originally appeared on Key Trends in Globalisation

Notes to Tables - peak month for exports in 2008

1. Peak January 2008
2. Peak March 2008
3. Peak April 2008
4. Peak May 2008
5. Peak June 2008
6. Peak July 2008
7. Peak August 2008
8. Peak September 2008

UK bank 'insurance' scheme will become even more unpopular because it is economically wrong

Unsurprisingly it was the Tories who proposed the new scheme whereby UK bank loans will be insured by the state - a method whereby losses made by the private banks are 'nationalised', that is underwritten by the tax payer, while bank shareholders have share prices propped up by taxpayer guarantees. It is, in short, a system whereby bank shareholders siphon money from the tax payer.

This scheme is wrong from the point of view of economic policy - what is required from an economic point of view, as Socialist Economic Bulletin has pointed out, is bank nationalisation in order to ensure lending to the economy restarts. Under the present scheme bank shareholders will continue to take tax payers money as profits instead of all money being used for counter-cyclical bank lending.

Precisely for that reason the scheme will be deeply damaging politically - people will understand their money as taxpayers is being siphoned off to the bank shareholders and bank managements who took the decisions which are responsible for the present deep economic crisis. The scheme is therefore already unpopular for that reason and it will become more so as the taxpayer begins to pick up the bill.

That the Tories should propose the public is robbed by companies is natural -that is why they proposed the scheme. But Labour should not be supporting it. Nationalisation of the core of the UK banking system is what has been required since last autumn and it should be proceeded to before even more billions of taxpayers money is lost.

The Sunday Times gets it on how China is using state owned banks to fight the recession

The Sunday Times today carries an article by Leo Lewis that factually sets out the way in which bank lending in China is now rapidly soaring as a part of its counter-cyclical strategy. This is, of course, in sharp contrast to the situation in Britain - where banks are sharply contracting lending, seriously worsening the economic downturn, despite the fact that they have received tends of billions of pounds in taxpayer bailouts.

The reason for the difference is, as Socialist Economic Bulletin has pointed out, of course that with a state owned banking system, as in China, banks can be instructed to increase lending as a central part of the strategy to fight recession. With a privately owned banking system, as in the UK or US, bail out funds put in by the taxpayer are appropriated by the need to deliver profits to bank shareholders and no increase in lending takes place.

Lewis attempts to present matters from the shareholders point of view - warning that such large scale lending programmes as in China are putting the needs of the economy before that of shareholders. But the needs of the economy should come before those of shareholders. A state owned core of the banking system allows lending to be maintained, or expanded, when faced with a severe economic downturn - which is what is required for the economy. A privately owned core of the banking system, such as in Britain, means bank lending shrinks when confronted with serious economic recession - the opposite of what is required.

Lewis's factual description of what is occurring in China shows clearly that a sharp contraction in bank lending, severely worsening recession, is not 'an act of god' which cannot be avoided. It is a consequence of subordinating the interest of the economy to those of private bank shareholders. The way out is to take the core of the banking system into state ownership and re-commence lending to the economy. Present policy in China shows what is required in this field.

Lewis notes: 'Gripped between the jaws of financial and economic calamity — and knowing that the banks hold the answer to everything — there are two choices a government can take with the sector: caulk and coddle or maim and martyr.

'It is still early days, but with new bank lending soaring 1,000 per cent year-on-year in December, it looks very much as though China is taking the Joan of Arc (maim and matyr) option.

'China’s banks may appear to be more like market-traded, market-led institutions than they did ten years ago, but that view is wishful at best... The biggest exposé of the banks’ true nature comes in the form of a recently produced graph of new bank lending in China, dating back four years. Between April 2004 and October 2008, the line bounces around in much the way you would expect it to in a booming economy with lots of simultaneous investment cycles and bubbles. Between November 2008 and now, it suddenly goes up. Vertically.

'The 1,000 per cent surge — a slew of 772 billion yuan in new loans to companies and projects — dates almost exactly from the moment lending quotas were scrapped and regional banks were told that their loan to deposit ratio could legally drop below 75 per cent. M2 — the sum of all cash and deposits — soared 18 per cent in the same month... as CLSA’s China strategist Andy Rothman puts it: “in China, there is only a credit crunch when the political leadership wants one.”... For those who truly believe that restarting the lending cycle again is a guarantee of sustainable Chinese growth above 8 per cent, the unfettering of the country’s banks could even be more significant than the government’s $580 billion spending package... The China Banking Regulatory Commission... endorsed a massive increase in lending to small firms...

'What sort of post-dated cheques has Beijing written out as guarantees to the banks that are now loyally doing the government’s bidding? Lurking behind the scenes, there must be informal absolutions offered for the banks that lend themselves to death. Good for them, good for Beijing and, probably, good for longer-term stability in China.'