Proper blogging will resume at the weekend but today I just wanted to post another graph – one I find especially striking – and try to bring together what these four graphs (posted this week) show us.
Mortgage Equity Withdrawal as a percentage of household post-tax income since 1971, the clearest way to see the UK credit cycle in operation.
Put it all together and we can see that the UK has serious problems – even leaving aside the government’s fiscal tightening. We have a Labour market which isn’t expected to recover to pre-recession levels until post 2016, we have private business investment that is still nearly 20% below pre-recession levels and seems to be stagnating and we have real wages that have been falling for almost 18 months.
Now of course the government’s plans will merely compound this – putting more people out of work, adding to the squeeze in living standards & doing very little (other than cutting corporation tax and crossing their fingers) to deal with the shortage of business investment.
But today’s chart reminds us of something else – that the problems of theUKeconomy pre-date 2008.
Paul Krugman’s address to the Cambridge conference on Keynes makes for interesting reading – I’d highly recommend it and agree with much of his analysis.
But leaving aside the macroeconomic argument, I’m actually more interested in what he says towards the beginning about Keynes and ‘Keynesians’.
“I’d divide Keynes readers into two types: Chapter 12ers and Book 1ers. Chapter 12 is, of course, the wonderful, brilliant chapter on long-term expectations, with its acute observations on investor psychology, its analogies to beauty contests, and more. Its essential message is that investment decisions must be made in the face of radical uncertainty to which there is no rational answer, and that the conventions men use to pretend that they know what they are doing are subject to occasional drastic revisions, giving rise to economic instability. What Chapter 12ers insist is that this is the real message of Keynes, that all those who have invoked the great man’s name on behalf of quasi-equilibrium models that push this insight into the background, from John Hicks to Paul Samuelson to Mike Woodford, have violated his true legacy.
Part 1ers, by contrast, see Keynesian economics as being essentially about the refutation of Say’s Law, about the possibility of a general shortfall in demand. And they generally find it easiest to think about demand failures in terms of quasi-equilibrium models in which some things, including wages and the state of long-term expectations in Keynes’s sense, are held fixed, while others adjust toward a conditional equilibrium of sorts. They draw inspiration from Keynes’s exposition of the principle of effective demand in Chapter 3, which is, indeed, stated as a quasi-equilibrium concept: ―The value of D at the point of the aggregate demand function, where it is intersected by the aggregate supply function, will be called the effective demand.”
I agree that there is a divide in the ‘Keynesian school’, but I’d argue it is actually a three way divide – Chapter 12ers, Book 1ers and, the largest grouping, those who haven’t actually read the General Theory.
Krugman defines himself as a Book 1er and this is very much the mainstream amongst ‘Keynesian’ economists – Joseph Stiglitz would be another. In an LRB review of Skidelsky’s (superb) ‘The Return of the Master’, last year he wrote that Skidelsky (a Chapter 12er) has ‘gone astray’ by focusing too much on Keynes’ definitions of risk and uncertainty, the core of a Chapter 12 argument.
In a letter to the LRB, Paul Davidson (editor of the Journal of Post-Keynesian Economics) took issue with this writing that:
“For Keynes the inability of firms and households to ‘know’ the economic future is essential to understanding why financial crashes occur in an economy that uses money and money contracts to organise transactions. Firms and households use money contracts to gain some control over their cash inflows and outflows as they venture into the uncertain future. Liquidity in such an economy implies the ability to meet all money contractual obligations when they fall due. The role of financial markets is to assure holders of financial assets that are traded on orderly markets that they can readily convert these liquid assets into cash whenever additional funds are needed to meet a contractual cash outflow commitment. In Keynes’s analysis, the sudden drying up of liquidity in financial markets, occasioned by sudden drops of confidence, explains why ‘unfortunate collisions’ occur – and have occurred more than a hundred times in the last 30 years, according to Stiglitz.
By contrast, Stiglitz implicitly accepts the orthodox view that all contracts are made in real terms, as if the economy were a barter economy. Consequently people’s need for liquidity is irrelevant. Stiglitz indicates that he and Bruce Greenwald have explained that financial markets fail ‘because contracts are not appropriately indexed’, i.e., contracts in our economy are denominated in money terms rather than ‘real’ terms. He suggests that if only such contracts were made in real, rather than monetary, terms we would not suffer the ‘unfortunate collisions’ of economic crisis. If only we lived in a classical world, where contracts would be denominated in real terms! But in a money-using economy, this is impossible.”
I’d agree with much of that and argue that Keynes’ focus on the nature of uncertainty and it impacts a capitalist economy is actually one of his two major contributions to economic thought. The other being his work on international economics and preserving a role for action by nation-states, rather than his better known theories on fiscal policy.
I agree with Krugman that a simple IS/LM model or Samuelson Cross is sometimes a lot more useful as an aid to macro policy making than a complex DSGE model. As Charles Goodhart, a former Chief Economist of the Bank of England, once commented a DSGE model “excludes everything I am interested in”. Wilhem Buiter is correct to argue that:
“Most mainstream macroeconomic theoretical innovations since the 1970s (the New Classical rational expectations revolution associated with such names as Robert E. Lucas Jr., Edward Prescott, Thomas Sargent, Robert Barro etc, and the New Keynesian theorizing of Michael Woodford and many others) have turned out to be self-referential, inward-looking distractions at best. Research tended to be motivated by the internal logic, intellectual sunk capital and esthetic puzzles of established research programmes rather than by a powerful desire to understand how the economy works – let alone how the economy works during times of stress and financial instability. So the economics profession was caught unprepared when the crisis struck.”
But even if a simple IS/LM model is less likely to lull us into a false sense of security about the limits of our knowledge than a full blown DSGE model, it still has it limits.
Keynes’ focus on uncertainty, I’d argue, actually directs us away from the ‘mechanical’ thinking of imagining that policy makers can easily influence the economy by pulling certain levers – thinking that is now, oddly enough, most associated with those who now call themselves ‘Keynesian’.
A commentator asked yesterday if I thought the UK economy was simply stuck. I’ve argued in recent days that the prospects for the recovery are weak but also that fiscal policy is constrained and the left needs to acknowledge this – so I can see why people might think I am throwing up my arms and saying ‘we’re all doomed’. But I’m not.
There is always an alternative.
And today’s Ed Balls speech helped outline such an alternative.
No doubt the Tories will attack Balls speech as a reckless plea for more spending and more borrowing. They’ll call him a deficit denier and say he is not serious about dealing with the public finances. But they’ll be wrong.
Because the interesting thing about the Balls speech today is quite how modest the proposals are.
He isn’t making the case for a major stimulus or the reversal of deficit reduction. He is simply setting out a growth plan that is credible, affordable and, I suspect, would likely be effective.
A temporary VAT cut would instantly lower inflation, increase real wages and put money in people’s pockets. It would directly ease the crisis of living standards that is one ofBritain’s major economic problems of the day.
But it is also easily reversible and the timing of its rise could be set out in advance – making it a much easier sell to markets.
It would cost something in the region of £12-13bn. Which sounds a lot, but in the context of the borrowing forecasts recently being raised by over £40bn anything which helps restore a decent rate of growth is helpful.
The UK economy is 4% below it’s pre-crisis peak – one idea would be to announce that VAT would return to it’s previous rate once this 4% was made up.
Such a move would be widely welcomed by retailers and other businesses.
Combined with the fiscally neutral package of using a bonus tax of around £2bn to fund house building, a youth employment programme and more regional funding growth – the Balls plan outlined today would help increase growth, lower unemployment and alleviate the squeeze in living in standards.
Notice that the majority of the package is based around tax cuts – this is hardly a return to Brownian tax and send solutions.
Personally I’d like to go a little further – increase investment allowances to encourage more capital investment. But this is an excellent start.
Sadly the OBR isn’t allowed to test the effects of opposition plans on growth, employment and the deficit. A great shame – as I imagine this would score highly.
Real wages (average earnings growth minus retail price inflation) have now fallen for 17 months in the UK.
The OBR expects this to continue throughout 2011 and 2012 and into 2013. And yet they believe consumption will grow in excess of real household disposable income.
As I’ve explained before, this forecast is driven by a falling household savings ratio. In other words the government expect households to borrow to maintain their consumption.
And as I’ve pointed out, despite all the talk of exports and investment – the OBR still expects the consumer to play a crucial role as a driver of economic growth.
The problem is there is very little evidence that cautious households are prepared to borrow – something made very clear by the chart below taken from Bank of England data.
If household’s debt appetite remains subdued and real wages continue to fall – how exactly is consumption expected to grow?
Against this background it is unsurprising that Sainsbury’s CEO Justin King has today described the retail environment as ‘tough’ and noted that ‘higher fuel costs and the government’s austerity measures were eating into household budgets, forcing many customers to trade down to Sainsbury’s cheaper, own-label “Basics” range’. ‘
I’m a fan of Paul Krugman – he writes well and frequently, I share many of his views and he has the added enhancement of having won a Nobel Prize. Because of this many left leaning commentators in the UK (myself included) frequently quote him to add credibility to a view they are expressing. So I don’t disagree with him lightly. But I worry that one argument he has been pushing lately may be off-target in a US context and actually dangerous in a UK one. I’m talking about the idea of the ‘confidence fairy’.
Krugman argues that much of the US (and indeed European) right are basing their economic agenda on a believe in an imaginary ‘confidence fairy’. They (the right) argue that any increase in government spending would cause more uncertainty, damaging the confidence of business (and possibly consumers) further and leading to a fall in investment (and possibly consumption) that would more than offset the expansionary effects of further government spending.
The US has the advantage of being the world’s sole issuer of the reserve currency of choice, so in a US context Krugman is on firmer ground. But this isn’t an advantage which the UK has.
I think it’s right to worry about the ‘confidence fairy’, indeed I think not to worry about the confidence fairy would be actually dangerous.
As I’ve been trying to explain for the past few months, the fiscal policy debate is actually fairly nuanced. The real debate is about a balance of risks – the risk of extreme austerity hammering the recovery versus the risk of a bond market taking fright at a slower pace of fiscal adjustment and driving up interest rates. The Treasury places more emphasis on the later risk, whilst I worry more about the former.
But that isn’t to say that the later risk doesn’t exist.
I supported the then government’s fiscal stimulus in late 2008 and would have liked to have seen a second stimulus at the 2009 budget. Demand was falling off a cliff in late 2008 and the VAT cut (not my ideal type of stimulus it must be said) together with the bringing forward of investment stopped the economy falling off a cliff. A second stimulus (more focussed on investment) possibly would have meant that the recession ended earlier than it did and helped to kick start a more robust recovery. We’ll never really know.
But I think there is a difference between arguing the case for a stimulus in late 2008/09, at a time when most world governments were doing the same, and arguing for one now (as some on the left are doing|).
Britain is a very open economy, we have a high propensity to import – I worry that a stimulus in Britain alone would mainly leak abroad with less macroeconomic impact that it’s proponents claim. In effect government debt would be increased without a large kicker to growth. And much as many on the left don’t want to face this – there would be a market reaction. Osborne, Cameron, Clegg and co are wrong to argue that Britain was ‘on the brink of bankruptcy’ last May. There is simply no evidence for that in the market prices of UK government debt at that time. But this was, at least partially, because of the existence of the strong framework for deficit reduction set out by Darling.
There is room for a more growth friendly fiscal consolidation – using a higher banks’ levy and/or bonus tax to fund specific earmarked, high impact programmes such as more social home building for example. Equally the pace, if not the end point, of deficit reduction can be changed. As I have argued before I am a fan of the Dolphin/Lent proposed ’deficit reduction averaging’ approach – whereby the pace of reduction would be adjusted to reflect the strength of the underlying economy. I think this is actually a more credible and realistic course than either the Darling or Osborne plans.
We have seen since May last year the importance of confidence. Osborne’s over-tough talk and the general air of gloom he created, led to a collapse in consumer and business optimism. The result of which has been six months of zero growth and stagnation before his fiscal adjustment has even started to really bite. As I have argued, Osborne has placed too much stress on appeasing bond markets and not enough on supporting the real economy. But that doesn’t mean there should be no stress on keeping the markets on side.
What I am trying to say is that the traditional macroeconomic policy levers are failing. A spending led stimulus programme risks higher debt for no real growth impact, tax cuts (Osborne’s preferred ‘growth package’) seems a exercise in wishful thinking with little evidence that it would help, interest rates cannot be cut further and more monetary stimulus (QE) would probably simply result in higher asset prices.
George Osborne has got it wrong. His fiscal contraction is too deep and damages the economy, his corporation tax cuts and emphasis on further labour market flexibility are unlikely achieve higher growth. But that doesn’t mean proposing the opposite is the right course either. Talking about a ‘confidence fairy’ is unlikely to help.
In an ideal world we won’t be starting from here. But here is where we are.
Labour needs new and original policies. Policies which aim to make the economy less dependent on increasing debt (either government or private), policies which help wages to grow and allow for solid, domestic, private sector growth.
I’ve been inspired to break my ‘no blogging when on holiday’ rule by a few reports this week.
We got the IMF’s latest update on the economy, the downgrade in growth forecasts was no surprise – the IMF was simply out of line with the OECD and other forecasters. The UK is now in a downgrade cycle, one can reasonably expect the OBR to downgrade it’s own forecast when it’s next updated (which I assume is in November at the next economic and fiscal outlook) and I doubt we have seen the last downgrade from the Bank of England.
These downgrades make for grim reading for the Treasury and will make the task of reducing the deficit that much harder.
But they don’t necessarily spell good news for Labour.
The IMF, the ratings agencies and (despite recent wobbles) the OECD remain backers of George Osborne’s approach. We can disagree with them, we can point of the potential pitfalls of there approach and we can worry that the strategy may prove self-defeating but we can’t close our eye to this.
Those (like myself) that argue against the speed and depth of Osborne’s austerity agenda (too far, too fast) can marshal Nobel Prize winners, current and former members of the Member Policy Committee and various other prominent economists on our side. But so can George Osborne.
One sometimes gets the impression reading left wing blogs that George Osborne is a complete economic illiterate and out of touch with all sensible opinion. This isn’t exactly true.
As I’ve tried to point out the real debate here, as in so much of macroeconomic policy, is around a balance of risks – in this case the risk of a bond market panic driving up the cost of borrowing (which I perceive as less likely than HMT) versus the risk of tough austerity damaging the economy (which I perceive as more likely).
What I occasionally worry about is that elements of the left perceive government spending as the only answer.
I’ll be very clear – cutting government spending at a rapid pace whilst demand is weak risks serious damage to the recovery. But it is unclear to me (despite good work by, for example, Anne Pettifor) that more government spending is necessarily the answer.
Labour oversaw a relatively large expansion in state spending in the second half of it’s time in office (although without increasing tax revenues by a corresponding amount). Whilst many of the outcomes of this were beneficial (vastly improved health and education services, a marked fall in child poverty), outcomes that we should be proud of and strive to repeat, the overall macroeconomic impact is debateable.
The question that people in Labour should be asking themselves is this – do we just want to go back to 2006? Before Northern Rock, before Lehman’s and when Labour had a reputation for economic competence. Back in 2006 it was business-as-usual for Brown at the Treasury, a steady increase in state spending increasingly financed not by taxes on ‘voters’ but by bubble-related revenues from frothy asset markets and a credit boom.
As important work by CRESC has shown, the UK’s ‘undisclosed business model’ was reliant on a combination of finance in the South East (including London) and then para-state in the regions. The actual productive and real private sector was anaemic.
This model may have succeed in generating a decent rate of GDP growth but is failed many ordinary people.
As recent and highly relevant work from the TUC and the Resolution Foundation has shown. The TUC note that:
The wages of middle income Britain have grown by an average of just 56% since 1978, despite GDP increasing by 108% over the same period. For workers in some skilled trades incomes actually fell in real terms between 1978 and 2008.
The Resolution Foundation’s recent work has demonstrated that between 2003 and 2008 median wages flat-lined and disposable income actually fell in every English region outside London despite headline economic growth of 11%.
I remain convinced that ‘wage-led growth’ is the not only the best route out of the current crisis but also offers a more sustainable future and a model of growth that will benefit ordinary people. Osborne’s policies in this area are totally wrong, he is adding to rather than alleviating the squeeze in living standards. His economic projections are underpinned by a rising level of household indebtedness. He seems to agree with Mervyn King that this is all somehow inevitable.
I’d rather we on the left spent more time focussed on this and less arguing about the right level of government spending.