UK: Canary in the coalmine or light at the end of the tunnel?
Marshall Auerback here with some thoughts on the UK given the recent stellar performance of Sterling.
“The Conservative belief that there is some law of nature which prevents men from being employed, that it is ‘rash’ to employ men, and that it is financially ‘sound’ to maintain a tenth of the population in idleness for an indefinite period, is crazily improbable – the sort of thing which no man could believe who had not had his head fuddled with nonsense for years and years. The objections which are raised are mostly not the objections of experience or of practical men. They are based on highly abstract theories – venerable, academic inventions, half misunderstood by those who are applying them today, and based on assumptions which are contrary to the facts…Our main task, therefore, will be to confirm the reader’s instinct that what seems sensible is sensible, and what seems nonsense is nonsense.” – J.M. Keynes in a pamphlet to support Lloyd George in the 1929 election.
Is the UK once again the economic sick man of Europe? Or is it, as Alistair Darling, chancellor of the exchequer, argued in his Budget speech on Wednesday, just one of a number of hard-hit high-income countries, which can recover if given the right dose of fiscal medicine? We suspect the latter, assuming that the government avoids listening to the siren songs about “national insolvency” and continues to be “profligate” from a public sector perspective as Lord Keynes urged as early as the 1920s. There is ample historic precedence for this: During WWII, a radically different approach was initiated in the United States. Government spending exceeded tax collections in 1942, 1943, 1944, and 1945 by 14.5%, 31.1%, 23.6%, and 22.4% of GNP respectively. Unemployment was under 2% by 1943, and output increased from $209.4 (billions of 1958 dollars) to $337.1 by 1943. By comparison, what the UK is borrowing today is modest.
No question, the numbers announced in last month’s budget certainly look grim: the IMF is now forecasting a UK general government deficit at 9.8 per cent of GDP in 2009 and 10.9 per cent next year. In the UK Budget, the Treasury forecasts the general government deficit at 12 per cent of GDP, or over, in 2009-10 and 2010-11.
To hear the pundits, this level of borrowing leaves the UK on the threshold of another 1970s-style currency crisis of the kind that could mean the UK would have to go cap in hand to the International Monetary Fund. The fear is that the explosion of public debt and gilt issuance, exacerbated by the UK government’s increasing financial exposure to the banking system, will lead to a sovereign default crisis in which sterling would collapse. It is a good scare story, and it is also a hysterically inaccurate one. In a fiat currency world, a sovereign government that issues its own floating rate currency can never become insolvent in its own currency. This is not Iceland writ large. In fact, we would argue that the UK’ s high level of government borrowing is a necessary precondition to economic recovery, as it offsets private sector deleveraging and prevents the onset of Fisherian style debt deflation dynamics. If anything, the only flaw we saw in this budget was the decision to implement any tax increases of any kind, no matter how great the political appeal. Instead of piling on new taxes that threaten recovery, the Budget should merely have conceded, as President Obama’s did, that tough decisions on taxes and spending may be needed in the future. But the unpredictability of the economic outlook and the danger of prolonging the recession make it foolish to decide right now on the fiscal adjustments required.
There is no question that the UK has some unique features which make it more than just another casualty of the global credit crunch. Weekly wages fell at the fastest rate in 60 years in February as City bonuses were slashed and workers agreed to reduced hours in the wake of recession, the latest official figures show. Of the 219,390 “announced job losses” recorded across the EU in the first quarter of 2009, the highest number (63,314) was in the UK, followed by Poland (38,975), Germany (17,461) and France (11,779). There is a good reason for this: a large number of these losses are concentrated in finance. For many years, policy makers placed a big bet leveraging London up as the centre of finance, thereby rendering the country uniquely vulnerable to the current contraction of finance as a percentage of GDP. Furthermore, the sectors of the UK economy that have collapsed – housing and finance – are particularly revenue-intensive. As a result, notes Martin Wolf of the Financial Times:
The ratio of current receipts to GDP is expected to shrink from 38.6 per cent in 2007-08 to 35.1 per cent in 2009-10 – a fall of 3.5 percentage points. Moreover, as a general rule, the debt-fuelled spending of the private sector was highest that have seen the largest swings in the balance between private income and spending. The shift in this balance in the UK’s private sector between 2007 and 2010 is forecast (implicitly) by the IMF at 9.6 per cent of GDP (from minus 0.2 per cent to plus 9.4 per cent). The swing in Germany, in contrast, is just 0.6 percentage points.
That said, the overall consensus for the UK is that it will be amongst the worst performing economies in the world, worse than the euro zone, and we think the level of fiscal expenditures being planned by the government might make its performance one of the best IN A RELATIVE SENSE. In these times of economic stress, it is worth remembering the old expression: In the land of the blind, the one-eyed man is king, particularly in a country which can do fiscal policy, a state of affairs uniquely not present in the European Union. As strange as it sounds, public sector profligacy is preferable to prudence, because as the private sector’s spending and borrowing go into hibernation, government borrowing must expand significantly to compensate.
Some paint a morbid picture of the UK government having to absorb $4,500bn (€3,400bn, £3,100bn) of UK bank foreign currency liabilities – three times GDP – and ending up in a debt default and a situation akin to Iceland or Ireland. No one should take this argument too seriously. If these liabilities, which include non-UK banks, were to become part of public debt, so too would a matched £4,600bn of foreign currency assets. The total balance sheet would rise sharply but, on a net basis, nothing much changes. In this vital respect, the UK is unlike Iceland, Russia and many other countries with foreign currency asset and liability mismatches. Moreover, the UK’s much feared current account deficit is now a benign 2 per cent of GDP and falling precisely because of sterling’s weakness, which has acted as a shock absorber for the British economy, not a harbinger of impending currency flight.
The solvency canard, which seems to underlie most of the phobia surrounding the UK’s finance, is based on flawed reasoning. Credit or fiat money systems cannot be analyzed as if they were commodity money systems, and conventional economics still does not get that. In fact, assumption of a gold standard lurks behind many parts of contemporary mainstream economics, including the view that governments are somehow budget constrained, as illustrated by the commentary underlying the recent UK budget. Problems would only arise if a large portion of the UK’s debt was foreign currency denominated, as was the case for the Asian NIEs in the 1997/98 financial crisis.
As soon as Darling mentioned the headline figure that public finances would be an additional 175 billion pounds in the red next year, the shock reverberated around City dealing rooms, pushing the pound and government bonds lower. The figure in question represents an eighth of Britain’s national income, that the government will be forced to borrow this year, more than four times what the chancellor expected a year ago.
For all of the bloviating from the press on this issue, sterling actually closed the week up against the dollar post the budget and is now some 10% above its crisis lows, when the fashionable talk was all about “Reykjavik on the Thames”. In a country with a currency that is not convertible upon demand into anything other than itself (no gold “backing”, no fixed exchange rate), the government can never run out of money to spend, nor does it need to acquire money from the private sector in order to spend. This does not mean the government doesn’t face the risk of inflation, currency depreciation, or capital flight as a result of shifting private sector portfolio preferences, but the budget constraint on the government, the monopoly supplier of currency, may be different than we have been taught from classical economics, which is largely predicated on the notion of a now non-existent gold standard. The UK Treasury cuts you a benefits cheque, your cheque account gets credited, and then some reserves get moved around on the Bank of England’s balance sheet and on bank balance sheets to enable the central bank (in this case, the Bank of England) to hit its interest rate target. If anything, some inflation would probably be a good thing right now, given the prevailing high levels of private sector debt and the deflationary risk that PRIVATE debt represents because of the natural constraints against income and assets which operate in the absence of the ability to tax and create currency.
In addition to ideological opposition to high levels of government spending, many critics of the UK government’s approach display an ignorance of simple financial balances accounting. A high level of private sector debt delinquencies and defaults suggests private debt burdens got too high relative to private income flows. Liquidating or restructuring existing private debt then makes more sense than getting banks to loan more money to the private sector. Private debt liquidation, which is the Austrian solution, can take the whole system down if enough people try to do it at the same time, or if a large enough institution does it in a disorderly fashion. As Irving Fisher noted, attempts to pay down debt can lead to higher real debt burdens as forced asset and product sales drive prices into the ground. We had a taste of that with the Lehman bankruptcy. Debt liquidation might form some part of the solution when seeking to eliminate private sector indebtedness, but it cannot be the main course.
If not, then the private sector needs to be in a position to net save and pay down debt. That cannot happen unless some other sector is willing and able to deficit spend. Some of this can be achieved through increased exports, although if every country sought to depreciate their currency in the manner of sterling, the result would likely be a further collapse in trade, since “beggar thy neighbour” devaluations mark protectionism by another name: two potential candidates, the government sector or the foreign sector.
Given the contraction in foreign demand and rapidly diminishing trade flows, that leaves government to deficit spend if the private sector is going to net save. This is not high Keynesian theory – it is double entry book keeping, which we have been doing for 5 or 6 centuries now. Think T accounts, 2, sides to every transaction, rather than micro household behavior, and you will avoid the more obvious fallacies of composition. At the lowest level of manufacturing capacity utilization in post WWII history, and a rapidly rising employment rate of 7% in the UK (and rising), the crowding out perspective is not terribly relevant, is it?
There is therefore a built-in contradiction in a recent Financial Times editorial, (“Sudden debt?”, April 25, 2009), which readily distinguishes between the UK’s current economic plight and that of an emerging market:
There is, however, a vital difference with most emerging countries, which labour under what economists call “original sin”: they cannot issue debt in their own currency. That multiplies their vulnerability, since currency depreciations automatically add to their debt burden, reducing their ability to repay.
This, at least, is a problem the UK does not have – yet. The yield on 10-year gilts has spiked since the Budget speech but remains a moderate 31 basis points above the bund. The short and long ends of the yield curve have barely budged. And although the record deficits will cause the UK’s public debt to double – the government expects it to stabilise at 79 per cent of gross domestic product – that only brings it just above German levels. Japan, whose debt stands at about twice its GDP, shows that this is perfectly affordable so long as the bond markets are happy to refinance it
And yet the editorial still goes on implicitly to raise the issue of solvency by noting that “if gilt investors began to doubt its commitment or ability to close the deficit, the market’s willingness to refinance UK sovereign debt could come to a sudden halt. The government must pre-empt perilously self-fulfilling doubts before it is too late.” A commitment to close the deficit is precisely what doomed Japan throughout most of the 1990s, when premature attempts at “fiscal consolidation” actually increased budget deficits by foolishly deflating incipient economic activity. It is the reversal of trade deficits and the increase in fiscal deficits, which gets a country to an increase in net private saving. That in turn will stabilise growth and improve the deficit picture. Once this is achieved, any notions of national solvency should go out the window.
So who will buy the massive new quantities of gilts? Phrased in this manner, the question still reflects a lack of understanding of a monetary system in a fiat currency world. The real question, posed by Professor Charles Goodhart (a former member of the Bank England’s Monetary Policy Committee), is: why issue so many gilts? Like all other governments, Her Majesty’s Government in the United Kingdom spends by crediting bank accounts (bank deposits go up and bank reserves are credited by the Bank of England). All else being equal, this generates excess reserves that are offered in the overnight interbank lending market, putting downward pressure on overnight rates. The purpose of gilt sales, then, is to substitute interest bearing gilts for undesired reserves, which would suggest that government deficits per se do not exert upward pressure on interest rates. Quite the contrary: they put downward pressure that is relieved through gilt or bond sales. But if the objective is to keep long rates down, why issue so many long dated instruments? There is no reason that the central banks could not simply offer a whole spectrum of maturities with spectrum of rates and let markets choose what they want to hold.
Yes, there may well be practical political constraints. The problem of course is that if enough investors read significant government spending as an inflationary expansion of the monetary supply (even if deflation is getting printed in the monthly CPIs as is the case today in the UK), then a shift to inflation hedges, which can include equities since they are after all claims on real productive assets, can occur.
In addition, if the Bank of England continues to pursue a quantitative easing program designed to trash yields on cash and near cash instruments, and if it is successful, fewer private investors by definition will be interested in owning gilts (especially if they realize at some point the BOE will be abandoning quantitative easing, as would be expected once a recovery is underway).
Plugging existing holes in the balance sheets of financial institutions does not really accomplish anything that improving private sector money income flows through fiscal deficit spending does not accomplish better. Loans that are getting serviced do not go into default. Some of these loans were Ponzi loans from the get go, and would only fly if home price appreciation continued forever. Those loans need to be liquidated, and while there may be a place for the central bank to lower mortgage rates to try to stabilize home prices, the Bank of England has no business trying to set off another housing bubble. Better to bolster private income growth so existing loans can be serviced rather than have the public sector taking positions in banks.
Which again brings us back to the government’s fiscal spending: The more fiscal deficit spending is trained on building out infrastructure or encouraging new investment growth in leading industries (say by procuring solar panels for federal buildings to help that industry reach economies of scale and lower unit costs to be more competitive with oil based technologies, or say by getting government out of the way on stem cell research), the less we have to worry about a) a new growth model that replaces the UK/US consumer debt driven model, and b) nominal income or wealth being created with no real output or productive capital stock being created. In this way, government as employer of last resort programs is preferable to more transfer programs to keep households limping along. In fact, an employed labor buffer stock is a more effective price anchor than today’s unemployed buffer stock, because all studies show business prefer to hire people already working rather than the unemployed.
The notion of government as employer of last resort is a very interesting fiscal policy option that has been hinted at tentatively by the Labour government, but generally with great reluctance, because of the fear that it may result in a larger budget deficit. But the real key toward a substantial UK recovery (as is the case in the US) is not restrained fiscal activism, but substantially more government spending to offset the implosion of private sector demand. Once the government honestly addresses the solvency issue of a government spending and borrowing in its own currency, there is nothing that could in theory prevent the UK Government from offering a job to anyone who applies, at a fixed rate of pay, and let the deficit float. This would result in full employment, by definition. It would also eliminate the need for such legislation as unemployment compensation and a minimum wage.
Of course, this is a fairly revolutionary notion, albeit an accurate picture of what can be achieved in a fiat currency environment with gold standard constraint. Gordon Brown’s government has a credibility problem and a problem of political fatigue. They need to figure out how their emperor with no clothes story can be best revealed to the general public. If budget deficits do not require Treasury financing, then this needs to be made plain and palatable for the citizenry to embrace, painted as an opportunity rather than a risk. This new class of government employees, which could be called supplementary, would function as an automatic stabilizer, the way unemployment currently does. A strong economy with rising labor costs would result in supplementary employees leaving their government jobs, as the private sector lures them with higher wages. (The government must allow this to happen, and not increases wages to compete.) This reduction of government expenditures is a contractionary fiscal bias. If the economy slows, and workers are laid off from the private sector, they will immediately assume supplementary government employment. The resulting increase in government expenditures is an expansionary bias. As long as the government does not change the supplementary wage, it becomes the defining factor for the currency- the price around which free market prices in the private sector evolve.
So where do we go from here? In many respects, the UK is an interesting test case for the global economy and the success or failure of its future fiscal policies have huge implications, given that the country stands at the crossroads between the two competing approaches embodied by the US and European Union respectively. One thing we can say with some degree of certitude is that the UK should not fear a public sector led expansion, given that private sector-led expansions are almost always inherently unsustainable because (as the past 20 years has demonstrated), they generate growing debt burdens that must eventually be reversed. That reversal can be cushioned and, indeed, largely offset by public sector debt expansion (assuming that the debt is denominated in the “home” currency), which does not suffer from the same need to be reversed, given the government’s monopoly role as the creator of currency and ability to tax.
It is important to get rid of the fallacious reasoning that government expenditures are in any way comparable to typical household expenditures. The government is sovereign. This fact gives to government authority that households and firms do not have. In particular, government has the power to tax and to issue money. The power to tax means that government does not need to sell products, and the power to issue currency means that it can make purchases by emitting IOUs. In the words of James Galbraith:
No private firm can require that markets buy its products or its debt. Indeed taxation creates a demand for public spending, in order to make available the currency required to pay the taxes. No private firm can generate demand for its output in this way. Neither of these statements is controversial; both are matters of fact. Nor should they be construed to imply that government should raise taxes or spend without limit. However, they do imply that federal budgeting is different from private budgeting, and should be considered in its proper, public context.
While it is common to regard government tax revenue as income, this income is not comparable to that of firms or households. Government can choose to exact greater tax revenues by imposing new taxes or raising tax rates. No firm can do this; even firms with market power know that consumers will find substitutes if prices are raised too much. Moreover firms, households, and even state and local governments require income or borrowings in order to spend. The federal government’s spending is not constrained by revenues or borrowing. This is, again, a fact, completely non-controversial, but very poorly understood, as evidenced by the persistent cries of UK profligacy in the context of its recent budget. We need to proceed boldly, but can only do so by disposing of a number of traditional bogeymen that no longer apply in a post-gold standard world: public debt burdens, national solvency, and “crowding out”. Above all, it is crucial to understand that the global desire for private sector deleveraging depends on another sector to do the opposite if it is not to become economically disruptive. For one sector to run a surplus, another must run a deficit. This is a basic accounting identity that seems to have been lost by the vast majority of economists and pundits. In principle, there is no reason why one sector cannot run perpetual deficits, so long as at least one other sector wants to run surpluses. But certainly for the current environment there is nothing, nor should there be anything, which should stop the UK government from running large deficits so that the private sector can happily build up its savings again, as was the case in the US in the aftermath of World War II.