Fiscal Chickens Coming Home to Roost

This is my third attempt to post. Each time I finish a post, it seems events are overtaking me, which says a great deal about the volatility of the current situation. One of the elements that prevented the publication of the last attempt at a post is a report by the Bank for International Settlements (BIS), which I found through a Telegraph report. The report is of particular interest, as this comes from a mainstream institution, and makes very worrying reading. In fact, many of the points made in the paper are a mirror of the arguments that have been made on this blog, since the day that the blog was started. I will review a few of the key points.

The overall thrust of the paper is to look at the developed economies that are currently running large fiscal deficits, so that there is considerable focus on the PIIGS (Portugal, Italy, Ireland, Greece and Spain), as well as on the US, UK and Japan. One of the early points that is made is that the current deficits are not simply a temporary aberration, but are structural in nature:

Even more worrying is the fact that most of the projected deficits are structural rather than cyclical in nature. So, in the absence of immediate corrective action, we can expect these deficits to persist even during the cyclical recovery. (p3)

One of the longstanding arguments of this blog is that the UK, and other economies, must undertake reform of their economic structures, and I long ago suggested some reforms for the UK which would, over the medium term, see reductions in government expenditure, whilst maintaining health and welfare systems (NHS, Education, Benefits , taxation). These posts were specifically made due to the absolute necessity to reduce the structural deficits, and redirect activity in the UK economy into real wealth creation.

Another theme of this blog has been to continually ask where the growth in economies might actually come from. Whilst the mainstream economists make their projections of future GDP growth, what is notably absent from such projections is exactly where, or what sector, might conceivably produce such growth. On a couple of occasions, including in a comment in the Guardian comment is free section, I have challenged anyone to offer a sector that might produce these magical projections of growth. On each occasion I have done this, I have been met with silence. Apparently, growth will just happen, because it just must. It might be noted that I am not talking about the so-called 'growth' which results from massive government borrowing, which is really just a growth in debt. This is what the BIS report says:

We doubt that the current crisis will be typical in its impact on deficits and debt. The reason is that, in many countries, employment and growth are unlikely to return to their pre-crisis levels in the foreseeable future.8 As a result, unemployment and other benefits will need to be paid for several years, and high levels of public investment might also have to be maintained. (p4)

Aside from the weasel words at the end, in which the word 'investment' is used, the message is very clear. There is no reason for the magical growth to take place. In fact, the report goes on to give very clear reasons later for why growth is likely to be constrained in the future, due to the cost of servicing massive deficits:

The distortionary impact of taxes is normally further compounded by the crowding-out of productive private capital. In a closed economy, a higher level of public debt will eventually absorb a larger share of national wealth, pushing up real interest rates and causing an offsetting fall in the stock of private capital. This not only lowers the level of output but, since new capital is invariably more productive than old capital, a reduced rate of capital accumulation can also lead to a persistent slowdown in the rate of economic growth. In an open economy, international financial markets can moderate these effects so long as investors remain confident in a country’s ability to repay. But, even when private capital is not crowded out, larger borrowing from abroad means that domestic income is reduced by interest paid to foreigners, increasing the gap between GDP and GNP.

What they are really discussing here is the downward spiral. The cost of the borrowing now, even if fiscal reform were undertaken, is going to have a long term impact on the ability for economies to grow. If the debt binge continues, the problem of the downward spiral will be more acute.

Another point made in the paper again echoes the theme of this blog, but also reflects the views of many other commentators and analysts. The cost of pensions and health care are, due to demographic factors, and the rising cost of health care, about to explode. At this very moment in time, governments should not be running deficits, but running surpluses to fund these future costs. The BIS report puts this more delicately as follows:

The related unfunded liabilities are large and growing, and should be a central part of today’s long-term fiscal planning.

It is essential that governments not be lulled into complacency by the ease with which they have financed their deficits thus far. In the aftermath of the financial crisis, the path of future output is likely to be permanently below where we thought it would be just several years ago. As a result, government revenues will be lower and expenditures higher, making consolidation even more difficult. But, unless action is taken to place fiscal policy on a sustainable footing, these costs could easily rise sharply and suddenly. (p16)

Another problem seen by BIS is that, although the deficits are unsustainable, the bond markets are too short sighted to see this yet, as their time horizons are too short. However, they warn that 'the aftermath of the financial crisis is poised to bring a simmering fiscal problem in industrial economies to boiling point' (p1). Their point is much like the analogy of the steady appearance in cracks of in a dam of belief that I have often used. It is the belief of the markets that bonds invested in the developed world are 'safe', even though the fiscal policies of many economies are completely unsustainable. Eventually, the bond markets will realise their mistakes....the cracks in the dam of belief in the 'safety' will eventually lead to a deluge.

As for the possible reactions of government to their unsustainable fiscal position, they also contemplate the idea that governments will seek to inflate their way out of debt, with money printing one of the options in the indirect default armoury. They do not put it as bluntly as I do, but the message is clear:

Finally, looming long-term fiscal imbalances pose significant risk to the prospects for future monetary stability. We describe two channels through which unstable debt dynamics could lead to higher inflation: direct debt monetisation, and the temptation to reduce the real value of government debt through higher inflation. Given the current institutional setting of monetary policy, both risks are clearly limited, at least for now. (my emphasis - p17)

Overall, their report makes alarming reading, but I suspect that nothing in the report will surprise the regular readers of this blog. What might surprise readers is to see the same arguments that have long been made in this blog now appearing so clearly in a publication from mainstream economists. I strongly recommend reading the report in full. With the exceptions of a few places, it is a relatively easy read for those who have a reasonable grasp of economics (and most readers of this blog seem to have a very good grasp, so the report should pose no problems).

Whilst many of the concerns expressed in the report have long been the subject of this blog, it is interesting that such a highly respected organisation should write this report at this time. Evans Ambroise-Pritchard of the Telegraph noted, correctly, that the UK is seen by BIS as particularly vulnerable:

Britain emerges in the BIS paper as an arch-sinner. The country may have entered the crisis with a low public debt but this shock absorber has already been used up, exposing the underlying rot in the UK's public accounts.

Tucked away in the BIS report are charts and tables showing that Britain faces the highest structural deficit in the OECD club of rich states, with a mounting risk that public debt will explode out of control.

Interest payments on the UK's public debt will double from 5pc of GDP to 10pc within a decade under the bank's 'baseline scenario' before spiralling upwards to 27pc by 2040, the highest in the industrial world. Greece fares better, and Italy looks saintly by comparison.

The BIS said the UK's structural budget deficit will be 9pc of GDP next year, the highest in the advanced world. A primary surplus of 3.5pc of GDP will be required for the next twenty years just to stabilize the debt at the pre-crisis level.

In the context of this report, it is interesting to take a view on the current UK election. What first struck me on this journey through the UK news was a recent report of nervousness in markets about the £GB, leading to a fall in the currency:

"The sensitivity of sterling to election news is likely to increase over the next month – while it has appreciated recently, we think a further significant advance from these levels is unlikely until the uncertainty around the election is resolved," said Adarsh Sinha, an analyst at Barclays Capital.

One trader said: "It's been a phoney war for months and the markets are all over the place. We just need some details to work from, not just this wish-list stuff, or it's just going to get worse over the next few weeks."

Ratings agencies have already warned that the UK's prized top AAA credit rating is under threat unless a credible fiscal plan is put forward soon after the election.

This nervousness is inevitable, with both the Labour Party and the Conservative Party both offering little to reassure the markets. Even in the Guardian, we have this from Simon Jenkins:

We have had the hilarity of health service spending being protected by "a £1bn cut in sick leave among NHS staff" (Labour). We have had an extravagant pledge of "a right to a new school" (Tories). We have had free care for the elderly (Labour), tax cuts for marriage (Tories), new trains for all paid for by more potholes (Liberal Democrats), no rise in VAT (Tories), no more council taxes (Liberal Democrats) and any cancer drug you like paid for by holding down national insurance on the NHS (Tories).

This is from David Wighton of the Times:

On the other hand, they [the Conservative Party] don’t want to cast doubt on the Treasury’s forecast that growth will shoot up to 3.25 per cent next year. Most City economists reckon this is way too optimistic. And, privately, the Tories probably agree. But if they admit that growth will almost certainly be lower they are faced with a big problem.

They will have to come up with even more unidentified cuts in public spending, promise further tax increases, or admit that they will cut the deficit by less than Labour promises to do — none of which is a big vote winner.

And finally, we have this from the Telegraph, written by Jeremy Warner:

On fiscal consolidation, the Labour Government's plans are widely thought inadequate as well as unduly reliant on taxing wealth creators more heavily. Meanwhile, the Opposition has struggled to deliver a coherent message on either deficit reduction or tax.

One moment the Conservatives promise to make deficit elimination the priority, the next they pledge to reverse the Government's planned rise in National Insurance, but with no credible explanation of where they will find the money.

There is a commonality to all of these reports and analysis, and that is that the politicians are living in a world of fantasy, and that the bond markets have recognised this. Both Labour and the Conservatives are just not telling the truth - that there must be real austerity, and that the UK is on the edge of a precipice.

Alongside this news, the situation in Greece continues the roller-coaster ride, with news that there is capital flight from Greece, and surging bond yields. Meanwhile, the Euro continues to weaken as fears spread in the wake of the Greek crisis. What we are starting to see is the fiscal chickens coming home to roost in Greece, and the same process is now threatening the UK. Now that the election process has commenced, there is still no sign of addressing the fundamental problem that investors need firm commitment to action, not wish lists. I am perhaps repeating myself, but where Greece leads, the UK may well follow, at least if the election continues on the current trajectory. A good summary of the situation again comes from the Telegraph:

Labour now promises £15bn of public sector efficiencies – which begs the question of what it has been doing for the past 13 years? Now, Cameron's efficiency chief, Sir Peter Gershon, has topped that, claiming the Tories could deliver another £12bn. That implies up to 40,000 job cuts – though talking about them is hardly a way to voters' hearts.

And that's the problem. Are we really in for four weeks of campaigning on just about everything but the central issue? Public spending this year is expected to reach a stonking £704bn – a figure the CBI believes Britain could cut by £130bn over time. How you cut it is a key political battleground – always assuming career politicians have any idea how to go about it.

The reality is that, one way or another, the fiscal chickens laid by the UK government are coming home to roost. As the BIS report points out, there is a reluctance from politicians to address the problems, and that they only seem prepared to do so as a result of an external push. The big question that this raises is not whether there will be a push, but when the push will take place, and how bad the fallout might be.