‘Duncan Weldon has literally nothing to add to the debate’

Sorry for lack of posts here over past few days.

In case any readers have missed me (unlikely), here’s some other stuff I’ve been involved with.

Me on the 50p tax rate at Guardian Comment is Free and again, responding to some criticism, at Left Foot Forward.

Me on the IMF and the dangers of cutting too quickly at False Economy.

I have an essay in this (very good) collection on growth from the IPPR.

Although given that the TPA say: ‘Duncan Weldon has literally nothing to add to the debate’ - you might not want to bother…

The 50p Rate is Working

Table PSF6 of today’s public sector borrowing figures (page 22 of this pdf) is worth a look.

It shows that income tax receipts (in cash terms) in January 2011 came in at £23,793mn up 17.8% on January 2010.

Meanwhile National Insurance Contributions (NICS) over the same period were up only 4.2%.

Income tax receipts soaring well ahead of NICS – could it be that the 50p rate is effective and raising revenues?

The Economic Consequences of Mr Osborne

I spoke at Progressive London on Saturday afternoon on the UK economy and the government’s economic strategy.

One of the other speakers at the meeting I was involved with was Victoria Chick, co-author of an excellent 30 page book with Ann Pettifor entitled ‘The Economic Consequences of Mr Osborne’, I read this last year (whilst the blog was on an employment related break)  and would highly recommend it. It’s very remiss of me not to have plugged on here already.

So, here it is.

Go and download it.

Globalisation and Second Best Solutions

As I’ve made clear on more than one occasion, I strongly disagree with Mervyn King’s views on fiscal policy and his belief that falling real wage are inevitable. I also think he was allowed himself to wander too far into the political debate in the UK – damaging the Bank’s credibility as independent institution.

But on some issues I agree with him, most notably on the need for a substantial reform of the banking system.

FT Alphaville have an excellent summary of a recent paper (only eight pages and worth reading) from the Governor on the question of global imbalances and financial instability.

As they report “it’s really quite heady stuff for a central bank head. There’s a not-so-subtle yearning for Bretton Woods, plus a tacit admission that regulation can only go so far in combating banking crises, which, at their heart, are caused by gluts and greed.”

The key chart is below, showing the strong correlation between international capital mobility and the appearance of banking crisis.

King notes that regulation can only go so far in preventing crises and compares the post war Bretton Woods system to the current international regime: 

[The current system has] also coexisted, on average, with: slower, more volatile, global growth; more frequent downturns; higher inflation and inflation volatility; larger current account imbalances; and more frequent banking crises, currency crises and external defaults. However, to some extent these period-average metrics obscure significant improvements over the current period, with the ‘great moderation’ period post-1990 associated with much better outcomes than those achieved in the 1970s and 1980s. Nevertheless, with the important exception of infl ation, the outcomes achieved during the Bretton Woods period were better than those attained since 1990. While this does not imply causation of course, it does suggest that better outcomes may be possible.

King ends by calling for a ‘grand bargain’ amongst the major economic powers:

What is needed now is a “grand bargain” among the major players in the world economy. A bargain that recognises the benefits of compromise on the real path of economic adjustment in order to avoid the damaging consequences of a move towards protectionism. Exchange rates will have to be part of such a bargain, but they logically follow a higher level agreement on rebalancing and sustaining a high level of world demand.

I fully agree, and have argued previously that a grand bargain (along the lines of Keynes’ proposed International Clearing Union) is what is required to resolve some of the underlying problems in the world macroeconomy.

But what if such a bargain can’t be struck?

Nouriel Roubini has recently written that:

We live in a world where, in theory, global economic and political governance is in the hands of the G-20. In practice, however, there is no global leadership and severe disarray and disagreement among G-20 members about monetary and fiscal policy, exchange rates and global imbalances, climate change, trade, financial stability, the international monetary system, and energy, food and global security. Indeed, the major powers now see these issues as zero-sum games rather than positive-sum games. So ours is, in essence, a G-Zero world.

Paul Mason has listened some of the current flash points in the ongoing “currency wars”:

China versus the USA: in which the US wants China to allow the RMB to rise against the dollar, weakening China’s competitiveness by raising the price of Chinese exports.

There is the USA versus the Emerging Markets: in which the USA’s quantitative easing policy is seen to be exporting inflation, again forcing the currencies of Brazil, South Korea and other export giants to rise against the dollar.

With the Brazilian real up 40% against the dollar in two years Brazil responded to QE2 with
a. A tax on foreign purchases of bonds, designed to suppress the flow of capital in Brazil
b. $40bn of intervention into the spot market for its own currency
c. This month, a ban on short selling of the dollar against the real in Brazil

There is the Euro versus the dollar. Analysts at Goldman Sachs estimated that the entire negative impact of European austerity programmes in 2010 could be offset by a fall in the Euro’s exchange rate to parity with the dollar: to the extent that this does not happen, Europe bears the cost of its own crisis.

Then there is north Europe verus south Europe. The Eurozone is locked into one exchange rate but peripheral Europe has, over a nine year period lost competitiveness against the core industrialised and export-led countries above all Germany. Southern Europe cannot devalue, so it is being forced to impose an internal devaluation by the Eurozone authorities – which means massive austerity, wage cuts and the erosion of welfare state provision.

Then there is Japan versus America. When America did QE, so did Japan – in part justifying the move on the grounds that QE was an act of exchange rate competition.

Finally there is Britain versus the rest of the world. Sterling underwent a 25% devaluation during the Lehman crisis, stabilising at a net 20% fall against the currencies of its main trading partners. In this way Britain has offset the cost of the crisis, avoiding double-digit unemployment but amplifying the impact of the commodity price inflation that has now taken off. (My emphasis)

Last December I wrote that:

I am simply not convinced that a belief in “free trade, global integration and open markets” is the best starting point when considering globalisation. And I’m far from convinced that centre-left policy makers retreating into a more protectionist mode is a major risk. The bigger risk, as I see it, is centre-left policy makers (who like the authors of the IPPR press release remain convinced of the benefits of free trade) reacting to the world as they wish it to be rather than as it is.

Now let me caveat this – my ideal solution to the question of global imbalances would be some form of International Clearing Union (as proposed by Keynes as Bretton Woods), in the spirit of this I thought the Geithner Plan presented at the recent G20 summit was a worthy aim. I agree with Gordon Brown that a Global New Deal focussed on correcting imbalances and creating jobs and, in a first best world, some form of progressive multilateralism is the centre-left’s base response to globalisation.

But we don’t live in a first best world. We live in a world of rising currency and trade tensions. We live in world in which Germany seems unprepared to engage in multilateral action within the Eurozone itself, let alone globally.

Leaving aside the current currency and trade tensions, we live in a world in which the future of globalisation will be shaped more by China than by liberal democracies.

The only thing I’d add to that now is the below quote form Harold James (an eminent international economic and financial historian) taken from his book on the End of Globalization:

Nobody would suggest that the restrictive trade regimes of the 1930s adopted in country after country represented an optimal path. But there is a powerful argument that they represented a viable, and indeed perhaps the only viable, second-best option. When other countries were imposing monetary deflation and restricting their trade, an attempt to preserve incomes by means of protective legislation represented a logical strategy against externally imposed misery.

Osborne gives the banks another hand out

According to a front page FT story this morning George Osborne is looking to relax the rules on UK banks’ liquidity, in effect allowing them to hold less gilts and cash.

Barclays apparently claim that the UK’s tough liquidity rules, designed to prevent a repeat of the post-Lehman crisis, cost it around £900mn last year.

The FT reports that Nick Clegg and Vince Cable agree with Osborne.

The effects of this story are already being felt in the stock market where UK banking stocks are having a good day. FT Alphaville quotes one broker as saying: 

• Chancellor Osborne investigating ways to ease liquidity rules for UK banks according to FT overnight.

• Assuming a 50% reduction in cost of liquidity buffers boosts Lloyds PBT by >5%.

• The Liquidity Coverage Ratio(LCR) and Net Stable Funding Ratio(NSFR/LCR ratios) are not widely disclosed except for Barclays (End 2010: LCR 80%; NSFR 94%) which guides a liquidity buffer cost of £0.9bn per annum equivalent to c9.5% of 2012E Group PBT.

• Given Lloyds generally weaker liquidity position the benefit of easier liquidity is likely to be greater. Tougher liquidity rules have been a key concern re: LLOY’s NIM going forward; Other UK banks also clearly benefit but to lesser extent.

• Hint of easier liquidity rules being investigated by Osborne is consistent with Mervyn King’s (regulatory hawk) influence on FSA being reduced. The BoE governor will only become head of FSA after King retires in 2013 – which some believe has been deliberately timed- which could be a positive for the banks in the short term.

This is big news, George Osborne is relaxing rules on the UK banking sector, rules designed to prevent a future crisis by forcing the banks to hold more liquid assets – assets that can be easily sold in a crisis to raise cash.

This is the same pattern we saw with Project Merlin, Osborne will do nothing to damage the resale value of the banks. Given a choice between a better functioning, safer system and a larger pre-election war-chest from the sales of RBS and Lloyds, he is taking the second option each and every time.

I’m rapidly losing faith that the UK will see any major banking reform after the Vickers Commission reports in September.

EDIT – Wrong word in last sentence, now changed! (hat tip Tim)

The Dangers of Spending Cuts: Some Advice from the IMF

Recently I’ve been telling a lot of people that if they want a clear and balanced overview of how the government’s coming spending cuts might hurt the economy they should look no further than the October edition of the IMF’s World Economic Outlook. In particular they should read chapter 3.

I realise that many people don’t have a strong desire to read through 32 pages of economic analysis, so I thought I’d summarise the key points below.

Whilst looking at this – try to remember two things:

First, the scale of Osborne’s planned fiscal consolidation (this graph from a June edition of the Economist will help).

 

And second, that according to the OBR that the trend growth rate for the UK economy over the next few years is some where between 2% and 2.5% per year.

So we have trend growth of somewhere between 2% and 2.5% per annum and a fiscal tightening of about 6.2% of GDP over the next 4 years.

The IMF estimates that spending cuts of 1% of GDP subtract 0.5% from growth.

However they also believe that the effects of spending cuts are typically cushioned by the central bank cutting rate sand the value of a country’s currency falling.

The Bank of England has no room to cut rates to support growth (they are already at 0.5% and are more likely to rise rather than fall in the coming year). Sterling is unlikely to fall much further, it already depreciated heavily in 2008-09 and in an era of more managed exchange rates (‘currency years’) it’s hard to see a much greater fall.

If interest rates don’t fall and the currency doesn’t lose value then the IMF estimate that spending cuts of 1% of GDP subtract 1% from growth.

In previous periods of large fiscal austerity (Canada & Sweden, for example, in the early 1990s), countries were able to grow by exporting their way to growth. Although spending cuts suppressed domestic demand, these countries could still rely on external demand.

What is very unusual about the current situation is that we have austerity policies across the developed world. Europe already and the US starting in 2012.

The IMF estimate that if other countries are cutting at the same time, if interest rates cannot fall and if the currency does not depreciate, then spending cuts of 1% of GDP subtract 2% from growth.

As they say:

Overall, these results illustrate that changes in both the interest rate and the exchange rate are important to the adjustment process. When countries cannot rely on the exchange rate channel to stimulate net exports, as in the case of the global consolidation, and cannot ease monetary policy to stimulate domestic demand, due to the zero interest rate floor, the output costs of fiscal consolidation are much larger. Thus, in the presence of the zero interest rate floor, there could be large output costs associated with front-loaded fiscal retrenchment implemented across all the large economies at the same time.

We are about to find out how large the costs of ‘front-loaded fiscal retrenchment’ actually are.

An Investment Target?

In an excellent article in today’s FT Martin Wolf lambastes the government’s approach to growth.

Will has summarised the key points over at Left Foot Forward.

Wolf rightly notes the ‘frighteningly low level’ of investment as % of GDP, just 15% – down 2% from the ‘pitiful’ average of the past 30 years and identifies this as a major challenge for policy makers.

This is a point I’ve repeatedly made myself.

He argues that:

The government should have used – it still could use – the current exceptionally low costs of borrowing as an opportunity to promote a much enlarged programme of investment in infrastructure.

 Again, I agree.

I’m wondering though – should the government announce an investment as a share of GDP target? Maybe 18% to begin with?

The government could then commit itself to increasing public investment to hit this target if private investment failed to materialise.

Thoughts?

Inflation/Deflation & Interest Rates

Guido is boosting that he has won his bet of inflation/deflation with Giles. Well done him.

The combination of this and today’s Bank of England rate setting meeting got me thinking about inflation.

My own views are quite nuanced and have varied a bit over time, so bear with me whilst I outline them below and please remember that for much of this time I was talking about the developed economies as a whole rather than just the UK.

Back when I worked in fund management, I was reasonably convinced from mid 2007 onwards that deflation not inflation would was the primary challenge facing the developed economies. I was more worried by the fallout from the credit crunch that been developing since June 2007 (when two Bear Sterns (remember them?) hedge funds had collapsed on sub-prime losses) than about inflation, as I told the IHT at the time:

Inflation, a concern several months back, has been drowned out by the collapse in the market for U.S. mortgage debt and the slump in confidence caused by seizure of the credit markets. That is not to say inflation has disappeared; it is just not as malignant as many observers would have us believe.

The credit crunch poses a bigger threat to markets than inflation. Bank-lending policies have been loose, and it is difficult to analyze the content of balance sheets and counter-party risk with any degree of confidence. We are moving client portfolio weightings in financials to near zero, and switching into the telecommunications sector where we see value.

The one thing that can be said with any degree of certainty is that the situation for the U.S. consumer can only get worse. So far, $197 billion worth of U.S. mortgages have been reset this year. This is significantly less than the $521 billion that is to be reset in February and March 2008.

As I saw it the impact of a collapse in bank lending would be a contraction in demand which would offset inflationary pressures.

I stuck to this view throughout 2008. As commodity prices soared and headline inflation picked up this became a somewhat uncomfortable experience, but I was eventually vindicated from Autumn 2008 onwards.

I started blogging back in March 2009, so there is a better paper trail of my views from that point on, for better or worse… I wrote back then of how I was worried about the prospect of a deflationary spiral and pointed out the instances of deflation around the world. I also noted that Sterling’s large fall had helped the UK avoid deflation.

By May 2009 though my views had shifted away from an outright risk of deflation, partially due to the actions taken to avoid it. At this point I began to speculate on the possibility of the UK experiencing both inflation and deflation.

I returned to this theme in September last year. And I stand by what I wrote then:

But – energy prices (maybe driven by supply constraints) are increasing and are likely to continue to increase.

Similar issues with food (see this http://ftalphaville.ft.com/blog/2010/09/17/345981/china-1789-and-potash/ )

Possibly cotton to (which feeds into clothing, see Primark warnings the other day http://www.google.com/hostednews/ukpress/article/ALeqM5iCpYY9BEsMGEPKWk74528tL3-U4g ) although maybe that one is possibly short term.

We basically have a trade off between rising primary product costs, which is likely to continue, and stagnant wages.

Plus a general lack of corporate pricing power across the West as consumers are over stretched.

I would not be at all surprised if we ended up in a situation whereby core inflation (i.e. excluding food and energy) was falling but headline inflation remained broadly positive (even 3/4% or so).

This becomes self perpetuating. Given the low elasticity of food and energy demand, rising prices here act as a tax on other consumption, further reducing demand and further reducing prices.

We then have the worst aspects of deflation – falling corporate profits and probably rising unemployment, without the benefit of rising real wages.

 

The only point of this I’d revise now would be to say – we possibly have headline inflation of up to 5/6% in 2011.

As I wrote in September:

Interesting to see how central banks play it. I’d have thought they need to concentrate on core inflation here – keep interest rates low. You can’t solve a supply problem with interest rates!

If they panic about headline inflation and raise rates (certainly possible), then the entire macro picture becomes even more scary.  

I stand by that to. UK inflation is being driven by global commodity markets and VAT hikes, there is very little that the Bank of England can do to stop this. Any rate hike today or in the coming months risks disaster.

The Wage Squeeze in the 1920s and Now

Last week I had a post over at False Economy discussing real wages, the wage share of GDP and the coming squeeze in living standards.

This was inspired by Mervyn King’s recent comments that the UK is experiencing the longest squeeze in living standards since the 1920s.

That speech got me thinking about an old report from Policy Exchange (pdf). In November 2009 their report on ‘Controlling Spending’ outlined what became the intellectual foundation stone of George Osborne’s approach to the macroeconomy – ‘expansionary fiscal tightening’, or the idea that cutting government spending can lead to higher growth.

This report used 12 case studies, the first of which was the ‘Geddes Axe’ of the early 1920s. The huge cuts in government spending of that era are the best precedent for what Osborne is attempting now.

Policy Exchange hails those cuts (23% of government spending and 35% of civil servants) as a huge success:

Spending was reduced very markedly and did not rise again for at least a decade. Even when it did start to rise again, the culture was such that spending cuts were proposed. Growth was considerably stronger subsequent to the consolidation than before it. The severe recession in the immediate aftermath of the Great War gave way to the ‘roaring twenties’.

But they offer no real reason as to what drove that growth (which proved short lived in any case). Which brings us back to King’s comments on the ‘longest wage squeeze since the 1920s’. Look at what happened to real wages (the column on the right) during the area of cuts starting in 1921:

Geddes worked by reducing living standards.

This shouldn’t really surprise us – responding to recession by cutting wages is the preferred policy of the Tories.

Thus, a pattern is emerging. Depressions in twentieth-century Britain have  typically appeared at the end of an extended period of sustained expansion. The  economic pressures are perceived first in the City which reacts by calling for  cuts in public spending and other measures to restore confidence in sterling.
Industry is also faced with the need to respond to market forces. The experience  of this century suggests that British industry will also press for retrenchment  by government even if the cost is the loss of some measure of State support for  industry and the weakening of the corporatist structures in which business  leaders had a considerable stake. Thus, by the time that depression begins to  hit employment (and changes in unemployment always follow changes in the  national income), there is a considerable climate of opinion which blames the  level of government spending and the level of wages (maintained in part by the  closeness of the unions to the centre of government) for many of the economic  problems. These opinions are exposed to an electorate which had become  accustomed to annual rises in real living standards. The frustrated expectations  among the mass of the population, which in other circumstances can be a  pre-condition to revolution, are channelled in the British case towards economic
liberalism and orthodox finance. During the three depressions of this century,  organized labour has been in no position to offer a challenge to this movement.  In the British context, therefore, ‘orthodoxy’ or ‘monetarism’ are the natural  policies of depression
Booth, A (1982) ‘Corporatism, capitalism and depression in twentieth-century
Britain’, The British Journal of Sociology 33 (2)

As I’ve argued here over the past few months Labour should be questioning ‘export-led’ growth and George Osborne’s new economic model of higher exports and investment is premised on higher unemployment and lower wages. There is, as they say, an alternative.

Econbrowser on the UK

The well respected US blog Econbrowser has an excellent post up on the UK economy which I highly recommend – it draws together work from a variety of sources (IMF, Gavyn Davies, RGE Monitor, etc).

If you read one thing on the UK economy this month, make it this.

Two highlights are a chart from Davies and quote from RGE.

 

Our main criticism of Plan A is that it is unnecessarily front-loaded in terms of cash impact, as opposed to policy approval. It is inevitable that hastily cobbled together measures to cut costs quickly will have a more detrimental impact on the economy (i.e. a higher fiscal multiplier) than more considered measures aimed at reducing long-term spending. Likewise, the severe cuts to capital expenditure and government investment will have a higher fiscal multiplier than reforms to long-term health provision or pension costs.