Tuesday, March 27, 2012


This is (as I start writing) intended to be a very short post. I was just browsing through the economics news and found this rather fabulous quote in reference to Spain's shrinking economy:

It is unclear how he can slash the budget deficit from 8.5pc of GDP last year to 5.3pc to meet the compromise target agreed with Brussels after a bruising confrontation.
“It is frankly impossible, given that it would aggravate the recession and this would crush state revenues,” said Jesús Fernández-Villaverde from the University of Pennsylvania.
This is 'fabulous' as it is a very clear illustration of a point I have made several times. It illustrates just how intellectually bankrupt a large swathe of academic economics actually is. I will just start by putting the quote in a usable format:

  • Cutting borrowing will make the recession worse
  • If the recession is worse, then state revenues will be lowered
  • Therefore, if borrowing is cut, state revenues go down
  • If state revenues go down, then payment of existing debt becomes impossible
 What this really means is something like this (this is simplified/basic principle only):

  • I am borrowing 200 units of new debt per year
  • I have to pay 100 units per year from tax revenue to service my existing debt
  • The 200 units create activity in the economy as the borrowed money is used for consumption of goods and services
  • The activity in the economy from the borrowing of 200 units sees 50 units of the borrowed money returned to me in tax revenue from the tax on the consumption of the 200 units
  • If I do not borrow at all, the tax revenue from activity in the economy will only be 50 units
  • If I cut borrowing to 100 units I will only see 25 units of tax returned to me from the 100 units borrowed
  • Cutting my borrowing to 100 units means that I have the 50 units + 25 units of tax revenue from the borrowing
  • If I only receive 75 units I can not pay for my existing debt, which requires 100 units
  • Therefore I will continue borrowing 200 units so that I can pay for my existing debt which gives me the 50 units of no borrowing tax revenue + 50 units of tax revenue from the borrowing and consumption of 200 borrowed units
  • If I do not borrow 200 units I cannot pay my existing debt.
  • If I borrow 200 units, I increase my existing debt.
  • If I cannot pay for my existing debt without borrowing, how will I pay for next years greater debt and greater annual servicing costs?
In short, the process is one in which I borrow 'x' amount for others to consume, and then tax that consumption of the borrowed money in order to return a fraction of the debt to me and pretend that this is revenue, not a fraction of the money borrowed earlier. If I do not do so, I can not support my debt. In short, I need to borrow money in order to make payments on previously borrowed money. In doing so, my debt pile gets bigger, necessitating more borrowing to pay previous borrowing. It is an upwards spiral of debt in order to keep paying existing debt. It is also a downwards spiral into greater and ever less sustainable debt. It is a good method of destroying an economy - unless a choice is made to just not pay the debt.

And this is a solution? Really? 

Note: This is a bit of rushed post, but I hope it all makes sense. If there are any errors in the logic, please feel free to point them out. Also, if (and I apologise in advance if I think it is no better) you can offer an even simpler and clearer explanation, I may use it as a post, with full credit to the author (as anonymous, or by name according to your preferences, so let me know). I really think this is one of the most fundamental examples of just plain odd thinking in economics. As such, getting it as clear and logical as possible would be great. I still feel that my explanation is not quite there, or might not quite hang together.

Update, 30 March 2012: A very good explanation from Carrew below, which integrates the fundamental problem of dishonest politicians.TheFatBigot (I really like this name) also weighs in with some good points about GDP and the underlying foundations of revenue, as does MR. Anonymous has picked up on the rather distorting economy as a medical patient metaphor, and proposes a more apt variant. In the case of Carrew and TheFatBigot, they offer some very good explanation. However, although very good, and somewhat simpler, but I am still looking for the 'killer explanation' that skewers this dangerous economic thinking (something which those less interested in economics might grasp with ease). Further efforts would be welcome.
Update, 2nd April 2012: There are some more good thoughts and explanations below.  An anonymous poster has had a good go at it as well. Perhaps between the various comments and my own explanation, someone can provide a good synthesis that takes the good points from all? As ever, I am impressed with the readership of the blog.

Lemming: Apologies, I found a comment from you which escaped the approval process for some reason. I am not sure how long it sat unpublished, but apologies if it was a long time.

Thursday, March 22, 2012

The UK Budget

As you would expect, this year's budget has been followed by a raft of analysis and opining. I thought I would leave my thoughts for a couple of days, to see what emerges as the detail is subject to analysis. I also wanted to see what was said at the Institute of Fiscal Studies (IFS), which tends to offer a more thorough analysis. Paul Johnson, the director of the IFS is underwhelmed with the budget:

Within the tight fiscal constraints, Mr Osborne introduced a range of tax changes, including the reduction in the 50p rate. Despite the range of changes it is hard to see this as the Budget of a truly tax-reforming Chancellor. The hotchpotch of reforms bears as many marks of political expediency as it does of strategic reform.
Interestingly, despite much discussion about the phasing out of allowances for pensioners, Johnson suggests that they will not impact many. Unfortunately he does not detail numbers. James Brown considers the 50% tax rate and the methods for analysis of the impact, but the real impact of a reduction in the rate remains unclear, and perhaps might be described as arcane. I suspect that, with enough effort, the positives and negatives of shifting this rate might be presented equally, dependent upon the side of the political fence that you are sat upon.

Stuart Adams looks at business taxation, tax avoidance and stamp duty. He is critical of the changes in stamp duty, suggesting that for example that it will end up creating avoidance, but also arguing that stamp duty is in any case a 'damaging' form of taxation. The tax avoidance measures, he argues (quite reasonably) will be subject to court interpretation. The change to corporation tax, he argues, will increase the competitiveness of the UK.

I would guess that regular readers will know what I think about this budget. Yet more tinkering around the edges. Although not agreeing with the Independent's general analysis, they did get this point right:

The Chancellor wants Britain to be "open for business", ready to rise with the globalised world economy. He is even taking an extra percentage point off corporation tax. All well and good. But for all the talk of striving and adapting, the reality is that the outlook for the British economy remains bleak and the Chancellor can only tinker around the edges. [emphasis added]
The best that can be said for the budget is that it does not make a bad situation much worse, but still sees profligate spending. Perhaps the most pertinent comment and discussion comes from Jeremy Warner in the Telegraph, who copies an OBR chart into his piece:

He titles the piece, 'Britain's post-war tragedy' and points to ongoing mismatch of government income and expenditure. The chart tells the story. It is a story of bribing the electorate with their own future earnings.

A good example of the idiocy of this budget was the idea of tax breaks for more 'creative industries'. The government thinks that these kind of silly measures make a difference, and will no doubt keep many a bureaucrat and tax accountant busy with analysis of the rules, will see companies distort their business models to fall within the rules, and so forth. Yes, yet a new piece of complexity in the tax system, in which the government thinks it knows the best type of investment and industry to earn the country income (see note at end of post). Of course, the 40 million cost of the new tax breaks mean that there will be higher taxation somewhere else, and I am sure that those who make up for the shortfall for this tax break will applaud the idea. At least, on the positive side, it is a very small amount of money, and spread over the corporate tax base will make little difference.

Overall, for all the excitement in the press about the budget, it is fundamentally 'business as usual' with no radical reform. Sure, there is some tinkering, but to no significant effect. There is still no real sign of addressing the structural problems within the UK economy, and little to address the poor competitive position of the UK economy. I noted a piece in the Telegraph today, which suggested the following:

Ireland tumbled back into recession at the end of last year, dousing political claims that the "Celtic Tiger" has benefited from its tough austerity programme.
I am perhaps unusual in suggesting that real austerity will carry with it a shrinking (apparent, as it was always smaller than it appeared) of an economy. I argue that reductions in government expenditure are the way ahead, but accept that the path will be painful. Government borrowing and spending flatters the size of an economy at a future cost, and only when government borrowing and spending stops do we see something of the real size of an economy. It means that shrinking the rate of growth of government borrowing will see economic contraction. However, this is necessary, as hard as it is to do. The premise upon which this budget is built is expansionary fiscal austerity. It is pure fantasy.

The only real answer is reform to the structure of the economy. Tinkering around the edges will lead to a spiral of contraction, as piecemeal cuts shrink the economy, leading to more piecemeal cuts. It is a strategy that will simply prolong the pain, and in the medium to long term make the pain even worse. However, as the situation stands, there is no real austerity, just tinkering into decline. I have no care for which political party does it, but real structural reform is the only solution. It is simply recognising that the government can no longer afford to pay for everything that it currently undertakes. The longer this tinkering goes on, the greater the debt that will be accumulated, and the worse the situation will become.

The point is this. The tinkering will see the problem get worse, but will not leave an economic platform that will leave the country with an economic foundation to build upon. It will leave the country with a legacy of piecemeal cuts that will lead to poor provision of government services which will be determined by immediate political expediency, with no vision and no strategy. Cuts will lead to shrinking of the economy, and the shrinking of the economy will lead to reactive cuts. The government will lose credibility, and there will be ever stronger arguments against cuts. As debate rages, as compromises are made, the economy will continue its relentless decline. 

In the end it is about hard choices. It is about asking what can really be afforded, about what are priorities. In the end, it is about less government, and the government going back to principles. For example, read my post on benefits reform seeks to retain the principles upon which the benefits system was founded, but removes cost and perverse incentives. It presents a challenging and radical reform, and provides a reform that keeps an essential service in place at an affordable cost. I am not proposing that this is the solution, as there may be better answers. However, as I have done, it is necessary to ask questions of how government services are provided, and to what areas. In a country that is poorer than it appears, it is the only solution.

Note 1: Something odd happened with blogger whilst writing the post, so I hope it reproduces ok.

Note 2: I have previously posted on reforming taxation, and I have quoted from the post below:

The same goes for businesses, with capital allowances (13 categories and endless sub-categories), and all kinds of other incentives for businesses to do what the government believes is the 'right thing', such as R&D credits (100% allowance) and so forth. What we have here is the government saying that it knows better than a company how that company should allocate resources. Why? Are the government more knowledgeable about how to run Unilever, than Unilever are? The government seems to believe that it 'needs' to provide incentives. Surely a company knows when it needs to make an investment.

A good example is R&D. The first point to make is that the total amount of tax paid in corporation tax is going to be the same, as any losses made due to taxes not being paid through R&D investments will just be extracted from elsewhere. This means that a company that is not spending so much on R&D subsidises a company that is spending on R&D. The result is that the post-tax profit at the company not investing in R&D are reduced in order to fund the R&D in another company. Why? Why is it that one company is subsidising the R&D of another company?

To make the point clearer, think of it this way, in a simplified form. The government wants 100 units of corporation tax per year and there are a total of 100 identical sized companies paying corporation tax. On average, therefore, each company must pay an average of one unit of corporation tax. Amongst all of these companies, 20 of the companies do a lot of R&D so that they then each get an allowance of half a unit of tax back, making a total of 10 units lost from the 100. What then happens is that every other company must now pay 1.1 units of tax instead. In other words, some companies are subsidising the R&D of other companies.

But R&D is a good thing, right? That is what everyone says......for example, the government says in the 2007 Budget Report:
'Supporting science and innovation which is central to success in the international economy, as global restructuring focuses developed economies toward knowledge-based and high value-added sectors'
Let's examine one of the companies in this example that is not spending heavily on R&D. Let's imagine that they would like to make a sales drive to expand into new markets in Europe. They want to spend considerable amounts of money on developing their brand throughout Europe. The trouble is that they need to keep profits at a certain level to keep shareholders happy. As they are now paying an addition 0.1 units of tax, they are more constrained in their ability to invest in their expansion into Europe. In particular, the reduced amount of profit makes raising the money for the expansion more difficult, as their returns are lower than the companies spending heavily on R&D. The companies spending on R&D get tax relief, but the spending on brand building does not qualify. Even though the expansion into Europe would make them a more successful company, the tax system does not see it that way.

In this example, spending money on R&D (whether a good or bad investment) is considered a better business investment than building an international brand. The fact that both routes might equally create growth, and bring wealth to the UK, does not figure in government thinking. The fact that branding can add significant value to a product (the aim of the government R&D tax allowance is to develop high added value) is irrelevant. Instead of expanding into Europe, the company is instead directed into spending on R&D, which may not be the best approach for the success of their business. The expansion into Europe may the better use of their resource to achieve long term growth and profit, but the government knows better.

In all of this, the single unifying theme is that the government knows better. As such, they know better than you or I as to whether we should drink a pint of beer, or a shot of whisky. They know better whether a business should invest in building a brand or invest in R&D. They have lots of policy advice that says so....