UK BUDGET (GENERAL ELECTION) DEBATE?

2008-2009 and 2009-2010 UK budgets at a Glance - courtesy of Daily Mail. Budget Day has been announced for 24th March, only weeks before a general election, scarcely time enough to pass The Finance Bill, thus government finance will be at the heart of the white heat of electoral debate - about whether spending cuts are required now or later and whether frontline services will need to be cut or not. Labour says cut later when the economy can afford it. Conservatives say cut sooner but not frontline services, and not the NHS, and won't confirm if tax rate rises are in their plan - though the chosen head of the Conservative proposed Office for Budget Responsibility (OBR - inspired by the US Congressional Budget Office), Sir Alan Budd and other HMT ex-mandarins interviewed by the BBC say frontline services will inevitably have to be cut, and some tax rates will rise - to rebalance the budget i.e. reduce the borrowing requirement.
Labour has a planned schedule for reducing government borrowing and already has in train £15bn in efficiency gain cuts and more than same again in expected annual asset sales i.e. somewhere in public sector there are always some cuts happening and 'other' income sources operating. Should election politics seek to make a big issue out of government budget deficits and public spending cuts?If government spending and borrowing are not responsible for the global credit crunch crisis and recession, and not solely to be blamed for the budget deficit rising should they bear substantial cuts, or should we rely on the economy's recovery to restore balance to the government's budget?
Government services are part of the total economy, part of the real economy; not outside it. Will it help the total economy's recovery if the public sector part, currently a substantial economic buffer in the crisis, that it should now be cut back too? Public spending is akin to an automatic stabiliser. Rising unemployment caused a 12% rise (£23bn) in social security and other related spending. With a 15% rise (£5bn) in defense spending, these two necessary items are half of the total government spending increase this year. Fall in employment and slightly larger rise in registered unemployment explain much of the loss of employment tax income and the higher social security spending. Total government public spending rose 9% this year, but that explains only 40% of the rise in government borrowing; the rest, £75bn is caused by inevitably falling tax revenues: £56bn less tax from business and employment and £20bn less from VAT. Tax from business fell 32% (£17bn) and from employment fell 10% (326bn). This is no more than expected in a recession when the economy lost over 9% of output (unadjusted for inflation). Public spending has been very stable in the economy; an important source of stability. It should not be a business enterprise budget that can be expanded or cut in line with the general economy. Its role is to be a counterweight to economic cycles.see also: http://www.wheredoesmymoneygo.org/prototype/
Year to date government borrowing may be roughly 11% ratio to GDP and slightly higher is expected in 2010-11, but that is the amount required to provide for recovery, and proportionate to how governments of either party responded to past recessions relative to depth of recession.Adjusting budget setting for the direction of the economy is to some extent like a sat nav operation. It is the economy that dictates the deficit far more than government choosing it. Chancellor Alistair Darling in his December 2008 Pre-Budget Report forecast the UK economy would shrink 3.5% in 2009, before expanding by 1.25% in 2010 and by 3.5% in 2011. Commentators and analysts at the time described the figures as overly optimistic. In April 2009, Darling said the UK was facing the deepest recession since WW2. He was again rounded on for his forecasting. But, the 2009 forecast has since proved to be quite accurate. When positive growth returned in the fourth quarter of 2009, output was 3.3% down on a year earlier, up 1% in cash terms and GDP for the year is 3.58% down at current prices. But 5-7% real growth was lost over the recession and 8-10% in cash-flow terms. The UK had experienced a long period of 15 years of positive growth and high private sector borrowing and asset bubbles therefore it was not surprising that recession was particularly deep. If the economy grows positively in 2010-2011, there could be a £100bn recovery in government revenues without tax rate rises. One quarter to one third of that recovery will be from tax exerted on the government's own additional borrowing and spending plus £30bn from business taxes and asset sales. The remainder could come from the indirect effects of the £200bn quantitative easing.
What risks this amount of budget balancing is continuing negative net lending by the banks to business as well as mortgages and consumer loans. 90% of all foreign trade requires trade finance and a similarly large % (uncalculated) in domestic trade. banks are not currently helping economic recovery - leavingthe matter entirely to the government sector. Only when bank lending rises can we envisage cutting back in the government budget deficit. Banks claim in there defence that they are not dictating lending levels - that these are subject to borrower demand. This is not entirely true - not least if it was true bankers should not get bonuses for gowing their loan books. Banks have tightened credit conditions. UK banks have also not filled the gap in lending to UK borrowers by foreign banks. Since the above graphic, bank lending to businesses has become negative - no umbrellas in the rain, at least not generally. Deposits have grown but banks are still striving to close their funding gaps before resuming lending growth. Hence, UK businesses are deprived of liquidity and this is reflected in sluggish trade and business investment.





















The pattern of world trade is changing and UK needs to reduce its external trade deficit, for which it is hoped the lower trade-weighted exchange rate helps. But, the effects of that have not yet fed through.











As with much else in the UK economy, the same story may be told of the problems of securing recovery in the USA economy.A high budget deficit is necessary to cope with lower tax revenues, kick-starting the economy, and doing so in the face of falling lending to US businesses, plus need to narrow current account, reduce the trade deficit. Without trade deficit reductions, then the economy's growth path returns to another credit-boom model and that is only sustainable by banks yet again financing the deficit through selling large tranches of securitised loanbooks!If more is not done to secure business and exports through higher bank lending to business and less proportionately to property and mortgages, then the high private sector debt levels that fuelled credit-boom growth will be returned to and prove to be longerlasting as a general burden than government debt. And, in the case of the USA, the sensible reduction in government borrowing is contradicted by the Congressional Budget office for the years after 2011, for reasons implicit in the design of CBO model projections that I judge to be political-ideological. I wonder if the UK Conservatives idea of an Office for Budget Responsibility will be similarly minded. George Osborne told the BBC that the OBR will depoliticise budget setting decisions i.e. as Chancellor he will rely on OBR predictions over his own - and presumably over that of HM Treasury? OBR echoes of course Labour's George Brown and his Ministry of Economics in the 1960s that eventually The Treasury snuffed out. Would a Conservative Chancellor think to ask the Bank of England for macroeconomic reasons to strongly advise the banks to restructure their lending portfolios? It was the bias towards mortgages that denuded lending to non-finance non-property businesses, especially manufacturing.

POLITICS OF SOVEREIGN RISK

All governments have had to take unusual, even relatively extreme, measures to cope with world-wide credit crunch, US-led (Anglo-Saxon) recession, and the ensuring domestic (and in international markets) inflammatory politics. Market traders chasing short term profits (profiting from both price rises and falls) love sovereign risks (where a country's total value is questioned) because if that is so then everything else is up for reconsideration and for portfolio churning. After broker-dealers, prime-brokers, money-brokers, FX dealers and equity-traders' profits have dried or been hit by some losses, nothing better restores the bonus-finances than a sovereign debt crisis, or better still a whole series of them! This is why what politicians say is not just about the story; it becomes the story. I doubt that politicians are sufficiently aware, especially just after a recession, how much what they say and do is at the centre of how financial markets behave! - the subject of this essay. Markets move on news-only some of the time. Politicians' statements on national debt and borrowing, and so on, are big news in the financial markets - why, because they can be exploited to get prices to gyrate more. Research has shown that at least 25% (60 days out of 250) it is only news (not numbers, results reporting, economic analysis, or chartism) that move market prices. In stock markets, daily price changes of 1.5% or less are normal vibration, what I call 'camera shake', but that means an individual stock can have a normal inter-daily price variation of 3%. It is easy therefore to associate company announcements, industry sector news, politician's and regulators', and other news, with a change in price, and when you trade at the heart of the markets to guess immediately the popular direction of a price change. It is only persistence of incremental price changes over several days that are meaningful. The long period falls of bank shares in 2008, and today the Greek 'debt crisis' are examples of that, helped very much by the feedback looping effects of follow-up instant news and then also next day's news and weekend press stories. This does not mean that there are fundamental-technical factors at work; it may only be the effect of political argument and prolonged disputes among analysts. Markets like arguments with at least two sides (bull and bear) pulling equally well because they need two-way markets to trade in. Hence there is a tendency for many to seek to prolong disputes about facts or to make them fuzzier, more uncertain. Big questions such as the direction of a currency rate or a whole market index are ideal, because no one can really be certain of what all drives price changes. Traders can individually, by sowing rumours, and collectively, by inspiring volatility, make end-investors nervous - rattle their cages. I recall a train ride some years ago from London to Cambridge with a LIFFE own trader - he may read this. It was a Friday. New York had opened and the US Treasury secretary made a speech in which he twice said the $ dollar was too high. The S&P500 fell a 100 points or more and my friend was up £300,000 by Bishop's Stortford, having I calculated made more than the first class ticket price of the journey every second. His office phoned three times to report and to ask whether to take the profit. He dithered thinking this is Friday; he has the weekend to analyse matters further. Then, when New York returned to trading desks after lunch (liquid lunches still de rigour then), the markets decided to rhetorically ask, "what does the US Treasury really know about the $ anyway?" and promptly bounced back. Within fifteen minutes, when alighting at Audley End, my friend was down $50,000!
This should be the markets response to OECD sovereign risk anxieties - what do they know? - and if Europe's Maastricht Criteria didn't exist or were set higher or turned off for a period fo 2-5 years, say, who would care about the ratios of today?
Yesterday, George Osborne, UK Con-servative opposition shadow chancellor, said that if the country re-elects Labour the UK will lose its sovereign debt AAA rating, which the ratings agencies would down-grade, and suggesting there would be a run on the pound and so on - nightmare scenario stuff! This kind of rhetoric or political grand-standing is irresponsible mis-direction, not what someone in power or close to gaining power should be indulging in - professional politics perhaps, but unprofessional for a budding Chancellor. Of course, the UK ratios look high, largely a reflection not of the domestic economy but of its size as a global financial centre. When the cross-border borrowing (matched by assets) is removed the UK ratio remains high, but this is also for reasons of the size of the finance sector and also the UK's above-average property values that are the collateral-security for much of UK private debt, up to 70% of what appears in UK banks' balance sheets. As the charts below show the US and UK economies' total debt levels are where they are today because of private sector borrowing - mainly by finance sector. These debts impact everyone more than the governments' shares, which however high these appear to be relative to GDP (annual national income), they are only a small and relatively stable part of the total - and by far the least risky of all of a country's debt - which is mainly owed internally not externally, except in poor emerging market countries.
The UK and the USA economies are intimately linked. Their debt profiles reflect similar responses to the credit crunch, with their central banks having greatly expanded their balance sheets to replace private sector funding of banks' medium term borrowings, as well as guaranteeing banking assets, mortgages especially. But, the size of their on-budget national debts (dark blue in charts below) is typicaly of all OECD countries. Politicians have a choice - to sound like they know only what the general public hears and then mirror back the public's anxiety, or they can sound as if they have privileged insider knowledge, the advantage of expert advice, and either way an Olympian view? Governments strive to sound like experts and opposition parties like Joe and Jenny Mainstreet. UK Conservative candidate to become the next UK finance minister (Chancellor of the Exchequer, Second Lord of the Treasury), the Right Honourable George Osborne MP, with his across-the-despatch-box, street-fighting, politician's rosette firmly pinned on, chooses to ignore the other side of the balance sheet, the professional economist's details, in order to rail about gross debt, not the net or comparative position relative to other credit-boom countries similarly striving to climb out of recession. Electoral politics, yet again, even now after forests of newsprint and €$£billions of airtime about the credit crunch, is not about debating tricky details; instead it chooses to shout and stump about, angrily, pronouncing on symptoms, as if there is nothing new or deeper to learn. As a possible future Chancellor, he should, may I suggest, re-orientate his posturing to look more like the Chancellor he intends to become - try to look like someone who can and does, pragmatically as well as judiciously, read balance sheets and economic statistics until he understands them? Instead, so far, he seems easy meat for simple theorems, as sadly Margaret Thatcher was too, such as the idea that rising national debt always pushes up interest rates, or that government action cannot ever truly reflate economies, or that borrowing today must mean higher tax and/or severe spending cuts tomorrow, that nothing government does is ever a free lunch. In his latest polemic, by drawing attention to the ratings agencies he vests in them too much 'hostage to fortune' power to hold countries to ransom - and at a time, as he ought to know, when governments and their new regulatory NGOs are investigating the ratings agencies to the extent of threatening their continued existence? It is also dangerous to vest power in the hands of credit ratings agencies whose models and behaviour through the credit crisis are under severest scrutiny by EC, US and other regulators, and have been disavowed by major banks.
Apart from that, the problems of borrowed debt, insofar as these are not adequately netted off by appropriate assets, the bulk of nations' debt is a private sector created, not directly a public sector created problem, and very clearly so in the US and UK, but elsewhere too. Osborne and the Conservatives, Republicans in the USA, and Christian Democrats in Germany, who are making a political mountain out of government indebtedness are surely conspiring in diverting public concern from private debt and the role of the banks, when the debt-mountain is mainly that created by the finance sector.Sovereign risk, whether about the UK, Spain, Ireland, Greece, or even the Euro Area or the USA is a matter of calculated confidence in a country's ability to service interest and redemptions and to sell its government bonds and bills at a price very close to face value. The very idea of any OECD country losing triple-AAA is shocking because it is extremely unlikely - even in the politically highly animated case of Greece. Its crisis is about compliance with Maastricht and Euro Area prudential ratio ceilings, not about whether it can absolutely service its debts, but about the discount and penalty margin the piranha-infested markets are exerting on it. It is also about the country's trade deficit financing, not whether it can finance that, but the now higher margin cost of doing so.
In the case of the UK, the markets see that there is are political accusations flying at the government propelled by the upcoming general election. The anxieties manufactured are a boon to traders profiting in volatile markets who can also themselves add to that volatility. The Conservatives want to invoke memories of the sterling crisis of 1976 and Labour can recall Black Wednesday 1992, which statements about sovereign risk by George Soros make us worry that once the hedge funds have finished staking out the Euro, the £ is the next target! Currency exchange rates are relative to other currencies, but I cannot see a technical or fundamental reasons currently for why sterling should be targeted by the markets, by hedge funds, and not after it has already fallen last year. Hedge Funds ought to be politically more cautious at a time when there remains a strong impetus towards making them more transparent and subject to closer regulatory oversight. An estimated $12.1bn of short positions are outstanding against the Euro, according to the Commodity Futures Trading Commission. At the beginning of February, there was just over $7bn of short positions against it. Some hedge funds, thinking the better of it,have closed out their positions against Greek debt. other hedge funds raised their bets against the debt of Greece and other troubled Euro Area economies and then had to raise their bets too against the euro. But, they must also assess how far they can go and not fear a regulatory backlash. The biggest hedge funds are very concerned about fierce criticism by US and European politicians especially that their sovereign risk bets add to the crisis of confidence in sovereign markets. Lord Turner, chairman of the FSA, the UK micro-prudential regulator, is one of several heavyweights to call for investigations of speculative positions in financial instruments that gain from a fall in prices of sovereign and corporate debt. In his case he can not only call for a review but implement one and then devise limits and penalties.
Is there a solid UK financial accounting anvil for all the verbal hammering of sovereign debt - No! It is partly long-established market lore that following recession shocks these should be followed by sovereign debt crises. Recessions are real enough, but sovereign debt crises very rarely are among OECD countries. And, given that the recent/current recession shock was triggered by banking insolvencies and the great increase in size of central bank balance sheets this necessitated, the popular expectation is therefore for the mother of all sovereign debt crises. But, central bank balance sheets are precisely that, balanced. In the case of UK government debt balance it too is very robust, with £600bn in government liquid assets plus banking bail-out investment gains to come, plus that its debt and fiscal deficit are not much out of kilter with its peers - somewhere within the mixed range, and employment/unemployment and property values have retained unexpected resilience, how much of the debt (at least one third) is internal to government, and much else including first phase of recovery in GDP and tax revenues, the gross position of government finances should not be technically worrying at all, in my and others' considered view; the net position and the macro-economics of the government's stance should be celebrated as prudent and efficient.
But, of course, that does not satisfy party political need. Labour unfairly accused the Conservative Government in 1997 of financial mismanagement when fiscal deficits had been the main recovery weapon from the recession in '91 and a brief anxiety attack in '95 when the US economy stumbled due to a very harsh winter that propelled the UK Chancellor Ken Clarke to break his fiscal stance forecast, which he sensibly regularly did anyway. The Conservatives are not slow this year to return the same jibes they failed to defend in '97, something they could not do convincingly in the last three general elections when there was no recession and Chancellor Gordon brown had maintained a fiscally prudent (conservative) stance.
This time Chancellor Alistair Darling is talking politely back to explain his necessary recovery measures - to which the opposition parties are, of course, deaf.

One of the reasons apart from the foolish war or foolish post-war management why Tony Blair had to resign was a public feeling cheated by, and now intolerant of, political spin meistering. Ironically, when economic crisis hit, the same public appeared to miss the glossy spinning of hard facts. It was frightened and wanted feel-good assurances. PM Gordon Brown, after a decade of poker-facedness (necessary, and expected of, Chancellors), provided assurances, but earnestly without smiling, groaning with solidity, not sparking with exuberance of rising to a great challenge - he read the situation as requiring trust in sound policy, and in public again buttoned up his natural humour - yes, it exists! His smile can seem churlishly sweet rather than seious and sunny. Blair's smile for years seems stitched to his face like The Joker. He eventually mastered seriousness in public, but, ever embulliant, cast that off at the slightest opportunity until the consequences of the war got to him too. Brown had far less opportunity to practise a Sunny Jim look, (possibly remembering that it didn't work for Callaghan when PM). Chancellor Alistair Darling, Brown's very close friend (if not quite the collegiate buddy that Ed Balls became and who wants his job), has a most highly evolved sense of humour, but felt he must, above all, tell the precise truth, believing that when the public tired of spin they wanted truth, straight facts, something expected of Chancellors, and that led to his statement (that reportedly angered Brown according to Andrew Rawnsley's book) saying that this is (was) the longest deepest recession for 80 years etc. They both said we will get the economy out of the mire and restore prosperity. I don't buy Rawnsley's take on this because it is possible to quote Gordon Brown having described the profundity of the credit crunch and recession many times, if perhaps less nationally and more globally! Either which way, the public is still not getting happy-smiling positive news. Instead, the politics of spin, as now led fearlessly by the Conservatives is to be prophets of doom and gloom unless 'you vote for us!', blackmailing (not bribing) the electorate how to vote. is this not spin of the wrong kind demanded. Her Majesty's Opposition, led by David Cameron's idea of what is a patriotic choice, seeks to insinuate itself into power (a most apt phrase) by any negative means including telling the public it has a patriotic duty to vote the Labour government out of power - a dangerous form of stump, or sump, politics - populism in a multi-party democracy. The beleaguered US and UK governments try to reassure their electorates with 'steady as she goes' and 'trust us to finish our job' messages. When electorates are jaded and cynical and hurting, they need facts as much as assurances. They also need to see the major parties agreeing on some key aspects of economic recovery if they are to gain confidence in that. How can anyone trust politicians in general when they so mercilessly, emotionally, even satirically, condemn each other in such serious matters as where the economy is heading short term? Instead, an uncompromising disputatious political anxiety-making currently prevails in the bite-sized media (and in sloganising that advertisers promote). This is damaging to political recovery as it is also damaging to voter participation. UK and the USA political public punch-ups would have been unpatriotic in the global war of WW2; is it not so in the present global economic crisis - or is that a totally unrealistic expectation, to expect that at least in matters of economic policy when economies are in crisis globally? It is an election year in both UK and USA, and, of course, taking economics out of other issues like health and education would leave only moral ethics and not all politicians are comfortable with that?And this political anxiety takes its toll on consumer confidence (lower consumer spending) - acting as an additional drag on economic recovery. The faltering economies of UK and USA, and fear of double-dip in the Euro Area, embolden the FX, bonds and money markets in pursuit of short term profits, for whom, especially short-sellers, 2010 promises to be a bumper year. It was the '92 attack on sterling, when Norman Lamont was Chancellor, and which was preceded and succeeded by attacks on some European currencies that propelled the EU into creating the Euro in place of the EMS currency snake, to provide a defensive scale to Europe's currency in the world. When the UK Bank of England was forced into extreme measures to defend the pound in '92 all the pressure was off by simply withdrawing from the EMS, and within a year or sooner the UK's foreign currency reserves had been restored. When the 1976 sterling crisis triggered by IMF negative outlook reports the UK Chancellor Denis Healey had to negotiate borrowing rights with the IMF none of which were in the end required, but there had to be spending cuts.
Healey, Lamont and Darling share an unusual hirsute distinction of highly distinctive 'caterpillar eyebrows'. Such irrelevant coincidences are no less fatuous than other coincidences that markets like to fuss over to rumble the tummies of everyone's risk appetites. I would not be surprised by some brokers' notes headline of "the eyebrows have it!" and "caterpillar risks!"Our three caterpillar eyebrow chancellors experienced desperate exchange-rate crises, and also share a chest-beating need to announce sharp spending cuts - though I do not see how government spending was or is to blame directly for these crises. In past post-recession periods, such spending cuts as often a not did not amount to much, and may not do so now. Budgets were re-balanced by recovery more than by spending cuts. President Clinton balanced his budget by economic growth supplemented by a regular $10bn cut in defence spending and by delegating major programmes to the 50 states. Reagan and both Bushes talked and walked spending cuts but never looked like balancing their budgets. Today, if California was a country, it would be the biggest sovereign debt crisis, but spending cuts wouldn't solve it.
Today, in the UK, despite higher year on year deficit spending, some cuts are already in train - about £15bn worth before the recent political furore about whether to cut more now or later? The current savings being pursued are in efficiency savings, offset by bringing some spending programmes forward. Sizeable spending cuts are not desirable in the teeth of recession or the early stages of recovery, but that is not to say restructuring of government spending, not least to be more tax efficient, is not a great idea - where some areas are cut and others boosted. This was part of governments' Keynesian thinking before the 1980s. Since then, such thinking was replaced by a decades-long presumption that however much government spending is described as 'tight' to, at the same time, assume government spending in general can always make room for substantial cuts even in a crisis; £90bn is currently an oft-quoted figure in the UK. What is missing is a more subtle and more realistic idea of redirecting spending to benefit recovery, doing so at least risk of requiring tax hikes. This line of thinking is opposed to another politically fashionable presumption that there are no 'soft choices', only 'hard choices'. Choices are not in practice so two-sided, more bi-pedal. A classic example of a hard choice that was also hard and soft either way) was Edward VIII's decision, prompted by political pressures, to choose his private duty over his public duty. Politicians over-indulge a belief in public duty to favour 'hard choices' as if economic survival and progress has only ever been secured by always preferring hard over soft bedsprings. There is also a delusion that private business success is always based on taking hard decisions. In truth, such decisions are often the product of one-sided analysis of the balance of facts. An example of such one-sidedness in macro-economics is to no longer look at differences between gross and net of tax cost of different public spending. That practical view was outlawed (by convention) at The UK's HM Treasury after 1979, for reasons entirely political - not logical in economic house-keeping terms. Similar blinkers became similarly popular among US legislators, and extremely so at the Congressional Budget Office. Making anything sound sensible is a matter of how tightly drawn (simplified) the wider context is. A major context today is that our banks, for their own (internal) house-keeping reasons, are cutting back on customer loans (by about 8% in the UK in 2009) that may continue for much of this year (I predicted a total cutback of c. 15% in USA and UK). Banks see this as a necessity forced on them by their balance sheets as cross-border interbank lending shrinks (in Europe) and by the economics of funding gap finance that are only now beginning to return to a near-normal economic cost - if not yet an attractively viable market cost - and that is despite the boon to corporate debt of the Bank of England and US Treasury QE measures of buying in $200bn and £200bn of government bills and bonds (by using off balance sheet assets). In the UK QE equates to a quarter of UK National Debt, and as much as the Government is expected to issue in new bonds in 2010. Hence the fiscal deficit stance by the UK Government of 8-12% ratio to GDP (similar to that in the USA) is wholly appropriate - and no less than any super-hero economists recommend when asked. Of course, banks, who now have for regulatory reasons to hold much more of new government bonds themselves, are keen to lever what discounts they can in the primary issue market by exploiting sovereign debt anxiety-making, and, as traditional Conservatives, there is an additional motive: the kneejerk tendency to rattle Labour's cage in an election year. But, this is also further evidence of banks not waking up fully wide-eyed to the new political-economic realities, failing to acknowledge fully the hatred and mistrust of them by business and household customers, and by the general voting public. Banks cannot be certain of how much better or worse off they will be depending on which party wins or whether the UK election outcome is a hung parliament - or in the USA a handicapped White House? They should fear the possibility that one thing everyone can agree upon is resentment and suspicion of banks - the mob will have its pound of flesh. Banks should duck low, hide their arrogance, behave obsequiously humble, and conscientiously do their best to shoulder the burden with government of ensuring speedier economic recovery. If they did that they'd be super-heroes too - an unlikely story?

DEFICIT AND DEBT DEBATE - POLITICAL MANIA

In the lead-in to the general election in a few months the sore-head-in-hands debate about government borrowing and the national debt is especially politically venal. One effect is to rule out discussion on whether public spending cuts are necessary at all? The debate is focused by 67 economists and their supporters validating Darling's wait to see if recovery is secure then 'cut later' and the 20 economists and their supporters backing Osborne's let's not wait 'cut now'. The 67+ say that cutting now is foolish and arguments for doing so are without any rigorous proof. The 20+ say it is a matter of market confidence and thereby elevate appearance over substance.
There is also underlying this a fightback by monetarists and general equilibrium theorists apalled at the whole world apparently re-embracing Keynesian thinking.
At least the Keynesians have empirical macro-economics models and the National Income accounting system to rely upon. They 67 are not just theoreticians, but aware of the only models that predicted credit crunch and recession, which were Keynesian - emphasising the accounting link between net acquisition of financial assets and trade balances, which pre-crisis had globally become very extreme that is not central to FSA, Bank of England and other similarly expert views.
The 20+ opponents take their ideas from relatively isolated factors echoing and being echoed by the limitations of media comment and debate. Some of their supposed fears are for loss of confidence in UK that might hit the currency and even of a buyers strike for UK government debt. But is this reality or merely political flag-waving - is there really a possibility of banks refusing to buy gilts in the £200 billions of auctions in 2010? Buyers regularly threaten partial strikes to lever a discount in the primary market. But there has never been such a strike to my knowledge and indeed there cannot be one now because financial services firms are hungry for government debt including by being forced to buy and hold onto twice as much as normal to shore up their capital solvency. In the UK especially there is the usual high demand for long-dated debt by insurers and pension funds. Gilt maturities are well balanced between short, medium and long dated. Demand, respresented also by annual turnover in the secondary gilts market trading is at least £3 trillion (official DMO figure). With new issuance last year and this the turnover should nearly double. It should be double this already, but even with less than half, probably less than one quarter, truly available at any time for trading, turnover seems low, indicating pressure on banks and others to hold their gilts and the effect of uncertainty on pace of future base rate rises.
The only purpose of strike rumours is to generate small primary market discounts, a moot matter when £198bn has been 'bought in' this year under QE. Government has about £300bn in gilts that it could 'restructure' and sell directly into the secondary market without changing National Debt. Some, perhaps politically-minded commentators, e.g. Daily Telegraph, say they fear a "re-run of 1976 IMF debacle" and a "full-blown (government) funding crisis", or perhaps some would welcome precisely that if only it can be manufactured before the general election 1976 was a crisis for Labour but not a full blown one - that was Black Wednesday 16 years later for the Conservatives when the cure was, following my advice given on Tuesday, as I like to think, to withdraw from the EMS currency snake. '76 was a crisis of confidence' without doubt, and it was political, but the UK never did not have to draw on the IMF standby credits provided i.e. there was an over-reaction to current economic data that was subsequently revised upwards as is most often the case with UK National Income data.
Some commentators want to characterise National Debt at more than double the official total (including public sector pension future liabilities + off b/s liabilities). This is a silly argument, and could be more devastingly applied to private sector indebtness - and arguably should not be so applied to estimating pension fund shortfalls as if pension funds should not take sensible account of future premium and investment income. If public sector debt should be so calculated gross (without net balance) then why not include all the liabilities of the nationalised banks as well for another £3 trillions plus £1 trillion plus of BoE/HMT off balance sheet repo swaps with assets of the banks?
Gross debt is important to know, but so are the the full balance sheet of assets, liabilities and collateral, worth in the government's about £1.5 trillion at market prices, plus another £2.5 trillions at the nationalised banks excluding funding gap borrowings.
Nearly half of the National Debt is today internal to government, merely representing debts between various arms of government including the more than one quarter held by Bank of England which offsets its t-bill etc. off budget/off b/s borrowings from HMT? Commentators have been very unclear about how to interrpet
UK government borrowing of £200bn in 2010-11 while at the same time having bought £198bn in under QE in 2009-10? The same question arise in the politicised debate about US Federal debt.
Even if UK National Debt triples in ratio to GDP compared to pre-crisis levels, this will be because income and corporation tax receipts not only fell but are taking a few years longer than normal to recover. This will only happen if the private sector is not pulling its weight in dragging recovery forward sooner. The 20+ economists cannot say why government deficit spending constrains the private sector from gaining recovery sooner?
Public spending cuts won't help, and if new debt issuance is any less than planned, there will also be an unmet demand I calculate, from the banks and others. Then UK financial sector firms will have to buy a lot of foreign government bonds with predictably higher external account deterioration including in the trade balance, which continues needing to be financed.
New global and EU financial risk regulations are enforcing banks to triple their holdings in capital reserves of government bonds; they have to get these from somewhere? In fact, we can say, there is a level below which government borrowing and outstanding debt dare not fall - quite apart from questions of delivering positive or negative growth impulses to the economy, and also of restructuring debt when base rates significantly change or shift from one trend path to another, and also funding redemptions when it is considered this should be budget-neutral.
There is too much politics based on counting on only the fingers of one hand. The media is full of hyperbole about the "vast unprecedented scale" of new government debt issuance. Average net borrowing was £30bn for a decade after gross issuances of about £50bn annually. In the past decade, UK National Debt stable when not slightly falling remained stable in ratio to GDP, but only until the credit crisis and recession struck. Redeptions should rise and of course were overtaken tenfold by QE. - See: http://www.dmo.gov.uk/documentview.aspx?docname=remit/drmr0910.pdf&page=Remit/full_details table 2.B
Today, National Debt is about £850bn (over 60% ratio to GDP, rising to 78% medium tern. But, let us not ignore that in the same period UK personal debt doubled in a decade to £1,400 billions (to more than 100% ratio to GDP) and total (gross) private sector debt doubled to nearly 500% ratio to GDP i.e. private sector gross debt is 6-7times greater than that of the public sector, and 10 times more ater deducting government internal debt, half of which is non-marketable.
Of course, there are asset (including future expected income streams) and collateral offsets, but government has these too and of such better credit quality than the private sector. It must be obvious that Government has in gross debt terms been far more prudent that the private sector and in net debt terms also. It has officially over £600bn in financial assets before the crisis, which with nationalisation and asset swaps has now increased depending on how one chooses to measure it (whether or not to include off-balance sheet items) to 4-6 times this.We should not buy into Prof.Rogoff (one of the 20+) et.al.'s absurd interpretation of the correlation between high national Debt and low economic growth as if the former dictates the latter and not the other way about?
Why should over-leveraged private debt not worry us as a cost to UK economy now and in the future? Is the historically-high private debt not also a burden on UK citizens and tax payers?
Gross UK National Debt equals only the total of 6 biggest UK banks' funding gaps (850bn), gaps that the banks found they couldn't refinance cost-effectively, or at all, hence their technical insolvency problems!
The UK banks lost £1 trillion in capital writedowns and defaults that government made good for them using off-balance sheet swaps, of which in time the banks will recover 30-50% of nominal losses and same again from sell-offs, then same again in medium term in net interest income plus more than same again in asset value recoveries as another 90% recession-effect loss temporaily hits heir capital reserves. One consequence however of Government stepping in where private sector failed is that it will generate £2-300bn in medium term gains for taxpayers sufficient to cover a third to half of medium term budget deficits (a complicated accounting). This gain is threatened by the Conservative (and others) idea of selling out of the banks cheap sooner rather than later!
Finally, there is another attempted rewriting of history gaining traction among some of the fiscally most conservative media, to say that "financial market didn't cause the crisis" (S.Telegraph (21 Feb), that it was "fraud" (by which is meant some theory of 'printing money and risking inflation), political incompetence, "guaranteeing bank bailouts" that "warped risk incentives and stopped financial markets from working"! This view aligns with one of the effects of the debt crisis debate, which is to divert the subjective impression of the credit crunch nd recession from focusing on the banks to blaming government - it is a perverse aspect of the 'better government is smaller government' ideology to blame anything scandalous on government sins of either omission or commission.
That is either sublimely and very subtly true or simply the most absurd wishful thinking? Governments may be to blame in how far credit boom growth was tolerated, for ignoring worsening external trade & payments balances, and even giving up social housing provision, and in how certain other matters were handled. A favourite bete noir is to blame too much or too little regulation, or incompetent regulation. But, regulation is an international matter.
If such errors should be centre-stage, in this government was surely also encouraged by financial markets who over-leveraged in 'interbank' and related credit derivatives, and not least the fast growth in banks' funding gaps. But, it is debateable what powers the Bank of England (responsible for systemic macro-prudential risks) and the FSA (responsible for individual firms' micro-prudential risks) to ensure they are listened to by banks and others before the credit crunch. To this should calumny should be added the irresponsible diversion by banks of lending to finance, mortgages and consumer credit while not growing (even decreasing in real terms) lending to 'productive' sectors especially exporters. Banks (and others) chased highest short term profits and ignored macro-economic risk diversification and liquidity risks. The credit crunch was not unprecedented, except in its scale and global systemic effects.
Banks are ignoramuses in macro-economics not because they lack the resource to do better, but because they are in the habit of choosing to be so. They prefer having a very poor or no understanding of the role they play in the wider economy, which in much of economic history was deemed below their pay or profits grade. That for some years has been a major sin of mossion. If the private sector is ever to substitute for government as the only engine of growth in a recession, to lessen how much government has to apply Keynesian deficit-spending reflation in a recession, this has to be led by banks. But, so far, they have shown themselves far from ready to do so! Banks and markets are deleveraging and continuing to do so - is that how anyone sensibly thinks they should be allowed to continue? The government must feel very frustrated by the terms of the media debate much like Alice at the Mad hatter's Tea Party. More borrow & spend to make recovery more likely - "That's nonsense" as a policy according to some,such as Liam halligan writing in The Sunday Telepgraph, a policy that should have died in 1979 he says when Callaghan siad it was no longer an option. It is after that when the 'end to boom and bust' became a buzz-saw of markets and a conservative mantra that Labour aped in the 1997 election as basis for giving the Conservative Government a good kicking over how public finances were in a mess, which was as far from being true or fair as the claims offer in political reserse today - poetical justice perhaps. I doubt Callaghan when Prime Minister really understood what Peter Jay tried to teach him, Keith Joseph and Margaret Thatcher about Chicago monetarism. Keynesianism was clearly not dead or ineffective, despite all the rhetoric to the contrary. It was applied by Ken Clarke in the 1990s and by Brown in 2001 when he kept UK for first time in over a century from directly following the USA into recession! Anyone wishing to dispute this have to explain how else within a politically acceptable timeframe the economy can otherwise recover other than by government alone getting its boots on and mucking the economy out of it ordure-covered recession?
Note: Andrew Rawnsley's book serialised in The Observer, for all the storm in a teacup generated about whether Gordon Brown is a bully or not, rightly or unfairly so, Alistair darling emerges as a hero of the hour, and Gordon too, in addressing the crisis most valiantly and I believe (firmly know) most successfully.

60 ECONOMISTS SUPPORT DARLING

Darling storm-tossed but unflappable.
More than 60 leading economists have backed Alistair Darling’s wish to delay spending cuts until 2011 (subject of course to the general election outcome), creating a dividing line within the profession on the crucial issue of how to reduce the UK’s public debt. Two letters in today’s FT warn of the risks of damaging Britain’s fragile recovery by “reckless” early cuts. They are a direct riposte to 20 economists who wrote to The Sunday Times at the weekend supporting the Conservative party’s argument that fiscal tightening should start sooner or soonest. Of course, it seems unfair to cut public spending when it is not to blame for credit crunch or recession, and anyway where to cut with least economic damage? In my opinion the answer is certainly not in labour-intensive services. There is a lot of cant about the budget deficit and the national debt. The media is casual in its unthinking description of public finances in 'a mess', 'in disarray', 'unsustainable', and other horror-fuelled characterisations. The opposite is true. Actually, no-one is claiming that high deficits and national debt are sustainable long term; he question is how sustainable it is in the short to medium term. But even in the short term it makes no sense to look only at one side of any balance sheet. And, sadly, I have to say that all 80+ economists are remiss in this also. It is pointless to look at the budget deficit and national debt gross, not net. Over the past year while the debt grew towards £1 trillion and the deficit to £140 billions (or 8.8-12.8% ratio to GDP depending on what is currently the most credible view of total GDP?) there has also been a growth of that proportion of debt internal to government, not least buying in up to £200bn of gilts using off-balance sheet funding, and the gaining of substantial assets in bank shareholdings without resource to the general government budget. Looked at in this light the net position is neutral to positive, hence the case for spending cuts is vacuous as well as dangerous, and indeed it may be argued that both deficit and debt should be i gross terms higher to deliver adequate deficit-spending growth impulse to the economy! We are getting a lesson in the politicians' and general public's inability to look at matters in double-entry balance sheet terms, a myopia that opportunistic politicians and their economist allies are not slow to egregiously (irresponsibly) exploit! In the medium term I calculate that the profits to be realised from the governments' bail-out of the banks will actually pay for 40% of projected UK budget deficits, though there is some question how much of that may be foregone by exiting bank support schemes early to attract institutional investors back into buying banks' shares?
There is also a critique to be offered about many economists and commntators on the subject that they have an exaggerated idea of the size of government in the economy, look too much at consumption expenditure explanation for GDP/GNP ignoring income side of the account: and worst of all assume a fixed cake in which the more flows through public sector (government) the less is available for private sector to freely enjoy and keep, which is only a short term truth, mainly at micro-level, but a medium term falsehood at macro-level i.e. insofar as government can finance recovery more painlessly and cost-effectively than relying on private sector impetus, which is understandably lacking in courage and weak by being atomistically self-serving, a realistic as opposed to a false economy we must rely far more on government in recession years than the private sector to proceed in the right direction.
All that aside, what are the economists saying?
Letter 1
From Prof Lord Layard and others.
Sir, Last Sunday 20 fellow economists wrote to The Sunday Times advocating a more rapid reduction of Britain’s budget deficit than is currently planned in the Pre-Budget Report. “There is a compelling case”, they said “for the first measures beginning to take effect in the 2010-11 fiscal year.”
We disagree.
First, while unemployment is still high, it would be dangerous to reduce the government’s contribution to aggregate demand beyond the cuts already planned for 2010-11 (which amount to 1 per cent of gross domestic product). Further immediate cuts – even supposing they are practicable – would not produce an offsetting increase in private sector aggregate demand, and could easily reduce it. History is littered with examples of premature withdrawal of the government stimulus, from the US in 1937 to Japan in 1997. With people’s livelihoods at stake, a responsible government should avoid reckless actions.
Second, Britain’s level of government debt is not out of control. The net debt relative to GDP is lower than the Group of Seven average, and on present government plans it will peak at 78 per cent of annual GDP in 2014-15, and then fall. Even at its peak, the debt ratio will be lower than in the majority of peacetime years since 1815. Moreover British debt has a longer maturity than most other countries, and current interest rates on government debt at 4 per cent are also low by recent standards.
Third, since the crisis began, private households and businesses have had to increase their saving in order to reduce their debts. It is this saving that finances the government deficit. If the government did not take up the slack, there would be a deeper recession. But fortunately, wise counsel has prevailed so far, and public spending has been maintained as an offset to reduced spending by the private sector.
Of course there needs to be a clear plan for reducing the government deficit. But the existing one for next year appears sensible. What is needed then is much more detail for the following years, and a radical plan for the medium term. That is what the debate should be about.
A sharp shock now would not remove the need for a sustained medium-term programme of deficit reduction. But it would be positively dangerous. If next year the government spent less and saved more than it currently plans, this would not “make a sustainable recovery more likely”. The weight of evidence points in the opposite direction. Letter 1 is signed by: Lord Layard,Emeritus Professor of Economics, LSE; founder of the LSE Centre for Economic Performance; Chris Allsopp, Reader in Economic Policy, University of Oxford and former member of the MPC; Alan Blinder, Gordon S. Rentschler Memorial Professor of Economics and Public Affairs, Princeton University, and former Vice Chairman of the Board of Governors of the Federal Reserve; Sir David Hendry,Professor of Economics, University of Oxford; Sir Andrew Large,Former Deputy Governor of the Bank of England and former member of the MPC; Rachel Lomax,Former Deputy Governor of the Bank of England and former member of the MPC; Robert Solow,Nobel Laureate and Emeritus Institute Professor of Economics, MIT; David Vines; Professor of Economics, University of Oxford, and Fellow of Balliol College; Sushil Wadhwani,CEO, Wadhwani Asset Management and former member of the MPC.
To clarify a couple of points: the writers are not saying that households will invest in government debt directly from their savings. In fact, the purchases will be almost wholly by UK banks less that bought by foreignors to finance the UK's trade deficit. The banks are under so much pressure to buy Gilts for their capital reserves the puchase will come from funds hitherto applied to banks' proprietary trading. The deficit is worth about one seventh of UK banks' capital and will reduce the banks' speculative exposures and funding gaps indirectly and help the quality of their solvency. The effect is not to productively absorb higher surplus household savings - these are reducing banks' funding gap borrowings. The main point missed is that the deficit opened up because of lower tax revenues in the recession in order to maintain public spending on services and other matters, but is also tivial in macro-economic terms compared to how pivate sector borrowings and financial and property firms' debt got into disarray to several times GDP compared to the Government's debt/GDP ratio of an expected peak o only 78%. The panic concern about government finances is a blind; it is private sector finances that need fixing.
Letter 2 From Lord Skidelsky and others.
Sir, In their letter to The Sunday Times of February 14, Professor Tim Besley and 19 co-signatories called for an accelerated programme of fiscal consolidation. We believe they are wrong.
They argue that the UK entered the recession with a large structural deficit and that “as a result the UK’s deficit is now the largest in our peacetime history”. What they fail to point out is that the current deficit reflects the deepest and longest global recession since the war, with extraordinary public sector fiscal and financial support needed to prevent the UK economy falling off a cliff. They omit to say that the contraction in UK output since September 2008 has been more than 6 per cent, that unemployment has risen by almost 2 percentage points and that the economy is not yet on a secure recovery path.
There is no disagreement that fiscal consolidation will be necessary to put UK public finances back on a sustainable basis. But the timing of the measures should depend on the strength of the recovery. The Treasury has committed itself to more than halving the budget deficit by 2013-14, with most of the consolidation taking place when recovery is firmly established. In urging a faster pace of deficit reduction to reassure the financial markets, the signatories of the Sunday Times letter implicitly accept as binding the views of the same financial markets whose mistakes precipitated the crisis in the first place!
They seek to frighten us with the present level of the deficit but mention neither the automatic reduction that will be achieved as and when growth is resumed nor the effects of growth on investor confidence. How do the letter’s signatories imagine foreign creditors will react if implementing fierce spending cuts tips the economy back into recession? To ask – as they do – for independent appraisal of fiscal policy forecasts is sensible. But for the good of the British people – and for fiscal sustainability – the first priority must be to restore robust economic growth. The wealth of the nation lies in what its citizens can produce. Letter 2 is signed by: Lord Skidelsky,Emeritus Professor of Political Economy, University of Warwick, UK; Marcus Miller,Professor of Economics, University of Warwick, UK; David Blanchflower,Bruce V. Rauner Professor of Economics, Dartmouth College, US and University of Stirling, UK; Kern Alexander,Professor of Law and Economics, University of Zurich, Switzerland; Martyn Andrews,Professor of Econometrics, University of Manchester, UK; David Bell,Professor of Economics, University of Stirling, UK; William Brown,Montague Burton Professor of Industrial Relations, University of Cambridge, UK; Mustafa Caglayan,Professor of Economics, University of Sheffield, UK; Victoria Chick,Emeritus Professor of Economics, University College London, UK; Christopher Cramer,Professor of Economics, SOAS, London, UK; Paul De Grauwe,Professor of Economics, K. U. Leuven, Belgium; Brad DeLong,Professor of Economics, U.C. Berkeley, US; Marina Della Giusta,Senior Lecturer in Economics, University of Reading, UK; Andy Dickerson,Professor in Economics, University of Sheffield, UK; John Driffill,Professor of Economics, Birkbeck College London, UK; Ciaran Driver, Professor of Economics, Imperial College London, UK; Sheila Dow,Emeritus Professor of Economics, University of Stirling, UK; Chris Edwards,Senior Fellow, Economics, University of East Anglia, UK; Peter Elias,Professor of Economics, University of Warwick, UK; Bob Elliot,Professor of Economics, University of Aberdeen, UK; Jean-Paul Fitoussi,Professor of Economics, Sciences-po, Paris, France; Giuseppe Fontana,Professor of Monetary Economics, University of Leeds, UK; Richard Freeman,Herbert Ascherman Chair in Economics, Harvard University, US;Francis Green,Professor of Economics, University of Kent, UK; G.C. Harcourt,Emeritus Reader, University of Cambridge, and Professor Emeritus, University of Adelaide, Australia; Peter Hammond, Marie Curie Professor, Department of Economics, University of Warwick, UK; Mark Hayes, Fellow in Economics, University of Cambridge, UK; David Held, Graham Wallas Professor of Political Science, LSE, UK; Jerome de Henau,Lecturer in Economics, Open University, UK; Susan Himmelweit,Professor of Economics, Open University, UK; Geoffrey Hodgson,Research Professor of Business Studies, University of Hertfordshire, UK; Jane Humphries,Professor of Economic History, University of Oxford, UK; Grazia Ietto-Gillies,Emeritus Professor of Economics, London South Bank University, UK; George Irvin,Professor of Economics, SOAS London, UK; Geraint Johnes,Professor of Economics and Dean of Graduate Studies, Lancaster University, UK; Mary Kaldor,Professor of Global Governance, LSE, UK; Alan Kirman,Professor Emeritus Universite Paul Cezanne, Ecole des Hautes Etudes en Sciences Sociales, Institut Universitaire de France; Dennis Leech,Professor of Economics, Warwick University, UK; Robert MacCulloch,Professor of Economics, Imperial College London, UK; Stephen Machin,Professor of Economics, University College London, UK; George Magnus, Senior Economic Adviser to UBS Investment Bank; Alan Manning,Professor of Economics, LSE, UK; Ron Martin, Professor of Economic Geography, University of Cambridge, UK; Simon Mohun, Professor of Political Economy, QML, UK; Phil Murphy, Professor of Economics, University of Swansea, UK; Robin Naylor, Professor of Economics, University of Warwick, UK; Alberto Paloni, Senior Lecturer in Economics, University of Glasgow, UK; Rick van der Ploeg,Professor of Economics, University of Oxford, UK; Lord Peston, Emeritus Professor of Economics, QML, London, UK; Robert Rowthorn,Emeritus Professor of Economics, University of Cambridge, UK; Malcolm Sawyer, Professor of Economics, University of Leeds, UK; Richard Smith,Professor of Econometric Theory and Economic Statistics, University of Cambridge, UK; Frances Stewart, Professor of Development Economics, University of Oxford, UK; Joseph Stiglitz,University Professor, Columbia University, US; Andrew Trigg,Senior Lecturer in Economics, Open University, UK; John Van Reenen,Professor of Economics, LSE, UK; Roberto Veneziani,Senior Lecturer in Economics, QML, UK; John Weeks,Professor Emeritus Professor of Economics, SOAS, London, UK.Many hundreds of other economists would sign this letter if asked. It is signed by many friends especially those from my Cambridge years. But I notice that few are macro-economic modelers; nearly all are theoreticians albeit of an empirical bent i.e. sceptical of abstract long run theory. They usefully point out that just as the deficit is automatically generated by the long deep recession it will also be automatically reduced by recovery. What may be less appreciated or not thought to be a vital point, when higher savings in the economy are required and when banks and institutional investors (in all countries)are forced for stability and solvency reasons to invest more heavily in government bonds there needs to be a healthy domestic supply, not least after £200bn of QE, otherwise they have to buy substantial foreign treasury bonds with worse consequences for the external trade balance. There is in fact a level of government borrowing always required below which it should not fall. This, most economists generally have ignored.
What the economists are responding to is party politics in the lead-up to a general election. Opposition parties are, like the Irish, averse to letting the truth stand in the way of a good story. New Labour gave The Conservative government a similarly totally unrealistic kicking in the 1997 election by claiming public finances were in a mess. At that time, mysteriously, Chancellor Ken Clarke, perhaps resigned to losing, did not riposte with the obvious question to New Labour "what would you have done differently to get the economy out of recession (in '91 & '92)?" This time, while we are still in a recession, not the case in '97, Chancellor Darling is defending his wicket and has the above economists supporting him.60 economists are less than the "350 economists from across the world" who recently wrote to G20 leaders calling on them to introduce a financial transactions tax on speculative dealings in foreign currencies, shares and other securities. It is less than the 365 economists who (in vain) wrote in 1981 to The Times calling on the 'Thatcher' government to alter its economic policy to end the current recession.
What did the 20 economists who support the Conservative Party's policy state? They said:
IT IS now clear that the UK economy entered the recession with a large structural budget deficit. As a result the UK’s budget deficit is now the largest in our peacetime history and among the largest in the developed world.
In these circumstances a credible medium-term fiscal consolidation plan would make a sustainable recovery more likely.
In the absence of a credible plan, there is a risk that a loss of confidence in the UK’s economic policy framework will contribute to higher long-term interest rates and/or currency instability, which could undermine the recovery.
In order to minimise this risk and support a sustainable recovery, the next government should set out a detailed plan to reduce the structural budget deficit more quickly than set out in the 2009 pre-budget report.
The exact timing of measures should be sensitive to developments in the economy, particularly the fragility of the recovery. However, in order to be credible, the government’s goal should be to eliminate the structural current budget deficit over the course of a parliament, and there is a compelling case, all else being equal, for the first measures beginning to take effect in the 2010-11 fiscal year.
The bulk of this fiscal consolidation should be borne by reductions in government spending, but that process should be mindful of its impact on society’s more vulnerable groups. Tax increases should be broad-based and minimise damaging increases in marginal tax rates on employment and investment.
In order to restore trust in the fiscal framework, the government should also introduce more independence into the generation of fiscal forecasts and the scrutiny of the government’s performance against its stated fiscal goals. letter is signed by: Tim Besley, Sir Howard Davies, Charles Goodhart, Albert Marcet, Christopher Pissarides and Danny Quah, all of London School of Economics; Meghnad Desai and Andrew Turnbull, House of Lords; Orazio Attanasio and Costas Meghir, University College London; Sir John Vickers, Oxford University; John Muellbauer, Nuffield College, Oxford; David Newbery and Hashem Pesaran, Cambridge University;
Ken Rogoff, Harvard University; Thomas Sargent, New York University; Anne Sibert, Birkbeck College, University of London; Michael Wickens, University of York and Cardiff Business School; Roger Bootle, Capital Economics; Bridget Rosewell, GLA and Volterra Consulting. The 20 economists' letter might imply there is no deficit and debt reduction plan. It, however, uses the word 'credible' without offering a reason why the government's medium term plan is not credible? My analysis suggests the government is being very modest and over-cautious in not targeting how much profitable gain there will be from its bank bailout measures and how quickly tax revenues will increase without higher tax rates. 'Credibility' can here mean appearance more than substance. The 20 say they worry about 'loss of confidence in the UK’s economic policy framework will contribute to higher long-term interest rates and/or currency instability' . The higher interest rate argument is really pathetic because all should know that 'crowding out' theory never found empirical proof - it's just a theory, and a very poor one. Higher interest rates to defend the currency is more credible, but this is such a contextually complex matter that my opinion is that the 20 lack a realistic perspective and sense of proportion. What has been happening across the FX exhagnge market continues not to be driven by relative economic performance and interest rates at all, but by all banks reducing their cross-border assets and liabilities, and in this respect the UK with £4 trillions of such positions after about £400 billions of deleveraging that sank the pound (usefully perhaps) what the 20 are talking about is inconsequential.
What we have here are 20 highly reputable economists who are insufficiently versed in what is going on in the financial markets and banks and the scale of thei balance sheet changes and how these impact the economy - they are living in an economics from pre-financial globalisation. This should not be true of Goodhart, long term colleague at the LSE of Mervyn King, but, no offence intended, his academic focus on the theoretical trees of financial markets interpreted in reductionist maths models I always felt blinded his research group from seeing the whole wood.
The 20 economists do advise sensitivety to economic circumstances, but I fear they do not have the applied macroeconomic modeller's understanding of timing. As noted by the 60 economists, the timetable for starting spending cuts is too soon to be sure of the robustness of recovery, just as, I may add too, we do not yet know how much of the government's budget revenue shortfall in 2009 will be recovered later as corporations' and others' tax provisions are realised, just as we do not know if banks will recover 30% or 50% of credit losses or have to eventually realise more than 10% of credit crunch writedowns.
In pointing up the high budget deficit it should be understood that much uncertainty remains that as in all previous experience will narrow that gaps we see nominally today - there is a difference between cash-flow borrowing and eventual outturn for the year seen in hindsight of 1-2 years hence. Output, inflation and even trade statistics are all severely revisable for up to 2 years.
Of the signatories, I am shocked at seeing among them Pesaran, Desai, Muellbauer, and Newbery, maybe not Newbery given his field is the most opaque mathematical economics, not empirical or applied, and not policy modeling. Roger Bootle is constantly a disappointment to me in his avowel (professional positioning) of almost neo-liberal economics since he can at least claim to have a macroeconomic model to operate, however flawed in medium term forecasting. Costas Meghir is also at the Institute for Fiscal Studies that I believe has in recent years taken an over-prudent view of borrowing over the cycle. Its stated view is "Whoever forms the next Government should put in place a fiscal tightening more ambitious over the next Parliament than that set out in the PBR, but without putting the recovery at undue risk with significant extra tax increases or public spending cuts in the coming year" - and in this respect at least does not favour cuts this year. But, in any case, it lacks an adequate model to sustain macro-economic views. Wickens is a general equilibrium theorist in closed economy models. Rogoff was at one time classified (by Stieglitz) as a market fundamentalist, and while this may be harsh it is the case that his analyses of crises begin and end with public sector indebtedness and monetary-driven inflation. It is disappointing that a first class logician remins bounded by partially-sighted theory. I wish he would retrain his focus to look at private sector debt and illiquid one-way markets.I could make similar superior judgements of others but would be unfair and conceited.
My main objection to the 20 remains however that they have a blinkered mindset when focusing on problems to treat context as "all else being equal" i.e. context-free. This is perhaps permissable for theory but not for applied prescriptions. Rogoff, for example, has the integrity of self-doubt, his only accusation against Stiegltiz is the presumption of certainty of showing no self-doubt or self-criticism. Henec, I'm surprised that he sides with the 20 in being certain that earlier spending cuts and higher tax rates are needed. Others agree with Martin Wolf of the FT, and I would have expected Howard Davies to agree too, that it is better to overshoot in ensuring recovery than try to economise on deficit spending to do merely the optimally minimal and risk failure, which is I think the best comment to end on.