… has been a little quiet these past two weeks. This is mainly as I’ve started a new job over at the TUC as Senior Policy Officer covering macroeconomics.
I am planning on continuing this blog although posting will be a bit less frequent (I’ll aim for one or two posts a week). In the meantime please do check out Touchstone though.
The big announcement in Osbone’s speech from a macroeconomic point of view was the talk of ‘credit easing’ – Treasury action to ease loan availability to small and medium sized businesses.
Implicitly the Chancellor has therefore acknowledged that the ‘Project Merlin’ deal with the big banks to ensure credit gets to SMEs is failing. This is a good start but the devil will of course be in the details. Those details remain sketchy but is seems likely that credit easing will take the form of some sort of securitisation process whereby banks (or other investors) lending to SMEs can bundle those small loans into larger bonds and sell them on either to the Treasury, some new government arms length agency or maybe to the Bank of England. In effect this would make the funding of new SME loans much easier – and possibly cheaper.
This all raises a few questions. First, and crucially, how quickly could such an operation be gotten up and running? I suspect it could easily take well over a year. This is is not a quick fix to poor credit availability for SMEs.
Second how large will the programme actually be? This is the kind of crucial detail we really need to be able to assess the impact of such a move.
Third – what does this announcement, from the Chancellor, say about diverging views between HMT and the Bank? MPC member Adam Posen floated a similar (but more comprehensive and BOE funded) scheme a few weeks ago, has that been rejected by the Bank?
Fourth – what will the OBR make of this? Assuming the Treasury can pull together a concrete proposal soon it should be included in the autumn forecast numbers released at the end of November.
Finally – why an indirect scheme like this rather than some form of state backed investment bank focussed on SMEs? Surely that would be a more direct way of dealing with the problem of SME credit access.
As I’ve argued previously they are quite rightBritain has both an immediate demand problem and long term supply side problem. An increase investment has the potential to help resolve both of these issues by increasing demand in the short run and addressing supply side issues in the medium term. The problem of course is that the private sector, stuck in a deleveraging, balance sheet recession is unwilling to invest.
Hence the recent talk (denied) of a £5bn investment led government stimulus.
Now I’d start by noting that £5bn is a mere drop in the ocean in terms of the UK macroeconomy – welcome but nothing to get excited about. The amount of investment needed is much higher and it cannot all come from a government stimulus anyway. This is why banking reform to ensure it supports the real economy and wider structural reforms to the UK economy are much needed (proper structural reforms that actually help – not a handful of enterprise zones and talk of cutting maternity pay!).
But the talk of a £5bn stimulus (coupled with the FT’s revelations about a £12bn ‘black hole’ in the public finances) has led to a discussion on the nature of George Osborne’s fiscal mandate and the question of how much flexibility he has.
Both Vince Cable and Chris Huhne have emphasised that Osborne is targeting the structural deficit and so has room to allow the ‘automatic stabilisers to work’. I.e. if the economy slows further and tax revenues drop whilst welfare spending increases, Osborne will not have to bring in extra tightening to counter act this.
Huhne has gone further and argued that Osborne is targeting the ‘current structural deficit’ so could actually increase investment whilst still meeting his target.
Do these claims stack up?
Osborne set out his formal mandate his Budget speech last year:
The formal mandate we set is that the structural current deficit should be in balance in the final year of the five-year forecast period, which is 2015-16 in this Budget.
This mandate is:
Structural – to give us flexibility to respond to external shocks;
Current – to protect the most productive public investment;
And credible – because the Office for Budget Responsibility, not the Chancellor, will decide on the output gap.
So far so good – he’s targetting the current structural deficit so (if the FT is wrong about the OBR’s likely downgrade to the output gap) then he would have room to both allow the automatic stabilisers to work and to increase investment.
But, but, but… Osborne went on to say something he may well regret:
In order to place our fiscal credibility beyond doubt, this mandate will be supplemented by a fixed target for debt, which in this Parliament is to ensure that debt is falling as a share ofGDP by 2015-16. (my emphasis)
It’s this fixed target for a falling debt to GDPratio by 2015/16 that causes the problems. The current OBR forecast (almost certain to be revised heavily in November) is that debt/GDP will peak at 70.9% in 2013/14, fall to 70.5% in 2014/15 and 69.1% in 2015/16. I.e. Osborne is on course to meet his target two years early but by the narrowest of margins. The downgrades this Autumn are likely to mean he is meeting his second target just on time and with no rrom to spare.
In other words Osborne has no room to for a discrectiobnary stimulus without breaching his mandate. There is even a chance that the automatic stabilisers may have to be scaled back if he is to meet his target.
A few quick bullet points:
- Public sector net investment so far this financial year is £8.0bn against £10.9bn last year. Despite all Clegg & Cable’s talk in the past few days about ‘government investment as a stimulus’.
- Welfare spending is up 5% year on year. Nearly twice as much as the OBR forecast (3%).
- Overall borrowing is down 7% this financial year. The OBR predict it will fall by 16% in 2011/12.
That last point is crucial. We are already undershooting the OBR’s target and the economy (according to just about every independent forecaster) is set to slow further.
The November Statement is going to be grim for the government. Not only are the growth forecasts for 2011 and 2012 (and possibly 2013 & 2014) going to be revised down heavily but borrowing is going to be revised up.
The Eurozone doesn’t have a debt crisis. Individual Eurozone countries obviously do – and these individual problems are being exacerbated by the common currency. But at the level of the zone as a whole the debt dynamics look pretty robust.
The two charts below (data from the IMF’s April World Economic Outlook database) clearly demonstrate this.
All of which makes a Eurobond more appealing as a crisis solution – but as Chris notes maybe the problem is that I’m seeing this as a technocratic rather than a moral problem?
For the most vivid demonstration of this – I highly recommend the Eurozone crisis explained with Lego (as explained by JP Morgan)…
As the paper reports:
The Financial Times has replicated the model of government borrowing used by the independent Office for Budget Responsibility, which suggests the structural deficit in 2011-12 is now £12bn higher than thought, a rise of 25 per cent.
By repeating and extending the fundamental elements of the OBR methodology, it is clear that even if there is no slippage in borrowing from previous forecasts, the level of spare capacity in the economy is lower than expected, so the OBR will not be able to forecast as much catch-up growth as it did in March.
(Presumably they used this OBR briefing paper to replicate the exercise).
£12bn might not sound like much in the context of the deficit – but what really matters is that this is a forecast of the structural deficit. That’s what makes this story far more important than previous revisions to the deficit forecast. An increase in the structural deficit (the assumed deficit at a time of ‘normal’ growth) cannot by definition be eliminated by economic growth – it requires tax rises or spending cuts.
Before proceeding it’s worth noting two important caveats:
First – we shouldn’t really blame a higher structural deficit forecast on George Osborne. The OBR forecast is driven by a belief that the economy is actually capable of less growth than previously thought rather than by the current slowdown. That isn’t the governments fault. How they respond to this potential new forecast is what matters and we can judge them on that.
Second – Estimating the structural deficit is notoriously difficult. Although that said, Osborne has made this notoriously hard to calculate variable a target of fiscal policy so complaining that structural deficits are hard to estimate would make little sense from the government now.
Caveats aside let’s remember that raising £12bn more than targeted means putting VAT, for example, up to 22.5%.
So, if the OBR model does indeed imply that the structural deficit should be revised up by £12bn in November, what happens from here?
The best case for the government is that the OBR either changes it’s methodology (not impossible – they changed in June last year how they calculate public sector job losses) or decides that the structural deficit isn’t £12bn higher – which they can do without changing their methodology:
It is also important to bear in mind that these techniques are used to inform the judgement that the OBR makes about the size of the output gap in its central forecast, but that we do not apply them without question. We might make (and would clearly explain) a judgement that diverges from what they tell us if we felt that the weight of other evidence suggested that would be appropriate.
So it may be that the OBR decides that although its methodology implies a £12bn higher structural deficit, they ‘judge’ it to be lower. I can’t see Robert Chote, who has long warned that the UK’s growth potential has been badly damaged by the financial crash going for that – although the figure they come up with may be lower than £12bn (they might decide for example that enterprises zones and corporation tax cuts have raised potential growth – this seems unlikely).
The second thing that could happen is that Osborne could announce that he will no longer meet his fiscal rule of eliminating the structural deficit this Parliament. In effect this would be pushing £12bn of austerity back into the next Parliament. For Osborne to be forced to abandon a fiscal rule 18 months after making it would be highly embarrassing. Assuming the markets don’t panic at that (and I see no reasons why they would), this would be the best outcome for the UK economy if there is an additional shortfall. Osborne should accept the political hit and not try to shift it into an economic hit on the economy.
The most worrying outcome would be if the OBR announced that the structural deficit was £12bn higher and Osborne was determined to stick to his fiscal rules. In which case an additional annual £12bn of tax rises and spending cuts would be required this Parliament. Just what the economy doesn’t need in its current weakened state.
The November Statement is starting to look very interesting.
I’ve noted before that I have a lot of time for MPC member Adam Posen, in particular his views of the likely path of consumption. Which are turning out to be rather accurate.
As an expert of the Japanese lost decades (and often missed off plural is important here!) it is perhaps unsurprising that he worries more than other MPC members about how an economy recovers from a balance sheet recession.
This week he made a superb speech, which I’d highly recommend.
Posen not only retiterates his call for more QE (on which my own views are a bit more nuanced) but also sets out a truly radical plan to get credit flowing. One that I will quote extensively:
Yet most if not all countries have ongoing public lenders of various types (even the US has the SBA), and their existence on a limited scale, while perhaps wasteful at the margin, does not lead to the destruction of the private-sector banking systems in those countries. (Posen (2009a)) Let us remember that the UK and other western private-sector banks did that themselves during a period of financial liberalization and privatization unprecedented in postwar economic history.
In any event, these are not normal times. The existence of such a public institution for lending to SMEs and new business is a response to the dysfunctional credit system we now have, and is likely to allocate capital better under such circumstances than in the normal situation. Since adverse selection is at work in the banking system, it will be easier to find good investment projects and borrowers that were overlooked than in normal times. Ultimately, this entity can and should be privatized, perhaps in more than one part depending upon its scale, when the situation improves. And just like with the financial institutions currently in the government’s hands, such privatization would be an opportunity to restructure the British financial system to a more competitive one which provides better high-street lending, our historic financial weakness.
The other institution I would encourage the Government to set up would be an entity to bundle and securitize loans made to SMEs. Essentially, we need a good version of Fannie Mae and Freddie Mac to create a more liquid and deep market for illiquid securities which can then be sold off of bank(s) balance sheets. It is worth remembering that for decades the mortgage ‘agencies’ in the US provided a vital service and did not undermine financial stability. It was only in recent years when they were allowed to keep mortgages on their own books in pursuit of excessive short-term payouts to their management, and were not strictly enough supervised given their perceived government guarantees, that they did harm (admittedly quite serious).
That is why I suggest that such an entity should be a separate institution than the bank or banks which do the new SME lending, so it can be incentivized to scrutinize the loans being offered for securitization. I would also suggest requiring that the securities being issued by this agency – let’s call it Bennie, the “British Enterprise Investment Entity” –be comprised of loans very transparently sorted and distinguished by type, so segregated (no general Bennie securities). And I would say we should insist that the securities that emerge meet all the standards for high quality assets that the Bank of England currently insists upon to be willing to lend against something. And this is where the Bank of England comes in. Both of these entities, the new SME lender(s) and Bennie, would need an initial infusion of capital. The Bank could then commit to discounting the securities from Bennie (so long as they meet our previously set standards) and, as needed, various loans and other assets from the new SME bank (though obviously not individual corporate loans and not those bundles of loans rejected by Bennie as sub-standard). Some might say the Bank can already do that without any further agreement or announcement. I would suggest that this misses the point and perhaps an opportunity.
I.e. he not only calls for a state backed lending institution but notes how it could be funded using QE. Something I proposed two years ago. Radical indeed.
A year ago, there appeared to be a decent chance the UK would enjoy an export-led recovery. Export volumes, excluding oil and erratic items, were up 18% on a year earlier, boosting growth in manufacturing. RealGDPwas increasing strongly.
Now the picture is far less positive.
The latest figures on trade, released by the Office for National Statistics, show export volumes increased just 3.7% over the last year, and were down 2.8% comparing the latest three months with the previous three.
Import growth was 3.6% over the last year – just about matching export growth – and 1.1% over the latest three months. The export boost to growth has faded away.
Export growth is currently running at 3.7% per year and import growth at 3.6%. This compares to the OBR forecasts for the full year of 7.9% and 5.0%.
Whilst export growth is no where near as strong as predicted by the OBR, import growth is also weaker than it anticipated. The end result is that the trade balance is actually in better shape than the OBR forecast back in March. Back then it expected the Q1 trade balance to come in at -£13.1bn and Q2 at -£13.7bn.
The actual outturn (-£8.5bn & -£11.3bn) is therefore better than anticipated. That’s the good news.
The bad news is that this isn’t being driven by better-than-expected exports but by lower-than-expected imports and the reason we are importing less is because domestic demand has collapsed.
This is why the consensus view of the independent economic forecasters surveyed monthly by the Treasury is that the economy will now growth by only 1.2% in 2011. And the entirety of that growth will come from net trade. Domestic demand is expected to contribute zero per cent to GDP growth.
So the better performance in net trade is actually driven by domestic weakness and isn’t enough to offset the fall off in domestic demand. I’m not sure this is how George Osborne saw ‘rebalancing’ panning out.
Paul Mason has an excellent post up on the notion of a German Marshall Plan for the European periphery. Whilst such a plan sounds good, I have my doubts about whether it will actually happen.
Towards the end of his post Paul writes:
Keynes comes in for a lot of stick these days but his greatest achievement was not to design the rescue of 1930s capitalism through state intervention: it was two-fold.
It was to say:
(i) in 1919 don’t punish Germany and push it into a downward economic spiral that will cause social chaos; and
(ii) in 1941: hey, fellas, what’s the world going to look like when we win? Here’s an idea…
This parallel between the Europe of 1919 and the one of today is an interesting one.
To see what Keynes would have to say, I went to his short essay of 1919 ‘Proposals for the Reconstruction of Europe’.
Keynes begins by noting that the notion of cross border financial payments really only dates to the mid century on any large scale.
“the system [of international payments between nations] is fragile; and it has only survived because its burden on the paying countries has not so far been oppressive’.
After the Great War these payments became larger with both reparations and inter-allied loans. Keynes doubted this could continue:
‘I do not believe that any of these tributes will continue to be paid, at the best, for more than a very few years. They do not square with human nature or agree with the spirit of the age’
Keynes goes on to suggest a solution to this problem, based around inter-allied debt forgiveness, treaty modification and the establishment of a proto-IMF from which nations could borrow administered by the League of Nations.
Having sketched out a solution though, Keynes then writes:
‘It is useless at the present time to elaborate such schemes in further detail. A great change is necessary in public opinion before the proposals of this chapter can enter the region of practical politics’
With a policy change not coming and with populations unlikely to revolt, Keynes predicted what lay ahead:
‘There may, therefore, be ahead of us a long, silent process of semi-starvation, and a gradual, steady lowering of the standards of life and comfort. The bankruptcy of Europe, if we allow it to proceed, will affect every one in the long-run, but perhaps not in a way that is striking or immediate’.
Unsustainable cross-European transfers? Lack of policy will? A long period of declining living standards ahead? This all feels very familiar.
The past 24 hours have seena lot of comment on the notion that China (holder of $3.2 trillion of foreign exchange reserves) may intervene to buy Italian government bonds, providing vital support to the market.
I’m not holding my breath, mainly because this all seems very familiar:
October 2010 – China pledges to buy Greek bonds
December 2010 – Portugal asks China to buy its bonds
January 2011 – China backs Irish bailout
January 2011 – China promises to buy Spanish bonds
For the last two years the Euro-Crisis has worked to a familiar script, roughly put is goes something like this:
Government denies it is in trouble, government passes austerity package, growth slows, deficit either widens or refuses to come down, bond yields increase, government denies a bailout is coming, bond yields rise, EU authorities deny a bailout is coming, more austerity, deficit still high, bond yields hit 6%, talk of Chinese (other Asian) support, EU ‘rescue’ agreed at last moment – in reality just kicks the can down the road, more austerity, deficit rises.
It looked a few weeks ago like the ECB might have broken the circle by heavy intervention in the Spanish and Italian debt markets. I speculated a month ago that this wasn’t panning out to plan.
Post the resignation of Stark, and the rise of Italian yields to back about 5.7% it looks like we are back on script.
The problem is that Eurozone leaders are running out of road to kick the can down.