The following article is an edited version of a presentation made by John Ross at the 'Progressive London' conference on 11 July. It was originally published on the website of Progressive London.
As noted in the article it was made before the publication of the UK 2nd quarter 2009 GDP figures. Rather than rewrite the article the analysis was however left as it stood and subsequent developments are dealt with in notes in the article.
Such a perspective, as will be seen, is wrong. It is based on only one serious statistic - that the very rapid decline in share prices has halted and some recovery in this field has occurred. The perspective of substantial UK economic recovery in any near term period is not justified by consideration of the actual overall indicators of the UK economy. [Note – this presentation was given before the publication of the 2nd quarter UK GDP figures on 24 July. These showed the decline in output in that quarter at 0.8%, or an annualised rate of 3.2% - twice as bad as media projections. This evidently confirms the analysis made below].
As UK share prices, i.e. the FTSE, invariably follows US share markets, which are in any case far larger and more important than those in the UK, Figure 1 shows the movement of the Dow Jones Industrial Average in the present economic downturn compared to that in 1929. This graph measures, by the number of trading days since the previous hight point of the cycle, the decline of the Dow Jones Average after its peaks in 1929 and 2007.
The pattern shown is clear. From 9 October 2007 until 9 March 2009, that is for 358 trading days after its peak level, the fall of the Dow Jones Industrial Average tracked the decline starting in 1929 - apart from 1929 there has been no comparable decline in US share prices so these are unique and comparable events. This fall culminated in a decline of 54% from Dow's peak level. Since then the Dow has moved upwards although it is still well over 35% below its peak.
The cause of the halt in the decline in share prices, and partial recovery, since 9 March is evident. Governments have implemented the largest bank bailout/recovery packages in history, measured in trillions of dollars. These have been carried with a single overriding goal of shoring up the position of bank liquidity and bank capital/profitability ratios – which has an inevitable consequence of aiding bank share prices and therefore bank shareholders. This has been supplemented by some of the largest subsidies to non-bank corporations in history (e.g. General Motors, Chrysler, AIG).
If trillions of dollars are pumped into institutions then evidently their value, compared to the situation where such injections were not made, will be increased. The fact that even after this transfer of resources share prices have not been restored to anything like their previous levels shows just how serious were the losses involved. If this maximum possible state mobilisation of financial resources had been incapable of breaking the downturn in share prices then it would be possible to say with a high degree of certainty that the world had gone through a 1929 and had entered a new Great Depression.The second major category of US assets, Treasury bonds, are of particular importance given the situation of large US budget deficits. A major fall in US Treasury bond prices, reflected in a surge in their interest rate/yield, is one of the major risks facing the US economy. As may be seen from Figure 2 so far the yield on US Treasury bonds has risen back to its pre-crisis level after falling during a 'flight to safety' at the end of 2008 - the yield on Treasury bonds moves in the opposite direction to the price so the recent rise in Treasury bond yields is a reflection of a drop in their price. Furthermore, as inflation is dropping, the same nominal yield is actually a higher real rate of interest than prior to the crisis in 2008. So far it may, therefore, be stated that the situation on US bond markets is neutral but with downside risk.
Figure 2
In one crucial area, however, the reallocation of resources in the US has so far not succeed in restabilising the situation. This is house prices - and area of particularly importance as it was the decline in US house prices which underlay the financial crisis in the first place.
As shown in Figure 3 US house prices have continued to decline. As long as this fall in US house prices continues it will continue to exercise large downward pressure on the balance sheets of US financial institutions.
It is therefore clear that while share prices have been stabilised US asset prices as a whole have not been stabilised to anything like the same degree. Treasury bonds are neutral with downside risk and house prices have continued to fall.
Figure 3
The reason for the different performance of US share prices and US house prices is also clear. The transfer of taxpayers’ funds in the US was to companies and shareholders, not to consumers. But the overwhelming majority of houses are bought by consumers not companies. While, in effect, trillions of dollars has been transferred to the benefit of share owners in the US no equivalent transfer has taken place to consumers. Therefore share markets stabilised but house prices continued to fall.
To complete a brief survey of financial markets, it may be shown why any implicit view (the issue of 'green shoots' in this field) that if share prices fall rapidly they must necessarily recover rapidly has no factual foundation. Figure 4 shows, in addition to the movement of the Dow Jones since 2007, the decline of the Dow Jones Average after 1929, up to the point at which it regained its previous nominal peak level, and the decline of Japan’s Nikkei share index since 1990. As may be seen it took 25 years for US share prices to regain, even in nominal terms, their 1929 level – i.e until 1954. Japan’s share prices have still not regained their 1990 levels 19 years later. In short a major decline in shares is not necessarily 'V' shaped at all. It may be extremely prolonged.
Figure 4
Contrary to 'conventional wisdom'/myth, and the attempt of the UK government to force pension funds to invest in shares, the latter have in the last period actually been an extremely bad investment. Nominal UK and US share prices today are no higher than 12 years ago – which means significantly lower in real terms.
As Patrick Hosking noted in a major article in The Times: ‘The cult of the equity is still the mainstream view but… British shares are lower today than 12 years ago [Note – this remains the case at the date of posting this article]. Japanese shares are lower than 26 years ago.
‘Tim Bond, the man behind Barclays' Equity-Gilt study, has crunched up-to-date numbers for The Times and come up with some sobering findings. Only investors who put their money to work in 1983 or earlier would have done better placing it in equities than government bonds (gilts). From 1984 onwards, in any timeframe up to the present day, gilts have produced a better total return than shares. Over any timeframe of less than 15 years to the present day, even deposit accounts have produced a better return... capitalism has not been working terribly well of late.‘This is no abstruse matter. For millions of members of defined contribution pension funds, the expected outperformance of equities relative to gilts underpins their retirement hopes…’
‘Some argue that the notion of the free lunch given to long-run holders of equities is plain wrong. The idea that the risk of holding equities declines the longer one holds them is a fallacy, the sceptical minority say. If it were so, then the cost of an equity put option - an insurance policy against markets failing to rise to an agreed point - should decline the longer the time frame. It doesn't. No one among the rocket scientists on the big bank trading desks - for all their fancy stochastic modelling techniques - is keen to take that side of the bet.'To summarise, there is some short term recovery in share markets since March - which is what talk of 'green shoots' is really based on. But there has been is no serious long term recovery even in share prices - they have been stagnant for more than a decade and recent rises are simply from ultra-depressed levels. Such rises may be a source of profit to those engaged in short term operations on the share market. They give, even in their own terms, no indication of a prospect of economy recovery - indeed the fact that US and UK markets are below their level of ten years ago, and Japan's below the level of twenty years ago, is itself a statement of a share market perspective of economic stagnation.
Turning from financial markets to the productive economy, and to policy responses, the governments of every major country have abandoned neo-liberal policies confronted with the international financial crisis. All have adopted measures which have been labelled, and which in general they understand to be, ‘Keynesian’.
The consideration of what would be a really 'Keynesian' response, in the sense of being the policies advocated by Keynes, to the international financial crisis will be dealt with at the end of this presentation. For the present a rather 'loose' definition of 'Keynesianism' will be used to refer to all measures which seek to counteract the decline in investment which drives an economic downturn by indirect methods (reduction in interest rates, budget deficits, driving up of consumer demand to attempt to stimulate sates and increase business profitability, tax incentives for investment etc).This may be counterposed to what may be termed a 'Chinese' approach, outlined below, whereby direct measures are taken to maintain investment - via state direction of investment and use of large scale investment programmes by state owned companies. The key question in the economic downturn is therefore whether such indirect methods, that is 'Keynesian' ones, will be sufficient to stop the investment downturn or whether it will be necessary to take more direct control of investment? Or what combination of indirect and indirect measures will be necessary?
The reason that the focus of all these issues is investment is because, in any serious economic downturn, the fall in investment is the driving force of the recession. To illustrate this Figure 5 shows the change in the components of domestic output in the US during the most classic of all economic downturns, the Great Depression after 1929.[1 ]
As may be seen, the downturn in US GDP following 1929 was almost 30%. Consumer expenditure, however, fell by slightly less than US GDP and government expenditure continued to rise throughout the depression - not only under Roosevelt but even under Hoover. The decisive fact was that investment fell by 80% - this collapse being the driving force of the downturn.
The reasons for this pattern, which as will be seen applies in the current economic downturn, and in all serious such declines, is evident. In a privately owned economy investment decisions are taken by companies whose actions are determined by profit - not by the direct needs of economic growth. Regarding the other components of domestic demand it is relatively easy to maintain government expenditure, as administrative policy decisions may be taken. While it is somewhat more difficult to maintain consumer expenditure (due to the effect of increasing unemployment, the fact that household savings rates may rise in recession etc) even here relatively powerful instruments are available – increases in benefits paid by the government, tax reductions, pay from work creation and training schemes etc.
But in a private economy, by definition, the ownership of the decisive means of production are in private hands. In the UK, for example, state controlled investment is only a small fraction of GDP - less than 2%. The state, therefore, has no levers by which it can prevent the decline in investment taking place - as will be considered in detail below. However it the state were to take control of decisive sectors of investment, on a scale sufficient to determine its overall level, then there would no longer be a privately run economy.
This dominant role of the decline in investment in the present international economic downturn is evident from Figure 6, which shows the shift in components of GDP for the G7 countries taken as a whole. As may be seen investment had already started to fall in the G7 in the 1st quarter of 2007 – i.e. the international economy was already turning down when it was hit by the financial crisis in 2008.
Figure 6
'Keynesian' methods of demand management, principally budget deficits, have so far been able to control the decline in private consumption (via tax cuts, increased benefits etc) and to prevent a decline in government consumption (education, health etc). Indicating this since the 4th quarter of 2007 private consumption in the G7 has risen by 0.1%, while government final consumption expenditure has risen by 3.9%.
But indirect Keynesian methods have been unable to halt the decline in investment – because, by definition, indirect methods do not include the step of direct state measures to raise investment.Fixed investment in the G7 has therefore fallen by 13.4%.
Primarily under the impact of this fall in investment G7 GDP has fallen by 4.4% since its peak.This is, therefore, clearly a classic investment driven economic downturn,To give a measure of the scale of the current downturn Figure 7 shows that the current fall in GDP is by far the most serious recession since World War II. The combined GDP of the G7 countries, up the first quarter of 2009, has already fallen by 4.4% in this recession. The previous deepest fall in GDP in a year in any previous post-war recession was 1.1% in 1980. The decline in international GDP is already four times as severe in this downturn as in any previous post-war recession.
It is also worth making a comparison of the present downturn to 1929. The international economy has gone through three quarters of downturn and dropped by 4.4%. There are no quarterly GDP figures available for the US for 1929 but if the annual decline in of US GDP 1929 is projected over three quarters then the fall was 7.1%. The current downturn is therefore roughly four times as severe as any previous post-war recession and slightly more than half as severe as the US in 1929.Figure 7
In 1929 however, of course, the decisive fact was that the downturn continued for four years. The crucial question in this downturn will therefore be whether it will be possible halt this economic decline and confine it to a much shorter period than in 1929.
As would be expected the reason the reason this recession is far more severe than any previous one since World War II is that the downturn in investment is more severe than in any previous post-war recession. The maximum decline in investment in any previous recession was 10.2% after 1973. However in the G7 economies as a whole investment has already declined by 13.4% in this recession and the rate of decline has been accelerating. Figure 8 shows this trend.
Figure 8
This fall in investment started at different dates in different countries - see Figure 9. The largest decline in investment to date is 23.7% in the case of Japan. Investment is however declining in sharply in all major economies and it is likely to fall significantly further.
The most direct way to deal with a decline in investment is, of course, to take its control out of private decision making and to take state decisions to raise investment. This is the path which is being taken by China. China's GDP rose by 7.1% year on year in the first half of 2009 and by7.9% year on year in the second quarter. The driving force of this is a more than 33% investment in fixed assets in urban areas. In parallel with this direct expansion of state investment the banking system, which is state owned in China, has been instructed to, and is, rapidly expanding lending - in contrast to the contraction of bank lending which is taking place in the UK. China’s advantage is that it has direct means to control investment through its state owned companies and state owned banking system.
Turning to the UK, the economic downturn shows the same pattern as the international one. It is driven by the decline in investment. This is shown in Figure 10 which shows the shift in the domestic components of GDP.
Since the last quarter of 2007 UK government consumption expenditure has risen by 3.7%, private consumption has only fallen by 1.8%, but investment has declined by 14.7%. In consequence GDP has fallen by 4.9%. [Note - this was prior to the announcement of a further 0.8% decline in GDP in the 2nd quarter of 2009. The total decline of UK GDP up to the end of the 2nd quarter of 2009 is now 5,7% from its peak in the first quarter of 2008).
Figure 10
This fall in UK investment, however, is not evenly spread but particularly concentrated in housing and in private transport equipment (buses, trains, cars etc). The decline in these two fields, furthermore, started even before the international financial crisis – over two years ago in both cases.These trends are shown in Figure 11.
Figure 11
Taking the investment trends as a whole, UK total investment up to end of the first quarter of 2009 had fallen by 14.7%. However investment in transport equipment has fallen by 34.9% and investment in housing has has fallen by 29.7%. For comparison investment in non-transport machinery has fallen by 13.7% and investment in non-housing construction has fallen by 10.0%
As would be expected government investment is the only sector of investment that is continuing to hold up – because decisions here are not controlled by profit and the private sector. Since the 4th quarter of 2007 government investment has risen by 7.2%, whereas private investment has fallen by 17.6%.The trends are shown in Figure 12.
The problem is, however, that while government investment is rising the government share in total investment in an economy such as the US or UK is too small to halt the overall decline in investment. To be precise at the beginning of the investment fall in the 4th quarter of 2007 private investment was 88.5% of all investment and government investment only 11.5%.
Therefore while government investment has gone up by £0.5 billion this is far too small to offset the £9.6 billion fall in private investment - see Figure 13. It is this massive decline in private investment, as has already been noted, which drives the economic downturn.
Finally the inevitable consequence of this rapid fall in GDP, driven by plunging investment is, of course, a rapid rise in unemployment - as shown in Figures 14 and 15. Under the impact of the economic downturn Britain is rapidly returning to an era of mass unemployment with all its consequences not only in terms of direct human misery but of rising crime, rising racism and intolerance, pressure to abandon measure to protect the environment and deal with climate change in the name of short term economic expediency -and an overall worsening situation in society. In short, over the next years, if this economic downturn is not halted, Britain will become a markedly worse society.
Figure 14
What conclusions are to be drawn from this?
The first is that what occurs in the economic downturn, as with every serious one, will be determined by what happens to investment. Well established mechanisms exist to maintain government and private consumption. What occurs will be decided by whether the government is willing to take sufficient measures to maintain investment by both direct and indirect means - the issue of which is the appropriate combination of the two is dealt with below.
The imperative of dealing with climate change of course remains but an issue of timescales has become crucial. The time scale of dealing with the economic recession is months – there has to be strong state intervention to deal with the investment downturn.A radical policy must therefore combine short term very rapid action to deal with the economic crisis and measures to deal with climate change.What the are the combination of measures which are required?
Evidently budget deficit policies must continue - as already noted these have been maintaining consumer demand and government expenditure.The Tory policy of radical cuts in government spending, under conditions in which there is no equivalent source of private demand in either consumption or investment is economic nonesense - it will deepen the recession.As an indirect means to maintain investment, and deal with company cash flow problems, a crucial issue is to increase bank lending. This is, however, directly contradicted by the government's aim to restore the nationalised banks to private ownership as rapidly as possible - which creates an imperative to rebuild their capital ratios and therefore restrict lending. Vince Cable has been entirely right in pointing out that the government priority to re-privatise the banks cuts right across the imperative to increase lending. There must, therefore, be an end to attempts to re-privatise the banks and their policies should be set by the priority of economic recovery.
Third, properly Keynesian measures aimed at driving down long term interest rates, notably quantitative easing, must be introduced. These would both stimulate demand in general and would aid the situation with investment. This is dealt with below.Fourth, there are already two areas, transport and housing, where it is evident that indirect means to sustain investment will not be sufficient. Indirect methods such as maintaining low interest rates and increasing bank lending may be able to deal with declines in investment of five percent, or arguably of ten percent. But they are inadequate to deal with declines of thirty percent, which is the scale of fall that has been seen in both housing and transport. There must, therefore, be direct programmes of large scale state investment in housing and transport.
Fifth, short term measures to reverse the economic downturn must be combined with measures to deal with climate change and the environment. All investment programmes must therefore be calculated from the point of view not only of finance but of their effect on climate change. As major areas of investment, housing and transport, have considerable environmental impact this is entirely practical.Sixth, measures to maintain investment simultaneously with keeping up private and government consumption, will require major resources. To free up resources for these vital tasks programmes which contribute neither to protection of the living standards of consumers nor to investment must be cut - this means programmes such as Trident (where the change in position of the Liberal Democrats is to be welcome) and the building of aircraft carriers should be abandoned. Britain's level of defence spending must be cut to the same proportion of GDP as Germany if its economy is to compete.
Finally, as the economic situation is rapidly moving, and therefore the precise measures required can evolve, what should be the overall approach to the financial crisis?Once the nature of the economic downturn is understood it is clear why the most successful stimulus package to deal with it is China's. As already noted GDP in China rose by 7.9% year on year in the second quarter of 2009 when GDP in almost all other major countries was falling. The reason for this is that China can directly control investment through its state owned companies and has powerful indirect mechanisms to indirectly stimulate investment through lending by its state owned banking system. The consequence, as already noted, is that while in the UK and G7 economies investment was plummeting China's urban investment is rising at over 30% a year. This is the core of the reason why China's economy is continuing to grow rapidly,
However, to carry out a stimulus package on the scale of China it would be necessary for the UK state to own large sectors of the economy and for state owned enterprises playing a key economic role. Whether or not one things that is a good idea there is no political majority for such a step in the UK at present. Nor will there be one if indirect methods of a Keynesian type prove capable of turning round the economic downturn. Only if the economic situation deteriorates far further would it become evident that the only choice was between taking ownership/control of the decisive sectors of the economy, in order to halt the decline of investment, or allowing an unacceptable degree of decline of the economy. The UK economic situation, while serious, has however not yet reached that point.
In most economic areas indirect methods of halting the decline in investment can still be attempted. The exceptions are housing and transport where it is already clear that large scale direct state intervention is required if the decline in investment is to be halted.Finally, what would have been the view of Keynes of all this? This is not, of course, the most important issue - what is to be done practically is. But nevertheless it is an interesting question.
The measures which are being employed by the governments of the major countries to deal with the financial crisis are not those which actually were the central ones flowing from Keynes’ General Theory of Employment, Interest and Money.
The policies which in the media are popularly presented as ‘Keynesian’ centre on budget deficits – a policy priority which is defended by Nobel laureate Paul Krugman for example. Keynes himself did call for budget deficits. He however primarily focussed on monetary issues. The core policy that flowed from his views, and which he advocated, was the necessity to reduce long term interest rates through measures such as ‘quantitative easing’ (i.e Central Bank purchase of securities, above all treasury bonds). As he stated: 'In my view the whole management of the domestic economy depends upon being free to have the appropriate rate of interest.'[2] At present, while budget deficits are almost universal, quantitative easing is applied only on a small scale by both the US and UK.But, it should be noted, Keynes himself did not rule out, in certain circumstances, the state taking control of investment. Already in 1933 he had noted: ‘My proposals for the control of the business cycle are based on the control of investment. I have explained in detail that the most effective ways of controlling investment vary according to circumstances, and I have been foremost to point out that circumstances can arise, and have arisen recently, when neither control of the short-term rate of interest nor even control of the long-term rate will be effective, with the result that direct stimulation of investment by the government is the necessary means.’[3]
In the final chapter of the General Theory of Employment, Interest and Money Keynes noted: 'a somewhat comprehensive socialisation of investment will prove the only means of securing an approximation to full employment.' [4]
In normal circumstances this 'somewhat comprehensive socialisation of investment' is not required to prevent major economic downturn. In China at present 'a somewhat comprehensive socialisation of investment' is proving to be the most effective tool for combating the international financial crisis.At present in the UK there is not majority support for this 'somewhat comprehensive socialisation of investment'. In general indirect methods (reduction of interest rates, budget deficits, attempts to expand bank lending) will still primarily be used to attempt to halt the investment decline. However in two areas, housing and transport, it is already clear than such indirect methods will not be sufficient and direct state intervention is required. At present in the UK therefore the situation is one where a combination of indirect and direct methods to deal with the downturn in investment are required.
How the situation will proceed after this depends on the unfolding of the economic situation itself. China's economic response has already proved that it is the most successful in the world. But there is not yet a consensus in favour of such a model in most countries outside China.
The position that should be adopted in the UK therefore flows from this overall situation. If indirect means can be successfully used to reverse the investment decline in most sectors they doubtless will be. But the necessary approach is that the economy must be preserved from the the downturn. If indirect methods to preserve investment are not sufficient then direct methods must be used, Exactly what combination of measures are required to achieve this, in addition to those already outlined above, will flow from the unfolding of the economic situation itself.Notes
[1] In this presentation domestic factors in demand are dealt with. It is evident that after 1929 the situation of individual economies was greatly worsened by the precipitate decline in world trade. Furthermore one of the prominent features of the present international downturn is that the decline in world trade is actually worse than in 1929 - see Figure 15 below. However, for the world economy as a whole, of course, trade is not a factor. Therefore the basic shifts can be best illustrated by ignoring, for the purposes of analysis, the impact of the contraction in trade. As the downward trend in trade, however, is actually even worse than that in the domestic economy including world trade would further strengthen the points made in this article
[2] Keynes Collected Works XXV p149 cited Geoff Tily, Keynes General Theory, the Rate of Interest and "Keynesian" Economics MacMillan London 2007 p79.The alternative presentation where the core of policy was held to be budget deficits was one of the views labelled by Joan Robinson ‘bastard Keynesianism’
[3] Keynes, ‘Mr Keynes Control Scheme, American Economic Review December 1933, cited Geoff Tily, Keynes’s’ General Theory, The Rate of Interest and “Keynesian” Economics, MacMillan London 2007 p2.
[4] Keynes, The General Theory of Employment, Interest and Money MacMillan London 1973 p378.
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