Structural Change - The Necessary Pain

The economy of the UK is, it seems, about to undertake some significant structural change, and it is going to hurt. A lot. We still do not know the details of the forthcoming cuts, but analysts are already starting to pull out their calculators, and work out how they might impact upon jobs and businesses. The cuts were never just about reducing the number of civil servants, but about the knock on effects in the wider economy. This from the Telegraph, reporting the analysis of Begbies Traynor:

"We are concerned that the levels of business distress will increase again, potentially from the first half of 2011, once the full effects of the coalition government's fiscal tightening measures impact the economy and particularly amongst those private sector businesses most dependant on public sector contracts," said Ric Traynor, executive chairman of Begbies Traynor.

"It will not be until after the Government's Comprehensive Spending Review in October that we will know for certain the allocation of spending cuts, but there is a growing risk that, even if the UK avoids a double dip recession, it could develop a twin track economy, with public-sector dependent industries facing higher levels of financial distress than sectors which are less directly linked to government spending cuts."

Those sectors most heavily dependent on public sector spending include construction, IT, recruitment, advertising and business services.

The trouble is that this is an analysis which only goes so far. When these private sector organisations hit a brick wall, they will, in turn, hurt other private sector companies that provide goods and services for them. And then there is the withdrawal of the money from the economy as many of these workers, both directly and indirectly employed by the government, move from having employment income to unemployment income. In other words, the cuts in government expenditure will ripple out through the wider economy.

Is this a reason not to cut?

Some might argue that the knock on effects presents an argument not to cut. Better to keep on spending, as the consequences that ripple through the economy are too hard to contemplate. The problem with this view is that, somehow, somewhere, all of the activity of the people working for the government, and the businesses that service the government, must have an origin in productive output from the private sector.

This is not an easy concept to deal with, as the interaction of the public and private sector results in complex relationships. For example, a nurse working in the NHS represents a consumption of resources, but has a real output in terms of health outcomes for patients. This output is real, and might mean a worker being able to work and originate more added value within the economy. However, if we imagine that the nurse was not employed in the NHS, and instead worked in the private sector in another role, then that nurse would be creating an output that might be an origin of the added value that might pay for other nurses.

However, life is not that simple. We do not think of nurses just as adding value in the economy, but performing a role that is rooted in a sense of justice. i.e. many of us think that all people should have access to health care. As such, we do not restrict the activity of nursing to just help people who might go on to add value within the economy. In light of this, the NHS represents a net consumption of added value generated elsewhere in the economy. In order to pay for this, we must be generating sufficient added value elsewhere. Each nurse, for example, will consume goods and services from their pay, and those goods and services may originate from within the economy, or from an external economy.

When the nurse does her shopping, she may buy an avocado imported from another country, and that must be paid for from goods and services exported from the economy. Likewise, when the nurse drives to work in her car, that car may may be imported and somebody somewhere must be providing goods and services to allow for that import. If the nurse buys a domestic good, it may well be that the manufacturer of that good needs to import raw materials, and those must also be paid for from the export of goods and services. There are very few economies that even start to have the potential for autarky and, in the UK, autarky is an impossibility (if the UK is to maintain a reasonable standard of living/quality of life for the people).

Within this nurse example there is a balance at which there will be the 'right number' of nurses to ensure that there is the maximum value creation in the economy to pay for the health services. If there are too many nurses, there will not be enough creators of value to pay for the nurses...of course, it is the aggregate of all people employed in government consumption of value added in the economy that matters, and that is the question of priorities (e.g. the choice between one nurse versus one policeman).

The point that I am making here is that, overall, government is a net consumer, and is entirely reliant upon the added value that is generated within the private sector to fund this consumption. The amount that a government might sustainably consume is entirely dependent upon the amount of added value that is created in the private sector, and this is an unavoidable reality. The problem that arises in government consumption is that, in order to consume, there is an opportunity cost. If worker 'x' is employed in government activity, they are not employed in potential added value creation in the private sector. Likewise, if a company is utilised in supporting government consumption, the workers in that company are involved in that net consumption, rather than the creation of added value which might pay for that government consumption.

Somebody, somewhere, somehow, must be producing goods and services for export (and internal use) in order to support an economy, unless that economy is autarkic. That means that they must have an output which not only provides for domestic needs, but also a surplus to sell at a profit to other countries. Furthermore, the more added value that these enterprises create per unit of labour, the more goods and services that will be available for consumption within the economy, and the more available for export.

It is here that we meet the relationship between government net consumption and the wider economy. Government consumption must not reach a point at which they are consuming so much that there is insufficient surplus to pay for the imports of the country, as the country is not autarkic. If a country is autarkic, the amount consumed by the government is a splitting of resource between private and government consumption, and that is a political question. In the case of a country that needs/wants to import, it is a question of economic necessity that the country produces sufficient surplus of added value which is available to pay for the imports. The greater the consumption of the government, the less surplus is available for export.

We can see this in taxation. If a government is over-consuming relative to the private sector output, there will be higher taxation (or government borrowing). Taxation is the removal of added value in the economy into the hands of the government for government consumption of that added value, meaning that the added value is not available for export. The situation is somewhat confused by the fact that, for example, government employees are taxed, but the origins of the added value is in the private sector. In the case of government borrowing, this just means a deferral of the removal of that added value for consumption now.

What we have is a basic reality that the extent of government consumption is, in the long term, going to be constrained by the opportunity cost of employing 'x' number of people in servicing that government consumption. The principle is simple. If a person is employed as a result of net consumption of the government, they are not employed in creating the added value for the government to consume. In practical terms, this is the constraint upon government; that constraint is, in the end, determined by the absolute numbers of the workforce creating added value in the private sector, and the productivity of those workers.

If an economy is exceptionally productive, it is possible for the private sector to give an absolute greater amount of their added value to the government, and still be able to succeed in competition with others, but the total added value taken from the private sector must be determined by the relative productivity of the total number of workers within the private sector (excluding those supporting government consumption). The question for each economy is how productive the private sector is - or how much added value each worker produces. Fantastically productive workers, in relation to other countries, will allow for a larger public sector than those other workers (whether a large public sector is ever a 'good thing' is debatable, and not the subject of this post).

We can now return to those private sector workers who are (potentially) going to lose their jobs as a result of cuts in government expenditure. As they lose their jobs, some will still be in receipt of government money, in the form of unemployment benefits, but their net consumption from the economy overall will be reduced. They will be consuming less, and will therefore overall contribute to a lessening of the proportion of government consumption within the economy. They are being paid less, and all of the other expenses that surround each employee's activity disappear.

Furthermore, the skills and experience of that employee will become available to the private sector where they might contribute added value that might support government spending overall. Indeed, some employees made redundant will make this transition without any recourse to further government expenditure of overall resource. They will switch into new jobs straight away.

Buried within this scenario, of course, are the personal consequences for those that do lose their jobs. For some, this will be a major problem, and will be distressing. They will be angry at the government that has made the cuts. However, I would argue that this is a misplaced anger. The anger should be directed at a government that created an unsustainable job in the first place or, put another way, a government that sought to consume more overall than the economy could sustain. In over-consuming the resource of the country, they structured the economy in a way which was unbalanced, encouraging workers into sectors and activities that could not be sustained.

For the individuals who took work that was rooted in over consumption by the government, they had no way of knowing that their position could not be sustained over the long term. It really is not their fault that they lose their jobs, but the fault of a government that created an unsupportable structure. This is cold comfort for those workers. Likewise, the businesses that will go bust structured themselves to support the over-consumption, and it is not the fault of the proprietors that they have gone bust. They were incentivised by the government to direct their resources to unsustainable government consumption. Again, this is cold comfort when the axe falls upon their head.

The problem of austerity is that, whatever happens, the shift from government consumption of resource means that those employed in activities to support that consumption are going to be hurt, whether now or later. Someone must be hurt by a transition back to a sustainable path. That this is not their own 'fault' does not alter the absolute necessity of change. The best that can be done is to try to ameliorate the effects. We can all agree on the fact that this is unfair for the businesses and individuals involved, but to place blame on the 'cutters' is to place the blame on the wrong people. It was those that distorted the economy onto an unsustainable path that shoulder the responsibility.

I will end this post with a quote from an interview with the Chief Executive of HSBC, who seems to grasp the point:

"The reality is that is may be good to have full employment, but if that employment is driven by public employment it's telling you something very clearly... something is not functioning in your society."

In this quote, he is grasping the essential reality. Something is wrong when government consumption exceeds the ability for the economy to pay for the consumption.

Note: Over consumption in the private sphere offers similar problems, but the purpose of this post is to discuss government austerity measures.

Capitalism and Consumption

I am aware that, in the current climate, a defence of capitalism and consumption will not go down well with everyone. An interesting question on the subject was added to my last post by Lemming, a regular commentator. I will quote his question, as others are asking similar questions, such as whether there is enough resource for endless growth:

Can you design a system of capitalism which doesn't rely on economic growth to function? (Or is this simply a contradiction in terms?)

There is a fundamental problem in capitalism with respect to endless growth. Regular readers will know that I am somewhat cynical about the modern environmental movement, but I accept that there is a real problem in the medium to long term with resources. In the short term there is also a problem, but rather this is a matter of output rather than absolute limits on resource. In light of this, Lemming is asking a very pertinent question with wider implications. However, for the purposes of this post, I will ignore the longer term issue of resource, as this is a question that is too complex to cover in this post.

Another problem associated with economic growth is the relentless growth of advertising and media representation of society, in particular the lifestyle advertising that seems to encourage so much consumption. It is a matter of controversy how much advertising is a reflection of society, and how much it might 'make' society, and again I will not address this question here due to the complexity of the subject.

On the other hand Lemming's question does raise a more fundamental question. If endless economic growth is a problem it would imply that, at some point, economic growth should be frozen. This is a difficult idea, as it raises the question as to when exactly, or at what stage of development, growth should be stopped.

If we can think back to the world twenty years ago, would that have been an appropriate time to have frozen growth, or should we say that we should freeze further growth now? It is only when we ask such questions that the nature of the problem becomes clear. If we were to imagine that the world had frozen in terms of economic growth twenty years ago, then we must accept what the world would be like today without such growth (we will ignore the current economic mess for the sake of illustration - as the crisis is not a result of economic growth but the way in which the growth has taken place).

A simple example to illustrate the question is to ask whether we think that we should have foregone the development of fMRI equipment - which have allowed considerable improvements in our understanding of the brain, as well as being used to treat a range of medical problems. As soon as the innovation was introduced, it would have been a spur to economic growth, as it created a whole new industry and no doubt many offshoots. It might be argued that this is a very narrow and selective example but, if it were not for the massive advances in computing (for example), then the fMRI process would never have been possible.

The point in this example is that it is very difficult to separate out 'good' economic growth from 'bad' economic growth. For example, the boom in consumer purchases of computers has no doubt created significant economies of scale in the computer industry, as well as being an ongoing spur for continued innovation. The economies of scale and innovations that resulted from this ongoing consumption will have fed into many areas, even possibly fMRI scanning (e.g. cheap displays or processing power) and it is difficult to propose that such improvements do not have 'worthy' outcomes. As such, the boom in consumption of computers will have indirectly contributed to the development of fMRI, as well as many other innovations.

On the other hand there is a general backlash against the relentless consumption of goods by ordinary people, a sense that this neither makes us happy or really better off. Like many people, I am somewhat cynical about this almost mindless consumption, and do have doubts about what it might (of itself) really achieve. There seem to be ever more articles in which this consumption culture is being challenged, and the articles are sometimes linked to wider problems of the capitalist system (or quasi-capitalist systems might be a more accurate description).

As another example of consumption, once again we can return back in time to twenty years ago. At that point in time, for example, the Internet was relatively new, and only later emerged into ordinary life - alongside a burst in consumption. As a blogger, I inevitably see great value in the Internet - I see it as a great tool of freedom of speech, and would not like to see a world without it. The trouble is that, in order to see this development I have to consume huge amounts of resources individually, and many other people and organisations must consume resources to create the necessary infrastructure. All of this represents economic development and growth.

Once again, in my own consumption, I can point to what appears to be a 'worthy' reason for why this consumption can be justified. What if there is no such 'worthy' justification? We might take for example the endless cycles of consumption that are associated with home redecoration, or the purchase of (the much used example of) a plasma television. Surely there is no 'worthy' way to justify such consumption?

It is very easy to sympathise with a view that relentless economic growth driven by consumption is somehow unacceptable. However, there appears to be a curious 'moralism' that frames the arguments about consumption.

Astute readers may, at this point, see that in some respects I may be setting up a straw man. I am starting to try to link consumption with a notion of worthiness. However, in linking the examples of consumption here to worthiness, I am hopefully illustrating a point. The point is that it is actually very difficult to regulate/control what is acceptable consumption. For example, a person may travel to far away places and offer the justification that they are learning about other cultures and people. That such an activity consumes massive resources might be considered acceptable by the person who undertakes such travel. On the other hand, another person might claim that this is an unacceptable use of resource.

We can see this kind of measure of 'worthiness' of consumption in the example of 4x4 cars, which have become a symbol of relentless consumption and environmental harm. Amongst some people, such consumption leads to the attribution of social pariah status for the consumers. The problem is that, with the exception of a small minority, most of those who heap such a status on others will themselves be involved in some kind of 'unnecessary' consumption. Even amongst the minority who do significantly restrict their consumption, they will often be using the resources and enjoying many of the benefits that are resultant from the system of consumption that the 4x4 represents.

The idea that consumption is somehow immoral is nothing new. We can see it in history in the sumptuary laws, as in the case of Renaissance Italy. It is a long while since I studied this history, but I recall laws such as restrictions on the use of feathers in hats. In this case the laws were dictated by the church, but who might dictate the laws to restrict consumption today? Who is going to determine which form of consumption is worthy, and which is not? How do we measure a holiday to learn about Chinese culture against the purchase of a 4x4, or redecoration of a house against a connection to the Internet? There seem to be many people who seem to think that they know the answer, but I find it difficult to see how they might make the distinction.

There is another area of consumption 'culture' which is clearly a problem. This is the encouragement of indebtedness of consumers. I do not believe that there should be restrictions on borrowing for consumption, as that is a matter for individual people to determine. For example, some people might claim that borrowing to buy a house is 'good' borrowing, whilst borrowing to buy a plasma T.V. is not. Once again, I find it difficult to determine a way in which we can determine what is 'good' and 'bad'. Is a £200,000 mortgage debt a better thing than a debt of £1500 for a plasma TV? How might we determine what is 'good' and 'bad'?

However, there is a problem in the modern system of credit. One of the first points is that there is a system in which it is very complicated to work out how much debt we are really taking on. For example, cost of credit is often presented in terms of monthly repayments, rather than absolute cost. 'Interest free' credit is promoted to such an extent that it becomes irrational not to accept the credit. However, it is not interest free, as the interest is loaded on the goods upfront, thereby disadvantaging the cash buyers. This then encourages the use of credit.

These problems can be addressed through legislation. For example, information can be better presented, with an emphasis on the actual real cost of the credit. Consumer credit law might be devised such that retailers can not charge less for credit than they themselves are paying for the cost of the money that they are lending (though this might be complicated to administer). Teaser rates, variable interest rates, and a whole host of other methods for potentially leading consumers into debts that they can not repay are also amongst the subjects that should be addressed. For example, how can a consumer know what their debt obligations might be on a variable rate of interest, when even an economist is unable to make that prediction? All of these solutions would likely see a shrinkage in consumer credit, but would not restrict the freedom of an individual to access credit. The central point is that the system should be transparent and allow people to make well informed decisions.

This does not mean that individuals will not get themselves into financial problems. As with many of my posts, the emphasis is on provision of good and clear information such that individuals are making informed decisions. The government just sets out a framework in which costs are clear and transparent. For example, as there is no such thing as 'interest free credit', it is a fraud and should be exposed as such. It is not the role of government to protect fools, but to help individuals understand what the risks are in their behaviour.

I therefore accept a role of government, but only in making the role and nature of credit transparent.

In one respect, I do not accept the role of government, and perhaps this goes to address part of the problem that Lemming raises in his question. This is the problem of government manipulation of the money supply and interest rates in order to actively encourage consumers into consumption. At its most extreme, governments have recently been guaranteeing the lending of financial institutions in order to encourage yet more consumer debt accumulation. The real problem here is that 'economic growth' has been tied too closely to debt driven consumption.

Even as I am writing, it is possible to find in many government policy statements, and policy proposals, an ambition to 'get credit flowing'. What they mean when they suggest this is that consumers should resume borrowing to buy housing, borrowing to buy cars, borrowing to buy consumer goods. They see this as a 'good thing'. At the same time, they have lowered interest rates, thereby creating disincentives for individuals to take the more responsible route of saving money to fund their purchases.

This is the point that I suspect that underlies the question that Lemming has raised. I am guessing that he is looking around at friends and family who have 'binged' on credit, paid too much for their homes, and sunk themselves in a quagmire of debt. We can all see the painful results around us, and this has been encouraged by endless inflationary policy, and manipulation of the money supply in order to keep the economy 'booming'. All the time that governments have encouraged the boom, politicians like Gordon Brown were infamously promising that the 'good times' could last.

This is the growth of economies built on the foundations of endless expansion in credit. The role of the government in this process is that, as soon as credit growth shrinks, they seek to inflate the money supply in order to encourage yet more lending to consumers by the financial institutions. I would not claim that this is only the result of individual governments, as this problem has arisen through the actions of many governments. For example, I have detailed how the Japanese government expanded money, and how this money flooded into the West through the 'Carry Trade'. This money in turn inflated house prices, and provided 'cheap' money for lending to consumers.

Whilst the government is not holding a gun to the heads of consumers to make them borrow, they have sought to structure their economies to encourage such borrowing. This has come at the cost of a culture of relentless consumption, unsustainable growth, and the abandonment of thrift and saving. The result is that there has been economic growth based upon a boom in credit derived consumption, and this was both wasteful and unsustainable. As a clear example of the waste, we can now see swathes of new housing developments being abandoned in the US, and the system was unsustainable because there would always be a limit to such credit expansion.

Whilst it would be foolish to heap all of the blame for the model of economic growth based upon credit expansion, there can be little doubt that governments have contributed significantly to the problem.

The answer to Lemming's question, and perhaps the questions of others, is that there is no basic problem in economic growth, and no real problem in a system built around consumption. The benefit of capitalism is the provision of goods and services to meet the needs and wants of individuals, and it has consistently delivered on that promise, and provided the many innovations that arise from such a system that benefit us in a myriad of ways. Whilst some point to over-consumption as a bad thing, it is hard to separate out what is good, and what is bad consumption, what is good growth, and what is bad growth. On the other hand the encouragement of consumption built upon the encouragement of debt is certainly not good for individuals, or for the wider economy. This illusion of economic growth should not be confused with economic growth built upon using savings or income for purchase of goods and services.

In other words, the underlying system works. There are broader questions about how we might sustain such economic growth in the face of finite resources, and how the marketing of goods and services might ignite a desire to consume more than we would otherwise do. However, the problem arises as to how we might restrict consumption without making moralistic judgements, and how such consumption might be restricted in a way that is fair or just. If I wish to use money for all of the consumption necessary to use the Internet, then I would feel aggrieved if someone told me that this was unacceptable. Twenty years ago, the majority of us would not have even owned a computer, but we now all accept them as items we want, and which are useful to us.

This is the reality of economic growth. We are all tied into it and, as much as we may protest otherwise, we all reap the benefits.

Note 1: I would like to apologise for not posting for a while, and am very grateful for the comments and lively debate after my last post. In particular MattinShanghai has presented an interesting post which seemed to stimulate lots of debate, and many interesting follow on comments. I am hoping to post again on the weekend, as there are several interesting points in the news, such as the G20, the struggle to sell bonds, and the issue of inflation figures. It will be tough to choose which, so I may try to do a broad brush post.

Note 2: I know that the environmental question is a major factor in the discussion above, and no doubt some people will comment to that effect. However, I have yet to see anything on the table that can realistically solve the problem of resources. With regards to man made global warming and the Kyoto protocol, I would point people to Bjorn Lomberg, as he offers an interesting perspective. However, I do not want to get into the rather muddy waters of this debate, as it will distract too far from the main point of the blog - the current economic crisis and the immediate impacts. The purpose in this post was really to put a simple (perhaps simplistic) case forward for continued economic growth. It is a huge subject in reality, and the post was always going to be limited in scope.

Note 3: Lord Sidcup - yes, the $US is still hanging on in there. It defies logic, but somehow it just withstands whatever is thrown at it, including QE. With regards to the Schiff book, I am afraid I have not read it. I was disappointed you did not like the Ascent of Money - I liked his discussion of bubbles, and I broadly agree with his Chimerica thesis, though disagree with his views on the resolution of this situation. I don't recall the economic hitman point in the book, so can not comment on that point. Like many books it has strengths and weaknesses, but for me the strengths outshone the weaknesses.

Note 4: Lemming - some good questions, and sorry I can not answer all the points.

Note 5: I have noted that there are some commentators on the blog who appear to be white supremacists. I will always publish the comments, as I follow John Stuart Mill's 'On Liberty'. However, I might mention that I do not accept/ agree with any such views, as they simply do not relate to any reality I have ever seen. I note that other commentators are addressing the points that are being made, which is good.

Note 6: Some excellent links are being placed in the comments section. As ever, these are appreciated. Some interesting posts alongside these, and it is interesting to note that there is more contemplation of war appearing. One of my ongoing worries with the current situation is that it will be easy for the situation to lead to various forms of conflict, though I do not believe that China is in any kind of position to risk a 'hot' war. I have noted ever more news of Chinese assertiveness, and note that China has just done a deal with Argentina to use the RMB for settlement of trade. The march towards the RMB as a reserve currency marches on....whilst talk of IMF SDRs as a new reserve currency seems to be keeping everyone distracted.