Duncan’s Economic Blog

Tory Cuts?

Posted in Uncategorized by duncanseconomicblog on April 30, 2009

David Davis has an interesting opinion piece in the FT today. He is writing with his ‘former Chair of the Public Accounts Committee’ hat on rather than in his role as ‘Captain Liberty’ and makes an argument as to what could be cut from public spending.

There are some rather silly attacks on the government and some fairly ‘gimmicky’ suggested cuts, but nonetheless I welcome the article and would recommend reading it.

Here, at least, is a senior Tory prepared to be straightforward about proposed cuts. Some of his suggestions are even sensible. Many are not. But this is the debate we need to have. I do though think he is overstating exactly how much these proposed cuts would save. I’ll try and tot up the figures myself when I get a chance.

To summarise:

(i) ‘Pay and recruit freeze’ on ‘the entire public sector’. I am unclear if he means an actual recruitment freeze (i.e. not replacing people as they retire), which would surely be a disaster as the numbers of doctors, nurses, police constables, soldiers, teachers, etc fell. He admits this will be ‘controversial and uncomfortable’.

(ii) Public pension schemes should be closed to new entrants.

(iii) ‘Where salaries have really got out of line, as with doctors’ pay, lower starting rates should be introduced’. Cutting junior doctors pay? Really? Junior doctors are the ‘public sector fat cats’ David Davies has chosen to target?

(iv) Cancel Senior Civil Service bonus payments. As he says it would only save £25mn but the ‘symbolism’ is important. So he advocates cutting bonus payments as symbolism? From a party which attacked the 50% rate as ‘political’?

(v) Cut back in MPs’ expenses and Cabinet ministers’ pay.

(vi) Cancel ID cards and ‘government databases’. That’s be Captain Liberty speaking. In particular Contact Point and ‘internet scrutiny schemes’.

(vii) Renegotiate ever PFI contract now. This probably makes sense.

(viii) Big savers from the departments, ‘particularly the burgeoning welfare budget’. He notes this is heading towards £180bn within two years much of this because ‘ of Gordon Brown’s badly designed, fraud – and error-prone tax credit system’. Really? I assumed most the increased welfare spending was due to rising unemployment and that while recession thing.

(ix) He moves onto the issue of ‘welfare for the well off’. Noting ‘gimmicks’ such as ‘winter fuel payment and free tv licenses for the over-75s’. He wants these measures (and child benefit) targeted towards an ill defined ‘worst off’. He reckons this saves £8-10bn.

(x) Abolish regional government and devolve remaining functions ‘back to the counties’ or back to the centre. I’d be interested to hear what the Local Government Officer thinks about this, both in terms of effectiveness and cost saving.

(xi) Finally, he finishes off by questioning the need for ‘a wholesale upgrade of Trident’. Which did surprise me.

I’m not actually sure how much the above saves. I wouldn’t (at a first estimate) have thought much more than about £30bn of one off spending and about £20bn of annual spending. Not a huge amount againsta prjected deficit of £175bn this year. But if the Tories are intent to rebuild the public finances through spending cuts rather than tax rises then it will only be the start.


A smaller US or a larger Netherlands?

Posted in Uncategorized by duncanseconomicblog on April 29, 2009

Hopi has a great post up on the current polls. In the comments there has been an interesting debate on Trident renewal.

Much of the argument has revolved around the cost. All of this reminded me of a line in Willem Buiter’s ‘memories of Eddie George‘.

Eddie viewed the UK as a small version of the USA. I viewed it as a somewhat larger version of the Netherlands.

Now Professor Buiter was talking about the macro-economy, but I think the quote cuts to the heart of a debate on defense spending, of which Trident is only the most visible (and contentious) issue.

I think this raises two issues for all those involved in politics.

(i) Is it right that Britain still claims a global role (as does the US)? We are after all one of the world’s larger economies, possess a seat on the Security Council and historical links around the globe. Or should accept that we are actually little different from our cousins on the continent and be contend to be ‘a larger Netherlands’?

(ii) In what Charlie has dubbed the coming age of austerity, can we afford a global role and the defence spending that entails? Not just Trident, but the planned aircraft careers, etc.

We currently spend 2.4% of GDP on defence, much less than the US at 4% but more than Holland at 1.6%.

A very important side issue here, as noted by Hopi, is the role of the aerospace & defence industries in the UK economy. They are success stories and would a cut in our own expenditure badly affect them? I would mention that Sweden (only 1.4% of GDP spent on defence) has a vibrant and successful exporting defence sector.

Personally I support Britain having a global role. However I am mindful of a quote that good friend of mine is very keen on – ‘the language of priorities is the religion of socialism’. In an age of austerity, if cuts have to be made to public expenditure then defence would be on the front end of my list.

Even if we it means becoming a larger version of Holland.

Wasting our money.

Posted in Uncategorized by duncanseconomicblog on April 28, 2009

The Tories love to bang on about how Brown ‘cost Britain $7bn’ with his sale of gold reserves at the ‘bottom on the market’.

I’ve never really understood this argument. Is it premised on us selling our gold now? What if it goes up further? Surely we should have sold above $1,000 per ounce back in February this year or last March last?

Actually scratch that. Thatcher should have sold all the gold in January 1980 at $835 then bought it back at only $291 in March 1985. She could have then sold it at $496 in April 1987. Or is this getting silly?

I’ll tell you something sillier.

According to John Hawksworth, PWC’s chief economist, if, instead of blowing the money from the North Sea we had saved it, then right now the UK would be sitting on a sovereign wealth fund worth £450bn, bigger than the funds in Russia, Kuwait and Qatar combined.

So , let’s be clear on this – Brown’s gold sales: £4.8bn, Thatcher’s squandering of oil revenue: £450bn. People who live in glasshouses and all that…

Guest Blogging

Posted in Uncategorized by duncanseconomicblog on April 27, 2009

Over at LabourList.

Cameron versus the IMF

Posted in Uncategorized by duncanseconomicblog on April 27, 2009

I’ve just been reading David Cameron’s speech of yesterday. It scares me.

In particular (my emphasis):

Now some people say: let’s get through the recession, let’s get through the election we can keep on spending more, keep on borrowing more, and deal with the debt crisis later.

Wrong – seriously wrong.

The alternative to dealing with the debt crisis now is mounting debt, higher interest rates and a weaker economy.

They’ve just announced a spending increase – not a cut, but an increase – of £20 billion for next year.
They’ve delayed the cuts until after the election.
Now I wonder why that could be?

We opposed the £12 billion Labour wasted on the VAT cut.
We were against the fiscal stimulus.
We said they should reduce their spending plans back in 2008.
And now we’re saying they should abandon their irresponsible plan to increase spending in 2010.

I take the opposing line. In the face of a severe financial crisis the government needs to make active use of fiscal policy to maintain demand and prevent the recession becoming worse. I think that the effectiveness monetary policy is constrained by the problems within the banks. The Tories disagree and instead believe that we should let the Bank of England get on with it and do its job.

It seems not only do I disagree, but so do the IMF, whom the Conservatives seem pretty keen on nowadays.

However, during recessions associated with financial crises, fiscal policy tends to have a more significant impact, which is consistent with other studies that find that fiscal policy is more effective when economic agents face tighter liquidity constraints. The lack of a statistically significant effect from monetary policy during financial crises could be a result of the stress experienced by the financial sector, which hampers the effectiveness of the interest-rate and bank-lending channels of the transmission mechanism of monetary policy.

In other words the IMF thinks monetary policy (letting the Bank of England do its job) is not enough.

We face a deflationary recession caused by a lack of effective demand in the economy, cutting off the fiscal taps now will only make it worse.

The Government can see this, the IMF can see this, why can’t the Tories?

Gilts & the left.

Posted in Uncategorized by duncanseconomicblog on April 24, 2009

Charlie has an excellent post, which is well worth a read.

Credit (UK and Daily Mail Edition)

Posted in Uncategorized by duncanseconomicblog on April 24, 2009

So the Telegraph is running a horror story to the effect that the UK debt will be downgraded from triple A.

FT Alphaville is more realistic.

They also have this great chart, from the Japanese finance ministry.

Best of all though is the news that the Daily Mail is now officially junk.

Money, Credit & Quantitative Easing

Posted in Uncategorized by duncanseconomicblog on April 23, 2009

Paul, in the comments over at Hopi, asked about my views on money supply in particular and my views on ‘broad Keynesianism’ versus monetarism in general. (Warning: Potentially technical and boring post).

To start with, I don’t think of myself as typical Keynesian. I’m certainly not a ‘New Keynesian’ either, rather I’d be more comfortable being described as a ‘Post Keynesian’ in the tradition of Robinson, Kaldor and Minsky.

As Wiki puts it:

The distinctive feature of Post-Keynesian economics is the principle of effective demand, that demand matters in the long as well as the short run, so that a competitive market economy has no natural or automatic tendency towards full employment.

There are a number of strands to Post-Keynesian theory with different emphases. Joan Robinson regarded as superior, to Keynes’s, Michal Kalecki’s theory of effective demand, based on a class division between workers and capitalists and imperfect competition.

More specifically on ‘money’. This is quite a big issue (and as I health warning, my old job at the Bank of England involved compiling the UK’s monetary data).

I’ll talk mainly about broad money (i.e. the widest measure of money supply) and mainly about the UK. In the UK the broad money measure is M4 which is currently, and correctly under review. The background to the review really is worth a read if people are interested in this area – which I’d argue given quantitative easing is very important.

As the BOE puts it:

The United Kingdom currently has one broad money
aggregate, M4. Broadly speaking, M4 measures the amount of
cash (in sterling) held by the public, together with their sterling
deposits held at banks and building societies. The Bank defines
M4 as the UK private sector’s(1) holdings of:
• sterling notes and coin in circulation;
• sterling deposits with UK-resident banks and building
• sterling holdings of certificates of deposit, commercial
paper and debt securities of up to and including five years’
original maturity issued by UK-resident banks and building
societies; and
• claims on UK-resident banks and building societies arising from sale and repurchase agreements in sterling.

The two key decisions when deciding what constitutes broad money are (i) what is the money creating sector? (I.e. what should we decide are the institutions that (mainly through fractional reserve banking, can be said to create money?). In the case of the UK – that is currently only banks and building societies.

(ii) What is the money holding sector? As the Bank puts it (MFIs are monetary financial institutions (banks and building societies):

Once the money-creating sector has been defined — whether
on a functional or an institutional basis — a decision regarding
the people and institutions which are considered to be holders
of money is needed. MFIs are generally defined as lying
outside the money-holding sector, as one bank’s liability to
another bank (so-called interbank lending) cancels out across
the whole MFI sector. Although the money-holding sector can
be determined as all people and institutions that are not MFIs,
it tends to be defined more narrowly in practice. The UK
money-holding sector is currently defined as the UK private
sector other than MFIs, covering: households (including
unincorporated businesses, such as sole traders); non-profit
institutions serving households (eg charities and universities);
non-financial corporations; and all financial corporations
except banks and building societies. Some so-called ‘other
financial corporations’ (OFCs) specialise in financial activities
that closely resemble those undertaken by banks and building
societies. That raises questions about the appropriate
boundary between the money-creating and the money-holding sectors, which are explored in more detail in the next section.

I’ll not post it all up but the next section is a very interesting discussion. Basically the growth of the shadow banking system and the use of Special Purpose Vehicles (SPVs) in securitisations has potentially ‘broken’ the monetary data. Simply put there are now lots of quasi-banks which are not technically banks and so not treated as banks in the official data. Their holdings of money are included in the monetary data and have the effect of inflating the numbers – even when it will have no effect on economic activity in the traditional sense.

The effects have been dramatic. It’s worth taking a look at the ‘sectoral’ monetary data that the BOE produces monthly. In February M4 growth has a rapid +18.7%, but the growth of housholds’ money was a very modest +4.2% and the growth of non financial corporations’ money was actually a negative -2.1%! This was all hidden by non-bank financial business holdings of money growing at a staggering +55.6%.

I would argue that, in the absence of the shadow banking system – if all the new ‘non-bank financials’ were treated as banks, then money supply growth would be very, very slow indeed. This explains the rationale behind the decision to embark on a policy of quantitative easing (QE). It is certainly worth remembering when right wingers such as John Redwood bang on about money supply growth being too fast.

I take, unsurprisingly, a quite Post-Keynesian view on all of this. To an extent I reject the classical economic distinction between ‘real’ and ‘nominal’ variables. I think this distinction misses out the role of debt in the economy, which is typically not inflation adjusted. This is important.

A monetarist would argue that if we double money supply then we simply double prices and have no real change on economic activity. I’d argue that if we double prices, we typically don’t double debt and so the debt burden on consumers and corporates is reduced in terms of spending power available after debt payments and economic activity will shift as a result. Similarly if prices move down, and debt stays constant in nominal terms, then spending power – and hence effective demand, is reduced. This is what worries me about the prospect of deflation – we step outside the typical bounds of the business cycle and face disaster.

I’d argue further that money supply in and of itself is not the crucial variable – the crucial variable is credit, i.e. lending. It is lending that drives economic activity not money. Economists have focused on money for a long time. For decades this was reasonable. As most credit came from banks, money growth was a decent proxy for credit growth. As deposits (money) grew, and the liability side of the banks’ balance sheets expanded, credit also grew (the asset side of the banks’ balance sheets).

This cozy relationship though may no longer hold. The growth of ‘other credit providers’ – specialist mortgage lenders, credit card companies, car finance, store cards, the shadow banking system, etc – might have caused this relationship to break down. So money supply might soar with little impact on inflation or activity. Or banks might want to reduce their loan to deposit ratio from 130% to 100% (or even 90%) – again money supply (deposits) could soar with no growth in lending and hence little impact on activity. Mechanical monetarism doesn’t work.

So, will QE (an active attempt to increase the money supply) work? I don’t know is the honest answer. Paul Tucker, now Deputy Governor, made an interesting speech back in 2007 on these sort of issues. The important issue is the ‘bank lending channel’, i.e.the extent to which monetary policy works through the effect on bank lending. As the ECB put is in 2001:

The mechanisms through which the monetary policy of central banks affects real activity are not completely understood. A relatively recent strand of the literature emphasizes the special role of banks in the transmission mechanism through the so-called credit channel of monetary policy. According to this mechanism, monetary policy affects the real economy not only through the impact of interest rate on the aggregate demand but also through shifts in the supply of bank loans.

The literature, in as much as there is any, on this is scare. I suspect, given my views on credit, that the bank lending channel is one of the more important ways that monetary policy effects the economy. I also suspect that the bank lending channel is currently blocked. If I am right, QE will see an extra £75bn pumped into the economy (as gilts are taken out and cash put in through central bank purchases) and, probably, a £75bn rise in the money supply. The worry is that this will have little effect on the actual economy.

So, should we try QE? Of course. Either it works and provides a stimulus that prevents, or lessens, a slide into deflation or it doesn’t and nothing happens. Either way it does not cause hyper inflation as some seem to suggest. Hyper inflation is not caused by monetary policy alone, it caused by monetary policy in conjunction with social and political breakdown. Zimbabwe and Weimar Germany ‘printed money’ to finance most government expenditure in the absence of a functioning tax base. The UK is a long way from that.

In addition QE makes it easier to finance the budget deficit. The budget said we were going to borrow £175bn this year (12% of GDP) – if the Bank buys £75bn of gilts, the net effect is £100bn of new borrowing – about 6.9% of GDP, less than in the early 1990s. A good side effect of QE.

To conclude, after a bit of a ramble, I am suspicious that monetary policy can achieve much whilst the banking system is undergoing problems – one of the main reasons I argue for more use of fiscal policy to maintain demand.

50% Again/the IFS

Posted in Uncategorized by duncanseconomicblog on April 22, 2009

I have have a lot of time for the IFS. But that does not mean I have to accept their numbers without question. In particular Newmania, in the comments to my last post has been using the argument that they reckon that a 45% super tax would cost the exchequer money.

The IFS report is here.

They use a research report (dubbed BSS) in all of their estimates. Rather than simply take the headlines as repeated int he press it’s worth looking at the report in some deatil. Especially these bits, which didn’t make the headlines:

However, BSS point out that there is a great deal of uncertainty around this number. First, the paucity of data meant that the authors had to use a relatively simple approach, leading them to describe this estimate as ‘very preliminary’ and ‘tentative’ (BSS, pp. 15 and 18). The elasticity is estimated using changes to top incomes that happened during the 1980s, a period when the top rate of income tax was falling and when income inequality was increasing. This approach may then confuse responses to the policy with any underlying factor increasing income inequality, and this might mean that the estimated elasticity is too high. Furthermore, even if their approach to estimating the parameter was correct, the estimate was based on a small amount of data and is therefore subject to sampling error.

They also have a chart, below. This estimates three different (all possible) estimates of ‘taxable income elasticity’.


Note how on one of their estimates a 50% tax rate would raise over £1bn.

When examining any economic theory it is worth looking at the assumptions, the variables and the possible problems.

That 50% tax rate…

Posted in Uncategorized by duncanseconomicblog on April 22, 2009

The new ‘super’ rate seems to be taking up most of the headlines.

As I said earlier, I think it is just that higher earners pay their share and I think, politically, it is the type of issue I want to fight on.

Doubtlessly the research from the IFS saying it won’t raise much cash will feature prominently from Tories over the next few days.

Working out the likely behaviourial effect from proposed tax changes is a very hard task. Obviously a higher tax will lead to more people trying to evade it.

So, we need to focus on improving tax collection and make evasion harder.

As to the issue that ‘high earners will simply leave the country’… Will they really? Obviously the ultra rich (Philip Green, the Barclay Twins, etc) already have (Monaco mainly). But those earning £150-300k? That mainly work in finance in London? Where will they go?

I know people that earn that much, and they don’t vote Labour!, and I can’t imagine most of them uprooting their lives, moving their kids to a new school and heading off to Zurich or Singapore. I might be wrong. How many people will actually leave? As opposed to just threatening to leave? Seriously.

I will say, for the third time in recent days, we can’t pay back all of this debt by ‘taxing the rich’. But the rich should pay their fair share.

We’ve got a year until this tax comes in. Let’s beef up HMRC’s evasion teams. I imagine there are a fair few unemployed accountants and lawyers we can hire.