Situation Vacant – one new genius economist

There is an old joke that if you laid down all the economists in the world from end to end, you still wouldn’t reach a conclusion. It is certainly a tragedy that as the western world finds itself in the biggest economic mess since the 1930s, the economics profession is unable to articulate clear policies to resolve the problems.

Up until the 1930s, politicians did not see themselves as particularly responsible for the economy. The government’s finances were managed in the same way as any other family unit, in that you made sure that spending did not exceed income, and borrowing was only acceptable to cover the cost of emergencies like wars. Foreign exchange rates were all fixed by adherence to the gold standard and it was considered a shameful act to devalue.

This went wrong in the 1930s when the 1920s financial boom led to a banking crisis the following decade. As the banking system sought to deleverage its balance sheet, asset prices fell and unemployment soared. Wages fell but economic recovery did not come because the economy was in a Depression and companies and individuals did not have the confidence to spend. It took the economic genius, John Maynard Keynes to show how capitalism could get stuck in this Depression mindset with low growth and low interest rates. His solution was that governments should take advantage of their high credit status to borrow the excess savings that were being created by the lack of confidence and go out and spend them to kick-start an economic recovery. He always expected however that once recovery had returned, then governments would seek to run budget surpluses so that the extra borrowing was repaid and hence temporary.

Post-war politicians however focussed on the ideas that (i) budget deficits were now good for the economy and (ii) they had the power to manage the economy to deliver full employment, and ignored the idea of running budget surpluses in the good times to offset the deficits that should be run when bad times hit. As the decades wore on, the politicians promised their people more goodies from public spending, budgets only got balanced in economic boom conditions and the size of the governments’ debts relative to the size of their economies rose steadily.

Recent academic work (Rheinhart & Rogoff) has shown that as the Debt to GDP ratio nears 90%, the capacity for economic growth diminishes markedly. The Western world is at or past these limits and finds itself there just as the next 1930s style banking crisis has hit it. The standard Keynesian response of government borrowing and spending is now either not available since markets are unwilling to lend to some governments because they have lost their strong credit status, or not palatable since it is likely to damage longer term economic growth prospects.

In general the right-of-centre politicians (Merkel, Cameron, Romney) stress the need to get government deficits and debt under control, so as to retain the long term confidence of financial markets. This austerity agenda does nothing for short term economic relief however. The left-of-centre politicians (Hollande, Milliband, Obama) stress the standard, Keynesian policies of spending in the short term to enable recovery to occur. The problem here is that financial markets might only provide the funds at an unacceptably high interest rate, and trigger a wider debt crisis.

The positions of both sides contain important truths, but the arguments display the divisions between economists. Japan, over the last 20 years, can be used as an example to prove each is wrong. The Keynesian response of government borrowing and spending has not led to sustainable economic recovery but has led to a Debt to GDP ratio now of over 200%. However this massive debt burden has also not led to a financial market crisis (yet), as Japanese savers have been happy to lend to their government for miniscule returns.

A Nobel Prize, a place in history and the gratitude of the world surely await the economist who can untangle all this and provide the solution to our current problems.

UK austerity and the UK economic miracle – some surprising data

The official data produced by the independent UK Office for Budget Responsibility supporting the recent Budget, showed up a surprising fact about UK government spending. The major focus of the Coalition Government since it came to power in 2010 has been the control of government spending and consequent reduction in the budget deficit from the £170bn (and 11% of GDP) it inherited from the previous government. Yet the official data show that in each of the two fiscal years that this government has been in office, current government spending has risen in real terms, that is to say after inflation has been accounted for, and that in a two year period when inflation has been permanently above the Bank of England’s 2% target due mainly to the increases in VAT, which are part of the deficit reduction strategy.

It could thus be argued that in the UK, austerity has not yet even begun. That would not be entirely fair, since the measure of current government expenditure excludes capital or investment spending by government. Investment projects are possibly the easier areas of government spending to cut quickly, and there have been large real reductions in non-current government spending. Further, some parts of current spending were permitted to grow in real terms – these were health spending and overseas aid. In addition the automatic economic stabilisers of rising welfare entitlements and rising interest costs on the national debt, have meant that economic weakness tends to boost current government expenditure. Most areas of government spending have seen austerity cuts (with many more to come over the next few years), but for real government spending as a whole, there has been no reduction.

In fact history suggests that such a goal is very difficult to achieve. Mrs Thatcher’s government from 1979 to 1990 did not manage to reduce real government spending, and since then it has risen every year. In nominal (actual cash) terms UK government spending has never fallen year-on-year since 1945..

For the government, the plans for current spending reductions in the next few years imply that the really hard (and unpopular) work only starts now. This may well affect their poll ratings significantly for the next year or two without a clear improvement in economic growth. For the Opposition Labour Party, their claim that the government has been cutting too far and too fast, and that a slower pace of cuts would be more effective do not stand up to any scrutiny as real government spending has not yet even started to fall.

 

 

HSBC compiled some fascinating data for economic growth amongst the major Western economies for the first decade of this century.

2001-2010 average annual % growth rate               Overall                              Per Capita

Japan                                                                                                0.8                                       1.6

UK                                                                                                      1.5                                         1.2

Germany                                                                                           0.8                                        0.8

US                                                                                                       1.6                                         0.7

France                                                                                                1.2                                         0.6

 

There are several surprises here, first Japan’s “lost” decade, the subject of many lectures from Americans and Europeans, is actually a demographic issue. Per capita growth in Japan was double that of the US and Germany and France – Japan has for some time been very aware of its ageing issues and has invested heavily in automation and robotics in order to boost its productivity. Secondly the strength of the US economy is also mostly about demographics – in this case both a younger population than the other countries, arguably reflecting a greater openness to immigration.  Finally the strong performance in both columns of the UK economy – a recent paper from Corry, Valero and Van Reenen confirms this strong  performance and attributes it to service sector productivity factors such as technology and regulation (though NOT banking regulation!). Perhaps history will judge Gordon Brown’s stewardship of the UK economy in this decade more favourably than current commentators.