George Osborne’s Misconceptions About Countercyclical Fiscal Policy

Britain's Chancellor of the Exchequer George Osborne attends the Lord Mayor's Dinner For The Bankers And Merchants Of The City of London

George Osborne just came out in favour of counter-cyclical policy — saving more in the boom, and spending more during a “rainy day”. This is consistent with John Maynard Keynes’ notion that “the time for austerity at the Treasury is the boom, not the slump”.

The thing is, George Osborne seems to believe that right now we are moving toward a boom and need to adopt the policies of the boom:

Chancellor George Osborne has said he wants the government to be running a surplus in the next Parliament and can get there without raising taxes.

He told the Conservative conference the public finances should be in the black when the economy was strong as insurance against a “rainy day”.

His comments were taken as suggesting more years of spending restraint.

Business welcomed the goal but Labour said Mr Osborne had missed targets before and could not be trusted.

The BBC News Channel’s chief political correspondent Norman Smith said Mr Osborne’s underlying message was that austerity would continue after the next election despite the return to growth.

If 7.8% unemployment and a smaller real economy than 5 years ago doesn’t constitute a rainy day, I’d like to know what does. To me, and to many economists this kind of thing doesn’t just constitute a rainy day, it constitutes a full blown great depression. Eventually, sooner or later, someday the economy will return to growth and full employment. With the right luck — technology breakthroughs and other exogenous shocks etc — that could be two or five years from now. The experience of Japan, however, who have endured a 20 year depression suggests that it could be much later rather than sooner.

The safer alternative is to use fiscal policy — as Osborne himself implies — during the rainy day to directly bring back full employment sooner, rather than later by engaging in infrastructure projects and the like. Even if a government hasn’t saved money during the boom, interest rates are so low during the slump that it is cheap to do so, even in the context of soaring national debt levels as is the case in Japan today.

Getting the economy to a point where the government can run a budget surplus, of course, is still a noble ambition. But Osborne has shown no awareness whatever of the steps that need to be taken to get to that position. Infrastructure and housing investment and a jobs program would be a start. So too would liberalising planning laws and lending to and deregulating business startups so that more houses can get built and more businesses can get started. For now, Osborne is preaching responsibility while doing something deeply irresponsible — prolonging a depression with unnecessary demand-sucking job-killing austerity. The boom, not the slump, is the time for austerity at the Treasury and this (for the love of God) is not the boom.

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Debunking George Osborne’s “Recovery”

age-of-austerity-george-osborne-desktop

George Osborne spouts some nonsense about some so-called economic recovery:

The UK economy is “turning a corner”, Chancellor George Osborne has said in a speech in London.

Mr Osborne cited “tentative signs of a balanced, broad based and sustainable recovery”, but stressed it was still the “early stages” and “plenty of risks” remained.

Mr Osborne said that recent months – which have seen more upbeat reports on the economy – had “decisively ended” questions about his economic policy.

At this point, I have absolutely no idea what he is talking about. He appears to be inhabiting a parallel universe, one entirely separated from the reality which has seen sustained unemployment about 8% for the last 5 years — that’s 2.51 million people out of work who are looking for work — and a slump worse than the one Britain experienced in the Great Depression:

Screen-shot-2013-04-25-at-10.46.07

A tiny uptick after a huge and long depression is barely anything to celebrate. It is a probabilistic certainty that after falling off a cliff and lying prone on the ground awhile, things will one day sooner or later tick upward. Five years later is much later than sooner, and we’re not even back to the level of activity that existed in 2008. It could be eight or ten years at current growth levels after the initial events of 2008 that we make it back to that level of activity. And there is no sign that unemployment will begin coming down any time soon. In the long run, the sea will once again be calm and flat but no-one knows how long away the long run will be.

You cannot cut your way to growth. You do not stimulate growth by taking money and economic activity out of the economy. That is the manner in which you instigate depression. Supplies of capital and labour are both extremely slack — this is illustrated by the extremely low level of interest rates, and the high level of unemployment. Eventually the excesses of capital and labour will be used up, and the economy will return to full-employment and growth. But eventually could be a very long time. Waiting around when capital is available at the lowest interest rates in history and while unemployment continues to number in the millions is extremely dangerous and fragilising. Maybe the uptick will continue, and we will return to 2008 levels of activity by 2016 or 2018. Yet we would still have had a lost decade, one that probably could have been avoided had we not embarked on austerity in the wrong place at the wrong time. And it is possible that things may get worse, not better.

If I had been the politician who presided over this disaster, I would have resigned and hid myself away behind a rock. And it’s not just Osborne’s failure. The British media and other political parties have mostly failed to hold Osborne’s disastrous austerity policies to account. The fact that this depression has been a greater slump than the Great Depression is not the talking point that it ought to be. Perhaps that is because all the major political parties bear some responsibility, as Labour oversaw the start of the slump from 2008 to 2010, and the Liberal Democrats and Conservatives have overseen the continuation of the slump from 2010 to 2013. Whatever the reason, it is dreadful, and individuals from all sections of society continue to suffer for this disastrous mismanagement.

When All Else Fails, Housing Bubble

Last month I asked:

So what’s Osborne’s plan to generate growth?

Today we seem to have an answer.

As Anatole Kaletsky sarcastically put it:

That’s right — aside from an underfunded infrastructure pledge, a duty cut on beer and cigarettes, and a tiny and delayed corporation tax and national insurance decrease, George Osborne’s plan is to throw money at housing and hope for the best. 

Sounds markedly similar to the American strategy following 2001 when Greenspan “created a housing bubble to replace the NASDAQ bubble”, and we all know how that ended.

I’d tend to argue that the opposite is a much better idea. Instead of propping up the housing market, Cameron and Osborne should deregulate construction and planning (getting planning permission can be a long, costly task in the UK, and planning restrictions are estimated to add up to £40,000 to house prices) so that housing prices fall (if not absolutely at least priced in median wages) and Generation Y can start getting on the housing ladder.

As Faisal Islam put it:

But alas no. Instead of using the ultra-low interest rate environment and idle resources to invest in a quality business infrastructure  — high speed broadband, roads, railways, energy — and lower unemployment, Osborne has chosen to throw his stock in with the malinvestment-loving property speculators.

Unfortunately, pumping up credit bubbles can win elections (as we saw with Bush in 2004), so this may have improved the Tory electoral chances for 2015. But in the long run, we will see this as a dire move.

Save Our Bonuses!

With the British economy in a worse depression than the 1930s , bank lending to businesses severely depressed, and unemployment still high, a sane finance minister’s main concern might be resuscitating growth.

Prime Minister David Cameron And Chancellor George Osborne Ahead Of A Critical Week At The Leveson Inquiry

George Osborne’s main concern, however, are the poor suffering bankers:

Chancellor George Osborne flies to Brussels later determined to water down the European Parliament’s proposals to curb bankers’ bonuses.

But EU finance minsters in the Economic and Financial Affairs Council (Ecofin) are expected to approve last week’s proposals.

They include limiting bonuses to 100% of a banker’s annual salary, or to 200% if shareholders approve.

The City of London fears the rules will drive away talent and restrict growth.

Mayor of London Boris Johnson has dismissed the idea as “self-defeating”. London is the EU’s largest financial centre.

On Monday, a spokesman for Prime Minister David Cameron said: “We continue to have real concerns on the proposals. We are in discussions with other member states.”

But Mr Osborne’s bargaining power may be weakened further by Switzerland’s recent decision to cap bonuses paid to bankers and give shareholders binding powers over executive pay.

Now, I couldn’t care less about bonuses or pay in a free industry where success and failure are determined meritocratically. It is none of my business. If a successful business wants to pay its employees bonuses, then that is that business’s prerogative. If it wants to pay such huge bonuses that it puts itself out of business, then that is that business’s prerogative.

But the British financial sector is the diametrical opposite of a successful industry. It is a forlorn bowlegged blithering misshapen mess. The banks were bailed out by the taxpayer. They do not exist on the merits of their own behaviour. Two of the biggest are still owned by the taxpayer.  So I — as a taxpayer and as a British citizen — have an inherent personal interest in the behaviour of these banks and their employees.

In an ideal world, I would have let the banks go to the wall. The fact that the financial system is still on life support almost five years after the crisis began tells a great story. It’s not just that I don’t believe in bailing out failed and fragile corporations (although I do believe that this is immoral cronyism). The excessive interconnectivity built up over years prior to the crisis means that the pre-existing financial structure is extremely fragile. Sooner or later, without dismantling the fragilities (something that patently has not happened, as the global financial system today is as big and corrupt and interconnective as ever), the system will break again. (Obviously in a no-bank-bailout world, other action would have been required. Once the financial system had been allowed to fail, depositors would have to be bailed out, and a new financial system would have to be seeded and capitalised.)

But we do not live in an ideal world. We have inherited a broken system where the bankers (and not solely the ones whose banks are owned by the taxpayer — all banks benefit from the implicit liquidity guarantees of central banks) are living on taxpayer largesse. That gives the taxpayer the right to dictate terms to the banking sector.

Unfortunately, this measure (like many such measures dreamed up arbitrarily by bureaucrats) is rather pointless as it can be so very easily gamed by inflating salaries. And it will do nothing to address financial sustainability, as it does not address the problem that led to the 2008 liquidity panic — excessive balance sheet interconnectivity (much less the broader problems of moral hazard, ponzification, and the current weakened lending conditions).

But, if it is a step toward a Glass-Steagall-style separation of retail and investment banking — a solution which would actually address a real problem, and one advocated in the Vickers report — then perhaps that is a good thing. Certainly, it is not worth picking a fight over. The only priority Osborne should have right now is creating conditions in which the private sector can grow sustainably. Unlimiting the bonuses of the High Priests of High Finance has nothing whatever to do with that.

George Osborne Still Doesn’t Get It

In downgrading British debt from AAA to AA1, Moody’s was explicit enough to mention weak growth as the main problem. Now, I couldn’t in itself care less about what Moody’s thinks, because credit ratings agencies are themselves bastions of utter incompetence who continued to rate subprime junk mortgage-backed securities as AAA long after it became clear that they were dangerous default-ridden products. But Osborne himself made clear that Britain’s credit rating was the metric on which we should judge his performance. Yet although Moody’s mentioned weak growth as the problem, Osborne continues to talk about how reducing Britain’s debt-load is his main priority, something that he has completely failed to do:

That ultimately is the choice for Britain — either we can abandon our efforts to deal with our debt problems and make a difficult situation very much worse or we can redouble our efforts to overcome our debts and make sure this country can earn its way in the world.

Osborne is tackling this from the wrong end of the problem. Strong, sustainable economic growth is the way to tackle the debt problem in the long run. But Osborne’s fiscal austerity is not the way to strong sustainable economic growth, which means he is failing by on his own terms and by his own definition. In terms of growth, since 2007 Britain has done worse than comparable countries.

realgdppercapita

People like to talk of Japan’s problems with depressed growth, but since 2007 Britain has done worse than Japan.

And this lack of growth is the real reason why Britain’s debt load becomes ever more unsustainable, no matter how much austerity Osborne tries to implement.

So what’s Osborne’s plan to generate growth? Reduce regulation and taxes on small businesses and new businesses? Make it easier for construction companies to build new homes? Invest in infrastructure (ultra-fast broadband, improved roads and rail) and energy (solar, wind, hydroelectric, oil, natural gas)? Invest in science and basic research? Guarantee loans to unemployed people so they can become self-employed? Offer incentives to foreigners to invest in the UK?

Cutting spending (and yes — in real terms George Osborne is cutting spending) and raising taxes isn’t cutting it. It’s constricting growth. And at the next election if this depression continues, people will vote in droves for anyone but Cameron and Osborne.

The Unending British Deleveraging Cycle

Current estimates of what is known in the UK as the M4 money supply — cash outside banks, plus private-sector retail bank and building society deposits, plus private-sector wholesale bank and building society deposits and certificates of deposit — show a serious contrast between Britain and the United States:

UKvsUSM4

Could this divergence explain the strong divergence between UK and US real GDP?

RealGDP

I doubt it. It’s a chicken and egg question — does a prolonged deleveraging cycle explain real GDP weakness, or does real GDP weakness explain the prolonged deleveraging cycle? It may in fact be a self-reinforcing spiral effect where the first leads to the second and the second leads to more of the first, and so on. But there are a lot of other factors all of which may be contributing to the worsening situation — protracted weakness in business confidence, tax hikes, spending cuts, weak growth in the Eurozone, elevated youth unemployment, and uncertainty. All these factors are probably contributing to some degree to the weak GDP growth, and the prolonged deleveraging, and thus Britain’s depressionary economic condition.

But we can say that the difference cannot be that Britain’s monetary policy has not been aggressive enough. Britain’s monetary policy has been far more aggressive than that of the United States:

CB assets

How can we break the cycle? Well, as the above graph shows, more quantitative easing is unlikely to have a beneficial effect. The transmission mechanism is broken. What good is new money if it’s just sitting unused on bank balance sheets? What new productive or useful output can be summoned simply by stuffing the banks full of money if they won’t lend it?

The sad truth is that a huge part of the financial sector has failed. Its inefficiencies and fragilities were exposed in 2008, as a default cascade washed it into a liquidity crisis. And yet we have bailed it out, stuffed it full of money in the hope that this will bring us a new prosperity, in the delusional hope that by repeating the mistakes of the past, we can have a prosperous future.

The sad truth is that the broken, sclerotic parts of the financial sector must fail or be dismantled before the banks will start lending again, start putting monies into the hands of people who can create, innovate and produce our way to growth.

Cameron’s EU Policy Uncertainty

So, David Cameron wants a referendum?

I believe that small is beautiful, and that the European Union system is big and fragile. I am all for free trade, freedom of movement and immigration. But as for regulatory, monetary and fiscal integration — which is the direction that Europe has taken, especially since the self-inflicted Euro crisis that grew out the fundamentally flawed Euro system — how can Europe be responsive to its citizens when they are so numerous, so diverse and so geographically and linguistically dispersed? How can it be viable to have the same regulatory and political framework for Poland, Spain, Austria, Britain, Denmark and Greece? Political and monetary frameworks that are local and decentralised are usually responsive and representative. Big bureaucratic juggernauts are very often clunky and unresponsive.

That means that I am quite open to the idea of Britain leaving the political union, so long as we retain the economic framework that Britain voted for in a referendum on joining the European Economic Community — the predecessor to the European Union — in the 1970s. Britain never voted for political union, and the British public has been shown again and again in polls to be broadly against such a thing.

But David Cameron’s plan for an In-Out referendum in 2017 — but only if the Conservatives win the 2015 election — is misguided. It will just create five years of totally unnecessary policy and regulatory uncertainty.

There is empirical evidence to suggest that policy uncertainty can be very damaging to the economy. A 2013 paper Scott Baker, Nicholas Bloom, and Steven Davis used automated text analysis techniques to count key words relevant to uncertainty in the media. They combined the news analysis with data from tax code changes, disagreement among economic forecasters, and information from equity option markets to create an “uncertainty index”:

UncertaintyIndex

They looked at changes to gross domestic product, private investment, industrial production and unemployment, and found that spikes in uncertainty foreshadow large and persistent declines in all four. First, GDP and private investment:

GDPInvestment

Next, industrial production and unemployment:

Policshocks

The last thing that Britain needs is five years of policy uncertainty. If Cameron wants to have a referendum on E.U. membership, why not do it now? 82% of the public favour such a referendum — presumably not only UKIP and Conservative voters, but also Liberal Democrats and Labour voters. If we vote to leave, then we leave, if we vote to stay, we stay. We — and the markets — will know exactly where we stand.

Frankly this strikes me as more of a political ploy. The Conservatives are haemorrhaging support to UKIP. They are roughly ten points behind Labour in the polls. This strange announcement just seems like an attempt by Cameron to claw back support and distract from the disastrous state of the economy which just entered a triple-dip recession and which has been depressed since 2008. Ironically, this announcement may actually worsen the economic woe.