Today is a continuation of the theme developed in these past blogs – The enemies from within and When you’ve got friends like this … Part 1 and When you’ve got friends like this … Part 2 – which focuses on how limiting the so-called progressive policy input has become. One could characterise it as submissive and defeatist. But the main thing I find problematic is that its compliance is based on faulty understandings of the way the monetary system operates and the opportunities that a sovereign government has to advance well-being. Progressives today seem to be falling for the myth that the financial markets are now the de facto governments of our nations and what they want they should get. It becomes a self-reinforcing perspective and will only deepen the malaise facing the world.
Yesterday, I wrote about Tobin taxes. While on that theme, this article appeared last Tuesday (March 30, 2010) in the UK Guardian – Shielding a Keynesian recovery and was written by one George Irvin, who is a professor of economics at University of London. He is a regular Guardian contributor and generally takes what most these days would call a progressive position. Irvin is a prominent supporter of a Tobin Tax.
Most does not include me!
His opening gambit is that while “(p)rogressive economists want to see the state invest in recovery” this is not a viable option because “at present sterling would be open to financial attack”.
This is a commonly-held view among those who otherwise support government intervention to increase aggregate demand.
On the recent British Government budget, Irvin notes that:
Crucially, Darling’s budget accepts the logic of deficit reduction through massive cuts while differing with the Tories only on the timing of the cuts. Darling, Brown et al are not economic illiterates … Indeed, Darling has affirmed that his cuts will be deeper than under Thatcher. Why? Because the chancellor understands the need to send reassuring signals to the international financial markets.
So this so-called “progressive” position is, in fact, awarding game, set and match to the financial markets.
Irvin poses an alternative scenario to the austerity package introduced by the Chancellor in the British budget last week:
Imagine for a moment the chancellor announcing that budget balance doesn’t matter over the coming parliament, that a 4% inflation target is entirely acceptable and that only state investment-led growth will get us out of crisis … Imagine him saying that the money will be made available either through quantitative easing or by adopting a Robin Hood tax. This is what I and many progressive economists would like to hear.
First, the most recent UK inflation data shows that the annual rate is falling and is around 3 per cent and the trend surprised economists (Source). That is, in the context of a very significant rise in the budget deficit and the Bank of England’s huge (and largely unnecessary) quantitative easing program. It surprised economists because like Irvin they do not understand much of what is happening at present.
In this context, why would he announce a higher inflation target? He should instruct the BOE to abandon any explicit target anyway.
Second, the chancellor would explain very clearly to the British public, which is the only constituency that he is accountable to (he is not accountable to the City), that the budget deficit was supporting (probably) millions of jobs and helping the households reduce their debt exposure and protect them from losing their jobs.
He would explain that the UK government was sovereign in the sterling and would never default on its debt and that claims to the contrary were the erroneous daydreams of mainstream economists who didn’t understand or refused to admit to understanding that fact.
He would explain that the UK government was responsible for maintaining aggregate demand when private spending had collapsed and that the principle tool that was effective in doing that was net government spending (deficit) and the extent to which the deficit had to expand was defined by the demand gap left by the private sector measured against full employment capacity output levels.
He would explain that the falling sterling might reduce the capacity of Britons to holiday in the south of Europe or elsewhere and would add some price pressure (albeit finite and small) to the UK but was nothing that should cause alarm. He would outline in detail that the decision to float the sterling and avoid, for example, entering the EMU, empowered the British government, via the fiscal and monetary policy freedom it engendered, to defend the living standards of the British citizens, which was the only reason why government should exist anyway.
He would put a graph up showing that the Australian dollar reached a parity of $A1 = $US0.485 in March 2001 and was now around $A1 = $US0.9195 and the sun still shines down there and the economy largely avoided the recent recent with some early and significant fiscal policy intervention.
He would show another graph would show that in Australia, which has an exchange rate much more volatile than the sterling, that the lowest values of the $A coincided with rising budget surpluses and that as the deficit has expanded the $A has strengthened. Of-course, he would also say that such a correlation is meaningless because there is no statistically significant association between currency movements and fiscal balances that can be determined by researchers anyway.
That is the sort of budget speech that “progressive economists” would like to hear!
Third, no “money” was made available by quantitative easing that would support aggregate demand. It is a commonly held myth that quantitative easing “printed money” which poured into the banking system and expanded their capacity to lend. The policy did nothing of the sort. It involved a portfolio switch which aimed to lower longer-term interest rates and stimulate investment demand. It failed dramatically to do that.
Progressives should disabuse themselves of these mythical conceptions. Please read my blogs- Quantitative easing 101 – Building bank reserves will not expand credit and Building bank reserves is not inflationary – for further discussion on this point.
Fourth, a Robin Hood tax only seems progressive. As I explained yesterday in this blog – Robin Hood was a thief not a saviour – the better progressive alternative (which would be as complicated as introducing and enforcing a Tobin tax anyway) is to scale down the financial sector to bring it back in line with supporting the real economy. The British economy has seen a larger financialisation than most advanced nations and so is more exposed to this unproductive sector. It should be leading the charge to eliminate significant parts of the sector by outlawing transactions that are pure gambling (for example, the OTC derivatives trade) but which affect everyone when things go awry.
Anyway Irvin takes the standard line which progressives have fallen into as the crisis has unfolded and governments have been running stimulatory deficits for the first time in a long time. He says that if the Chancellor had had announced such a “progressive” position:
The result could be the immediate downgrading of Britain’s credit rating and – far more seriously – another fall in sterling’s nominal value similar to that in 2008, perhaps bringing it down to €0.80. That sort of shock would precipitate even more loss of confidence, and quite possibly another round of banking failure. Of course, we cannot know with certainty that this would follow – but even if there is only a 50/50 chance, no sane chancellor could afford to take the risk. The simple political truth is that Britain is deeply vulnerable to financial attack.
I cringed when I read that. It smacks of the long-standing British sense that their national pride is tied up in some way with the value of the sterling. It plagued them during the fixed-exchange rate days when they would refuse to devalue despite bleeding foreign reserves as their current account deteriorated.
The lower sterling will actually help Britain’s export sector and will redirect British consumers to the home market. Both changes will help the national economy recover and reduce the budget deficit somewhat.
The general point is that it is an extremely costly strategy trying to reduce a deficit by denying (or waiting for) growth. Britain has a growing trade deficit (grew in January compared to December – (Source) which continues to drain growth so a lower parity is not something I would be worried about.
Further there is “no mechanical link between the exchange rate and the inflation rate”. Who said that? Not I although I agree with it. The Bank of England’s inflation outlook tells us that:
The exchange rate is a key factor affecting inflation prospects, although it is very difficult to predict. There is, however, no mechanical link between a change in exchange rates and inflation.
A change in the value of sterling can have a direct influence on inflation through changes in import prices … But this is primarily a one-off impact on prices and so a temporary influence on the inflation rate.
So what sort of shock really is a further modest fall in the sterling? Not much.
The risk of further banking failure is possible but just means that there is a lot of work to be done restructuring the banks in the UK. Artificially restricting economic growth because the banks’ balance sheets are still in poor (perhaps irretrievable) shape is no strategy. Why should millions of workers be deprived access to jobs and essential public services just because the banking industry is in danger of collapse because they are so indebted in foreign currencies?
Some of the cuts already in place in the UK are targetted at education which will also undermine Britain’s long-term prosperity not to mention disadvantage a generation of its citizens.
The progressive position would be to let the precarious banks fail and ensure that British citizens are not disadvantaged by that. The British government has the fiscal capacity to take over all banks and make sure the depositors are protected should it come to that. In the meantime, they should be announcing much tougher reforms of the banking sector than they are currently considering.
It is Britain within the EU that is blocking bank break up plans being proposed by the Americans. I will come back to this point soon.
So I think Irvin is just whipping up a non-issue and handing over sovereignty to the financial markets unnecessarily. The point is that the financial sector in the UK is too big by far – dangerously so. That should be the focus of the British government while they support aggregate demand and get employment growth going. Downsizing the City of London should be a major policy priority.
Irvin seemingly realises the bloated nature of the “City” (comprising about 21 per cent of all UK employment which is disproportionately large compared to the advanced economies). He thinks there are two ways out. The first:
One is to impose capital controls. But such controls, supposing for a moment that capital controls could be effectively imposed in today’s world, would be tantamount to closing down much of the City of London and inviting retaliatory trade attack. Crucially, such controls are incompatible with EU membership, and the EU accounts for nearly 60% of UK trade. Leaving the EU is neither a sensible nor a realistic option.
Capital controls are a controversial subject although the IMF, a fierce opponent of controls in the past, has now (last month) advocated that in some cases they are justifiable. This is a complex topic and I plan to devote a whole blog or blogs to it next week.
But the closure of “much of the City of London” is actually what is required to rebalance the British economy which has relied on the financial sector to generate private employment in London and the public sector do generate the bulk of new jobs elsewhere in Britain for some years now. Please read my blog – UKs flexible labour market floats on public spending – for more discussion on this point.
The question of Britain’s EU membership is more complicated and I will deal with that another time. The fact that the IMF is now supporting capital controls will change the debate significantly.
The second option proposed by Irvin is:
… to join the euro. That is no panacea either. It would take time, it would entail conditionality and a referendum on the matter would probably produce a no vote. Some might argue that the EU stability and growth pact is at least as fiscally constraining as meeting current Treasury rules and that joining the euro would leave Britain unable to pursue an independent monetary policy. Others might argue that without the power to set interest rates, we would run the risk of a new housing bubble. But our monetary policy is already constrained by world fnancial markets, and the power to set interest rates has not prevented our housing bubble.
This would be madness and I find it an amazing situation that a self-proclaimed progressive economist would be even suggesting this option for a sovereign government which is basically enduring an extended demand failure because its government isn’t courageous enough to stimulate the economy sufficiently and has in the past allowed the financial sector to dangerously distort the composition of British industry.
It is not a matter a time delays or that the citizens wouldn’t like it that is the point. They clearly are issues. But the major point is that it would force Britain to take the Irish route – which in historical terms would be something of an irony.
Irvin’s claim that the SGP restrictions would be as constraining as the “current Treasury rules” (which I examined in this blog – Clowns to the left, jokers to the right) are correct. But why would a progressive not be attacking the absurdity of the UK Fiscal Responsibility Act 2010 rather than accepting it as a eternal constant.
The Fiscal Responsibility Act 2010 is a political document and should be resisted politically. If the progressives aren’t doing this then what hope is there for the place?
Further, the comment that “monetary policy is already constrained by world financial markets” is factually wrong. The Bank of England is totally sovereign when it comes to setting interest rates. In fixed-exchange rate systems or pegs a nation’s monetary policy is constrained by world financial markets. That is the whole point of having a flexible exchange rate – to give the government via the central bank the capacity to set its own rate structure.
The Bank of England can set whatever rates it wants. The fact that financial flows might be sensitive at the short-end is somewhat irrelevant as we noted above – the exchange rate will move but the world won’t come to an end.
But for Irvin, the “progressive” the exchange rate is everything: He concludes that
Britain cannot avoid cuts and pursue radical Keynesian stimulus and redistributive policies, much less effect a proper Green New Deal, given the vulnerability of sterling. Without a financial shield, Britain almost certainly faces the erosion of its social services, a collapsing infrastructure and long-term stagnation.
So lie down Britain and die!
All flexible exchange rates are vulnerable to international speculation which is why I advocate cleaning this segment of the financial sector up once and for all. I note that some readers have argued (via comments) that speculation is good and I am naive. I might be the latter but they haven’t read what I have been arguing carefully enough.
Some speculation is good! When a counterparty wants to bet on exchange rate movements to provide hedge cover to a manufacturing firm exporting or importing goods and services across borders then that plays a smoothing role and is beneficial to the real sector. In this context, the role of forward markets is productive.
I have always separated financial transactions that support the real economy from those that are not related in any way to the real production system. It is the latter category of activity that dominates the financial sector these days and is totally unproductive. It doesn’t advance public purpose and as has been demonstrated in the current crisis – causes havoc when the complexity of the trades breaks the relationship between risk and return. I see most of the OTC market in the latter category and would outlaw it.
The real problem facing Britain not mentioned by the so-called progressive Prof. Irvin is summed up by the latest data for March 2010 from the Office of National Statistics.
By way of summary around 10.6 million people are unemployed or have given up looking (making them hidden unemployed). The record number of hidden unemployment is artificially holding the unemployment rate down. The number of economically inactive people of working age (that is would want to work) increased by 149,000 over the quarter to reach a record high of 8.16 million or 21.6 per cent the highest since the ONS started estimating this measure in 1971.
The total of unemployed and economically inactive comprises 28 per cent of all adults of working age.
The employment rate is the lowest since 1996 and full-time employment continues to decline after 2 years of recession. Long-term unemployment is at its highest level since August 1997.
And if you examine the employment creation, the only significant growth in employment is within the public sector.
What does Irvin think will happen if the British government was to follow his advice? I found his docile submissive manner to be deeply disturbing as a commentary on the state of the progressive movement in the UK.
In this context, I thought the approach advocated by his fellow UK Guardian economics correspondent Larry Elliot in his March 31, 2010 article – Begin by breaking up the big banks – was much more prescient.
Elliot concludes that the UK is:
… sleepwalking towards an even deeper crisis. It’s time to pinch ourselves, and embark on fundamental reforms …
I agree and I have written about this before. Please read my blog – Breaking up the banks – for more discussion.
Elliot takes us out to 2025 when the “detox decade is over” and things are back on track – “house prices are soaring, debt levels are rising and banks are making record profits”. Further, “little has been done to tackle the structural weaknesses in the financial sector that caused the near-meltdown of 2008”. Before too long “a financial crisis erupts, just like the one at the fag end of the noughties, only bigger”.
This will definitely happen (probably before 2025) if governments fail to address these structural issues. All the focus now is on public debt and the size of deficits with little understanding that those aggregates are not a problem per se but a symptom of a problem.
The large increase in public deficits and the changes in the public debt ratio have been significant by historical standards because the collapse in the private economy has been historically atypical. The budget deficit is endogenous after all and is like a mirror.
The budget deficit mirrors what is happening in the private economy and when private spending collapses the deficit rises significantly – in sympathy. The discretionary changes in fiscal settings have not been outlandish anywhere. They have been too subdued as evidenced by the huge rise in labour underutilisation.
The real underlying problem is the financial sector and that should be structural reform priority number one.
Elliot says that there will be another major crisis:
… unless policymakers realise that the most pressing issue facing them is not public borrowing, VAT or national insurance, but what they plan to do about the banks. Which, despite what the politicians say, is not much … Real reform of the financial sector means asking fundamental questions. Is the current structure inherently risky? Are the banks shortchanging their customers? Could we devise a more sensible system? To which the answer, in all three cases, is yes.
He argues that in the 1930s “the last time the banks made a complete mess of things” governments achieved fundamental reforms to the banking sector.
He advocates breaking the banks up to reduce their size because the claims that the mega-banks “can do things that smaller banks would be unable to do” have been proven in the current crisis to be false. He considers the risks of the large banks to be too great for governments to bear – given they are the ultimate underwriter.
I was interested in his calculation of how much the banking failures have cost:
… the banks have cost the global economy: assuming output tends to rise by 3.25% and that 25% of the lost output never comes back, the loss to world GDP would be $60tn. For the UK, the cost is £1.8tn, more than the current annual output of the economy.
These losses are huge and will impact on generations to come. When the neo-liberals cry about the burdens of the public deficits that the future generations will have to bear they are talking nonsense. The actual burden we are leaving for our children and their children is the dead-weight losses of real income and the opportunities that that income would have provided them.
Why don’t the conservatives and the free-market lobby ever acknowledge the scale of these things?
Anyway, that is enough for today. Next week I will deal with capital controls because there have been a lot of queries about them and where Modern Monetary Theory (MMT) stands on them.
The Saturday Quiz will appear sometime tomorrow and I have plenty of questions up my sleeve to give you something to ponder over the holiday break.
The only problem with the holidays is that the surf gets too crowded!
But then I took some time out late this afternoon and went to the early show to see the movie of the first of Stieg Larsson’s book – The Girl With the Dragon Tattoo – which has just opened in Australia. I preferred the book but the film was pretty good and worth seeing.
That is enough for today!