The state of the world - an economic perspective

I know Scotland is a land of preaching, and I want to take as the text of my sermon today Mervyn King’s statement to the House of Commons Select Committee on Economic Affairs, reported 6 days ago:
 
Asked whether the country would ever recover from a squeeze on living standards on a scale not seen since the 1920s, he said: ‘You may not get it back for many years, if ever, and that is a big long-run loss of living standards of all people in this country’.
 
I want to spend a little time probe the logic of this dismal assessment. What King must be assuming is unchanged economic policy, ie. the policy of the Coalition government. Otherwise it doesn’t make much sense.
 
I could get you all back quite quickly to the living standards you enjoyed three years ago, if you put me in charge of the Bank of England’s printing press. I would send every household a cheque for £100 a month, every month for one year, to be spent in that month, or it would be cancelled. Let me tell you something: we’d get back to full employment, and full employment output in double quick time, and help other countries on the way too. The plan was first proposed by Silvio Gesell in the 19th century and Milton Friedman labelled it ‘helicopter money’.
 
I don’t know why people are so against it. It’s probably the deep rooted feeling against giving someone something for nothing, a feeling which unfortunately doesn’t extend to the vast rewards of top bankers.
 
But to get back to the theory of the matter. Disraeli is supposed to have told a rebellious Tory MP ‘Damn you principles; stick to your party’, I want to vary this and say ‘Damn the noise and stick to your theory’. To avoid being tossed about by every twist and turn of the news, you need a theory. Keynes famously said that ‘practical men, who believe themselves completely exempt from any intellectual influences, are usually the slaves of some defunct economist’.
 
There are two defunct economists who compete for our allegiance today. One of them is David Ricardo, the other is John Maynard Keynes himself. Every single thing about policy you read on the op-ed pages of the FT has reference to one or other of these gentlemen, though you will rarely hear their names invoked.
 
The government’s theory of economic policy is directly inspired by David Ricardo: let me calle it Ricardian-Osbornism. It goes like this. The private sector creates wealth, the government squanders it. Therefore the smaller the government – the less it taxes and spends - the more thriving the economy will be.
 
Now here’s the killer punch: ‘Government borrowing is simply deferred taxation’.
 
I mentioned that this theory of policy is derived from Ricardo and the statement I have just made –that government borrowing is simply deferred taxation - is called ‘Ricardian equivalence’. The deficit, it is claimed, is actually a tax: only it’s a deferred tax, which we have to pay in due course, sooner rather than later. What has happened then is that the last Government left us all with 10% of deferred taxes. And that is a terrific obstacle to recovery. Because it means that forward looking private individuals and firms have to save an extra 10% of their incomes to pay these taxes as they fall due. That means they will spend 10% less than they would otherwise have done. The only way therefore to restore private sector spending is to cut the deficit as quickly as possible which would remove the need to raise taxes. Hence the government has embarked on a four year program of spending cuts which will reduce the deficit from 10% of GDP to zero . The private sector will then spend 10% more, thus creating more productive private sector jobs to replace the less productive public sector jobs being shed. Cutting the deficit is the royal road to recovery.
 
I have given the basic outlines: there are many refinements involving market reactions, rates of interest, and so on. But notice that even Mervyn King, who supports the policy of fiscal austerity, does not believe that it will bring us a very quick recovery. He is hedging his bets. He is right to do so.
 
For there is an opposite theory of economic policy which I have labelled Keynesian. Keynes of course is also a defunct economist, though he lived more than a hundred years after David Ricardo, and more significantly through the years of the Great Depression of the 1930s.
 
The Keynesian theory goes something like this. When the economy is growing according to trend the Ricardian theory makes good sense. But it is wrong, dead wrong, when the economy has suffered a serious injury. It’s like telling a sick person not to call a doctor on the ground that a healthy person would be better off without taking a lot of pills. In other words, the Ricardian theory would be an excellent cure for unemployment, if there was no unemployment to cure.
 
What do we suppose happened between 2007 and 2009? We know that a great part of the world’s banking system suffered a massive heart attack. The pumping of money into businesses and households, which is what banks do, stopped, and that meant that all incomes fell, and people had less to spend. In the language of Keynes the seizure of the banking system led to a dramatic fall in aggregate demand, or total spending. If everyone starts buying less, the economy starts producing less. In fact the whole economy goes into a downward spiral. This is what happened in 1929.
 
Now here’s a thought experiment: if we could imagine this kind of banking shock hitting a society without a government, then the patient would in fact die: or what comes to the same thing, industrial society would come to an end, the population would shrink, through starvation or disease, to that level which could support itself by growing its own food. We had an approach to this for a few years in Russia following the collapse of communism in the early 1990s, when the state, in effect, ceased to function. But in the west we never had anything approaching this even in the Great Depression. And the reason was that we had governments which had to spend money to fulfil their functions, and it was this spending of government money which kept frozen economies going, though at a much lower level. What happens is that as the private sector reduces its spending the government deficit automatically rises: partly because its revenues fall off with the decline in taxable incomes, and partly because it social expenditure rises to pay increased unemployment benefits. Keynes called these effects ‘nature’s circuit breakers’; we would say automatic stabilisers.
 
But Keynes would have said they were not enough. They bring the slump to an end and that in itself starts to bring about a natural recovery. As soon as enough things stop falling, people start to expect them to rise. But the last thing we should do, according to Keynes, is to start cutting government spending before the recovery is firmly established.
 
Let me put on the screen a slide representing the course of a number of recessions since the Great Depression. As you can see the Great Depression was by far the longest and deepest. The downwards slide went on for three years. After that there was a recovery. Compare our own 2008-9 experience. You will see that the black line followed the red line downwards for 5 quarters: then it levelled off. Practically all who have studied the matter –except our very own Chancellor –are convinced that huge coordinated stimulus measures taken between the autumn of 2008 and the spring of 2009 had, by the end of 2009, cut off another Great Depression. In short, governments were acting on the Keynesuian theory, though they rarely used his name.
 
However, no sooner had the global economy stabilised than the engines went into reverse. In June 2010, the G20 governments agreed to embark on what they called ‘fiscal consolidation’, or in simple language, to slash their budget deficits even before their economies had recovered to anything like their pre-recession condition. Not all governments followed this: not the Chinese, and the Americans only partially. But in Europe we all became fiscal hawks, with our very own Chancellor the most hawkish of all.
 
Why? Analysts, economic historians, will debate this question for years. After all, there is nothing in economic theory which says that you should aim to eliminate a deficit in four years rather than five or ten. I would have said ‘We will commit to cutting the deficit as and when circumstances allow’. Undoubtedly European governments were spooked by the sovereign debt crises which erupted on the peripheries of the Eurozone in the spring of 2010, led by Greece , but spreading by contagion to Ireland and Portugal. Suddenly these governments were having to pay 7% or 8% on their borrowing. The bail outs, organised by the ECB and the IMF, had stringent budgetary conditions attached.
 
In June 2010, George Osborne announced in Parliament, that if Britain did not produce a drastic fiscal consolidation package of its own, it would have found itself in the same boat as Greece. Well, anything’s possible, but it was extremely improbable. Not only was the British government able to borrow (even before the fiscal tightening was announced) at historically low real interest rates, but, unlike Greece, Britain had never defaulted on its sovereign debt.
 
However, in my view, even greater than the fear of markets, was the tug of simplified economic theory. This came in two versions. The first, endlessly repeated by Cameron and Osborne, as that by going on borrowing we were piling up the burden of debt for future generations. This is simply wrong, and I will not pass any of you in an exam in economics unless you can tell me why.Let me give you a clue, and and ask you to consider why a household is not the same as a government.
 
But equally important, I believe, was the instinctive feeling that, as a society we had been living beyond our means, and the slump was in some senses the wages of sin. The boom has been the illusion – a debt fuelled illusion –the slump was the reality, the occasion to purge our system of its rottenness. And the chief illusionist was the government, spending billions which it did not have. And beyond even this was the feeling that, well, government spending is after all wasteful isn’t it, and the slump is as a good a moment as one will ever get to cut out the fat.
 
Once the immediate danger of a continued slide down to a Great Depression was over, all these submerged feelings came bubbling to the surface, and some of them are reflected in Mervyn King’s prediction of a hard and choppy road to recovery.
 
On one point I do believe the Governor is right.There was something of an illusion about the previous boom, which is incarnated in the hugely excessive rewards being earned by the City of London, rewards which, as Adair Turner has point out, were wholly out of proportion to the social usefulness of the City, but which swelled the coffers of the government and gave it the illusion that the public finances were well under control.In the period leading up to 2007 British incomes became much too dependent on the earnings of the City, and therefore a financial crisis was bound to make our recession particularly nasty.
 
So if we are to avoid this kind of disaster in future we have to find a way of rebalancing the British economy away from such reliance on the City. I will explain how I think it should be done in the last part of my talk.
 
But meanwhile, what about the prospects for recovery? If what I have called the Ricardian theory is true, then the cuts already implemented and, more importantly, the confident expectation of further cuts over the next four years, should already be having a stimulative effect on the economy. We should be starting to enjoy the benefits of what economists of a Ricardian persuasion have called ‘expansionary fiscal contraction’. People should be starting to spend the money they know they will no longer need to set aside to pay higher taxes. So the recovery should already have started to speed up.
 
But what has actually happened? Since the start of the austerity programme every single forecasting agency, national and international, has revised its growth estimates downwards, giving as the most important reason the withdrawal of the stimulus! –that very withdrawal which was supposed to spearhead the recovery. For the OECD area as a whol;e GDP growth is expected to be lower this year than last year. In short, the robust recovery is being pushed further and further into the future.
 
As for the UK, let me quote from a recent column by economist Danny Blanchflower: ‘The problem is that consumer and business confidence has collapsed, net trade is still negative, unemployment is rising, youth unemployment is on course to hit the million mark along with falling house prices, and growth was negative in the fourth quarter [of 2010]. The private sector survey PMI projected a near zero growth for 2011.
 
Let me make two points. I don’t take numerical projections of this kind too seriously. I don’t know whether Britain will grew 2% or under 2% this year. Their main use is to indicate trends, what I would call more or less, slower or faster. And none of them point to a robust recovery. People talk about China acting as the locomotive. In fact what is happening in China is important for our recovery but indirectly. Only 3.6% of our exports go to China. But rapidf Chinese recovery does impact on oil and commodity prices and the rise of these will have a negative impact on our growth prospects by squeezing real incomes.
 
The second point is perhaps one which all investors should bear in mind. There is a recovery going under way, and that means there will be profitable investment opportunities. The depressed 1930s didn’t consist entirely of Jarrow marches or depressed areas. Millions of people prospered: the Midlands and South East boomed, there was a big boom in private housing; the motor car ownership passed a million. Keynes made his fortune on the recovery in the US stock market between 1932 and 1937.All I am saying is that the pickings will not be as easy as they were in the boom years. With reduced incomes and job opportunities people will have less to spend on private pension plans. So the challenge for pension providers will be to develop more attractive – and dare I say it as a consumer rathen producer –simpler products and choose good managers for their assets.With an ageing population the opportunity is surely there, but it will need to be skilfully exploited.
 
I promised to close by saying what I would do. Well, this is how it looks to me. We have to accept fiscal consolidation as a fact of political life. The Coalition may be driven off course, but I assume that it will fulfil its programme and cut its defict by approximately £100bn in the next four years. As a Keynesian I also assume that this will have a net deflationary effect –whatever happens to the actual consumer price index. As Meryvn King noted practically the whole of the recent surge in inflation is due to the one off increase in VAT, the spurt in oil and commodity prices, and the fall in the exchange rate. Take away these and your are left with a 0.7% inflation rate, well below thje 2% target. In other words, the risk are still on the side of deflation, which is why I expect interest rates to stay where they are.
 
Many are now starting to talk of another bout of QE.And if there’s a new policy initiative, this will probably be it. But there’s a big, big, theoretical snag in quantitative easing, which is that printing money is not the same thing as getting it spent, and it’s the spending not the printing of money which impacts the economy. What you’ve had in both UK and USA is a very big expansion in bank money, but a very mediocre growth in broad money –M4 or M2. In other words, the money being printed is going into the reserves of the banking system, and not being lent out to those who most need it –businesses and households. What we are seeing, in short, is what Keynes called ‘liquidity preference’ – a strong preference for keeping one’s money in cash or near cash, rather than commiting it to illiquid investments which might yield a higher rate of return. This reflects of course the extreme uncertainty about the future course of recovery as well as real problems in the balance sheets of financial institutions.
 
So how would I try to square the circle. The central need is to deploy idle cash to finance long term investment. I the government can’t do this directly because any further increase in borrowing is untenable, we must find an alternative vehicle.
 
A National Investment Bank, initially seeded with capital by the government, could mobilise funds on the open market to support long term private investment. The essence of banking is the ability to make loans up to a multiple of several times the initial capital. Such a bank could borrow money now languishing in idle balances to finance long term investments worth a large multiple of the government’s initial outlay. The loans could be made attractive to investors –especially I would have thought pension funds by guaranteeing index-linked returns over the time periods relevant to pension policies.
 
There are successful examples to draw on, from the German KfW to the Development Bank of Japan in Asia, Brazil’s National Bank, and many others. Take as an example the European Investment Bank. The EU governments which control it have contributed euros 50bn in initial capital, and the bank has raised a further euros 420bn on the capital market. It has used this to fund major infrastructure projects throughout Europe, from the port of Barcelona to the Warsaw beltway, and from France’s famous TGV network to Britain’s new, world-leading offshore wind industry. It has consistently turned a profit. In Britain we have a Green Bank, but it lacks the funding to have any serious impact. Our infrastructure is rated one of the poorest in the developed world. The government talks big about the need for long-term investment. Here is a chance to do something practical about it.