Tuesday, June 29, 2010

The Fed Criticises Bloggers?

Over the last couple of days, in reviewing the news, I have noted that there is an increasing sense of panic and chaos in the world economy. Today, it seemed particularly bad. I typically look at the Telegraph, the Times, the New York Times, the Guardian, and Reddit as a daily routine, and occasionally the Economist. Today, I was confronted with the following economics headlines in the Telegraph (selected examples):

  • FTSE 100 Joins in Global Market Tumble
  • Warnings of Double Dip Recession Flash Brightly Across the World
  • Bank of England Starts to Dust off its Inflation Fighting Credentials
  • Roubini: Greece Needs Orderly Debt Restructuring to Avoid Default
Perhaps most shocking was a headline for a commentary by Ambrose Evans-Pritchard titled 'Time to Shut Down the Federal Reserve?' The content of the commentary was not as radical as it appears, and is a response to a rather idiotic paper by Kartik Athreya of the Richmond Federal Reserve, in which he advises that people should not take economics blogs seriously, as the writers do not have a PhD in economics from a decent school. Ambrose Evans-Pritchard, quite reasonably, points out that the experts played a major hand in the development of the economic crisis. Zero Hedge offers an even more scathing reply to the paper, saying:

Alas, all Kartik achieves is to convince the general public that feeding Fed "economists" alcohol after midnight and letting them directly upload their resultant gibberish to the Fed's broad RSS feed the second they think they have a coherent thought , is generally a disastrous idea. In his piece, which has no other intention than to discredit and outright malign bloggers such as Matt Yglesias, John Stossel, Robert Samuelson, and Robert Reich, Athreya says: "In what follows I will argue that it is exceedingly unlikely that these authors have anything interesting to say about economic policy. This sounds mean-spirited, but it’s not meant to be, and I’ll explain why." Instead in what follows, the Fed presents 4 pages of thoughts so meandering, that the author's blood alcohol level must have certainly been well above the legal norm for the duration of the writing of this ad hominem pamphlet.
I am focusing on this paper by Athreya, as it contrasts nicely with the headlines. The Masters of the Universe, sitting in their ivory towers are clearly not in control. Instead, they pull their levers, enact their policy, and it all comes to nothing but more chaos. They propped up the financial system, supporting their selected 'too big to fail' banks, they printed money and poured it into the markets via their favoured financial institutions, and they aimed to drop interest rates to the floor. Despite this, we still see a world economy racked with volatility and close to panic.

That they had a role in the blowing of the bubbles that took a crisis and brought it to the point of disaster appears to be forgotten by people like Athreya. Their arrogance is quite astounding.

What we are now witnessing is that it is not possible for the Masters of the Universe to eternally prop up a system that is structurally flawed. They can continue to pour money into the system, continue to prop up bankrupt financial institutions, but there is a limit to how long they can bury the underlying structural flaws. When money is invested unwisely, someone, somewhere is going to have to pay. It is only a question of 'who' and 'when'?

This is the problem. If you invest in a piece of commercial real estate at an inflated value of $1 million, and the value falls to $500,000, then somebody must accept the loss. For example, if it is a half empty shopping mall, it is not producing the expected return, and the valuation reflects this underlying reality. There is not enough demand for retail space out there. The capital that has been invested in the shopping mall has been misdirected. Workers have input their labour, materials and energy have been consumed, and there it is; a half empty shopping mall built with borrowed money and no prospect of returning that borrowed money. Somebody, in the end, is going to lose their money.

The only way that the shopping mall will recover is if consumers go on another debt fuelled spending binge. If they were to do so, it would only be a matter of time before the debts, wherever they originate, will finally become due, and the problems will return. If consumers are spending 110% of their income, there must come a time when they can no longer spend. If a government is spending 110% of its income, there must come a time when it can no longer spend. We have seen this happen, so why will it be different this time?

If we think of our half empty shopping mall, it should never have been built. The actual demand for shopping malls is, in reality, aligned with actual income, not income + borrowing. Whilst it is possible to build shopping malls based upon income + borrowing, the long term viability of the shopping malls finally comes down to income without borrowing. If the shopping malls are built upon an assumption that income + borrowing is an eternal state of affairs, at some point the investors must lose money. Too many shopping malls will be built, as they are servicing both present income and future income, at the cost of less income in the future. They are building capacity based upon an unsustainable structure.

The unsustainability must finally lead to a point in time where the shopping mall lies half empty. At that point in time, whoever invested their money in the shopping mall will face a loss. Whether a bank, or an individual investor, they are faced with holding an asset, one which has taken labour, energy and materials to build, and which can not return the money that it took to build. How is the money going to be paid back? Who takes the loss?

The essence of the actions of the central banks has been to enact policy to stop anyone taking the loss. However, it does not matter how much they try, there will still, in the end, be far too many shopping malls in relation to the actual income of consumers. What the central banks can not do is the only real solution, which is to jump back in time, and stop the building of the shopping mall or the borrowing of consumers that was the driver of the investment in the shopping mall in the first place. So you come to a point in time where the shopping mall is there as a physical reality, but the demand for the services of the mall are not there.

And what of all of the people who were employed in the shopping mall, or employed in services that supported the shopping malls' operations? The shop assistants and managers, the shop fitters, the security companies, the importers, and so forth. All of these jobs will disappear, with each new unemployed person's training and skills rendered useless (or at least less useful). They must retrain, find new employment in a sector that does not have over-capacity. However, they are not alone, as all over the economy, other sectors built upon the income + borrowing paradigm are in the same position. So it is that the consumer demand falls as unemployment rises, leading to even more contraction of the demand for shopping malls.

How is it possible for the Masters of the Universe to turn back this tide? In their arrogance, they actually believe that they can do so. Pulling this policy lever, or that policy lever, they seek to change the world such that the economy is not structured around actual income and the ability to service past borrowing. They deny that the shopping mall was built upon an unsustainable structure, and try to hide the reality that it represented excess capacity.

Returning to the PhD economists of the central banks, the Masters of the Universe, they have their mountains of theory, they have their magic formulae, they have their policy levers, they have their belief that they can control the system - but - can they really make a world in which nobody loses when an economy has been subjected to structural failures, where investments were directed into sectors that were intrinsically unsustainable?

As each day goes by, it becomes ever more apparent that the Masters of the Universe are, in reality, delusional and impotent. At best, they can delay restructuring. However, in doing so, they will just continue with the investment into unsustainable sectors of the economy, and contribute to further structural flaws in the economy. The more they seek to turn back the tide, the greater the ongoing mis-allocation of resource. And they have the arrogance to criticise those of us who do not have their approved qualifications?

Note: I use shopping malls as my example as they are an easy target. However, this is just a convenience, and does not reflect the extent of the structural problems. There are a multitude of sectors facing the same problems, with each sector with overcapacity having a plethora of downstream overcapacity.

Friday, June 25, 2010

Who will be Paying the Bills?

My last two posts have prompted a lively debate on the blog, and it is interesting to see how the debate parallels that which is taking place around the world. The G20 and G8 summits appear to be seeing the same divisions, with Obama on one side encouraging continuance of massive deficit spending, and the Canadian and many Europeans (e.g. Merkel, Cameron, Borroso) saying that the deficit spending has gone far enough (or perhaps already too far). This is from the Guardian:

Signs of deep rifts at the G8 and G20 summits in Toronto over how quickly governments should cut deficits added to financial market jitters today, with the Americans warning of the dangers of a double dip recession if all countries started to rein back spending at once.

The leading European economies, especially Germany, are putting a new emphasis on cutting back government spending, and there is a possibility that a G20 communique, due to be released on Sunday , will set out an indicative timetable of how far and fast countries should retrench spending.

David Cameron, making his first appearance at a world summit and packing in a frantic round of bilaterals to start building personal relations, was praised by the summits' host for his deficit slashing budget earlier this week.

The Canadian prime minister, Steve Harper, said that he welcomed Cameron's responsible and difficult decisions, saying the British prime minister's budget "had raised the very fiscal consolidation agenda that we are trying to steer the G20 towards".

Canada wants the G20 to endorse the idea that national deficits should be halved by 2013.

I highlight this, as the gap between the US approach to deficit spending and that of (for example) Germany can not be wider. There is a major fracture in the perspectives on economics between different countries.

The problem is that, there is no opportunity for either side to ever prove itself right, except through enacting their different approaches. However, in one respect, the Obama camp will be proven correct. That is, if there is a major move towards cutting of expenditure, a recession will almost certainly be the outcome. This will then give them an opportunity to say 'I told you so' and blame the problem on the cuts.

What we will never actually see, is what happens next if countries continue to rack up huge deficits, and the dangers that might flow from this enactment of policy. It will allow history to be rewritten to say that, had the spending continued, then the world would economy would have recovered, and all would have been well.

Set against this, I would point to the following article, which points to the underlying change in the world economy, a change which I have continually highlighted on this blog as inevitable, and the real driver behind the economic crisis:

Ten years ago, the world’s richest countries accounted for a significant majority of the globe’s economic activity. But the pendulum is swinging in the other direction, according to the Organization for Economic Cooperation and Development.

A new O.E.C.D. report finds that rich countries and poor countries now each contribute about an equal share of the global economy. And by 2030, developing countries will account for 57 percent of world G.D.P.

This has been at the heart of the thesis of this blog. The world has changed; the distribution of wealth in the world is changing, and it means that the developed world is no longer in the position where it might assume eternal wealth. We are now at the stage where month by month, we can see the reality of the change, and the attempts by many developed countries to turn back the reality failing. My argument, since before even starting to write this blog, has been that, for over a decade, we have misconstrued apparent economic growth for real economic growth. This is the view of the Economist:

Throughout the 1980s and 1990s a rise in debt levels accompanied what economists called the “great moderation”, when growth was steady and unemployment and inflation remained low. No longer did Western banks have to raise rates to halt consumer booms. By the early 2000s a vast international scheme of vendor financing had been created. China and the oil exporters amassed current-account surpluses and then lent the money back to the developed world so it could keep buying their goods.

Those who cautioned against rising debt levels were dismissed as doom-mongers; after all, asset prices were rising even faster, so balance-sheets looked healthy. And with the economy buoyant, debtors could afford to meet their interest payments without defaulting. In short, it paid to borrow and it paid to lend.

I was one of the doom-mongers when I first started writing about the economy. I was seen as (at best) a part of a mad fringe, but today we see the Economist saying exactly what I was saying long ago. However, even now, the problem remains that growth in debt is still mistaken for economic growth, and I despair of the mainstream ever 'getting' the distinction.

At this stage, it is worth offering a perspective on the scale and depth of the existing levels of debt in the developed world. The Economist has a special feature on indebtedness and produced the following chart which ranks countries by debt sustainability (sorry about the size):

I strongly recommend taking a look at the interactive debt chart at the Economist here (sorry, can not be reproduced here). They follow their chart with this commentary:

THE headlines are all about sovereign debt at the moment. But that is only part of the problem. Debt has risen across the economy, from consumers on credit cards, though industrial companies borrowing for expansion and financial companies using debt to buy risky assets.

The interactive graphic above [in the Economist article] shows the overall debt levels for a wide range of countries, based on data supplied by the McKinsey Global Institute. In theory there is no maximum level for debt relative to GDP, but Ireland and Iceland (not on this map) found the limit in practice when they hit eight-to-ten times GDP.

The massive debt accumulation does not tell the whole story. What we can see is that the debt is simply being used for consumption. It is not creating growth, but is leading to diminishing returns in growth - in other words, the real growth is taking place outside of the developed world, and the developed world is just living off that real growth. The chart below from the Economist tells the story:

What this chart shows is the reality that has long been the subject of this blog, including in a recent post on post-Keynesianism. The money that is being borrowed and thrown into developed world economies is not producing a return. I made a comparison with China, where the government spending can make a return. It is very clear from the chart that borrowing more is not the answer (I know that the post-Keynesians will claim that their kind of borrowing and spending will be different....but see my post for why it will not).

However, it is quite possible for the US, for example, to continue to borrow from the new wealth creating countries and the oil states and appear to continue to be relatively prosperous. However, underneath such apparent prosperity is the reality that there are now the emerging economies that are being coming increasingly competitive, and taking a greater share of global wealth. Countries like China and India commenced with low end, low added value goods, but are rapidly rising up the value chain, and are starting to compete in the higher added value segments. The emerging economies will increasingly be meeting the developed world in the market for higher added value goods and services, and the developing world will win market share.

This leads to the question of whether there will be a miracle of a return to the pre-crisis 'normality'. Can the developed world return to past levels of wealth, at the same time as new and aggressive entrants are entering into more segments of the world market. The Obama solution is built on the believe that, at some point in the future, growth in the economies of the developed world will return, and this will then allow for the existing economic structures to be maintained, and at the same time producing enough growth to repay debts accumulated now. After all, this has been what has taken place following previous recessions.

This view ignores the changes that are taking place in the apportionment of wealth, and also ignores internal factors that will further diminish potential for wealth creation, as well as the problem of structural entitlement programmes that will push up costs and diminish the ability to pay down debt. The first problem is one I have already discussed, the second and third are resultant from the basic demographic problem of ageing populations. In order for developed countries to simply stand still, there would need to be a significant productivity miracle, which will allow a shrinking workforce to support a growing population of retired people. The problem is that the developed world is not standing still, but is falling backwards.

If government borrowing and spending is removed from the equation, it is apparent that the economies of most developed countries are facing reversals in wealth as a result of the competition from the emerging economies. I think I might now be in a position where, when discussing the economic growth in the pre-crisis decade, few would propose that there was an underlying increase in the wealth, but rather an illusion of wealth created by debt. Since the crisis commenced, governments have replaced this debt with government debt, and this can only be sustained for so long. What this creates is a moment in time where existing economic structures might be retained, but no more than that.

In order for the changes in both the internal and external environments to be accommodated in the medium to long term, something must change. On the one hand, in response to the internal changes, there is the choice of using ever greater taxation to pay for the costs of a growing pool of retired people from a diminishing workforce. This would place a significant burden on the upcoming generation, whose potential for a 'good' lifestyle would be diminished through significantly higher taxation. Alternatively, the structure of the economy might be reformed through the reduction in entitlement programmes, or through allocation of funding now to support future entitlement programmes. At present, however, the assumption is that 'growth' will allow these entitlement programmes to proceed without any action now, or negative consequences on the upcoming generation.

Furthermore, when considering these future increases in costs from a shrinking tax base, they will also need to service the debts that are being accumulated in the present. As such, in addition to having to service the cost of a growing retired population, the shrunken tax base must also apportion more of their income in order to service debt. As such, there seems to be a huge assumption that either the upcoming generation are going to be hugely more productive than the previous generation and / or they will be willing to see much higher tax levels than the previous generation.

Furthermore, developing economies such as China are also major lenders into many of the developed economies, meaning that, as they continue to develop, they will have access to future resources and output of the developed world as they continue their growth, possibly allowing for an accelerated rate of growth. The upcoming generation must therefore achieve all of this as the emerging economies continue to grow their share of the economy, and move ever further up the value chain in competition with developed economies. I am now not alone in this point of view, and again from the Economist:

But in parts of the rich world such optimism may now be misplaced. With ageing populations and shrinking workforces, their economies may grow more slowly than they have done in the past. They may have borrowed from the future, using debt to enjoy a standard of living that is unsustainable. Greece provides a stark example. Standard & Poor’s, a rating agency, estimates that its GDP will not regain its 2008 level until 2017.

Rising government debt is a Ponzi scheme that requires an ever-growing population to assume the burden—unless some deus ex machina, such as a technological breakthrough, can boost growth. As Roland Nash, head of research at Renaissance Capital, an investment bank, puts it: “Can the West, with its regulated industry, uncompetitive labour and large government, afford its borrowing-funded living standards and increasingly expensive public sectors?”

Some of the commentators on the blog might note the use of the expression Ponzi scheme, as there has been a debate in the comments section of the blog on just this subject. The point is that there is no way in the world that the current economic structure of the developed world can be maintained. I have asked, and asked and asked where the real growth might come from to support developed world economies. It now seems that even the mainstream is coming to this question, and it is about time.

As such, when we look at the current debate, we can see two simple divisions. On the one side, there are a series of assumptions that there will be a growth miracle that will outstrip the results of demographic change in a world of increasing competition. On the other side is an assumption that something must be done now to accommodate the changes in the world. The consequence of the former, barring a miracle in productivity, is that the upcoming generation are going to be saddled with huge burdens, even assuming that the borrowing might be sustained into the near future.

On the other hand, the consequences of cutting now is to commence a process of realigning the economy to the actual wealth creating potential of the economy, and starting to face the problems that are rapidly accumulating. At its most basic, it is accepting that there needs to be a restructuring now, rather than imposing a huge (and probably in reality an unsustainable) burden on the future. I believe that, in the past, I commented on another Economist article that pointed out that, in the future, there will be a conflict of interest between the generations. The current debate about continuing of spending versus cutting now is in reality exactly this debate.

I have always realised that, if governments cut now, the consequence will be shrinking economies. I have never seen any way out, except to take this 'pain' sooner or later. However, I have always argued that sooner is better than later, as the accumulation of debt can only compound the existing problems. No doubt, if governments manage to really cut now (and that is still uncertain), then we will later see retrospective history claiming that the cuts were responsible for future problems that will indeed arise. However, such a perspective would be to ignore the real changes in the world economic structure, and these changes are not of the sort that can be wished away or ignored. The choices are simple, and the choices are 'who pays, and when?'


A long time ago I wrote some posts which proposed reforms which would try to maintain the essential underlying principles of several entitlement programmes in the UK (e.g. NHS, Education and Benefits) . I wrote them from a basic principle; that we could not afford the current structures going forwards. I sought to balance the underlying social and political demands with the coming shrinking of wealth. What we are now seeing is the discussion of necessary cuts, and I can only hope that these are undertaken in conjunction with the necessity for reform of the systems themselves.

What I would like to see is that, in the recognition of the difficulties ahead, that those in the future might enjoy something similar to what we (in the UK) have grown used to. In other words, the same underlying protections but pared down to achieve the original basic principles at the time of the establishment of the benefits. In addition to cuts, it is therefore necessary to reform, and I hope that this is the next phase in the transition. Unfortunately, since the time of writing the proposed reforms, governments have racked up ever greater debts, making it ever less possible to achieve this goal. This is why I have, since the start of this blog, argued against government borrowing.

As a further note to US readers, the examples of reform I give might seem to be puzzling in the context of the US experience. I am a firm believer that safety nets, education, and health care should be available to people, and you will see in the examples methods that might allow for these to be achieved in the context of the UK's history and situation.

Monday, June 14, 2010

UK Office of Budget Responsibility

I have a semi-finished post on the Keynesians, but could not help but comment on the report from the Office of Budget Responsibility (OBR). The OBR seems to be a good idea but, as you will see, the OBR starts with assumptions and projections that are highly questionable. I will start with their preamble, which is as follows:

In the body of the report we describe certain departures from previous forecasting practice and we emphasise three in particular. The first is our stress on the uncertainty of the forecasts, particularly of the fiscal forecasts. We illustrate this principally by the use of fan charts. The second is that we have based the range of fiscal outcomes around our central view of prospects. The previous Government used deliberately cautious assumptions for some key variables in its fiscal projections. We have departed from that practice and, as we have said, have used other methods to illustrate uncertainty.
So far so promising....

We then move onto to their central forecast for economic growth, which shows the following GDP growth forecasts (for the purposes of this exercise, I will pretend that GDP is a meaningful metric, but you may wish to see my discussion of US GDP to see why it is a dangerous measure):

2011 - 2.6 %
2012 - 2.8%
2013 - 2.8%
2014 - 2.6%

It seems that, the UK is about to enter a period of relatively high growth. However, before we all become too excited, I thought it might be a good time to look at the 'economic growth' achieved during a massive credit bubble (chart from ONS).

Perhaps I am missing something, but it seems that, somehow.....the UK will achieve GDP growth rates that are close to those achieved during a massive credit fuelled bubble. It looks rather problematic, does it not? Where will the growth come from?

If we look at the forecast assumptions, it all starts to become somewhat dubious. First of all, there is that wonderful concept of the 'output gap'. What they do not explain is an output gap of what? The FT definition of the output gap is 'the difference between an economy's current output and the estimated maximum potential output (full capacity)'. This is how the OBR calculated the gap (see appendices of report for details):

  1. the productivity gap accounts for around ½ percentage point, reflecting both the large fall in actual output per hour over the recession and a judgement that underlying trend productivity has been adversely affected by the financial crisis;
  2. the fall in average hours in the recession implies an average hours gap of just over 1 per cent;
  3. just over 2 percentage points is attributable to the employment rate being below its estimated trend level. This is broadly consistent with the degree of spare capacity implied by indicators of recruitment difficulties.
These are some almighty assumptions in there, and the report does not say a gap in output of 'what'? To their credit, they do acknowledge that this is a somewhat difficult metric to calculate, but nevertheless they do not explain what sectors have the 'output gap'. Whilst there might be a notional maximum output, it is not clear how this translates into future output. If we think of the 'growth' during the bubble period, as I identified in my essay 'A Funny View of Wealth', there was no increase in output of genuine wealth creation, just 'growth' associated with debt fuelled consumption.

If we think of the way in which the economy grew, to service debt fuelled consumption, this implies that the 'output' that is not being utilised is in these sectors. For example, where consumer spending has fallen, there will be underutilised capacity in the retail sector (e.g. empty commercial property). How can this output be returned towards its notional maximum? The only way that this output might move to its maximum, in the short to medium term, would be if there was another credit boom - a highly unlikely scenario. The point is that, the output gap assumes that there is capacity in the right sectors ready to expand towards maximum capacity, but what if the capacity is in the wrong sectors?

Even if looking at, for example, employment, are the unemployed in a position to rapidly transition from their experience in one sector into another sector. For example, if we look at the expansion of the government pay roll (estimated at about 1 million over the last ten years), if reducing that payroll, what kind of retraining would be needed to make these workers productive in other sectors of the economy? Equally, how easy is it to take a person who has worked in the service sector, for example a shop supervisor, and redeploy them into manufacturing? That person may have potential for 'output', but in what?

Then there is the macro-picture provided by the OBR. They have noted that the emerging economies are looking stronger than the US or Europe, and that Europe is the UK's main trading partner. I will quote their analysis in full, as it is actually very vague:

The forecast for UK export markets growth (a measure of world trade weighted to reflect the geographical pattern of UK exports) is weaker than that for world trade throughout the forecast period, particularly in 2010 and 2011. This reflects the relatively weaker outlook for advanced economies compared with emerging countries and, in particular, the UK’s main trading partner, the euro area. UK export markets are forecast to grow by 4 per cent in 2010, 4¾ per cent in 2011, and by close to 6½ per cent thereafter, in line with its long-run average.

If Europe continues its turbulent ride, with potential for yet further weakening of the European economic situation and weakening (or collapse) of the Euro, where this ongoing growth might come from is not specified. Is it going to be the US, Asia or where? They later suggest that, they have based their assumptions on survey evidence, but there is no clarity on the 'where to?' question. On this, the report offers no explanation, which suggests this is nothing more than an optimistic guess, based upon currency devaluation. Whilst agreeing that devaluation has potential to drive exports, how will this work in a world of a devaluing Euro? Our most significant trading partners are seeing their own devaluation, and they are also significant competitors in export markets. Is the devalued pound enought to pull the UK out of its problems, when the US is still in trouble, the EU is in trouble, and even China is now slowing.

Then we come to domestic demand, and I have to start with a quote from their report:

The central GDP forecast embodies a rebalancing between external and domestic sources of demand. Private sector demand contracted sharply in the recession, while government spending contributed positively to GDP growth. Although recent data suggest that private sector final demand has started to recover, we expect it to remain relatively weak in 2010. For this year it is government consumption and inventory accumulation that make the largest contribution to growth. Over the year as a whole, we expect GDP growth to remain subdued, with output rising by 1¼ per cent. On a quarterly basis, growth increases from 0.3 per cent in 2010Q1 to 0.6 per
cent in Q2 and holds in the 0.6-0.7 per cent range throughout 2010 and 2011
That's right, government debt fuelled consumption is a major contributor to GDP 'growth'. This is, yet again, debt fuelled consumption being measured as 'growth'. Sure, we can keep on borrowing more and more, and sure, that borrowing will (in the short term) create lots of activity. But it can not be sustained, as borrowing has to be finite. However, the picture becomes seriously muddy in the following paragraph:

GDP growth rises to 2½ per cent in 2011 and again to 2¾ per cent in 2012 as credit
conditions ease and uncertainty subsides. All components of private sector demand are expected to strengthen, while government expenditure detracts from growth. Private consumption growth is forecast to rise from ½ per cent in 2010, to rates slightly below its long-run average and below the rate of GDP growth. Investment remains weak in 2010, but then recovers strongly as the recovery in business and dwelling investment gathers pace. Investment is expected to grow by around 8 per cent from 2012. This, together with a relatively stable household saving ratio, means the private sector financial surplus eases slightly throughout the forecast, as the government deficit contracts.
The first point in the above is a grand assumption. Why will credit conditions ease and uncertainty subside - we do not know because it is simply given as an assertion. What follows is built upon this assertion. For example, dwelling investment means (presumably) a return to significant growth in the property market, meaning that (once again) the UK economy is going to be built upon residential property. But where will the money for growth in this sector originate from?

If you view their projections for employment, from 2010 - 2011, they are forecasting an increase in employment from from 28.8 million to 29 million, and thereafter increases by 300,000 per year. There is no substantive reason given for this increase in employment, except that presumably this will follow from GDP. However, although it is not absolutely clear in the report, presumably the increase in employment is calculated in the GDP growth. If so, we have a partially circular calculation.

With regards to the corporate sector, they are placing a considerable weight on business investment to drive GDP growth upwards. In a chart of GDP expenditure share, they show net trade as an ongoing negative, government spending in decline, consumer spending in decline (and argue that consumers will increase savings), and that business investment spending will be on the increase. As an explanation for why, they offer a chart that shows business investment in the recovery from the 1980s and 1990s, implying that business investment will plot the same course in this 'recovery'. There are two problems here; first they assume they are seeing a recovery (when the economy is still being propped up by government debt based spending), and secondly they are assuming that we are in the same world as the 1980s/90s.

With regards to the latter, the world in the 1980s and 1990s was not in the midst of a global crisis. Our next door neighbours in Europe, our main trading partners, were not on the brink of crisis. The world was a very, very different place. At that time, there were not the massive emerging economies creating a hyper-competitive environment. As such, why should a pattern of activity from a completely different set of circumstances apply now?

Whilst they present a case that consumer savings will present a growth in the funds available for investment, the question of 'invest in what?' is not addressed. One problem is that there is no certainty that such savings will be invested in the UK. Another is that, before a business invests, it must see opportunities for profitable investment, and it is not clear where these might be. By the OBR's own reckoning, export growth is going to be relatively small, presenting few opportunities for investment, and again we come to the question of the output gap. According to their arguments, presumably, there is considerable slack in capacity for exports, and this slack will need to be utilised before any further investment.

Then there is domestic demand as a potential driver of business investment. However, if consumers are moving from consumption to saving, then it is not clear that this sector would encourage business investment. In fact, quite the opposite will take place. The same goes for government expenditure, which will be reducing over the period of their forecast. Again, there will be no impetus for investment from this source.

We then come to housing. Is this going to be the source of business investment? If so, then it appears that we are destined to repeat history, and have an economy built upon residential property investment. This is, of course, an unsustainable investment path, and offers no long term route out of the problems that are apparent in the UK economy. The route for the UK to pull itself out of trouble must be the export of goods and services, the route to generating income with which to pay debts owed to creditor countries.

What we can see in this report is an assumption that the world is simply going to return to the pre-crisis economic system. The assumption that the UK will follow the same path out of the current economic problems as took place in previous decades says it all; nothing has really changed and the economic crisis is just a blip in the path of normality. The assumption that underpins this report is that everything will return to 'normal', despite the fact that the structure of the world economy has changed, and is in the process of further change. It is a naive and forlorn hope.

Whilst applauding the principle of the OBR, I can not help but return to the chart above which shows the GDP growth in the credit boom of the pre-crisis years. If, we are returning to such growth levels, there must be a new factor that explains where such growth might come from. On reading this report, I can only conclude that the OBR thinks this will happen, because it will just happen. The lack of acknowledgement of the structural problems in the UK economy, and the world economy, makes the report questionable. The UK economy, over a period of over ten years, has seen 'growth' being built upon credit (both government and private), and this has left the UK economy structured to accommodate this credit based consumption. A decline in the value of the pound is not going to see a magic restructuring of the economy in the way that they imply. At some point, the credit fuelled structure must go, and that must mean a period of painful transition.

Is it really possible that the UK economy will just return to 'normal'? I do not believe so. After all, normal was conumption of more than was produced.

Saturday, June 12, 2010

Post-Keynesian Solutions - A Reply to a Critic of the Blog

I have recently been given a lesson in the correct terminology for the various forms of Keynesian thought from a regular commentator on the blog, who posts under the title of 'Lord Keynes' (hereafter LK). For a long time now, he has posted comments critical of the perspective of this blog, and demonstrated a strong grasp of the various forms of Keynesian arguments. For a short while, I did engage with his arguments, but found that I ended up doing nothing but engage with his arguments, rather than writing the blog.

The reason for this is that, at whichever point, LK would provide reams of 'evidence' in support of his assertions. In recent times, he has even proposed that, for example, the Austrian economists provide no evidence for their theory, which is clearly not true. What LK and other Keynesians do is pick and mix from the available evidence, present arguments for the defence of their arguments based upon the policy/experience of country 'x' doing policy 'y' with the result 'z'. Typically, what they do is identify an individual policy, and then separate it from the broader context of the policy. In doing so, they appear to provide a cast iron case in favour of their policy.

I do not think that the Keynesians are alone in this, but they seem to be masters of the art. One example oft cited by LK is fairly typical, in which LK suggests that the Scandanavians have managed to be successful despite a large government sector (quoted from the comments section):

Denmark, Sweden and Finland are successful economies that run current account surpluses and that have substantially lower unemployment than the US or the UK, yet nearly half of all GDP is taken as taxes and spent by the government.

Germany, a manufacturing powerhouse and very wealthy country, takes 40.6% of GDP as tax revenue.

The UK is actually around the middle, not the higher end, of the spectrum.

By contrast, Haiti only takes 9.4% of GDP as tax revenue (before the earthquake, I might add), and what is it?? An economic basketcase!
The Haiti case simply makes my point. Apparently here is proof that low government expenditure is bad for your economy. No context, just a figure as 'proof'. We can also take the case of Sweden, which according to the World Economic Forum, is ranked as 4th in the world for competitiveness. The report uses the following pillars for the ranking:

  1. Institutions
  2. Infrastructure
  3. Macroeconomy
  4. Health and primary education
  5. Higher education and training
  6. Market efficiency
  7. Technological readiness
  8. Business sophistication
  9. Innovation
Note that the ranking systems does not include tax against GDP. In the Economic Freedom of the World 2009 report Sweden was ranked 4oth, despite the rankings scoring very negatively for large size of government expenditure with Sweden ranked 127th on this measure. According to a ranking of business regulation, Sweden comes in at number 18 overall, but is also number 7 for trading across borders. According to the IMD world competitiveness rankings, Sweden comes in at the 6th most competitive country in the world.

I can go on. For the informal economy, where people work outside of the official economy, Sweden is ranked = 82nd. According to the Economist Intelligence Unit, Sweden ranks number 2 for 'e-readiness'. Sweden holds 11th place for the number of patents in the US patent system, and ranks 4th in the world overall. Sweden lies at the third best in the world on rankings for perceptions of corruption. The country also rates at number 3 for technological achievement. Sweden has the 6th highest level per capita of spending on research and development, and the second highest aggregated (curiously after Togo as number one). On the technological achievement index, Sweden ranks 4th (creation of technology; diffusion of recent innovations; diffusion of old innovations; and human skills). On the global innovation index, Sweden ranks as number 4 (though this does include government policy such as patent law, and fiscal policy). Sweden is the world's most networked economy.

Of course, what the Keynesians will say is that this is all an achievement of government policy and the large proportion of GDP that goes into the state. However, how can a generous benefits system support, for example, the innovation that is shown here? Is the innovation what allows spending of this size, or is it that the spending causes the innovation. Cause and effect - how do you untangle these? Is the ability for government to spend so much the effect or the cause? I expect that LK will answer some of these rankings with examples of how government action facillitated the ranking. The problem is that this takes the particular context of one country as an exemplar for another country.

When the Keynesians propose country 'x' as an exemplar, they appear to view all countries as having identical strengths and weaknesses, and take no account of, for example, business culture. For those like me, who have worked in US, UK, French and German companies, as well as having worked with the Japanese, the Italians, Swiss, Chinese and so forth, it is apparent that there are real differences in business culture.

For example, hhilst I have worked with Swedish people, I have not done so enough to have a clear perspective on their business and working culture. However, I have had considerable experience of working with another oft cited example from the Keynesians, and that is the Germans. In particular, I have worked for a German multinational. My experience of working with Germans was that I was deeply impressed. They have a culture of thoroughness, of attention to every detail, and this is ideal for a manufacturing base. When compared with a British company, it was all very impressive. It is not just the experience of working within a German company, but also my experience of working with Germans in general. How does this kind of factor fit into explaining the success of country 'x', 'y' or 'z' in the examples given by the Keynesians. The answer is that, because it can not be measured, it does not appear (comments from those who have worked with German business welcomed).

The point I am trying to make here is that policy 'x', 'y' or 'z' does not operate in a vacuum, but in the context of a long history of economic policy, social policy, educational policy, particular resources, particular stages of economic development, and the global economic context of the particular time and so forth. As I have said, the Keynesians are not alone in this, and this is why economics is a matter of such debate. Cause and effect are actually very difficult to identify when looking at any individual policy. It is why opposing schools of economics are able to justify their positions in direct opposition to one another. I will give another example of this generalisation from country 'x' to country 'y' later.

One of the most interesting points that LK is making is that high government expenditure can sit alongside economic success, and this is why he cites the examples of Scandinavia etc. What he does not cite are the counter examples such as the UK. The UK has seen a steady expansion of the size of the state in the UK over the last ten or so years. However, having expanded the state, the UK is now in deep economic trouble. Is this not a counter example to those that he has given? Could it be that there are factors specific to the cited examples that allow them to support such a large state, but the UK lacks those factors? LK will not doubt suggest that the UK state misused their increasing control over the output of the country....

In a recent example, I mentioned the work of Carmen Reinhart and Kenneth Rogoff 'This Time is Different', a book founded upon empirical evidence, and LK immediately responded with a list of authors who have criticised their work. No doubt, the critiques included counter examples, and this is what we always find. For every example, in a complex history of economics, and a complex world, there are always ways to present a counter argument - as there is endless variability in contexts. In the end, what we are always left with, is the underlying theory, and which theory we choose to believe, and which interpretation of the 'facts' is most credible.

For example, LK puts the explanation for post war economic growth as follows (in the comments section):

The sources of post war growth can be found in effective financial regulation (to prevent asset bubbles), discretionary fiscal and monetary policies, and Keynesian demand management.
It is an explanation that has often been offered by LK. Note that the economic growth during this period takes no account of increased productivity of labour, or the many innovations that took place during this period. If we want to see an explanation for why an economy gets richer, would it not be useful to take into account the innovations and technologies? Instead of this, LK looks at the monetary and fiscal policies, and Keynesian demand management as explanations. I will ask a simple question.

If a factory yesterday can make 1000 toasters per hour per unit of labour, but in a years time can make 1200 toaster per hour per unit of labour, does this not represent a real increase in material wealth?

What we have are two different explanations for the same thing; growth in economies in countries like the US and Europe. In my version, we can see real changes in output per worker as new and more efficient production methods, systems and machines are introduced, creating real increases in output per worker (and this includes services), and we can see a real and measurable outcome of such innovation. On the other hand, we can see abstract and indirect theoretical transmission mechanisms that are represented by 'effective financial regulation (to prevent asset bubbles), discretionary fiscal and monetary policies, and Keynesian demand management.' The post world war growth, according to LK is resultant from Keynesian policy....and there is no way to comprehensively disprove his view.

My answer to the LK argument is that economic growth is created by the kinds of innovations that make increases in outputs, and development of new goods and services, possible. Those innovations are created in the competition between suppliers of goods and services, each trying to outdo each other in the market, in a battle for profits and survival. Whilst monetary and fiscal policy might have an influence, along with the regulatory regime, these are not the drivers of economic growth. Instead, they are potential hindrance of economic growth, and the best outcome that they might achieve is a neutral effect upon growth. None of these lead to the innovations that mean that there can be more output of good or service 'x' by worker 'y'.

In other words, government monetary policy, fiscal policy, and regulation do not create the innovations that create real increases in output. In the end, you can choose which is the better explanation of the post war growth. Was it government policy, or a period in which innovation created massive gains in output?

One argument might be that elements of government fiscal policy might have some indirect impacts, such as the proportion of government spending being used in effective and efficient education programs. Some government funded research programs might also lead to innovations that will impact upon output in the economy. However, how those research programs might produce results in comparison to the actual investment in research, in comparison with having the money being used in research by private organisations/individuals, is a question for which there is no neutral answer. For example, elements of the modern Internet flowed from US government defence research, but the application benefits in the civilian Internet were coincidental but huge.

But then again, the huge amount of money poured into defence programs must surely eventually result in some kind of breakthrough...

In proportion to the total of government expenditure, how might we measure such benefits, and how might they be compared to private R&D expenditure? If the money were left in private hands, what kind of economic growth might it achieve? We do not know the answers to such questions, and there is no neutral way of making such an assessment. There is no data that might objectively measure such a thing.

This brings me onto LK's favourite term, which is the idea of 'industrial policy'. This is a bit problematic, as it is always vague and undefined. I will quote some examples from LK:

That is why they need to nationalize banks, tightly regulate them, control allocation of capital to productive investments, adopt aggressive trade and industrial policies and rebuild manufacturing and output of tradable goods and services. (here)

This can be done through social policies to help families as well as immigration and vigorous industrial policy. (here)

It's [the US] main problem is that it allows it multinational corporations to ship its jobs to East Asia.
This can be fixed quite easily through industrial and trade policy or by taxing corporations according to the value added in the US. Yes, that means higher prices for manufactured goods. But it also means employment, investment, stronger industries and a healthy economy. (here)

The rise of China was very little to do with comparative advantage. It rose through aggressive industrial policy.
The UK and US can use aggressive industrial policy as well to rebuild their manufacturing sectors. (here)
Only in one case have I found anything that might explain what industrial policy might really mean, and that is a link provided by Lord Keynes to a Google books page on Taiwan's emergence as a modern economy. Other than suggesting a formula which might, or might not have, contributed to Taiwan's growth, it is all rather vague. If we look at LK's blog, we find a few indirect references:

The only region that showed an increase was East Asia, precisely the region dominated by the protectionist state-led model of industrialization, led by Japan, South Korea, Taiwan, and (from the early 1990s) China. (here)
In another post, LK discusses the New Zealand experience of industrial policy, but never makes clear exactly what that policy was, or how it might have succeeded. Instead, he discusses external factors, and claims that the big fall in GDP was a result of neo-liberalism. Once again, we have a selection of factors that suit the argument being made (if you read the post, it does not mention many of the factors involved, such as what drove the eponymous instigator of the liberal policies known as Rogernomics to declare that the country faced economic ruin - and the instigator was a Labour MP).

What we have here is some very vague suggestions from LK, that are never fully elaborated. I used Google to search my site for industrial policy comments from LK, and could not find anything which might explain how this industrial policy might really work. There are certainly indications that the intent is to introduce capital controls, impose tariffs (direct or indirect) and to control industrial sectors - as well as hinting at mercantilist policy. However, I will not comment on these here, as they are only speculation.

Then there is the Keynesian perfectly circular arguments for government borrowing. These are the arguments that government borrowing is unconstrained, and that government borrowing might be a way to lead an economy out of recession. According to LK, there is no limit to government borrowing, and that government borrowing creates economic 'growth'. This is a recent comment from LK, in which he claims 'proof' that economic stimulus works:

Secondly, the Western countries have returned to mild growth and are not contracting: this is proof of the success of fiscal policy (you are mistaken to say that Keynesian stimulus can never be proved “wrong”: if we got a major depression and negative growth in the face of large fiscal stimulus, then this WOULD demonstrate that something is wrong with the Keynesian theory).
The most interesting thing here is that LK actually thinks that the consumption of borrowed resource represents economic growth. The simplest way to illustrate why this is such an odd idea is to pull away any restraints on borrowing. For the sake of illustration, let's imagine that the US had a credit line of an additional $1 trillion this year, in addition to their current huge borrowing, and that the US utilised that credit line. If they did so, they could start any number of huge projects, all utilising that borrowed money, and there would not just be GDP growth, there would be a massive boom in the economy. GDP growth would sky rocket.

If this is the case, why not just borrow that additional $1 trillion. The economy would boom, tax revenue would boom, and the economic growth would mean that the debt to GDP ratio would fall, suggesting that the debt is more serviceable. If this is the case, then it would seem that, the more that is borrowed, the greater the economic growth, and the more successful the economy. On this basis, every economy should add ever more borrowing every year to ensure endless economic growth. After all, the growth reduces the debt to GDP ratio, and increases the tax revenues to ensure repayment of the debt. Here is a recent example of this thinking from Krugman, offering a critique of German austerity measures:

"But that doesn't make sense. Even if you manage to save 80 billion euros – which you won't, because the budget cuts will hurt your economy and reduce revenues – the interest payments on that much debt would be less than a tenth of a per cent of your GDP. So the austerity you're pursuing will threaten economic recovery while doing next to nothing to improve your long-run budget position."
So here you have it - cutting a budget deficit hurts tax revenues. This is so circular, that I find it beyond belief that any person might suggest this as a realistic approach to economics. If government borrows money, and that borrowed money enters the economy, then more activity will take place, which will create more government tax revenue, meaning that the government can claim that the economy is growing whilst improving their ability to service the debt that they used to start the whole process.

It is a perfectly circular system. It is an economic perpetual motion machine. So what is the problem with this economic perpetual motion machine?

The trick to understanding this is not to think of government borrowing money, but of borrowing of resources. When a government borrows money from overseas, they are actually borrowing the output of that overseas country. For example, if borrowing from the Gulf states, it is the equivalent of borrowing oil. When that oil enters into the economy, it allows for increased activity in the economy as the oil is consumed. At each stage of activity in the economy, a percentage of that oil is consumed and that oil is a contributor to the output within the economy. It is a system in which real resources are being consumed. The problem here is that the consumption is consumption of Saudi Arabian output, not US output. In consuming the oil, the measurement is not of US output, but is a measure of US output + Saudi Arabian output.

All the time this consumption is taking place, there is an accumulation of an obligation to provide goods and services in the future to repay the loan of oil in the future. Those goods and services will necessarily require the consumption of resources (including oil) in the future to repay the loan of oil. If this is the case, then a percentage of the total resources of the US must be allocated to making this repayment. If those resources are being utilised to repay the loan of oil, then they will not be available for internal consumption. Remember, the oil resources that were borrowed have been consumed.

What all of this tranlates into is that, if you borrow and consume huge amounts of resource, it is possible to achieve growth in activity. I can not argue with this. It is self-evidently true. It is very easy to generate activity with borrowed resources. Just borrow more and more, and you will generate ever more activity. That this is the case does not in any way imply that this is a good long term strategy for an economy. It is actually the easiest thing to do - borrow money to create activity. It is so easy that we might think a monkey could do it. It is not clever, it is not sophisticated, and you do not need to have a PhD in economics to understand that if you throw enough borrowed resources into an economy, it will create activity. But where does it leave you, but with an obligation to repay that resource in the future.

What about if the borrowed resource is used for investment? It may be that some of those oil resources were borrowed and used to create new output, for example, building a factory. If this is the case, it might be that the factory will later produce goods and services that might help pay for the borrowed oil. The question here is to ask whether this is actually what is taking place? Are the gargantuan sums of borrowed money being directed into investment or consumption?

If it were the case that the huge sums of money were being wisely invested in new and productive investments, we would see a massive growth in the US economy as a result of the investments. However, we can not see any such resultant growth, but instead see the US limping along, with no real signs of recovery.

The answer of LK to this problem is to suggest that the massive stimulus spending is not being correctly utilised, and should be used for infrastructure projects/ other projects specified by the wise sages of post-Keynesianism. What I always find interesting about such proposals is that, if these projects were of genuine economic benefit, why were they not undertaken before? After all, all governments want economic growth, and there is no reason why such projects might produce such a return in the good times as in the bad times. What has changed? By curious coincidence, these projects move from being unconvincing in the good times, to convincing in the bad times. In other words, the value of the projects is being subjectively reassessed in the bad times. What was a poor investment becomes a good investment.

As an interesting example, LK cites the case of the success of the stimulus in China as follows:

First: the tremendous success of Keynesian stimulus in China and Australia.
To repeat a previous post:

In the face of a massive collapse in their export-led growth economy, what did China do?

They implemented a massive $586 billion dollar Keynesian stimulus – and then got a very impressive recovery, so impressive in fact that with growth in the first quarter of 2010 at 11.9%, there is talk that they may need to cool down the economy.

Does that sound like a “failure”?

Australia also implemented a large Keynesian fiscal stimulus, which worked very well, and it benefited from China's stimulus as well.

Conclusion? Countries that are close trade partners benefit tremendously from Keynesian stimulus in both countries.

Your failure to even address this point severely undermines your whole argument.

I am not sure whether LK has been to China, but there are large swathes of China that genuinely lack infrastructure. As one example of the government spending on infrastructure, the last time I was in China, I went along a pot-holed track and could see a massive new highway being built alongside it. The road was opening up a large area of Sichuan province to the rest of China, and would thereby pull that region into the Chinese economic system. There was little potential for economic development of the area prior to the road being built, as the communications were simply too poor to allow any growth. When I viewed the road being built, there could be little doubt that it was a genuine investment which would allow the people of the region to contribute to economic growth in the future.

You may note the difference here. In an emerging economy such as China, there are many projects that are not only attractive, but actually essential. This is not to say that all investments in infrastructure in China will repay the investment (it is a very corrupt country), but that it is easy to find good investment projects. Even before the crisis, China was investing heavily in such projects (as there were so many that were necessary) and they have just accelerated this process. Unlike a developed economy, these projects were self-evidently a good investment before the 'bad' times. Furthermore, China is a current account surplus country, meaning that it can pay for these projects without the risks in having to borrow the resources of other countries to fund the projects.

What we will see from the Keynesians is that they will suddenly find hundreds, if not thousands, of projects that have been crying out for investment. They appear as if by magic, as soon as there is a downturn. In the case of an emerging economy like China, many of the projects will be of great value, but in a developed economy, they are unlikely to be anything but of marginal benefit at best. In using China as an example, LK does exactly what I discussed earlier. He takes a case out of context to 'prove' his point, but in reality, proves nothing. I believe that I have answered LK completely here, and his use of this example just illustrates my point about context. Any comparison of the situation of China and a country like the US is pointless.

What of all those unemployed? According to the Keynesian arguments, all of these people are sitting around as unproductive resource. Would it not be better to employ this idle resource?

It is a tempting argument, if only for the dignity of the unemployed workers (which is a concern I share). However, in employing these people, for example in infrastructure projects, they are not a resource that is being used productively, but rather a resource which costs more resource to appear to be productive. If the infratructure project is not viable as an investment, then the additional resources needed to emply these workers mean that they are just consuming additional resources in their employment. Compared with having the unemployed worker sitting at home (for example on benefits) this represents a net increase in resource consumption per person who is employed on the project compared with being unemployed at home.

'Yes', in the short term, a person can appear to be gainfully employed, but at what cost for the future?

To illustrate the point, prior to the crisis exploding, there was high employment in many developed economies as a result of the credit boom. All of those people appeared to be engaged in productive and useful employment. However, the apparently productive employment was resultant from the borrowing of resources from other countries, and the consumption of these resources. Each of these people employed as a result of the credit boom looked every bit like they were making a net contribution to the economy, but many of them were just facilitators of consumption of the output of other countries. Their net contribution to the economy was actually negative, as they were part of a system in which consumption exceeded output. The result is the massive debt overhang in many developed countries. The Keynesian stimuli just offers more of the same. Just as the private debt overhang led to unemployment now, the government debt overhang will create unemployment in the future. It is just a delay, not a solution.

The private debt accumulation led to lots of employment in unsustainable sectors, such that resources were directed into an unsustainable economic structure. When the structure collapsed, unemployment went up. However, the stimuli measures have sought to turn this back, but by doing the same thing as the original problem. By trying to support an economy based upon borrowing, which entrenches an unsustainable structure.

This is the other problem with the Keynesian solution; it evades the underlying problems in an economy. If we think of the net over-consumption in the economy, it must be the case that, at some point, the balance must be reversed to pay back the previous over-consumption. By borrowing more money, the structure of the economy is left in a form in which large sectors of the economy are structured towards the over-consumption. If people are employed on infrastructure projects that represent a consumption of resource (not an investment), then the sectors of the economy that are supported by over-consumption are left in place. These sectors continue to have resources directed at them. Replacing private borrowing with government borrowing just leaves the same structure in place, completely unreformed.

This kind of problem, however, is not apparent at the time of the stimulus spending. In fact, none of these problems are apparent at the time of spending the stimulus money. This is why LK can claim success, as he has done, for recent bouts of stimulus spending. LK points to country 'x' and says look how they have returned to growth having spent 'x' amount of money on a major stimulus. As I have said earlier, it is no wonder that pouring masses of borrowed resource into an economy will stimulate activity. It really does not take much to see the cause and effect, but it is a different matter to see the long term consequences.

So why does LK think this will work long term? I will quote from one of his recent comments:

That the effect of a stimulus is “transient” is an utterly trivial point. Of course it is.
The whole point is to temporarily stimulate the economy back into growth, so that demand for private goods will be restored and private business confidence and output will rise - which creates a self-sustaining economic expansion.
Output of what will rise? If you are stimulating with borrowed resources, yes, output will rise, but it will rise in the sectors of the economy which otherwise can not support themselves. You are simply entrenching the structural problems, as I discussed earlier. It is not self-sustaining, as the parts of the economy that are supported by overconsumption remain in place. They can only be supported by ongoing borrowing for consumption.

I have noted in previous posts that, as economies such as the US and UK returned to so-called growth, we could see a commensurate deterioration in the trade balance. No doubt, all of the consumption fuelled by the borrowing will support the economy for a little longer, but the underlying structural problems are kept in place at the cost of accumulation of debt. It is a transient effect, and this in not an 'utterly trivial point' as LK claims. It is exactly the point. As soon as the stimulus is withdrawn, the economy will return to the problems that have not been addressed. This brings me to another point.

LK criticised me recently as follows (my words quoted in italics):

If the fiscal stimulus runs out of steam, have another one, and another one, and another one. If it is not working, a larger one will do the trick. If the larger one does not do the trick, then there is an even larger one that might be do the trick. In nobody will lend, print money. If that does not work, just print more.

I assume this is mainly meant to be rhetoric?
If not, which countries have tried 6 stimulus packages that failed? Answer: none.
Have any countries tried 5, 4, or 3 stimulus packages that failed? Answer: none.
In fact, have any countries even tried 2 stimulus packages yet??
Yes, Japan. It has long been using all of the tools advocated by LK. And when these did not work, the cry is that they should have done more of 'x' and 'y', they stopped the stimuli at the wrong time etc. No doubt LK will claim that Japan did not apply their various stimuli correctly...or they should have pushed on through with more of the same. More bridges to nowhere....

And this leads me on to the next problem, which is the idea that government borrowing is different from private borrowing:

In the real world, the government controls monetary policy. Its debt isn’t even remotely like private debt. An entity that has the power to create money cannot go bankrupt.
It can certainly use too many real resources, cause inflation in boom times, increase the external deficit unsustainably, or stupidly borrow money from private markets when it has no need to.
Within this argument, we see that LK is a supporter of printing money (or he will no doubt use the weasal term quantitative (QE) easing). I agree that borrowing money on private markets is foolish, but that is because I do not agree with the borrowing of money in the first place. However, the proposal of LK appears to be that the best route is to simply print money, and utilise this rather than money borrowed from private markets. As we know, this is what the UK was doing until recently. For those of us who pointed out this was inflationary, we are now being vindicated. The UK is indeed now subject to growing inflation, despite the 'output gap', despite the fall off in private credit. In fact, the UK is importing inflation due to the decline in the value of the pound, and this despite the Bank of England's continuous predictions of deflation. The only question remaining is how far the inflation might climb (although the austerity measures being proposed may put a halt to the inflation).

The problem is this. If you start down the road of printing money to finance deficits, you eventually create inflation. The transmission method of the inflation may be through currency depreciation, may be through a boom in credit, asset price appreciation or a host of different conduits. It may be that the effects are delayed, for example where the UK banks used the process of QE to rebuild reserves. However, eventually, the new money appears in the economy. When it does so, it must be sterilised, or it will lead to inflation, and here is the problem. In order to sterilise the money, the Bank of England must sell assets to destroy the newly created money, which means selling gilts. In doing so, the process of QE just becomes a delaying mechanism, as those gilts must be sold in private markets. Either that of the Bank of England must print money to sell the gilts to itself, thereby defeating the purpose of the sale (though I would not be surprised at such a lunatic policy).

It is an incoherent idea to suggest that a government does not eventually need to turn to private markets to finance their deficits. And if the private markets do not want to buy? What happens then? The money created remains in the system....and the inflation will follow...

And this is why government debt is like any other debt. Sure, a government can not go bankrupt in that they have no money, but a country can end up with a worthless currency that can not be used to exchange for goods and services. In order for a government to borrow, the potential lenders have to, in the end, believe that they will have the borrowing repaid in a value that exceeds their lending. So a government can print money, and default on its debts indirectly. However, a default is a default is a default, regardless of the specific form of the default. The more a government borrows, the greater the call of the creditors on the future output of the borrowing country. If the output does not increase faster than the borrowing (not including the output that is itself resultant from the borrowing), then, at some point in the future, there will be a loss of output for internal use in the borrowing country. Either that, or the country defaults on debt (for example paying with printed money).

And when a country defaults, with outright or indirect default, the credit will stop, or will be offered at high interest rates to reflect the risk. Whichever the case, the private debt markets will impose a fiscal discipline on the government. It is not that the private markets are evil and anti-democratic. They have a reasonable expectation of repayment when they lend money. If there is any evil (though I do not like this word) it is governments seeking to bribe their voters with borrowed money today which will have to be repaid by others in the future. It is the lie that this is sustainable and can be continued with no future consequence. I keep coming back to the point - it is easy, if not lazy, to just keep borrowing more money, in order to support a failing economy. Pouring borrowed money into an economy is the easiest thing in the world, but it is the repayment of the borrowing in the future that is the challenge.

A good example of this lazy and dishonest approach to economic management are the state pension schemes. As every year goes by, the liabilities steadily accumulate. As they do so, governments pretend they are not there, as confronting the problems of the accumulating debt would not be popular. The pensions will, one day, need to be paid, and that liability is going to become the liability of the following generation. It is no different from borrowing to build a hospital, or a new road. In both cases, the benefits accrue to one group now, at the cost of future tax payers. In the case of pensions, the provision of savings to support the pension schemes would come at a cost of less activity in the economy now. Less 'growth'. In the case of the hospital built with borrowed money, the same thing. In all cases, someone is going to have to pay for these benefits, just not the people who are enjoying the benefits.

This is the Keynesian policy writ large. The avoidance of only consuming what you can produce. Beneath all of the sophisticated arguments, it all comes to this central point. If you borrow, you must repay. I do not believe in government borrowing at all, but borrowing more than your underlying growth of wealth creating capacity means that someone in the future must pay for your consumption now. This is morally bankrupt and irresponsible.

And then I come to the question of why governments borrow in the first place. If there is unemployment, why borrow the money to alleviate the problem. Why not just tax more and use the taxes to pay for the unemployed? The reason is that the high tax would be unpopular. Why borrow to build a new hospital. Because paying for the hospital directly would be reflected in higher taxes for the users of the hospital. How much better to spend borrowed money and call it 'investment' or other euphimisms for passing on cost to those in the future. And for people like LK, they offer sophisticated arguments, endless cherry-picked evidence to hide the fact that if you consume more than you produce, unless your output increases above the rate of your borrowing, someone is going to pay in the future.

Someone in the future is going to have less, so that you can have more now.

There are many other arguments made by LK, and many other Keynesians. Within all of their arguments, we always come back to the same themes. Government borrowing is the solution to all ills, and if governments can not borrow now, they can always print money. It is the endless pushing of today's problems into the future. It is exactly like the pensions problem. Do not confront difficulties now, just leave them to the future. But this is the great attraction of Keynesian economics. It is why defenders of Keynesian policy gain so much support.

However, as one commentator put it in the Telegraph, the days of spend now pay later are over. Later is now. Many governments are now facing the point where the markets are asking how governments plan to pay back the money they have borrowed. In the world of LK, he proposes that the answer is to ignore the markets, and print money instead, ignoring that one day, like it or not, the markets must buy the debt. No doubt, printing money might delay the problem a little longer, avoid the absolute need for economic restructuring, but only at ever greater cost later. This is the problem with the soltuions offered - they delay confronting the problems to create a greater later cost.

I fully expect reams of counter argument from LK. He will, insist that his case is right, will contest the Swedish point, and so forth. However, for the readers of this blog, just think about the perpetual motion machine of government borrowing creating economic growth. Borrowing to consume now creates wealth in the future. Wise 'investments' appear from thin air. Think of the way in which China offers 'proof', entirely free of context. Think about the pension deficit, of how easy it is to pass the buck. Think of the arguments about how governments do not need the private markets for borrowing as they can just print money. Think how easy it is to pour money into an economy, but how difficult it is to pay back.

It is a lazy economics dressed up with sophistication and misdirection. It is easy to have a party on borrowed money, but less easy to deal with payment in the future. It is very easy to spend the money of future generations and have good times now. Any idiot can do this. The true genius of Keynesian economics is that they can dress this up so well with theory. In the end, my argument rests on one key point. If you consume more than you can produce through borrowing on an ongoing basis, you have a problem, and you can only delay facing that problem for so long.

Note: LK has written extensively on mnay subjects and, even with such a long post, I have not covered them all. In fact, to give a full response to LK would take a lifetime, so I leave this reply partly unfinished. I also note that LK has added some substance in his recent comments on industrial policy. Unfortunately, added after this post was written, and I really do not want to revise the section. This was time consuming enough.

Tuesday, June 8, 2010

The Fiscal Beauty Contest Starts

The realisation that endless government borrowing could not be sustained really started with the (still unfinished) Greek crisis. As the risks of sovereign debt became apparent, risk aversion, and sometimes panic, have gripped the markets for government debt.

In the title of this post, I mention a beauty contest. However, in some respects, what we are looking at is not a fiscal beauty contest - but a fiscal 'least ugly' contest. I proposed that the world was about to enter a beauty contest some time ago as, whatever happens, many of the major debtor nations are going to have to keep borrowing for a while yet, and that means ongoing access to credit. I highlight this, as it looks like the UK is about to embark on a path of radical change in fiscal policy, with a firm and decisive attempt to seek to deal with the UK's fiscal problems:

George Osborne braced the country for cuts in government spending of up to 20 per cent as he laid the ground for an austerity programme to last the whole parliament.

The Chancellor announced an unprecedented four-year spending review in which every Cabinet minister will have to justify in front of a panel of colleagues every pound they spend.

Mr Osborne said the task ahead represented “the great national challenge of our generation” and that after years of waste, debt and irresponsibility it was time to rethink how government spent its money.

There is, of course, a huge gap between rhetoric and achieving action on the ground, and this means that such announcements need to be treated with caution. The inspiration for the fiscal retrenchment is Canada in the 1990s, and the process will involve a careful review of each element of government expenditure, including asking the vital questions of whether any activity might be necessary or contribute to the economy overall. Whilst a similar process worked for Canada, this was undertaken in less stressed times, so that it may be more difficult to emulate the Canadian example than might be believed.

The interesting point about the case of the UK is that they are increasingly faced with little choice but to cut back savagely. Whilst not personally having any respect for the ratings agencies, I nevertheless accept that they impact markets. As such, the latest from Fitch highlights the necessity of action in the UK:

Britain's debt problems returned to the spotlight Tuesday after Fitch Ratings warned of the need for bigger austerity measures in a report that rattled investors but could help new Prime Minister David Cameron justify severe spending cuts to a worried public.

In its first major statement since Britain's Conservative and Liberal Democrat parties formed a coalition government last month, Fitch warned the U.K. "faces a formidable fiscal challenge" and needs to be more ambitious in cutting its debts. The warning comes as new U.K. Treasury chief George Osborne prepares on June 22 to unveil emergency measures to cut Britain's budget deficit, which at more than 11% of gross domestic product ranks among the largest among advanced countries.

The point of the Fitch report is that, in the least ugly contest, the UK still has a long way to go. However, as each country seeks to beautify their balance sheet, the pressure on other countries to follow suit will increase. In other words, even if the UK seeks to be fiscally sound, other countries will be forced to outdo the UK, as they too seek further funding. This is from the same article quoted earlier:

"As more European countries respond to market pressure by tightening fiscal policy more aggressively than originally planned … there is a risk that the U.K.'s existing deficit-cutting targets begin to look distinctly weak," Fitch analysts said.
This coordinated shrinkage in debt growth follows the coordinated growth in debt, or going from feast to famine. Whilst the view of this blog has always been to recognise the dangers in the growth of debt, and the absolute necessity to reform to fiscal responsibility, the coordination of the fiscal consolidation over so many economies presents significant dangers. In particular, the consolidations will force a drop of activity over many economies simultaneously, and with that drop in activity, each country that consolidates will see a major drop in imports, further ratcheting each economy down.

This potential systemic shock over many economies risks a collapse in confidence, and therefore a hard economic 'undershoot'. By this, I mean that the drop in activity will in turn undermine confidence more broadly than the real consequences of austerity might reasonably point to. This might further ratchet down economic activity. Just as the debt fuelled activity created massive over-confidence, the collapse in debt driven 'growth' might create under-confidence. And to add to the potential nose-dive, there is the talk of fiscal retrenchment in Japan:

Despite the prime minister's hair-raising words [that Japan will face a sovereign debt crisis if it continues on the current path], markets did not bat an eyelid, with the Japanese yen, the Nikkei stock market index and Japanese government bonds unmoved.

"Fiscal austerity measures are long overdue," said Chris Scicluna, deputy head of economics at Daiwa Capital Markets in London.

He forecasts that the government's budget deficit will be 8% of GDP this year, a number that Mr Kan has promised to reduce to zero by the end of the decade.

Having said all of this, the current move to fiscal austerity is not as severe as is popularly believed. It might be noted that Japan is not planning to pay down debt, but just slow the accumulation of debt. The same might be said for most of the so called austerity measures, as can be seen in the following chart:

The problem is this. The beauty contest is now enacted, and the only possible result is an ever fiercer spiral of fiscal consolidation, with the effects of this spiralling economies ever deeper into recession/depression. The chart just shows that there is still a long way to go to achieve a realistic and long term fiscal correction. The beauty contest will ensure further measures will change the shape of the chart.

The trouble is that, having splurged in the wake of the financial crisis, having simultaneously strained fiscal positions towards breaking point, there is nowhere left to go. Had it been the case that only a few small economies had built up so much debt, the world economic system might have been able to absorb the retrenchment, albeit with some pain. However, this is not what happened, and the collective market awakening to the risks of sovereign default can not be turned back. Even Japan, with its willing army of domestic savers, is twitching.

Then there is the US. With the 'safe haven' and reserve currency status, the US has chosen to remain on the path of ongoing growth in debt and spending. There is further talk of more more fiscal stimuli. The US is getting into ever deeper trouble, all the time relying on the safe haven and reserve status to last to eternity. In my last post, I discussed the risks in being perceived as a safe haven, and this is the latest news on the US trade situation:

WASHINGTON — The U.S. trade deficit rose to the highest level in 16 months as exports fell for the second time in three months, a potentially worrisome sign that Europe's debt troubles are beginning to crimp American manufacturers.

The Commerce Department said Thursday the trade deficit widened to $40.3 billion in April, up by 0.6 percent from March. U.S. exports dropped 0.6 percent, while imports declined by 0.4 percent.

U.S. manufacturing has been a standout performer as the U.S. recovers from the worst recession in decades. But the concern is that Europe's debt crisis will slow growth in that part of the world and dampen demand in a key U.S. export market.

For April, exports slipped to $148.8 billion, with demand for U.S. farm products falling by $647 million and weakness spread across a number of manufactured goods from electric generators to industrial machinery and aircraft engines.

This latest news serves to highlight the dangers described in my last post, that the safe haven status is a danger to the US economy. The US is in very deep trouble, and the safe haven and reserve currency status are encouraging them deeper into a quagmire. As long as the world keeps buying US treasuries, they seem willing to keep deepening the fiscal hole, all the while importing and consuming based upon debt growth. At some stage, the markets must realise that the beauty of the US has faded, and that in reality it is looking both tired and haggardly. The trouble is, the US is still deeply entrenched in the (neo-) Keynesian dream.

In the world of the (neo-) Keynesians, the answer is not to consolidate, but to continue government borrowing, to prevent a choking of 'recovery'. No doubt, in the future, as the inevitable consequences of the consolidation take place, they will blame the problem on the fiscal consolidation, rather than on the fiscal splurge and consumer debt splurge that preceded it. This despite the fact that this borrowing and spending was supporting an economic structure that could not be sustained...and that the choices of borrowing of the scale needed to support a continuation was becoming impossible. And that is the problem with their solutions, that they can never be proved wrong, as whatever is done, it always necessitates more to be done. If the fiscal stimulus runs out of steam, have another one, and another one, and another one. If it is not working, a larger one will do the trick. If the larger one does not do the trick, then there is an even larger one that might be do the trick. In nobody will lend, print money. If that does not work, just print more.

Their solutions have just been tried, and the result is what we see before us. Massive fiscal stimuli have been tried. Quantitative easing (printing money) to fund government debt has been tried. Despite this, the economic crisis just keeps coming back. The difference now is that we can see where these policies have left the world economy - on the edge of a cliff. They can not claim that the problem is a market failure, as any reasonable economic theory must account for the actuality of markets. That actuality is quite reasonable - the markets think that, if they continue to lend to the major debtor governments, they will not have their money repaid in real terms, or will not be paid due to default. The markets have recognised that there is no clear plan for how the ongoing debt accumulation, and repayment of debt, might be achieved/sustained.

Despite all of the money flooding into the US, the 'safe haven', the doubts about the sustainability of the (neo-) Keynesian approach are mounting. It is only a matter of time before the markets confront the US. With the commencement of fiscal retrenchment elsewhere, and the drive for deeper austerity measures, eventually the markets will turn more cynical eyes upon the US economy. By that time, the US will be even deeper in the quagmire of debt.

I might summarise the position as follows; just as the consumer debt spiralled and unwound, sovereign debt has replaced that debt and must eventually unwind. The nature and the speed of that unwinding is still uncertain. The politicians and policymakers have still yet to fully play their hands, and they will be confronted with resistance from their populations as they seek to win the beauty contest. Set against the governments will be the bond markets, the judges in the beauty (least ugly) competition. Furthermore, in the tangled world of mutual dependency of one economy upon other economies, it is still uncertain where the really weak players in the world economy might be. As the debt accumulation goes into reverse, the dependencies will start to become apparent, and may present some surprising outcomes. However, one thing is certain; whatever the eventual outcome, no country is going to come out of the progressive fiscal consolidation untouched.

Note: I have been planning to discuss the neo-Keynesian approach for a while, but have lacked the time to do the subject justice. I may devote a post to this subject in the future, in particular a response to the volumes of material posted in the comments section by a regular commentator who posts under the name of 'Lord Keynes'. In the meantime, I will leave the discussion as the brief comment above.