Yesterday, the British government announced that they had actually recorded a deficit in January which is rare given they normally get a big revenue boost in that month. The reaction to the news has been hysterical and calls to invoke fiscal austerity measures in the lead up to their national election are gathering pace. You can imagine that these calls are suggesting exactly the opposite of what I think the British government should be doing. Given that they risk locking a generation of their youth into a lifetime of disadvantage, job creation programs are required now which will require further stimulus. That is the only responsible course of action. The bond markets disagree. But if the governments around the world really represented the interests of their citizens they would use their capacities to render all these vandals irrelevant. Most people, however, do not understand what that capacity is and how the government could use it. Anyway, now to the news …
The news that has set all the conservatives off overnight and today is that the British government tax revenue in January dropped (when they normally rise) and spending has risen again. So the government normally runs a surplus in January because of timing issues but this January is the first since 1993 (when records began) that they have borrowed.
So what – is all I said to myself when I read the report.
Things are worse than they expected. The last quarter GDP growth results were barely positive and they followed 6 quarters of negative growth – the longest recession in modern British history. What would you expect to happen?
All I see in the data is that the budget is slightly bigger than everyone thought – which just means the UK economy is in worse shape than they thought. That is the real problem but isn’t mentioned in the flurry of financial data about gilt yields and rating agency threats that has dominated the media reaction to the news.
The graphic below captures the headline in today’s (February 19, 2010) UK Times newspaper, purportedly a quality newspaper that appeals to thinking Britains. It shows how foolish we humans have become in this time of economic crisis.
I read it … re-read it, wondered whether I would see something other that utmost folly in the headline if I stood on my head and read it again then decided that the world is going mad!
The headline has everything – hasn’t it? A terrible budget – and they just can’t help dropping the Greek word, can they?
They fail to mention that they are conflating two incommensurate monetary systems (UK and EMU). That would be too much to ask of them.
Then the sub-heading tells us that the amorphous markets are upset – among them those idiots who waved ten pound notes out of their air-conditioned offices at the demonstrators last year! They are upset. Why should anyone be worried about that.
Then to cap it off – really hitting home (sorry about the pun) – we see a story about why the household budget is even worse than the governments
To put this call for austerity into perspective, I had a look at the components of spending in the UK recently. The following graph shows UK real GDP growth on a quarter-to-quarter basis (%) from March 2008 to September 2009 (most recent data). You can get the data from the UK Office of National Statistics.
The other series in the left-panel are the quarterly contributions to growth – household consumption, gross fixed capital formation (investment) and net exports.
You can clearly see that consumption and investment fell in a heap in June 2008 as the financial crisis became a real crisis. The positive contribution shown for net exports is because the decline in imports outweighed the decline in exports and given imports are a leakage from the expenditure stream a contraction is considered “good” for growth.
But the reality is the contraction is consistent with export income falling and domestic growth so low that import spending collapses. Given imports provide benefits the contraction signals a further deterioration in the material living standards of the British people.
The right-panel shows the real GDP growth again but the blue line is the contribution of government consumption spending to real GDP growth over the same period. It has been mildly stimulative throughout the period except for the first quarter 2009 when it made no contribution. So the automatic stabiliser impact on the deficit has been dramatic but the discretionary aspects have provided positive support from output growth.
The purple line (offsetting government) is the contribution that government spending would have had to have made to offset the negative impacts of the contraction in consumption and investment. Even at that level, GDP growth would have been near zero. To have supported GDP growth more fully the discretionary rise in the UK budget deficit needed to be several percentage points of GDP higher than it was.
The actual policy position taken by the UK government has helped but barely.
And now the cretins are thinking that something good will come from a cutback in this support with GDP growth now just above the zero.
Within this context, there is a battle of economists going on in the UK at present. Last Sunday, a bunch of conservative British economics came out claiming in a grandstanding manner that while they were “non-partisan” [yeh, right!] the “Conservatives’ position” on the need for budget austerity was correct. They said without a plan:
… there is a risk that a loss of confidence in the UK’s economic policy framework will contribute to higher long-term interest rates and/or currency instability, which could undermine the recovery.
Their full letter is HERE. You won’t see any reference to unemployment in their letter. It is all about appeasing the amorphous financial markets as above.
Clearly, I totally disagree with their recommendations and as a test of their sincerity, I suggest they offer to resign their own positions (or if retired, hand back their superannuation entitlements) if the unemployment rate rises as a result of their recommendations which are almost assuredly going to be introduced (in some form) by the spineless British government.
I wonder if they would be so forthright with their arrogance if their jobs were on the line.
Yesterday, not wanting to miss out on the limelight, another group of economists – 50 no less – said the first group was nuts all with that English-type of politeness which I found at when I lived and studied there was actually not very polite at all. The story is HERE.
They said that:
… that the increase in the deficit in the last two years was unavoidable, given that the UK has just experienced the most severe recession since the second world war and GDP has plunged by 6%, forcing emergency government action to prevent the economy “falling off a cliff”.
That point is clear. The deficit would have been much larger and the national debt correspondingly higher if the British government hadn’t have taken some discretionary measures. As I show below the discretionary measures they took were inadequate as a consequence of being spooked by their poor polling in the lead up to the election this year and because they are largely conservative themselves.
One of the second group, David Blanchflower was quoted quoting Keynes (from 1932):
The voices which, in such a conjuncture, tell us that the path of escape is to be found in strict economy and in refraining, wherever possible, from utilising the world’s potential production, are the voices of fools and madmen.
All these discussions about financial markets, yields, ratings and the rest of divert our attention away from the real purpose of the economy – to make things, provide services and provide incomes and dignity to workers. That is the message of this quote.
The financial markets add very little value to our lives. Employment and outputs add significantly. As a sense of priorities, it is madness for us to allow pir politicians to allow concern about these amorphous financial markets (who caused the meltdown in the first place) to usurp our need for employment and income growth.
As I argued in this blog – Who is in charge? – a sovereign government always has the power over the markets!
I note that Paul Krugman is weighing in on his side of the Atlantic in favour of the second group of economists. He said:
I fully agree with the writers’ position. The crucial thing to understand is that fiscal contraction of an additional one or two percent of GDP in the near future has essentially no significance for the sustainability of government finances, either in Britain or here. The only reason to do it is to impress markets – to convince them of your willingness to bear pain. And absent structural reform – which is the real need – how much good does that do?
So let’s not impose useless punishment, there or here.
I agree with those sentiments even though I know Krugman doesn’t really understand how the monetary system operates.
Households and government budgets
In Times story by Ian King – Worried about national debt? Things are worse for Mr and Mrs Average – the author just revealed why he should join the unemployment queue himself. He certainly should not be allowed to write for the public except under the heading of Science Fiction.
King obviously downloaded some data into a spreadsheet and decided it was sensible to pose the question:
The latest figures for the public finances are appalling – or are they? Well, it depends on how you look at them. On a crude comparison with the typical British household, they may not be so bad.
Why? Consider this. According to the Halifax, the average mortgage outstanding on a UK home is £112,000. According to figures published by the Office for National Statistics on Wednesday, average regular pay now stands at £425 per week, or £22,100 per year.
In other words, a typical UK household containing one wage earner on average pay has outstanding long-term debts equal to 507 per cent of annual income. By comparison, the Government’s income for 2009-10 is expected to be £498.1 billion, against the current national debt of £848.5 billion. So the Government, with a debt of 170 per cent of its expected income this year, is comparatively better off. The comparison is slightly spurious: the homeowner owes money to his mortgage lender, while Britain largely owes money to itself, largely in the form of pension funds.
Don’t you just love it … “the comparison is slightly spurious”. Sorry, the comparison is totally spurious and has no foundation in any knowledge system that is reasonable.
The homeowner is financially constrained and will have to sacrifice spending or sell assets to repay the debts. They use the Sterling! The British government is not remotely in this situation and never has to sacrifice other spending to repay its debts. It issues the Sterling!
If we can just get that message out today then there will be progress in the public debate.
Repeat: a budget of a sovereign government is never similar to that of a household. They can never be compared and the principles and behaviours that restrict the latter have no application to the former.
King though was intent, and after noting that households who can pay their debts will not be foreclosed (duh!), he says:
… And that’s the point. A debt only becomes an issue when you can no longer meet the payments on it. This, unfortunately, is why many global investors are now raising the alarm over the UK’s finances. The national debt may be under control for now, but the budget deficit – the shortfall between what the Government spends and what it rakes in – is adding to it all the time, potentially pushing up the cost of servicing the nation’s debts in future to perilously high levels.
What exactly are perilously high levels of national debt? How does King define that? In relation to what? How worried are these unnamed investors?
The other day in this blog – A modern monetary theory lullaby – I showed that the US yield curve (for government debt) was not budging despite all the hysterics that bond dealers are worried and about to close the US government down.
So what is going on with the UK yield curve?
The BoE compiles the yield curve data on a daily basis and you can get the yields for UK government bonds (gilts) and the “sterling interbank rates (LIBOR) and on yields on instruments linked to LIBOR, short sterling futures, forward rate agreements and LIBOR-based interest rate swaps”.
From the UK Debt Management Office we read:
A gilt is a UK Government liability in sterling, issued by HM Treasury and listed on the London Stock Exchange. The term “gilt” or “gilt-edged security” is a reference to the primary characteristic of gilts as an investment: their security. This is a reflection of the fact that the British Government has never failed to make interest or principal payments on gilts as they fall due.
Repeat: “never failed to make interest or principal payments on gilts as they fall due”. End of story.
The following graph shows the instantaneous normal forward curve (nominal) for UK gilts for selected month-ends and yesterday since early 2008. We see a bit of movement at the short-end as the BoE cut rates and some movement at the long end as it’s QE program boosted the demand for long-term gilts (driving the price up and yields down). There has been some slight upward movement in recent months at the long end but nothing to signal an immediate end to the world as we know it.
But it remains that the UK is being forced to pay higher yields than even some EMU nations. This demonstrates the irrationality of the bond markets. Yesterday the German 10-year bond was offering lower yields (by about a percentage point) than the UK. The former as part of the EMU is exposed to insolvency and that risk has risen in recent weeks, while the latter (the UK) can never be insolvent and as they say above has never defaulted on a gilt.
Further, Portugal’s 10-year bond yield is less than 500 basis points above the UK’s. The former is very exposed to insolvency. So go figure. These markets get things wrong all the time – witness the global meltdown – it was all their own work!
In closing this section on households and governments, I note that the deficit terrorists in the US – via the Peter Peterson Foundation – are promoting Budget Ball which they describe as “a new sport developed to raise fiscal awareness, will debut on college campuses this spring starting with the University of Miami and Philander Smith College in Little Rock, Arkansas”.
It is a concocted way of brainwashing US university students into believing their personal finances are the same as the US governments. It is just sinister the lengths the conservatives will go to to reinforce their elite position. I am sure none of the Wall Street bankers who had their hands out would have gone to a budget ball game at the time.
I advise all students to boycott those tertiary institutions if you value your intellectual development and have any semblance of self-respect left.
The word from the BIS
In relation to the bond markets, I thought a paper that I read the other week from the BIS was salient.
In a speech last December – Unwinding public interventions after the crisis – a senior official at the Bank of International Settlements (the central bankers bank) told the gathering (of IMF officials) that:
The leverage-led growth model – a combination of excessive leverage in the financial system, overindebtedness of households, low interest rates and global imbalances – was at the heart of the crisis.
But the paradox is that the policies that have been adopted to remedy the crisis consist, all in all, of even more of the same: borrowing, debt, leverage.
Of-course, he didn’t make the distinction between private and public debt. It was as if the two are identical. They are not. Please read my blog – Debt is not debt – for more discussion on this point.
The BIS speaker went on to argue that we might be at risk because the output gaps may be less than we think. This is one of those debates that emerged in the 1970s where the conservatives claimed that things were not as bad in real terms during the stagflationary period. At present, the best measure of the real damage of the crisis is the labour market – that is the people-measure.
And unless the BLS and other national agencies around the World are lying (and I know there are lots of conspiracy theorists out there who think the national agencies do lie – they don’t!) then things are very bad at present.
But the BIS claim that upon this basis:
The dominant view (“it is too soon to tighten”) is highly questionable. Postponing the fiscal adjustment to a time when the recovery has consolidated may not be sustainable. Inaction and postponement could prove a risky policy.
Simply communicating on the design of future medium-term frameworks for consolidation may calm the rating agencies for a while but does not address the mounting concerns in the bond markets about fiscal solvency in the medium to long term.
There is a need to be mindful of where we are in the business cycle and to think ahead as to which aspects of the stimulus can be withdrawn and when. But we are so far from being close to an inflationary breakout that there is no upside risk at present.
The fact is that the fiscal support was too conservative anyway by several percentage points of GDP – so there was already a “withdrawal” from the outset compared to what should have been.
And as Japan showed in the 1990s, the ratings agencies are irrelevant to sovereign governments. I would outlaw them.
But the interesting point of the paper (which is why I am referring to it here at all) relates to the following comments on “central banks’ unconventional balance sheet policies”. In other words, the paper is addressing the aspects of monetary policy that go beyond setting the short-term interest rate which have emerged in the currenc crisis.
The BIS said:
Exiting from the outright asset purchases will be more challenging. Given the potential impact on asset prices, central banks may be tempted not to sell but to adopt a “buy and hold” stance. However, the key issue here relates to the potential role of central banks in directly influencing long-term bond yields and credit spreads: market participants should be under no illusion that we are entering into a new permanent accommodative monetary policy regime in which central banks would be able and willing to control the entire length of yield curves as well as credit spreads and mortgage rates. The unconventional measures should not be seen as an additional set of tools that central banks would use in their normal day-to-day conduct of policy.
In normal times, central banks will need to go back to their usual approach of controlling only the short end of the yield curve and of refraining from interventions with potential distorting effects on relative asset prices. Exiting from unconventional monetary policy is necessary to make clear that the unconventional will not become the new normal. The sooner the exit, the better.
This is an important issue that needs to be debated. What they are saying is the central bank can control the entire yield curve – as I explained in the blog – Who is in charge?.
In other words, all the angst about bond markets rehearsed by the commentators above is unnecessary. If the British government or any government is paying yields on their debt higher than they think is desirable then they can simply instruct the central bank (or change legislation to allow them to do so) to manage the yield curve.
The fact that central banks do not do this reflects the ideological position that monetary policy should be targeted at fighting inflation (with no particular regard for the real consequences – given they believe in the NAIRU myth) and that fiscal policy should be a passive partner in this unemployment-creating folly.
If governments started to use the capacity of their central bank operations to control longer-term yields then the bond markets, the rating agencies and all the rest of these self-serving forces – become totally irrelevant.
But then monetary policy would have to cede authority to fiscal policy. Which from the modern monetary perspective is how it should be. We would then be able to target higher employment growth and use fiscal policy to contain inflation.
The next step would be for national governments to just stop issuing debt altogether.
As an aside, the paper produced this graph which should disabuse those who consider the build up of reserves will boost bank loans. Please read my blogs – Building bank reserves will not expand credit and Building bank reserves is not inflationary – for more discussion on this point.
It would be madness for the British government election notwithstanding to make any net budget cuts at all. Given the appalling state of their economy they actually need further government stimulus not less.
I will finish today with another of Keynes’ famous statements that Blanchflower could have easily quoted also:
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 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 Quiz will be back again tomorrow sometime – it will be only a few hundred words in length but torrid! :-)
That is just enough for today.