The 2010 budget, bad economics leads to bad political results

by Michael Burke

The main verdict on the 2010 Budget from both The Guardian and the Financial Times was remarkably similar; Alistair Darling should be commended for avoiding any pre-election giveaways. While the FT would have liked more detail of how spending would be reduced in further years, both were agreed that the Budget would offer reassurance to the financial markets. Coverage in the other press is summarised by the BBC here.

With much of the debate in Britain focused on the level of the public sector deficit, there was surprisingly little attention paid to the fact that, with one month to go in the current financial year, this is now projected to be £11bn lower than the Treasury forecast of £178bn made in December. However, an analysis of the decline in the deficit is highly instructive- and completely vindicates the idea that increased government spending and investment are key to the economic recovery and a narrowing deficit. The full document can be found here.

The £11bn improvement compared to the forecast arises primarily from the stimulus measures taken in 2009. Of the total, £2bn arises from the tax on bank bonuses, which was derided at the time by many commentators, not all of them working in financial markets, as likely to produce nothing. Another £1.5bn was the result of lower than forecast interest rates on government debt. So much for the notion that cuts are needed to ‘reassure financial markets’. The interest rate decline took place when the stimulus was taking place.

The bulk of this £11bn improvement also derives from taxation revenue - this was £7.5bn in total (p.192). The stimulus measures taken in 2009 are responsible for this improvement in the deficit. They consisted of just over £5bn in tax and spending measures in current spending as well as just under £24bn in ‘automatic’ rises in spending associated with recession. In addition, there was a £21bn increase in net government investment. Even taken together, these measures are not especially large, amounting to 3.6% of GDP, with just over half of that being discretionary, not automatic spending. This discretionary spending was fractionally below the two per cent average stimulus provided by the G20 economies in 2009.

Stimulus works

This £50bn increase in spending produced a net reduction in the deficit projections of £11bn, of which, as has been seen, £7.5bn was directly attributable to the stimulus itself. Treasury projections are that the deficit will now be £53bn lower over the next 5 years, with further falls after that period. This is a 15 per cent immediate return on government investment, with a payback of the entire outlay in just over 4 years. Further returns are expected in later years.

This experience in Britain is supported by recent analysis from the IMF. The researchers applied seven econometric models (including two from the U.S. Federal Reserve, as well as the European Central Bank, the IMF, the European Commission, the OECD and the Bank of Canada) to the issue of how to revive economic activity via government spending. In the jargon, these are the ‘multipliers’, the economic impact of changes in fiscal policy. The main conclusion was that “the multipliers from government investment and government consumption [general government spending]…are clearly larger than…” all types of tax cuts and only “….targeted transfers [to the poor] come close to having the same multipliers as government spending” (p.16).

Better results were achieved when the fiscal stimulus was over two years rather than one and when interest rates are low. Under those conditions, the US multiplier for government investment was 1.5 after one year and accumulated to approximately three over five years. Similar results were obtained for the European Union. Therefore a $1bn increase in government investment lifts economic output by $3bn over five years. In terms of the boost to taxes alone, the initial government investment would be repaid within that period from the rise in activity. Government spending would also be reduced in other areas, especially on welfare and unemployment entitlements.

Abandoning A Winning Formula

Recent experience and the latest economic analysis both confirm that increased government investment boosts the economy and thereby acts to reduce the deficit. But this highly successful policy was abandoned in the 2010 Budget.

In terms of discretionary measures, the Chancellor offered a stimulus of £1.4bn alongside an ‘automatic’ rise in current spending of £38bn. However there will also be a reduction of £10bn in the government’s own net investment. So, last year’s stimulus of £50bn becomes just £29bn in 2010. If inflation is taken into account the total spending increase falls to just £12bn, and discretionary spending is changed from a positive £26bn last year to minus £8.6bn this year.

The contraction in government investment of £10bn is particularly damaging. The decline in investment (gross fixed capital formation) has been the driving force behind the recession; £46bn of the total decline in output of £80bn in UK GDP is due to the decline in investment. According to the Budget forecasts investment will fall again in 2010, by 2.6 per cent, having already fallen by 19.3 per cent in the recession - more than five times the decline in personal consumption (p.180).

This leaves the economy dangerously unbalanced. Again, using the Budget forecasts, the ratio of household consumption to investment which was 3.67 to 1 in 2008, is expected to be 3.95 to 1 in 2012. Without significantly increased investment, Britain will become an economy ever more reliant on consumer spending, exporting less and importing more, and more likely to suffer balance of payments crises, or experience a long-term decline in the pound... or both.

Outside the rabidly pro-Tory press, the plaudits won by the Chancellor are revealing. Despite the ‘windfall’ of an £11bn lower deficit, the increase in discretionary spending compared to the December Pre-Budget Report was just £200m. The remainder will be used for debt repayment. In that sense, it is a windfall for bond markets only.

This highlights the real priority of the Budget and goes some way to explaining the inevitable question; If stimulus has worked so well, why is it being abandoned now? It has been said that Business Secretary Peter Mandelson was the co-author of the Budget. Tradition has it that the Chancellor makes few speeches in the run-up to the Budget. But in a string of recent speeches on everything from railways to higher education to space technology Mandelson has provided important details of the contribution each sector makes to the economy and jobs (the higher education multiplier is 2.6, space 2.1, and so on), and then he goes on to announce that the government will be making cuts. We have already seen that investment is rapidly repaid to government even with multipliers much lower than these. So the cuts actually lead to depressed activity, lower taxes and a widening deficit, just as Mandelson himself has argued.

The Business Secretary and the Chancellor are fixated on improving conditions for the private sector alone to resume investment, rather than the needs of the economy and the improvement in government finances that depend on this overall economic performance. Talk of the economic returns from investment in these sectors is, for the Business Secretary, an invitation to the private sector to boost is profits as the government exits these areas. If necessary, he will smooth the way with subsidies to private business - funded by taxpayers.

This is also the content of the proposed ‘Green Investment Bank’, where a privatisation is used to co-finance investment in green technologies, along with the private sector. Yet on the government’s own forecasts total investment will continue to decline. The green investments are required now, not when the private sector deems them to be sufficiently profitable. And the returns would accrue to the taxpayer, to be used either for further investment or to pay down debt.

A winning formula of government investment has been abandoned in an effort to boost private profits.

The opinion polls showed the results. Prior to the budget the Tory lead had been steadily shrinking until it was down to only two percent in one YouGov poll. But an Angus Reid poll found 54 per cent disapproving of the budget compared to only 30 per cent who approved. An ICM poll found only 9 per cent of the electorate said the budget made them more likely to vote Labour compared to 24 per cent who said it make them less likely. The Tories lead began to expand again. In polls released on Sunday 28 March ICM showed the Tories lead increasing to eight per cent from six per cent. YouGov showed the Tory lead increasing to five per cent from the earlier two per cent.

Unfortunately the budget was not only bad economics it was also bad politics.

The scandal deepens in the bizarre logic of the bank bailout

by Michael Burke

Sometimes financial journalists don’t have the background and skills to do a story justice. An experienced crime reporter would be better suited to the task.
The management of Royal Bank of Scotland, which is 86% owned by taxpayers, is considering a buy-back of its own debt, perhaps as much as £10bn.
According to the Financial Times, the plan is in ‘an attempt to boost its capital strength and its standing with bond investors’. But RBS’s capital strength, measured by its ratio of ‘core assets’ to total loans is already 11.6%, much higher than both Lloyds and Barclays, which are below 9%. It is argued that RBS’s loan book is much worse than its rivals and it will face higher levels of default. Perhaps. But, given the disastrous merger of Lloyds with HBoS, it is difficult to see how RBS could be qualitatively worse, certainly not so much worse as to require hugely better capital ratios.
The real reason seems to be contained in the FT’s final phrase; the desire of RBS to improve ‘”its standing with bond investors”. Under EU rules, RBS will be prevented from paying interest to its bondholders for 2 years, because it has received capital from the State. The ban starts at the end of April, hence the rush. But this is the flimsiest protection against taxpayers’ money being shovelled into private hands, as the value of the shares and bonds in virtually all Britain’s major banks would be worthless without the guarantees already provided by the State. The fact is that many institutions, RBS, Lloyds, Bradford & Bingley, Northern Rock, etc., were such basket-cases that they also received direct injections of capital in order to stay afloat.
But even this flimsy protection is too much for RBS’s management. They intend to buy back £10bn in bonds at above market prices in order to curry favour with bondholders, using taxpayer funds to do so. It’s as if the burglar who robbed your home is now being paid to drive the loot away.
In addition the management hopes to pay down at least part of one slug of debt owed to taxpayers by issuing new debt to private bondholders. This will certainly be at a higher rate of interest than the 4% currently being charged, set generously low by government officials.
Now, why would a commercial enterprise pay more than the market rate to buy back bonds? And swap low-interest debt owed to the government for higher-interest rate to private bondholders, who might take a more hands-on approach to how the bank is managed? Why, in fact, would management not take advantage of the 2-year interest holiday imposed by the EU and use it to restore the business?
In an ordinary business, managed in the interests of shareholders, a management team which engaged in any of these actions would be thrown out, if not investigated for corruption. But RBS is no ordinary business. The main shareholder is British taxpayers. RBS is not being run in their interests, but in the interests of the once and future owners, private capital. Meanwhile domestic lending by banks in January is below the level at the beginning of 2007 and continues to decline, and the total bank bailout has cost £126bn.

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'

Germany's 'continental economy' - comparisons to the US, India and China

Data released by the German statistical service shows how much Germany, until this year the world's largest exporter, and still the second largest, relies on its European market - particularly in a period of severe economic downturn such as 2009.

Approximately three quarters of German exports were to European countries. 63% of all exported German goods were delivered to the member states of the European Union.

Asia, the second most important market for German export goods in 2009, trailed far behind with 14% of German exports. The US accounted for 10%.. Africa and Oceania (including Australia) accounted for only 2% and 1% of German exports.

In terms of imports Germany was almost equally Europe dominated. 71% of Germany's imports came from Europe, with 18% from Asia and 9% from the US. Goods from Africa and Oceania represented just 2% and 0.4%, of Germany's imports.

Germany's economy, in short, is not really a balanced 'international' one - in particular in an economic downturn. It is, in export terms in particular, a European continental economy with secondary add ons in Asia and the US.

What implications flow from this?

The first is to reinforce the decisiveness of preserving the Eurozone for Germany - as against somewhat facile talk that the Euro may split or disintegrate. Germany has by far the highest percentage of exports in GDP of any major economy - 47.1% on the eve of the international financial crisis in the 2nd quarter of 2008. This has increased hugely, from 28.0%, since the introduction of the Euro.

The fact that Germany is operating in a continental scale economy, Eurozone Europe, with a fixed exchange rate, allows it to gain or maintain tremendous economies of scale. Conversely introduction of unstable exchange rates,including the possibility for major European trading partners to carry out competitive devaluations, would almost certainly make it impossible for Germany to maintain such a high proportion of exports in its economy - that is it would greatly weaken the 'continental' scale of its economy. The Euro, in short, is not a 'monetary union' but a decisive mechanism for Germany to enjoy the advantages of a continental scale economy. As the gains are great German economic policy, being rational, can pay a major price to maintain the Euro - something to be kept in mind in the coming battles over debt in Greece, Portugal and Spain.

Second, the trade data casts an important light on the optimal size of a modern economy. It is well known that the world's largest and most productive economy, the US, has only a relatively small share of foreign trade in GDP. In the 2nd quarter of 2008, prior to the recent decline in world trade, exports accounted for 13.6% of US GDP and imports for 18.5% - evidently far below German levels. Exports of goods and services were only 5.7% of US GDP in 1929, 3.4% of US GDP in 1938, and 7.0% of US GDP in 1950.

The reason for the far more self-contained character of the US economy, of course, is the fact that it was the first continental scale integrated economy in history. The second continental scale economy was the USSR, which has since disintegrated, the third is China and the fourth is India. Germany's economic configuration is that of the single most important component of a continental scale economy attempting to come into existence in Europe. Whether it succeeds or not of course depends on the future course of European integration.

These parameters also cast a very interesting light on possible future dynamics of China's economy. China's economy is far more open than any economy of its scale has been historically. In real, that is parity purchasing power (PPP), terms China's has already been the second largest economy in the world for several years. In PPP terms China's economy is slightly over half the size of the US - on IMF calculations $7.9 trillion compared to $14.3 trillion. In terms of percentage of GDP, at official exchange rates, China's exports of goods and services peaked at 39.1% of GDP in 2006 - far exceeding the ratio of exports to GDP of the US. By 2008, under the impact of the upward movement in the exchange rate of the RMB, and the beginning of the international financial crisis, exports of goods and services had fallen slightly to 35.9% of China's GDP.

If China's exports in dollars are compared to a parity purchasing power figure for its GDP, however, then exports are only 20% of GDP. This is still above the figure for the US but not vastly so. It is entirely possible that as the size of China's GDP at official exchange rate grows towards US levels, both through economic growth and revaluation of the RMB, the percentage of exports in China's GDP will actually decrease. Unlike the historical pattern of most economies, which developed on the basis of their domestic markets and then expanded into exports, China may develop on the basis of exports and then statistically partially 'retreat' into a large scale domestic market. This would be a type of economic 'convergence' towards the type of $15 trillion GDP economy which is the scale represented by both the US and the EU.

Such a development would, of course, not be a retreat of China from globalisation - the absolute scale of China's exports, imports and inward and outward investment would continue to rise, but it casts the present rebalancing of China's economy towards domestic demand in not only a tactical but a strategic light. The only proviso that needs to be made, because of some confusions expressed in sections of the press, is that 'domestic demand' for China, as for every country, does not consist only of domestic consumption but also domestic investment. The present rise in the proportion of both domestic investment and domestic consumption in China's GDP, at the expense of its trade surplus, would constitute part of that process.

The process of 'globalisation' should therefore not hide the reality that the present is also an epoch of the integrated continental scale economy - with a common state to sustain a common currency, a unified budget, and the other features of an integrated economy. The US, China, and India have all created this, even if they are at different levels of economic development. Europe has not. Champions of 'national sovereignty' in Europe in fact lead their own nations towards decline. Whether Europe succeeds in creating a real integrated continental scale economy, or retreats into individual country units which are too small to be economically efficient in a modern world economy, will largely determine not only the continent's fate but that of the individual countries within it.

Germany's trade data shows the strength of the forces leading to the creation of a real European continental scale economy. The present parochial state of European politics - increasingly influenced by obsessions about banning minarets, immigrants, discussion of non-existent threats to ' convert Europe to Islam', and other forms of xenophobia and racism - leads the continent and the individual countries within it to decline.

It is a common pattern that a European country reached a peak of power followed by a prolonged period of fall - Italy in the 15th century, Spain in the 16th, Holland in the 17th, Britain in the 18th and 19th. Europe, which for several centuries was the world's most powerful continent, seems on the political level intent on pursuing the same path.

It remains to be seen whether the forces expressed in Germany's continental scale economy, and the parallel processes in other countries, can reverse the processes of decline which are expressing themselves in European politics.

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

Trend of the Tory vote - by John Ross

Updated from Thatcher and Friends, The Anatomy of the Tory Party by John Ross

A purely mechanical projection of the long term trend of the Tory vote would put the Conservatives support at the next election at very slightly under 39%. 'Purely mechanical' anythings should be avoided but it does not look from the opinion polls that the Tories are capable of breaking out of their historical decline and a 'purely mechanical' projection of the trend is not very far out- hence the narrowing of the gap between the parties. The decisive question of course will be how high Labour is capable of getting its vote up to. But the bar the Tories are capable of putting up is not extremely high. All the evidence is the Tories continue to be a party in decline.