Monday, February 22, 2010


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: 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+)'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.

Friday, February 19, 2010


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.

Wednesday, February 17, 2010


Niall Ferguson, the historian who has pegged out a media stake with his History of Money book to knowing about economics and money, has been over-reaching himself to concur with neo-liberal manufactured fears about government tax and spend - claiming last week that the US will face a Greek crisis - as if he knows what the Greek crisis is, which I doubt. see: and and also
Martin Wolf, writing in the FT, promptly dismissed this as hysteria.
Ferguson stated that, according to the White House projections, gross federal debt will exceed 100% per cent of (ratio to) GDP by 2012 (currently at about 60% ratio), adding that the US is forecast never to run a balanced budget again (actually if true this would be a great thing), and saying (totally implausibly) that monetary policy (i.e. near zero central bank borrowing rate), not (fiscal) deficits, saved the US economy; but that higher interest rates are on the way and, not least, that high fiscal debt is damaging (usually implying it alone forces up cost of borrowing, which is merely ideological theory without empirical proof, and which makes no sense anyway).
When the credit crunch was lacerating the banks and recession subsequently struck in 2007-2009 none questioned the solvency of OECD countries even when jaws dropped at the scale of the bail-out responses. Now that the smoke is clearing and the public wants its pound of flesh from the banks who were losing the blame-game game there appears to be a concerted effort to shift public anger and anxiety from banks' solvency onto government solvency. Brad DeLong of the University of California, Berkeley, responded that parts of Ferguson's argument are wrong or misleading, not least because White House projections are for federal debt (that part held by the public i.e. private and foreign holders) to be 71% ratio to GDP in 2012 and not to exceed 77% by 2020. All empirical economists, as opposed to theoretical ideologues know that monetary policy (setting of interest rates and money market tightening or loosening) would not have delivered even limited recovery. Higher central bank interest rates may indeed be on the way, but there is nothing in current yield curves in the markets to suggest it, nor in any medium term relevant factor projections. Moreover there is, as Wolf states reporting DeLong's view, no reason to balance budgets in a country whose nominal GDP grows at up to 5% a year in normal times.
Wolf says Prof Ferguson (a Scot-Brit who has a professorial chair in the US) is trying to frighten US policymakers out of sustaining or, better still, increasing fiscal stimulus, even if the true issue is longer-term sustainability. I think he is merely currying favour with Republicans and UK Conservatives.
Ferguson accuses opponents of believing in a “Keynesian free lunch”. Wolf cleverly spots the implication of this that Ferguson believes (religious sense of this word)in a conservative free lunch. Wolf's counter is that the benefits of the higher output today far exceed the costs of debt service tomorrow. In fact, one can add that depending on the composition of government spending and ho it draws its income from across the whole economy including a quarter derived from taxing its own spending as well as debt interest, the costs of debt servicing are small in net terms. Moreover, banks and other financial corporations need for solvency reasons to buy and hold the majority of any new future government debt issuance.
Ferguson is not a three-dimensional economist (as I term it) and therefore can casually indulge in the neo-liberal theocractic view that fiscal tightening today would have little effect on growth in economic activity. Only when monetary policy has room for manoeuvre and the private sector’s borrowing is unconstrained, can this benign view be half-right. But, as Olivier Blanchard, chief economist of the IMF, and colleagues note (in a recent report): “To the extent that monetary policy, including credit and quantitative easing, had largely reached its limits, policymakers had little choice but to rely on fiscal policy.”
The high-income growth (trade deficit) countries that have experienced the biggest jumps in budget deficits and national debts have, inevitably, been Ireland, Spain, the UK and US, as Stephen Cecchetti and colleagues at BIS pointed out in “The Future of Public Debt” (presented last week at a conference for the 75th birthday of the Reserve Bank of India). These countries had the biggest sustained credit booms and consequential asset bubbles because banks denuded lending to productive industries and exporters to favour mortgage and consumer credit lending. It is there, as a result, that private-sector spending has been most constrained by the pressure on banks to deleverage when their capital got wiped out twice in the credit crunch and recession, which governments have compensated them for by about half on a more than full commercial rent basis.
Jumps in fiscal deficits are the mirror image of retrenchment by battered private sectors i.e. as government deficits rise so too do private savings by the same % ratios to GDP. In the US, the financial balance of the private sector (the gap between income and expenditure) shifted from minus 2.1 per cent of GDP in the fourth quarter of 2007 to plus 6.7 per cent in the third quarter of 2009, a swing of 8.8 per cent of GDP (see chart). In the UK private savings rate has risen to over 8%!This massive swing occurred despite the Federal Reserve’s and HM Treasury's efforts to sustain lending and spending by the banks. Similar shifts occurred in other crisis-hit countries. There are many of those currently. If these governments had decided to balance their budgets, as conservatives myopically demand (mainly it seems for upcoming political election reasons), two possible outcomes can be envisaged in Wolf's words: the plausible one is that we would now be in a Great Depression; the fanciful one is that, despite huge increases in taxation or vast cuts in spending, the private sector would have borrowed and spent as if no crisis at all had happened. In other words, a massive fiscal tightening would actually expand the economy. This is to believe in magic.
The huge increases in fiscal deficits were appropriate to the circumstances. I would add that appropriateness is in both scale and quality - essentially to maintain and shift public spending targets despite a 5-6% fall in sales, corporate and income tax revenues. The only way to have avoided doing that would have been to prevent prior expansions of private credit and debt and therefore to severely cap the property booms. Such deficits cannot continue indefinitely, and in fact they do not do so. Wolf reports that as Carmen Reinhart and Kenneth Rogoff point out in a recent paper, once ratios of public debt to GDP exceed 90% ratio to GDP, median growth rates fall by 1% a year. That would be costly.
This view however is based on a context-free or abstracted view that fails to take account of the composition and quality of how the deficit spending is applied. In the case of Japan in the 1990s it was applied mainly to paying down banks' loan losses while government infrastructure spending continued to be cut back and so the domestic demand in the economy continued to slump. This is not Keynesian or how the US and UK are proceeding. This graphic is the wall Street Journal view of Europe's sovereign riskiness. A McKinsey Global Institute has also noted in a recent report: “Historic deleveraging episodes have been painful, on average lasting 6-7 years and reducing the ratio of debt to GDP by 25%”. The only ways to accelerate this they say would be via mass bankruptcy or inflation or by some ways to bolster and grow domestic demand if deleveraging continues - which is hard to square with any examples? In Japan's case, bank deleveraging continued as savings rates rose and the export-led growth policy merely resulted in the country buying more and more foreign financial assets. If fiscal deficit policy is ruled out, the only option would be foreign demand i.e. export-led growth. But, this has never been shown to do anything sufficiently to restore domestic demand by itself - it is a poor growth concept, and we can see it in China - a country bidding (on the back of false GDP figures) to be acclaimed as the world's second biggest economy when per capital employment incomes continue to average about $500 a month. China cannot continue to grow by trying to outcompete India or Vietnam for low wages. What is likely to offset contracting demand in the USA anyway where the trade deficit alone is about one third of the entire Chinese GDP (its real unfalsified GDP) - and what will externally pull other hard-hit economies? Nobody, alas, is the answer, althought the Brookings Institute recently had a stab at guessing it could be huge trade deficits by emerging market economies paid for by OECD aid.
The BIS paper also noted that long-run fiscal prospects, largely driven by fast growing pensioner populations, are dire. This, however, is absurd. Pensioners are the fastest growing tax-paying segment and rich pensioners pay more than enough to cover very poor pensioners (who are a third of all pensioners) - but in any case the USA is one of the fastest growing populations and therefore the pensioner overhang is much exaggerated in both population as well as fiscal burden terms. Projecting forward (on the basis of pensioners as somehow external to the economy) the BIS argues that ratios of public debt to GDP could reach 250% of GDP in Italy by 2050, 300% in Germany, 400% in France, 450% in the US, 500% in the UK and 600% in Japan. These projections are easily refuted in my considered view by empirical models i.e. the numbers by BIS (and others such as the CBO) is plain scare-mongering.
Wolf, on this makes a huge error in my view by saying the best approach would be sharp reductions in long-term growth of entitlement spending. When state pensions are already worth less in real terms than in the 1950s this is a recipe for a kind of Holocaust of the elderly, a fiscally-driven euthanasia. It is as irrational as the economic arguments that favoured German Lebensraum of the 1930s and 40s. Holocaust Memorial - let's not have another one from this financial economic crisis. Wolf adds, that furthermore, as economies recover, short-term fiscal action will be needed. Actions will have to include spending cuts and increases in tax, to restore revenue lost forever in the crisis. I entirely disagree. Public spending programmes are not at fault and should not have to be cut. They are engines of economic growth, and by maintaining them the so-called 'real economy' will recover faster and that is how public finances will regain their balance.
I agree with Wolf there is a dilemma if private deleveraging (by banks and by borrowers) and fiscal deficits continue in the US and elsewhere for years, which is an unlikely combination even if it did occur in Japan of the 1990s. Then triple A-rated countries, including even the US, might lose fiscal room to manoeuve. But, in this case the US external account would have come into balance an the test would be on the rest of the world to turn away from trade-led growth to doing more to stimulate domestic demand. This has not yet happened to Japan or Germany or OPEC or China, but while they are in denial about the pressure on them this is a dam that may have to break soon. It might well not happen to the US anyway, since Main Street would be in so much anger that democratic politics would be severely threatened. After all, Japan, Germany, China, OPEC etc. could only continue with export-led growth so long as the USA maintained it credit boom stance. But, according to Wolf, the USA could in time do so. I see this only happening if there was an absolutely hard and dedicated return to policy of export-led growth enunciated in 1992 by the President's Council of Economic Advisors in the USA that was thankfully not implemented. It would be the equivalent of the USA adopting some equivalent to economic isolationism. If the USA followed the 1990s path of Japan would it look like this? But the US is not Greece or Japan, even if Greece more than aped the USA in credit-boom growth and Japan kowtowed to the banks instead of the helping the other end of its economy's food chain. A massive fiscal tightening today would be a grave global error propelling the world back into deep long period recession or depression. The private sector must heal. That, not fiscal retrenchment, is the priority.
Martin is correct in his critique of ferguson. To be clearer; of course there is a Keynesian 'free lunch' - we've been lunching on it for most of the past century. In the case of the USA, those at the dining table include the rest of the world. This debate is part of a dangerous shift to focus unreasonable on public sector finances - whose difficulties are surely caused by private sector exuberance, but whose resolution is surely cheaper and less painful than applying euthanasia to banks. There seems to be an agenda or simply a kneejerk neo-liberalism to imagine that the world's credit crunch and recession impacts on future lunching problems are a product of governments' fiscal stances and national debts when the problem has surely been the meteoric rise of private debt and ballooning assets when governments bent over backwards to provide the private sector with overly benign conditions i.e. credit-boom economies ignoring their burgeoning external account deficits.
The UK and USA governments responded both heroically and severely by using off-balance sheet tools i.e. treasury bills in asset swap repos thereby protecting taxpayers. And, then delivering a similar salve via fiscal deficits to punt economies out of recession. The profits to governments (& central banks) from bank bail-outs should pay for almost half of fiscal deficits medium term and the remainder will be recoverable in renewed growth medium term. Prof. Ferguson is a historian whose book on history of money was nice but not insightfully new - he is not an economist or an economic historian specialist, and I find it surprising that he posits an ability to forecast some implications of future national debt, again none of which is new, merely populist fear-mongering. There is much feverish cant and paranoia about national debt including about solvency of even OECD states. If states didn't have any debt we'd have to force them too - the world, especially banks could not function without it. Then too, a fifth to over a third of OECD national debts are internal within government and net debt is relatively small, and when including income and assets as collateral, national debts disappear as solvency issues - and are certainly serviceable. It is the private sector debts we need to be far more concerned about in "tax on the future" terms.
This does not stop irrational projections that two-dimensionally project current short term trends into the long term. Those who engage in this, including Ferguson, simply do not understand economic factors and values as part of a double-entry accounting system and models which do not permit selected factors like national debt to take off alone unencumbered by countervailing effects and brakes into the stratosphere as if spent on some other planet. If the US budget deficit was to balloon as some projections such as, for example, those by the Congressional Budget Office do in respect of Obama's medical insurance policy or future cost of pensions the implication would have to be include a huge increase in US trade deficit - already near its historical peak - but we know this is simply not capable of being financed long term as it was in the last decade. Responsibility for the global problems also lie with trade surplus countries' failure to broaden and deepen their own domestic economies' demand.
The USA is a quarter of the world economy. It's Federal debt and budget deficit are best measurable in world terms - something the rest of the world also very much needs and depends upon. The EU should do more - get into harness with the USA to pull the world economy forward. The world economy is as vulnerable as it is robust, maybe. But, rich countries angry obsession with their frustrated ambitions risks neglecting the wider world picture. This is a world of mostly many trade deficit-led domestic credit boom growth countries and a few export-led domestic credit-constrained countries (e.g. Japan, Germany, OPEC). In the past century there were more of the former than the latter until in the past decade we saw a polar shift to a few major deficit economies (USA, UK, Spain, Ireland, Greece etc.) and everyone else in surplus or near balance, of which not a few included emerging markets who gained an unprecedented boom (first for half a century) a sustained period led by the BRICS, especially China. There now will be another polar shift. If the adjustment is chaotic and mismanaged the costs won;t be represented by red ink on balance sheets but by real blood on flags and battlefield body counts.