Inevitably, there has been a lot of comment in the UK press regarding the recent budget in the UK. As many commentators have identified, the problem with this budget is that it is so close to an election that it might be meaningless. Everything to do with the UK hinges on the forthcoming election. Perhaps more importantly, the UK may, if the election goes to Labour, may be the big test of the sustainability of massive government deficits, with a UK fiscal crisis potentially creating a broader crisis. It may also be the case if Labour does not win, but there may be a delay in the onset of crisis in these circumstances.
It is interesting that there is now increasing talk of the possibility of a hung parliament, or even outright Labour victory. In a recent post, I commented on the Economist's view that there is a coming battle between those reliant on the state for their livelihoods, and those who generate the wealth that ultimately funds the state. The UK is now in a position in which over 50% of the activity in the economy is rooted in the state. This is a situation in which there are more people reliant on the government keeping the spending taps open at full tilt, and a situation in which self-interest might short-sightedly determine the voting intentions of many of the electorate.
In this context, it is interesting to note the Telegraph column of Ian Cowie, who says the following:
What’s a first-time buyer’s vote worth? If you were longing to get out of rented digs, then a £2,500 tax cut – the most notable feature of the pre-Election Budget – might well be enough to do the trick. Nor is this group electorally insignificant. Official figures show that the number of people in privately rented homes has increased by 1m since 2001 to 3m today.His argument is very simple - the budget is offering a bribe to one million of the electorate to vote Labour. Another Telegraph commentator quotes Professor Philip Booth of Cass Business School, as follows:
Almost every Budget measure [on Wednesday] involved a spending favour for some small group or other, or some tax relief for a group that the Government hopes to sway behind the Labour Party at the election.The rest of the budget is simply a denial of the reality of the terrible state of the UK's fiscal position. Perhaps the most humorous addition to the budget was the addition of a so-called 'Green Investment Bank', with a remit to invest in a wide range of projects including 'green' energy investments. Among the targets are wind and solar power, both of which are virtually useless forms of energy generation. Within this provision, it is possible to see another expenditure aimed at a particular group, those who have strong beliefs in global warming, and is aimed at ensuring their votes go to Labour. By contrast, those who are cynical about global warming are not likely to vote against Labour on the basis of this expenditure.
Perhaps the most worrying aspect of the budget is the belief that the UK is about to enter a period of rapid growth. As Jeremy Warner of the Telegraph points out, a large portion of that growth is built upon an assumption of significant growth in exports, with the justification being that similar growth took place after the last £GB devaluation. As Jeremy Warner correctly points out, last time the £GB devalued, the world was not mired in an economic crisis.
Overall, what is apparent in the budget is an attempt to appease the clients of the state, and target narrow sections of the electorate through appealing to their self-interest. This is done with accompanying flimsy justifications, which serve only to allow people to tick the Labour box with no feeling of cognitive dissonance.
As you would expect, the other political parties have attacked the budget, but they still lack the will to really lead the UK and persuade the country of the absolute necessity for root and branch reform of the economic structure of the UK. What they are not telling the electorate is that, whilst Labour can promise to keep the spending taps open, eventually they will not be able to deliver on their promises. In other words, they need to tell the clients of the state that they are, whatever the promises of labour, going to eventually suffer cuts regardless of who wins the election.
The yield on gilts have climbed since the budget, and the head of the UK Debt Management Office (DMO) is yet again having to reassure the markets that gilts will not suffer a failed auction. That the DMO is having to makes such statements is of itself the story, not the statement of confidence. The UK is in deep, deep trouble, and a funding crisis must eventually come, unless serious action is taken to deal with the massive deficits. I have said it before, and will say it again, the current situation is one in which there is an agonising pause in the markets, with the coming election the only thing that is supporting the ongoing purchase of gilts. The gilt market is supported by 'wait and see', and this is a fragile foundation.
The real story, however, is the wider implications of a UK fiscal crisis. As I have often emphasised, there has been a stubborn resistance to the idea that the 'developed world' might be much, much poorer than many imagine. I have compared this belief to a dam, and each new concern about the economies of the developed world as small cracks in the dam. A UK fiscal crisis would represent the kind of crack that finally weakens the dam to the point of catastrophe. The likely outcome of such a crisis is that investors will flee to the illusory safety of the $US, before finally realising that the $US is in the line of the deluge.
Scenarios for the Way that the Crisis Might Resolve Itself
I recently added a comment to my last post, asking if the readers of my blog might be interested in my making a highly speculative post on how the economic crisis might finally resolve itself. Several readers expressed enthusiasm for the idea, and one suggested that I look at a best, middle and worse case scenario. The idea of a best to worst case scenario seemed to be very sensible, right up to the point where I started to write them up. The problem that arose was that, however much I tried to take an optimistic/positive perspective, the same problems started to emerge.
In particular, the underlying problems in the structure of the world economy simply would not go away, and no policy can reverse the underlying problems without considerable pain. The problem that I am referring to is the illusory level of wealth in the developed economies, and the fact that the world economy is still (largely) adapted to servicing wealth that is not really there. I have previously described the underlying causes of the economic crisis, which is to highlight that the entry of labour into the world economy has seen a massive supply shock, in which the labour force with access to the world market has approximately doubled, whilst the available resource for labour to utilise has not seen a commensurate rise (if you have not read it, I suggest reading this version of the argument as an introduction - note, there is a typing error; zero sum 'gain' should read 'game' ).
Interestingly, Alan Greenspan is now subscribing to the thesis that the massive input of labour was the root cause of the economic crisis, but is doing so to justify his argument that monetary policy did not cause the crisis. Whilst happy that somebody from the mainstream has finally noted what I identified long ago, Greenspan can hardly deny that the Federal Reserve also took a problematic situation, and contributed their own major input into the depth and scale of the crisis that followed.
Returning to the argument, the upshot of the change in the structure of the world economy is that we are now seeing a period of hyper-competition, in which wealth is moving from the developed world to the so-called emerging economies (I note that the Economist now calls them something like 'middle income'). However much money is created, however much money is borrowed, there is nothing that will change this process, short of bringing globalisation to a grinding and rapid halt. The essential problem that I was confronted with, when trying to paint optimistic scenarios, was that this change simply could not be wished away.
At its most basic, we can see the problems in the growth of the service sector in much of the developed world, all of which was designed to service debt fuelled economies, and the growth in manufacturing in emerging Asia to supply the debt fuelled economies with goods. Few now doubt that this structure was, in the end, unsustainable. However, there is a stubborn refusal to acknowledge the consequences of this system, and that it shaped the world economy in a way that now must change. Thus we have the policies of massive fiscal deficits, massive monetary easing and so forth. All of these policies are a stubborn denial of what we all know; that an economy can not live on overseas derived credit forever.
Greece is, of course, an illustrative case of what happens when there is a real possibility of having to live on the added value actually generated from within your economy. When the credit taps turn off, austerity follows. The economy in question sees their real level of wealth generation revealed and, as is illustrated by Greece, it is not a pretty sight. Even whilst Greece is trying (possibly unsuccessfully) to confront the underlying limits of their wealth creation, their ability to generate added value for exchange, much of the developed world is still in denial. Even as the signals, market analysis, and other indicators are increasingly flashing warnings, policy makers are clinging to the illusion that the developed world can return to the pre-crisis era.
The problem is that they are seeking to return to an era in which Asian countries steadily emerged as major competitors, but where the consequences of the emergence were hidden by Asian savings being recycled into developed world credit. In order for a return to this past, it is necessary for the credit to continue at pre-crisis levels. If, and it is a big if, they were to do so, the developed world credit junkies will eventually hit a level of debt that simply can no longer be supported. It is the Greek problem.
The problem for all of the scenarios that I played with was the same. At some point, the factories in Asia supplying goods into the developed world will need to restructure such that they no longer are reliant on servicing the credit fuelled portion of the developed world economy. In the credit fuelled countries, all of the jobs and services that are derived from overseas credit must also disappear. As indirect evidence of the problem of structure, I read the following in the Economist, regarding occupations showing growth in the UK:
England’s fastest-growing jobs between the second quarter of 2001 and the same period in 2009 include conservation officers (up 124%), town planners (94%), psychologists (67%), and hairdressers and the like (63%). Further investigation shows a big increase in semi-professional jobs (paramedics, legal associates, teachers’ assistants) rather than professional ones.The report also identifies that employment in heavy manufacturing is in decline. I mention this story because it represents the last gasp of the credit fuelled economy that must eventually restructure.
The big picture is this; in a post, sometime ago, I made an estimate of the size of the US economy if overseas credit were withdrawn, and came to the conclusion that the economy would shrink by 17%. Again, this is comparable with the situation facing Greece. If we think of the growth in the occupations in the UK, a similar story might unfold in many countries. Many of the jobs that are supported and growing on the back of government borrowing and spending are simply unsustainable.
In trying to consider scenarios, they must all confront these problems, and I simply do not see a positive outcome. The other problem is that, in trying to create scenarios, I kept on bumping up against the ongoing denial of the situation by policymakers. It seems that, whatever happens, they seem to be willing to resort to ever more extreme policy. In the UK, for example, the Bank of England has printed money to buy over a year of UK debt issuance, and there is still the possibility of more money printing to come. The trouble with policy extremes is that the extreme policy of country 'x' does not operate in a bubble, but eventually impacts on the policy of country 'y'.
The more extreme the policy of country 'x', the more likely that country 'y' will see an extreme policy response. An example of this is interest rates and the carry trade. If country 'x' has loose monetary policy in conjunction with low interest rates, this encourages the 'carry trade', in which money from country 'x' goes to country 'y' to benefit from higher interest rates. Money floods out of country 'x', enters into country 'y', potentially causing overheating of the economy, and currency appreciation. The policymakers of country 'y' then have to come up with a policy response to counteract the results of the policy of country 'x', and it will be an extreme response, as the impact of country 'x's policy is extreme. That extreme policy response will not only effect country 'x', but many other countries, who will, in turn, have to respond.
In such a system, although each policy takes a while for the effects to become apparent, there will be a steady ratcheting up of extremes of policy. At this stage, we are starting to see the effects of initial responses to the economic crisis, and the lagging responses in policy as the effects become apparent. The problem is now that there is less and less in the hands of the policymakers with which to respond - the only ammunition left is printing more money. All over the world, there is a massive demand for credit to fund government debt, but how might such a wall of debt be funded? The borrowing of country 'a' impacts upon the borrowing of country 'b'.
In other words, the massive issuance of debt in country 'a' is acting in competition with country 'b', and investors face a beauty contest with many of the entrants looking like the ugly sisters of fairytale fame. The UK is just slightly more ugly than the other contestants. The risk is that investors will look at the contestants, and decide that they are all too ugly to be worth their vote. Within this competition, the uber-judge is China, and China has now added the Euro to its concerns about the safety of the $US. Yesterday's Cinderella is today's ugly sister. And sitting in the middle of the ugly sisters is the UK.
The foolishness, the denial of reality and the extreme policy that the denial has generated, has brought the world to the brink of an economic disaster. For the moment, the Greek crisis is on pause, but a more serious crisis is developing in the UK. If the UK should topple, as is looking increasingly likely as the UK election unfolds, it is very likely that it will commence the final stage of the economic crisis. However much I tried, I found no best case, and no middle case scenarios for the way the final stage might play out.
The pitiful truth is that I am hoping for two things; that the Conservative party wins the coming UK election, and that they have not been telling the truth about their intentions. I just have to hope that they win and take an axe to the deficits, and that they commence a root and branch reform of the UK's economic structure. Even with a collapse of the UK economy the most probable catalyst of wider economic chaos, it nevertheless remains a forlorn hope. There are plenty of other potential catalysts out there.
In summary, there is currently no sign of a best or middle case scenario. Instead, the flashpoints for a savage deepening of the crisis are multiplying. The UK is moving closer to the brink, and we now have to wait and see whether those reliant on the state, those bribed by the state, might stand back and make a hard choice. Is the UK electorate mature enough to demand the necessary hardship? I worry that they are not....